127% Potential After Walmart’s Excellent Quarter

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Today, the world’s largest brick and mortar retailer announced the results from a seemingly amazing quarter. Walmart (WMT) brought in revenue of $138.8 billion and earnings per share of $1.41. That’s a sizable jump from what analysts expected, $1.33 per share.

These results came as the company blew away initial reports of a slow holiday shopping season. Since those reports back in December, we’ve seen companies like Amazon and Target report record numbers. Walmart’s report today follows suit.

The question is, however; will this trend continue?

Walmart’s fourth quarter marks the 17the straight period of sales growth. For a company that rakes in hundreds of billions in sales each year, that’s quite an accomplishment. Along with its 2019 fiscal year all wrapped up (its fiscal year ended Jan. 31), the Arkansas giant gave guidance for the next 12 months.

For 2020 (this current fiscal year), Walmart expects growth to continue at about 3% on a constant currency basis. Online sales are expected to continue making up the most of this with a projected 35% growth rate. However, the company signaled EPS might drop by a few percentage points following its acquisition of Flipkart, an online and app-based store in India.

Now, investors don’t seem worried by that one-time dip. Shares are up 3.6% on the day, as we write. More impressive is that they are up 20.3% since their December low. A company as big and widely-held as Walmart isn’t supposed to move 20% in a two-month period. But this isn’t a normal market.

That’s why there’s a real case that despite the company’s success and likely continued success, one might be able to profit off a short-term decrease in share prices.

For starters, the company’s performance is good. But its market valuation is all out of whack. It currently trades at 22 times earnings. Sure, we noted that Walmart is growing. But not enough to justify such an overvaluation for a relatively flat industry.

We’ve all heard of the battle between Walmart and Amazon. We’re not saying either has to lose. But Amazon isn’t getting any smaller. And Walmart will continue to fight tooth and nail for market share of the online ecommerce world… against a clear industry leader.

Secondly, when you actually take a look at the company’s financial situation, it does appear slightly different than you might think. Yes, sales and earnings both grew. But that’s on an adjusted basis.

During the last 12 months, Walmart’s operating cash flow fell and its capital expenditures rose. That means its free cash flow fell. In fact, its FCF dropped $877 million. Sure, the company is huge. But no one can ignore a nearly $1 billion decrease in realized profits. During fiscal 2019, its FCF came in at $17.4 billion. But look how it spent that money…

It has been on a share buyback roll the last few years. Over the last 12 months, it spent $7.4 billion buying back its stock. Add that to its $6.1 billion in dividends, that’s a total of $13.5 billion out of $17.4 billion spent on shareholders.

That sounds good. But if earnings drop over the next year and shareholders demand increasing dividends (which they’ll get) and continued buybacks (of which there’s already $11.3 billion currently authorized), these numbers will get tighter.

Of course, none of this poses any significant threat to Walmart. It is the industry leader for a reason. And it isn’t going anywhere. Its potential one-off earnings drop will likely be just that… a one-time thing. But you can see the argument for a short-term price adjustment.

If the company simply reverts to its mean – say a price-to-earnings ratio below 20 – that’d represent a short-term decline of about $6 per share.

Fortunately, there’s a strategy that takes perfect advantage of this scenario. In fact, even if shares don’t fall at all, traders could still profit.

A Strategy For Short Term Weakness

A bear call spread is a type of trade that does well when a stock does not. The way it works is by trading two call options.

First, a trader would sell a call option on a stock he thinks will decline. Then he buys a second call option on that same stock with the same expiration date, but a higher strike price.

This results in a net credit to his trading account. If shares don’t rise above the sold call, he profits. If shares do rise, his potential loss is capped by the second call option he bought.

His total maximum profit potential is the amount he received by opening the trade… his credit.

So, both his potential loss and his potential profit are capped.


Source: The Options Industry Council

The most appealing part of this type of trade is that his max profit is cashed in if the underlying shares just don’t do anything. It’s one of the few times where you can root for nothing to happen in the market.

Walmart shares, historically have been very good at doing nothing. Of course, if the above scenario – a reversion to the mean, thus a slight decline in price – occurs, this trade would still pay out the total max profit.

Let’s look at a real example.

A Specific Trade on WMT’s Reversion to the Mean

A trader looking to enter a bear call spread trade on Walmart could sell a March 15 $104 call for $1.62 per share and buy a March 15 $105 call for $1.06 per share for a net credit of $0.56 per share. Since each contract represents 100 shares of WMT, that’s a total account credit of $56.

That’s how much this trader stands to make on this bear call spread. Like we noted, if shares drop or even just stay where they are, the trader gets to keep this full amount.

The total risk of a bear call spread trade is found by taking the difference in strike prices ($105 – $104 = $1) and subtracting the net credit to open it ($1 – $0.56 = $0.44). On 100 shares, that’s a total possible loss of $44.

Think about that. This trade would pay out $56 if Walmart’s stock doesn’t do anything. Yet, if it does keep going up despite all those signs that it shouldn’t, the most the trade could lose is $44.

That’s a return of 127% on the amount at risk. There’s a fairly good chance that by March 15, when this trade expires, Walmart will be trading below $100 per share again. But even if it remains at around $103, this trade still returns the full maximum profit.

Also note that during this period, Walmart is also going to pay out a dividend, which will automatically drop its shares by that amount ($0.53 per share). This only adds to the potential for a flat to down month of trading… and thus a full profit for a trader using this strategy.

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