135% Return On This Obvious Market Miss

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In a market that trades more on rumor than fact, it shouldn’t come as a surprise that a growing, financially sound company like Urban Outfitters (URBN) has fared so poorly.

The $2.3 billion retailer has been steadily falling in share price over the last year from $45 to $23… all on relatively little news.

Sure, the company cut expectations for the year. But it is still likely to bring in $2.40 or so per share for this fiscal year.

That gives it a forward price to earnings of less than 10 – which represents a nearly 50% discount to the market. And growth is still on the way. By 2020, the company should be turning in profits near $2.70.

But performance and growth aren’t really what the market seems interested in these days. Just this morning, on news of higher-than-expected jobs numbers, shares opened into a free fall. Investors, you see, have been counting on the Fed cutting rates at the end of this month. If employment isn’t as bad as feared, that might not happen.

So, when looking at retail, investors are making large leaps of logic… or illogic. Stores are closing for the likes of Sears, Payless Shoes and Dress Barn. But that doesn’t mean business is terrible for everyone… especially a niche company like Urban Outfitters.

It still has a loyal customer following, with strong brand recognition and expansion plans. Yet, the company is being lumped in with those in the industry that haven’t been able to keep up with consumer trends.

Now, we’re not saying Urban Outfitters is a breakthrough buy right now. The company does have its share of headwinds.

Last quarter, even though revenue jumped by about $18 million, so did the cost of those sales. Margins slipped, sending operating income down year over year. These fluctuations, however, aren’t as drastic as others are seeing.

The company is still bringing in enough free cash flow to keep its debt at essentially zero (though, because of a change to accounting, it now considers lease liabilities to be long-term debt).

More importantly, despite the problems other retailers have had, Urban Outfitters has been able to actually grow its share buybacks over the last several quarters.

In just this most recent period, the company bought back 2.4 million of its shares worth $71 million. Under its current plan, it still has 12 million more already authorized to buy back.

That shows two key things the market is clearly missing right now. First, the company has been able to keep its financials in great shape even though the rest of its industry has struggled. Second, it has been able to put that great balance sheet to good use as its shares have fallen.

This all points to a clear overreaction. The market is not working like it should right now. Rumor is a more important factor in a stock’s price than fact. But, there’s a great reason to believe, for at least a short window next month, that those same investors will come around and take another look at what the company is up to.

You see, investors trade opinions and rumors between earnings. But leading up to those announcements, the analysts start making calls.

Next month’s earnings for Urban Outfitters will be a big one. After last quarter’s CEO commentary that the company saw less store traffic than hoped and margins starting to squeeze, investors fled. They haven’t looked back.

In August, those same investors will be forced to take another look. Margins fell slightly, far less than competition. Revenue actually grew and is expected to keep growing. And earnings and free cash flow have been great, giving the company more maneuverability than the majority of its industry.

This all points to a short-term rebound. And it doesn’t have to be large for option traders to take advantage…

A Strategy For Short Term Bulls

A bull call spread is a conservative way to trade expected rebounds like this one. The way they work is by buying a call option with a strike price near the current trading price of the underlying security. Then, the trader sells a second call option with a higher strike price.

What this does is let them profit as shares increase in value, but limits the amount at risk. Rather than place a straight bet on those shares increasing, the premium received from that second call option lowers the trader’s total amount at risk.

This is a conservative way to play this kind of movement because while risk is reduced, so is potential profit.

You can see how this plays out here:


Source: The Options Industry Council

As you can see, both the risk and profit are capped. But the higher shares rise between the strike prices of the two call options, the greater the profit goes.

So, no, Urban Outfitters probably isn’t a stock you’d like to hold for years on end. It operates brick and mortar stores that see less foot traffic. While it does have a relatively successful ecommerce platform, sales won’t rise forever. But investors’ overreaction does point to a short term rebound… just enough to make this potential trade very lucrative.

Let’s look at a specific set of call options to make that happen.

A Specific Trade on Urban Outfitters

Right now, a trader could buy a September 20 $23 call for $1.85 per share and sell a September 20 $25 call for $1 for a cost of $0.85 per share. Since each call is worth 100 shares of URBN, that’s a total net debit of $85.

That’s the most the trader would have at risk for the full two-plus months of this trade. The reward, however, is even better.

To find the maximum potential profit, take the difference in strike prices ($25 – $23 = $2), and subtract the cost ($2 – $0.85 = $1.15). On 100 shares, that’s $115.

So, if share rise to $25 by September 20, this trader would be looking at a return of $115 on the $85 he put down… or a 135% return on his total risk.

Now, shares do have to rebound to make that happen. But a rise to $25 per share would hardly be a difficult feat. That represents a move of just 6.9% over 11 weeks. To put that in perspective, shares of URBN have fallen 31% over the last eight weeks.

A rebound here, and not even a large one, offers a great return-on-risk opportunity… one that only works in a crazy market like the one we have today.

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