Trades

203% Profit Potential Setup By Kohl’s Terrible Earnings Miss

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When a company misses its estimated earnings for a quarter or year, shares almost always fall in price. Most of the time, the initial shock of financial underperformance leads to too large of a stock crash. But sometimes, even for large post-earnings declines, investors don’t go far enough.

That’s the case today with Kohl’s Corp. (KSS). Kohl’s is a major retailer in the U.S., with more than 1,100 stores across the country. So, when the company reports, all investors interested in the retail shopping industry pay attention.

The company just announced its first quarter financial results. And to all eyes, they were terrible.

Kohl’s top line came in at $4.09 billion, down 2.9% from the first quarter of 2018. Net earnings did even worse, with a decline of 5% to 61 cents per share. That loss was much worse than analysts expected, negatively surprising them by 9% for the quarter.

Worse still, the company drastically reduced its guidance for the rest of the year. It’s only reported just this one quarter of results and already Kohl’s has reduced its full-year earnings range from $5.80-$6.15 to $5.15-$5.45. That’s an average expected reduction in net earnings of 11.3%. You can’t expect to announce your company is 11.3% worse than expected and be rewarded by this stock market.

Obviously, shares crashed in early trading today… down 12%, as we write. But have they fallen far enough?

You could easily argue that a drop like this seems about right. After all, guidance was lowered by 11.3% and the stock fell 12%. But that doesn’t tell the whole story.

You see, the last time shares of Kohl’s were trading where they are now, at $55, was at the end of 2017. At that time, the company was growing massively. Its most recent year-end profit came in 11.5% higher than the previous year. And it was just about to announce another great year of growth two months later. So, its investors had reason to push its share price higher than it was trading before.

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Today, we have the exact opposite situation. Finances are falling, retail across the board is slumping and consumer confidence is falling. You’ll also recall that December of 2017 was also when President Trump got his tax cuts through. So, everything was way cheerier the last time Kohl’s traded at $55. This time is much bleaker.

With its numbers now tipping into negative territory – and not in a gentle way – investors should be exiting. But its stock falling to just $55 per share might not be far enough.

Consider where the company now stands in comparison with its peers. Its new full-year target earnings give it a forward price-to-earnings ratio of 10.5. That might sound cheap. But compare that to where its peers are trading.

Nordstrom is going for about 9.9 times its estimated earnings. Macy’s is trading at just 6.9 times its forward earnings. Meaning, for Kohl’s to trade just on par with its competitors, it still has further to fall.

That doesn’t mean the company is due for a J.C. Penney or Sears level freefall. Fortunately, there’s a way to play a milder fall from here. Even though it has already fallen so far, that doesn’t mean its too late to profit. With this strategy, you aren’t missing out.

A Strategy For Continued Stock Declines

A bear put spread is an options trade that involves buying one put option and selling another. The first part is the obvious one: buy a put option on a stock you believe will fall. The second, not so much: sell another put option with a lower strike price than the first on a stock you believe will fall.

What this does is give you the profits from the long put as the underlying shares decline in price. But it also limits the amount of money you have at risk.

Opening the short put gives you a premium, which can be used to reduce your total cost in the trade… making this strategy far cheaper than shorting shares or simply buying a put outright.

It does come at a different cost, however. It limits how much you stand to make on falling shares. If the underlying stock crashes far below the strike price of the sold put, you don’t see any additional profits.

However, if you have a situation where a slight fall is expected, the reduced entry cost is far more valuable than the chance at higher profits that aren’t very likely. For Kohl’s right now, this is the exact right tradeoff to take.

You can see this trade off here:

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Source: The Options Industry Council

Let’s look at a specific bear put spread trade in Kohl’s to show you how this strategy works in this situation…

A Specific Trade On KSS

Right now, a trader can buy a July 19 $55 put for $3.10 per share and sell a July 19 $50 put for $1.45 per share for a cost of $1.65 per share. Since each contract is worth 100 shares of KSS, that’s a total net debit of $165.

That $165 is the total money the trader has at risk for the whole duration of this trade. But his potential profit is even larger.

Despite giving up some profit potential by selling the second put option, he still stands to make a good return if shares of Kohl’s do keep falling as expected.

To find that potential maximum profit, take the difference in strike prices ($55 – $50 = $5), and subtract the entry cost ($5 – $1.65 = $3.35). On 100 shares, that’s $335.

So, if Kohl’s keeps declining in price, even just enough to start trading on par with its competitors, this trader is looking at a 203% return on the amount he has at risk.

But even if this decline of about $5 per share takes longer than expected, the play could pan out. It doesn’t expire until the third week in July – a full two months away.

So, considering that the company is heading in the opposite direction it was the last time it traded at $55 per share and that it is still overvalued compared to its peers even after today’s price decline, this potential 203% return on risk is definitely on the table.

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