In 1969, Laurence Peter – a professor at USC – coined the term “The Peter Principle” in a book with that same name.
The idea goes that successful employees are promoted up through the hierarchy of a company until the reach a position they are no longer competent at. Thus, at all major companies, management is basically always done by people who are in positions just out of their capabilities.
Now, I’m not saying Mark Tritton isn’t competent or will be unsuccessful in his new position. But there’s a potential concern here that Wall Street is just plain missing.
Let’s back up.
Yesterday, shares of Bed Bath and Beyond Inc. (NASDAQ:BBBY) jumped 25% on the news of a new CEO, Tritton. Tritton comes from the position of chief of merchandizing at Target.
No doubt, he played a crucial role in that company’s amazing success, building out both private labels and online sales. However, he’s got no real executive experience… at least at the top CEO level.
Investors, however, are clearly optimistic about Tritton’s abilities:
In today’s market, it’s quite understandable why something like this could spark investor attention. The retail market has been experiencing one of the worst periods in its history, with store closings and bankruptcies left and right.
Names like Toys ‘R Us and Sears have fallen like they were some dot com startups in the ‘90s. Others, like Kohl’s and Macy’s have been forced to drastically reduce their retail footprint with scores of store closures. Bed Bath and Beyond itself has been undergoing this process.
So, when the market identifies a turnaround specialist like Tritton, investors go nuts. That’s fine and could work out… if there were a path for BBBY to actually turnaround.
The problem comes from its obvious niche problem. While the giant Amazon has been beating up clothing retailers like Sears and J.C. Penney with its massive convenience advantage and two-day (and now one- and same-day) shipping, Bed Bath & Beyond is in even worse shape.
Consider this… if customers are overwhelmingly willing to buy clothes online without trying them on, what’s to stop them from buying lamp shades, bed spreads and coffee tables? Nothing. And that’s precisely the reason BBBY’s sales have been falling for years. It simply can’t compete in this digital marketplace.
Still, Tritton might just be the saving grace for the company. If he can build out the company’s digital footprint and launch high-margin private labels for the company, things could turn around… a little. But those things take money… something Bed Bath & Beyond has less and less of.
Gross profits have fallen steadily over the last several years. So has free cash flow, the fuel Tritton would need to begin turning things around.
Now, none of this is to say he can’t have some success. The company, despite declining numbers, has been able to keep some cash on the books. Its debt load is a bit high. But it has the cash to keep up… though, not with much left over for its massive 6.8% dividend and these likely new initiatives.
Even with yesterday’s rally (which is extending today), it doesn’t look overvalued. Though, with negative growth and a price movement of 29% in two days, upside is really limited in the short term.
In fact, all of this adds up to a short-term opportunity to play its downside. After this weekend, investors will have had time to process Tritton’s capabilities and BBBY’s growth prospects. It should seem obvious that they’ll conclude that maybe the company shouldn’t be 29% richer just because it was able to lure a Target chief onto its team.
Of course, shorting shares or simply buying puts outright is expensive, especially with the recent rally. The faster a stock moves, the higher the premium for options go.
Fortunately, there’s still a strategy using options that offsets that premium, while still offering significant profit potential. Let’s get into it…
A Strategy For Short Term Bears
A bear put spread is a type of options trade that does involve buying a put on a stock you believe will fall. However, it is offset somewhat by selling a second put option with a lower strike price.
The income from the sold put reduces the cost of purchasing the first. This reduces the total amount at risk.
However, this strategy does mean that the maximum profit potential is capped. Though, to be fair, BBBY’s balance sheet and positive (if smaller) free cashflow do mean the stock isn’t likely to completely collapse from here.
That makes this trade off well worth it, considering the higher-than-average option premiums. You can see how this strategy plays out here:
Now, for this strategy to work, shares will have to decline. But only to a point. A complete crash would still pay out handsomely. But it isn’t necessary to maximum your gains.
Let’s look at a specific example to see how a bear put spread on BBBY might profit a trader…
A Specific Trade on BBBY
Right now, a trader could buy a November 15 $13 put on BBBY for $1.11 per share and sell a November 15 $10 put for $0.17 per share for a cost of $0.94 per share. Since each option represents 100 shares of BBBY, that’s a net debit of $94.
That’s it. That’s the total the trader would have at risk for the duration of this trade. If shares climb above $13 between now and November 15, that’s what the trader would lose. However, as noted, this two-day 29% rally is clearly overblown.
Once investors take the time to really evaluate what’s happening – negative growth, shrinking markets and Tritton’s inexperience – shares could easily fall back below $10, where they were earlier in the week.
If that happens, this trade would max out the trader’s profits. And those are significantly higher than the risk.
To find the maximum potential profit of this bear put spread, take the difference in strike prices ($13 – $10 = $3), and subtract the cost ($3 – $0.94 = $2.06). Again, on 100 shares, that’s a potential profit of $206.
In other words, this trader could see a 219% return on his amount at risk. That’s essentially turning every $1 into $3 if shares of BBBY just retreat to where they were before the speculators got their hands on this news story.
None of this isn’t to say Tritton won’t be the savior of the company in the long term. He very well might find some operating niche to compete with Amazon, Walmart and his former employer Target. But that’s not going to happen overnight. And investors are impatient people. Once they realize the challenge ahead of Tritton, shares should fall back to earth… creating a nice short-term profit for smart traders.