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Trades

Best Buy’s Problem Could Make Your Summer…

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Stocks can move for any number of reasons pertaining to an internal issue: a spinoff, reorganization, earnings, change in leadership or change in market share. But other times, a company’s stock price is completely out of its hands.

Such is the case with Best Buy (BBY). The electronics retailer is doing just about everything you can think of right. It has transitioned to only strategically profitable locations, played up and expanded its Geek Squad advantage and poured capital wisely into online sales. But in today’s environment, that can only get you so far.

In what is becoming an all-too common theme this earnings season, Best Buy reported earnings that handily beat expectations. Yet, its shares are down 6.4% as we write due to “market conditions.”

The company didn’t lower guidance. In fact, it only confirmed its previous earnings-per-share target range of $5.45 to $5.65. That gives it a remarkably low forward price-to-earnings ratio of 11.7. But with all that going for it, the news driving Best Buy’s share price into the toilet was something else.

The products the company sells are at extreme risk. This latest round of tariffs and proposed tariffs out of both the White House and from Beijing involve hefty taxes on the import and export of electronics like smartphones and laptops. Unfortunately for Best Buy, those are the company’s moneymakers.

The company’s incoming Corie Barry specifically noted that the tariff rate hike from 15% to $25% on its products in the company’s earnings press release. Unfortunately, the story gets worse for Best Buy. With the escalation of tariffs from both governments, the company’s products get squeezed several times.

U.S. semiconductors get taxed when shipped to China. Phones and computers build there with those semiconductors get taxed again when coming back to the U.S. Then there’s the regular taxes we see at the end of our receipts when we buy those products from Best Buy stores.

Of course, as noted, this isn’t something Best Buy can control. And indeed, it isn’t just affecting this one company. Others, from Amazon to Apple have to absorb these margin squeezes. The cost of consumer electronics, therefore, will have to inevitably creep up across the board.

Investors, until this point, have been relying on the fact that this is going to be a universal problem for the industry. Therefore, Best Buy’s market share won’t really move as a result. That’s true. But there’s a problem with that logic that is now starting to work its way into the company’s share price.

Just because Best Buy isn’t hurt any more than its competitors doesn’t mean it isn’t hurting. These price hikes stemming from tariffs are going to play a larger and larger role in consumer spending on these products.

We’ve already seen with relatively low sales of Apple phones over the last year or two that the excitement over having the latest and greatest version has died down. Consumers are holding onto their versions longer and longer. That’s true of many electronics, but especially true of smartphones.

Best Buy needs that trend to stop. Not only does the company itself rely on direct smartphone, laptop and other device sales… it makes its largest margins from accessories and extended warrantees. And when do you buy a new phone case or laptop bag? When you get a new phone or laptop.

So, even Best Buy’s secondary and higher margin products are going to see continued declines.
These problems aren’t going to disappear until a proper trade deal goes through. And even then, there’s likely going to be a period before consumers come back to resume their buying trends.

Worse, the longer these problems exist – higher prices and lower consumer spending – the more likely it’ll reach even more important parts of the economy. If consumers spend less, other companies grow less. The lower those corporate growth rates go, the less likely they’ll spend on IT infrastructure and new computers. This will hurt Best Buy again.

With all of this in mind, now consider that even with today’s large drop in Best Buy’s share price, it is still sitting 33% higher than where it was five months ago. Sure, it is off its recent highs – both from before last fall’s drop and earlier this year. But with such a bleak sales outlook, investors are still giving the company too much credit.

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Now, does any of this mean Best Buy’s stock is headed for a giant crash? No. After all, the company did just report a great quarter and confirmed 2019 guidance.

Moreover, it doesn’t report its next earnings for another three months. So, unless investors run with this story and flee shares of BBY in the meantime, there’s a great chance this stock will simply sit still.

Fortunately, not all investment options rely on large price swings or earnings surprises. In fact, there’s a strategy we favor here that works perfectly for this short-to-medium-term price ceiling.

A Strategy For Short Term Bears

A bear call spread is a type of trade that doesn’t involve betting on collapsing share prices. But that doesn’t mean it doesn’t profit from those too.

Instead, it is a strategy that lets traders bank income upfront that they can keep as long as underlying share prices don’t rise. Meaning, this kind of strategy profits from either a falling or a flat share price performance.

The way this kind of trade works is by selling a call option on a stock you believe is due for some short-term weakness… not necessarily one that is destined to collapse. It’s for a stock that’s just not likely to go up in the next few weeks or months.

Then, the trader buys a second call option with a higher strike price. This limits the amount he has at risk. It makes both the potential profit and total risk known up front.

You can see how this trade looks here:

OIC Profile

Source: The Options Industry Council

The goal of this strategy is to keep the full credit that is deposited into the trader’s account at the open of trade. As long as shares move sideways or down, that credit does remain.

Let’s look at a specific example for this unfortunate Best Buy situation.

A Specific Trade on BBY

Right now, a trader could sell a July 19 $65 call for $3.70 per share and buy a July 19 $70 call for $1.16 per share for a net credit of $2.54 per share. On 100 shares each, that’s an upfront income of $254.

That $254 is the trader’s to keep as long as shares don’t rise above $65. With all the economic and consumer spending trends right now, that’s likely… at least for a few months.

As noted with this strategy, the risk too is known up front. To find it for this trade, take the difference in strike prices ($70 – $65 = $5), and subtract the income received at the beginning of the trade ($5 – $2.54 = $2.46). On 100 shares, that’s $246 total.

Now, think about that. Our hypothetical trader receives $254 right up front to enter this trade. He keeps that full amount as long as Best Buy doesn’t rally in price… a very unlikely possibility. In exchange, his total risk is capped out at $246.

That’s more than a 100% return on risk for a trade that requires absolutely no share price movement whatsoever. Best Buy can simply stop trading entirely for the next two months and that money is the trader’s to keep. You aren’t likely to find another scenario this appealing to an options trader right now.

1 Comment

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