Trade Update $BBY – Taking Quick Profits on Overbought Pullback

by Enis April 2, 2013 12:47 pm • Commentary

Trade Update April 2nd, 2013  12:47 pm:  BBY has had a quick pullback in the past week, though in the context of its strong up move, the 7% move lower is not that significant.  However, in situations where the stock gets extremely overbought and pulls back, it pays to be nimble in getting out on the short side in my experience.  Moreover, the call spread that I’m short is only worth 0.25 here, so I’ll take the gains on this trade and look to potentially re-enter a short biased trade if the stock gets back above $23.

 ACTION:  BBY ($21.60) Buy to close the Apr 23 / 25 Call Spread for $0.25 for a $0.50 gain

Original Post March 25, 2013:   New Trade $BBY – The 3 Month Double

For any who believe in the efficient market theory, Best Buy is a nice test case to illustrate inefficient markets.  The stock has gone from $11.23 on Dec. 28th, 2012 to trading $23.46 this morning, a double in less than 3 months.  In that time, the news flow, investor sentiment, and earnings momentum surrounding the stock has certainly changed.  But a double in less than 3 months, for a company that sells electronics in the same way that it has for years now?  That’s an inefficient stock market.

The stock certainly looks cheap.  A 10 P/E name paying a 3% dividend, with 10% earnings growth projected for the next 3 years.  Amazingly (in retrospect), you could have had it for half the price at the start of the year.  So why does the stock still have a 10% short interest (though down from 20% at the start)?

The 1 year chart of short interest:

1 year chart of BBY short interest, Courtesy of Bloomberg
1 year chart of BBY short interest, Courtesy of Bloomberg

From a peak of 54 million shares last May, the short interest has declined to about 29 million shares, still substantial, but near the lows of the past year.  So the shorts have been squeezed, but not as badly as might be expected on such a vicious rally, as they had covered a good bit over the past year.

The fundamental argument for a turnaround in BBY is built around better management cost control and a cheap valuation.  Here are a few key points the GS analysts made when they upgraded the stock on March 12th:

We are reinstating BBY with a Buy rating and a $25, 12-month price target. Management changes are catalyzing a more realistic approach to pricing; substantial cost cuts; and, the beginnings of a more concerted effort online. The firm has lowered expectations for 1Q, and excess returns have been squeezed by a tough marketplace. BBY’s competitive standing is stressed by a choppy product cycle, potentially oversized retail boxes, and a price gap vs. AMZN, however, valuation – still at the low end of our covered universe – suggests the opportunity for outperformance. We do not include any benefits from restructuring international, and model only a small buyback.

BBY remains in a challenged position, selling big-ticket commodities against lower-cost online competition. That said, we expect cost controls to aid profitability, and our estimates are now positioned above the Street for 2013-2014, even assuming ongoing gross profit declines.

 

The rest of the report goes on to stress the importance of cost controls, improved culture due to the management change, and international losses ebbing.  But the analysts acknowledge that BBY remains challenged from a revenue perspective.  The pricing of their products is still generally above the competition, and their online presence is negligible.  Moreover, the PC hardware market is in a secular shift that has hurt traditional hardware sales.

So valuation vs. no growth, which argument wins?  I’ve been watching this story develop patiently from the sidelines, and I finally feel that the entry is right for a fade-the-move trade.  Here’s the technical picture, shown by the 3 year chart:

BBY 3 year daily chart, Courtesy of Bloomberg
BBY 3 year daily chart, Courtesy of Bloomberg

 

The stock broke its 2.5 year downtrend in February (shown by the declining 200 day ma in black), and has rallied up to near 25.  But it’s finally in a zone where a good portion of supply likely exists, as the stock traded between 23 and 28 for 6 months before breaking down in 2012.  That’s why I like a short-biased entry here.  Moreover, the stock is extremely overbought on a RSI basis, with a current reading of above 80 for the past 2 weeks, and the call to put ratio made some extreme readings last week, suggesting potential buying exhaustion.

TRADE: BBY ($23.25) Sold the Apr 23 / 25 Call Spread at $0.75

-Sold 1 Apr 23 Call at $1.19

-Bought 1 Apr 25 Call for $0.44

Break-Even on Apr Expiration:

Profits: Up to 0.75 between 23 and 23.75, max profit of 0.75 at 23 or below

Losses: Up to 1.25 btwn 23.75 and 25, max loss of 1.25 at 25 or above

Trade Rationale:  I decided to sell a call spread instead of buying a put spread because when a stock gets this overbought, it’s rare that it goes down right away.  Rather there is usually a consolidation period where its momentum readings move lower while the stock might not move too much.  I think BBY is likely to move lower, but I don’t want to lose on decay while I wait for it.  I also chose April instead of May because it will decay quicker, and I don’t want to hold on to this trade for too long on a pullback, since there is headline risk.  While I’m risking 1.25 to make 0.75 though, I view my probability of profit here as much higher than a loss.