Name That Trade – $WMT: Everyday Low Price Range

by Enis February 19, 2014 1:00 pm • Commentary

Wal-Mart reports earnings tomorrow morning before the open.  WMT rarely moves much on earnings (4 quarter average daily move of 1.5%, 8 quarter average move of 2.5%), and the low implied move (about 2%) in the options market reflects that.

I outlined the technicals for WMT in yesterday’s CotD:

WMT is the behemoth in American retail, at almost $500 billion in annual sales, and a $250 billion market cap.  The stock has been rangebound between $70 and $80 for much of the past 18 months, but it has held its long-term breakout above the $70 level:

WMT monthly, Courtesy of Bloomberg

WMT monthly, Courtesy of Bloomberg

While $70 is obvious support, the stock’s all-time high of $81.37 was set in early December.  $80 is the main resistance area.

Expectations for Wal-Mart are quite low for several reasons.  First, retailers have reported weak earnings for much of the past 2 months.  Second, weather has been poor to start 2014, which has affected sales after the holiday season.  Finally, low-end consumers have been particularly weak for some time now, as WMT only grew sales at a 2% annual pace in 2013, its slowest rate since 2009.

GS research summed up the low expectations as follows:  

Ahead of 4Q results, expected February 20, we recap recent learnings about the cadence of business, and what we expect to hear alongside 4Q. *Four items likely to weigh on 2014 outlook: (1) Weather weighed on 4Q, and its impact likely persisted into 1Q. (2) While we cut numbers last month to reflect currency trends, we suspect the Street has not fully marked its FX models to market (note, since our cuts currency has swung modestly positive. (3) SNAP reductions, which are pressuring low-end spending. (4) Modest food inflation.

With such a backdrop, analysts have reduced expectations for this quarter to 1.60, which is 4% below last year’s result.  That would be only the second year-over-year earnings decline for any WMT quarter in the past decade, with the other being Q4 2009.

So no one is expecting much from WMT.  Meanwhile, the valuation for WMT is 14x P/E for a company expected to grow earnings 5-10% over the next 2 years.  Perhaps those earnings expectations are optimistic given the trends over the past year, but the cheap valuation likely implies that the crucial $70 support level will hold over the next few months.

With that in mind, we like a trade in WMT that targets the $70 to $80 range, anticipating rangebound price action for the next couple months given cheap valuation and big $70 support, against a very poor macro backdrop and consumer weakness:

Hypothetical Trade: Buy WMT ($74.65) Apr 70/75/80 Call Butterfly for $2.48

– Bought 1 April 70 Call for 4.85

– Sold 2 April 75 Calls at 1.27 each (2.54 total)

– Bought 1 April 80 Call for 0.17

Trade Rationale:

This trade has a profitable range of 72.48 and 77.52.  While it’s risk/reward is only around 1 for 1, we view the probability of WMT remaining between those two levels as a good bit greater than 50% given the push/pull factors for the stock.

However, we decided not to pull the trigger ourselves since it will tie up premium for 2 months waiting for the trade to decay.  But we wanted to lay out the idea given the interesting setup in WMT from a technical and fundamental standpoint. We may revisit the name when a slightly better risk reward presents itself.