Trade Update – $SPLS: Sold Long Call For a Double

by Enis September 2, 2014 2:55 pm • Commentary

In a rare shift for Staples, the chatter over the weekend surrounding the stock was actually positive.  Credit Suisse upgraded the stock on the back of the depressed valuation as well as the possibility for further consolidation in the industry, such as SPLS buying ODP (personally, I view that as unlikely, but I’ll take the positive move today anyways).

Barron’s this weekend had an interview Richard Pzena, who mentioned the bull case for Staples revolving around the corporate and online businesses, which I discussed in the original trade idea.

Our plan on our SPLS trade all along was to wait for a spike back to near the pre-earnings high near $13 in May:

SPLS daily chart, 50 day ma in pink, 200 day ma in yellow, courtesy of Bloomberg
SPLS daily chart, 50 day ma in pink, 200 day ma in yellow, courtesy of Bloomberg

While I do think the downside in SPLS is still quite limited, I’m not terribly confident about significant upside in the near-term above $13, so I’m going to sell the call on today’s pop for a double vs. my initial entry.

Action:  SPLS ($12.78)  Sold Jan15 12 Call at $1.20 for a $0.61 gain


New Trade – $SPLS: Have You Tried Staples?

Staples is one of the few left-for-dead stocks of the past 5 years, amidst a general market rally that has lifted almost all boats.  The stock is trading near a 10 year low after a bad earnings report in May, indicating that management’s restructuring plan was going poorly:

SPLS monthly chart, $10.50 support in red
SPLS monthly chart, $10.50 support in red

The company’s earnings report particularly disappointed on margins, as sales were actually in line.  GS research outlined the problems at Staples in a downgrade of the stock in late May, with the following thoughts:

The office products sector continues to suffer from twin secular challenges – erosion in paper consumption weighing on sales of core office supplies (Exhibits 1 & 2), and encroachment from ecommerce weighing on both market share and margins vis-à-vis the retail business. 

The sector’s two remaining firms, ODP and SPLS, are clearly working to do something about it, cutting stores and cutting costs. Both should benefit from restructuring activity, the closing of less profitable stores, and the associated sales recapture.

That said, we believe that ODP, coming off a lower base and with more dramatic cost opportunity, is likely to deliver upside to current Street forecasts, while SPLS, coming off a higher base, is likely to deliver on, but not exceed, Street estimates, as investments defray the benefits of cost reductions and sector consolidation. 

The analyst goes on to note that SPLS operating margins are already at 4.5%, substantially higher than the expectations for ODP to reach 3% margins next year.  Moreover, SPLS is reinvesting in its business to beef up its website arm given increased share online and competition from sites like AMZN.  At the same time, Staples management is diversifying its product offering away from just office supplies, and into more general consumer merchandise.  In short, the company is scrambling to maintain sales and various lifelines in a rapidly contracting market backdrop.

No surprise then that SPLS stock is near a 10 year low in price.  However, the pessimism surrounding the stock has certainly reached a fever pitch.  The stock is trading at only 1.17x book value, in distressed territory for a retailer that is cash flow positive:

SPLS Price/Book ratio, Courtesy of Bloomberg
SPLS Price/Book ratio, Courtesy of Bloomberg

There are other retailers, like JCP, that trade near book value, but JCP is a much more distressed situation than SPLS, with a much higher debt load and more future cash flow risk.  The maturity of much of Staples’ liabilities is 2018 and 2023, as outlined in the company’s filing:

The Company has various other lines of credit under which it may borrow a maximum of $160.5 million. At May 3, 2014, the Company had outstanding borrowings of $100.2 million and outstanding letters of credit of $0.2 million related to these lines of credit, leaving $60.1 million of available credit at that date.
The major components of the Company’s outstanding debt as of May 3, 2014 and February 1, 2014 are as follows (in thousands):
May 3, 2014
February 1, 2014
January 2018 Notes
January 2023 Notes
Commercial Paper
Other lines of credit
Capital lease obligations and other notes payable
Less: current portion
Net long-term debt
With the large majority of the long-term debt in Jan 2018 and Jan 2023 notes, liquidity risk for SPLS is minimal.  Moreover, the company has remained comfortably cash flow positive despite the declining sales and EPS, a much better overall situation than distressed peers like Office Depot.
Finally, Staples has a major advantage in its online business compared to its brick-and-mortar retailing peers.  The company has had a strong presence on the web for nearly a decade now (with advertising highlighting the fact that it has been the second largest online retailer in the U.S., behind Amazon, since 2007), and management is quite focused on investing in the website and related marketing to grow that segment even as the physical store sales decline.  That is a reason for future optimism if management can execute well.
The cheap valuation in SPLS combined with a kitchen sink type of quarter in May has led to a low expectation situation with limited potential downside given the overall business prospects and diversification (especially online) at Staples.  While the environment is still poor, the stock may offer a nice turnaround opportunity before the business actually improves.  Short interest is still around 15% and the stock is down nearly 30% on the year, so we know where sentiment stands.
Meanwhile, options prices are quite cheap relative to history, with implied volatility near multiyear lows, along with the rest of the market.
TRADE:  SPLS ($11.23) Bought Jan15 12 Call for $0.59

Break-Even on Jan15 Expiration:

Profits: above 12.59

Losses: up to 0.59 between 12 and 12.59, max loss of 0.59 below 12

Rationale:  The low level of overall premium, and the fact that SPLS is near the $10.50 support level, led us to pull the trigger on this trade.  The stock started the year near $16, and is retesting its lows of the year on the recent selling.  Since there are more than 6 months until expiration, that offers plenty of time to capture at least one major rally in SPLS in that period, with our risk limited compared to a long stock position.