Lowe’s (LOW) reports their Q3 results prior to the open tomorrow. The options market is implying a roughly 5% one day move in either direction which is rich to the 4 qtr avg of about 3.35% and the 8 qtr avg of about 3.7%. I think its important to note that heading into Home Depots’ (HD) results this morning the options market was implying about a 3.25% one day move, and so far the stock has traded in a an almost 3% range from yesterday’s close to this morning’s lows, and the stock is currently down about 1.5% on the day. Importantly the stock is now down about 3% from the all time highs made last week.
Back to LOW, the stock has appreciated 18% ytd, (inline with larger rival Home Depot’s performance) with all of these gains coming from the mid October lows. The stock went from unchanged on the year on Oct 15th to new all time highs just yesterday:
I think it is safe to say that good news is already in the stock at current levels. It also strikes me that the stock at current levels is not particularly cheap on a valuation basis, trading at 22x fiscal 2015 earnings that are expected to grow 22%, on sales growth of only 4% (analyst also expect sales to only grow 4% for the next 3 years). For a company whose dividend yield is only 1.57%, and properly levered with a $57 billion market cap, $1 billion in cash, and $10 billion in debt, it is clear that a good bit of their cash flow has gone and continues to go to share buybacks. In the six months leading up to Aug 1st, LOW used about $2 billion of cash to buy back stock.
So the obvious question is what do you pay for a stock that almost religiously manages their earnings and is only expected to see low single digit sales growth in perpetuity?
LOW’s expected 20% earnings growth on $57 billion in sales, growing 4%, with a 1.57% dividend yield, buying back about $4 billion of stock a year?
HD’s 20% expected eps growth, on $82 billion in expected sales, growing about 4% with a 1.94% div yield, buying back probably $7 billion a year?
Those HD stats make LOW’s market cap at $57 billion look at tad more attractive than HD’s $130 billion market cap, as they only have $2 billion in cash, and almost $17 billion in debt.
Put another way, LOW trades at 1x expected sales vs HD at 1.5x. So what gives??
The fact of the matter is that these sort of discrepancies usually happen for a reason. But it’s my sense that if HD could not rally today after posting inline results and guidance, it will take a beat and raise for LOW’s to rally. However, the stock could easily match the implied move to the downside on the slightest bit of bad news.
If I were looking to play for a move in line with the implied move, of about 5%, but to the downside, I would target a pull back to the prior breakout level of around $55, just above the stock’s 50 day moving average:
One trade I would consider if looking to play for a near term pullback:
is the Nov (this Friday expiration) 57.50 /55 Put spread for 0.50 The break-even is down at 57.00 (current price $58.6), down about 2.7%, with max gain of 2.00 if the stock is $55.00 or lower. But here is the problem with this trade. There are a few things that you need to get right to even have a shot at making money. Mainly, direction and timing. Getting the magnitude of the move right is kind of the least important if you don’t get the first two correct. Which is one reason we avoid directional trades around earnings with short dated options.
So another way to play is to pivot off of HD’s earnings move and bet that LOW also only moves a little. A good trade to fade the earnings event is the Dec 62.5/57/5/52.5 put fly. That costs about 2.15 here and catches implied vol in Dec at a decently elevated level. But it’s not enough to make us want to jump in as the risk/reward of risking 2.15 to possibly make 2.85. Even if the stock didn’t move much it’s a long time to stick around until Dec expiration to wait for the rest of the premium to decay. And that’s probably not worth the risk of an outsized move tomorrow.