The Striking Price

How to Play the Abercrombie LBO Rumors

STEVEN M. SEARS
Saturday, April 18, 2015

An options strategy with predetermined risk could be the ticket to nice gains.

On Wall Street, it often doesn’t matter if a rumor is true or false, only that it is tradable.

This is the approach some traders are taking, yet again, with Abercrombie & Fitch (ticker: ANF). The troubled teen retailer remains the subject of leveraged buyout chatter, as it has been for years.

Susquehanna Financial's Chris Jacobson notified clients recently that the rumors had sparked call buying, which got him thinking about how to trade the stock. Jacobson thinks that the LBO speculation will keep the shares from declining, as will Abercrombie's 3.6% dividend yield. In fact, his firm has a $30 price target on the recently $21 stock.

To trade Abercrombie, Jacobson would sell a January $18 put and buy a January $23/$30 call spread. (A call spread is created by buying a call and selling another with a higher strike price, but the same expiration.)

The shares were around $22 when he modeled the trade. The ideal outcome would be for the stock to be at $30 at expiration, Jacobson says, at which point the spread would see a "win" of $6.58 ($7 spread, less the premium paid). On the downside, if the stock were below $18, investors would be obligated to buy the shares at a net effective price of $18.42 ($18 strike, plus the premium paid).

The Abercrombie trade has risk, but it's predefined. If you can’t take the heat, go play bingo.

IN THE WEEKS PRECEDING the start of first-quarter earnings season, talk was widespread that corporate results would stink, thanks to a strong dollar, volatile oil prices, and the like. Earnings estimates were dutifully lowered.

But now the winds have mysteriously shifted, and there is talk that the quarter won’t be so bad, and that the second half actually might be pretty good. This speculation is helpful to investors picking options expirations and contemplating volatility levels. Time is risk so having a sense of how the market may evolve is risk management.

Dubravko Lakos-Bujas, JPMorgan's equity strategist, is telling clients that first-quarter earnings should be a positive market catalyst. He thinks that corporate reports will clarify the earnings impact of the dollar’s strength and oil's weakness.

Since 2010, he notes, the Street has habitually revised down earnings ahead of the typical reporting season, only for companies to beat the revised forecasts by 3.6%, while profits surprised to the upside in 95% of the quarters. Predicted profits have been lowered some 8% for the current quarter, which, Lakos-Bujas contends, is setting up for another positive earnings surprise.

HE MAINTAINS THAT full-year 2015 earnings-per-share revisions that now point to profit growth of just 0.7%, are too negative and will likely be revised higher. He says that Standard & Poor's 500 earnings will be raised from $119.66 to $123, in reaction to better economic growth.

Given this constructive backdrop, he's telling clients that companies in the benchmark index could deliver low single-digit revenue growth, slight margin expansion, and higher buyback and M&A activity.

Similarly, Jeff Saut, Raymond James’ strategist, argues that earnings forecasts have been reduced so much that the S&P's "bottom-up" estimate is about $5 too low.

Saut adds that profit margins might not be the mean-reverting risk factor feared by “negative nabobs.” Margins are 8.7% or 10.4%, depending on how you do the calculation, compared with a historic average around 6.3%. For the past four years, a regression to the mean hasn’t materialized, Saut notes, suggesting that there might be a structural change.

Reprinted by permission of Barron's Online, © 2015 Dow Jones & Company, Inc. All Rights Reserved Worldwide.

The views expressed in the above papers and articles are solely those of the author of the article, and do not necessarily reflect the views of OIC; the information presented is not intended to constitute investment advice or recommendations to purchase or sell securities of any company; and the information presented is based upon particular events that may or may not recur in the future.

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