Abandoned Value Stock Offers a Shot at 24% a Year in Income
In today’s extended market, it is difficult to find quality investment ideas that are not already bid up to premium valuations. The Federal Reserve has set target interest rates at historically low levels, which in turn, has forced yield-hungry investors out of fixed-income securities and into more risky equities.
For the most part, stocks that have pulled back to the point where they are trading at discount valuations have at least some issues that are concerning to investors.
Today, we’re going to look at an income opportunity on a stock that has struggled but is trading at what appears to be a solid floor. This company offers exceptional value (if it is able to get its operations back in line), and following the stock’s decline, option premiums are high enough to give us a lucrative amount of income.
Staples (NASDAQ: SPLS) has had a tough year so far. The stock lost roughly a third of its value from its late 2013 high, and is off 60% from its ultimate peak in 2006.
While the chart may not be much to look at, SPLS may be one of the few true value opportunities available to investors at this junction. But before I make the bullish case, let’s first look at some of the key competitive challenges the company is facing.
First, Staples has the misfortune of competing against a recently merged Office Max and Office Depot (NYSE: ODP). The combination of these two heavy hitters should yield operational synergies and allow them to close some stores while still keeping a wide geographic footprint. This should ultimately lead to lower costs, and these saving could be passed on to customers in the form of lower pricing. Obviously, this makes it more difficult for Staples to compete in terms of price and can cut into margins.
Secondly, Staples, along with many other brick-and-mortar retailers, is competing with Amazon.com (NASDAQ: AMZN). As leading online retailer, Amazon continues to build logistical synergies and can now offer most products to consumers at very attractive prices with low shipping costs.
With these pressures, it should not come as a surprise that Staples has experienced a decline in its stock price over the past few years.
But while Staples may be facing significant challenges, the company is still profitable. Analysts expect it to generate earnings of $0.98 per share this year, and the consensus estimate for next year (fiscal year end January 2016) is pegged at $0.97. That means investors are paying just 11.6 times earnings.
In addition, the company pays a quarterly dividend of $0.12. This puts the dividend yield at 4.3%, which is very attractive given today’s low-interest rate environment.
While Amazon certainly poses a threat to Staples, the office supplier was named the No. 3 e-commerce player in the United States, according to Internet Retailer data, and the company recently announced a price-match program to directly compete with Amazon.
Given the low valuation, the fact that SPLS appears to be finding support at the same spot it rebounded from last year, and the potential for bullish publicity surrounding its price-match offer, I believe the stock will stabilize here and potentially rally.
To take advantage of this situation, I want to use a put selling strategy. Specifically, I want to sell the SPLS Sep 11 Puts with a limit price of $0.40.
By selling these puts, we are accepting an obligation to purchase 100 shares of SPLS per contract at the $11 strike price if the stock is trading below this level when the puts expire on Sept. 19. I expect SPLS will remain stable or rebound and the puts will expire worthless, allowing us to keep the $40 in option premium per contract free and clear.
Of course, we still need to be prepared for the possibility of being required to purchase shares. To cover our obligation, we will need to set aside $10.60 per share, or $1,060 per contract, of our own capital (along with the $40 that we receive from selling the puts).
If the puts expire worthless, the $40 in income represents a 3.8% gain on the $1,060 set aside. Since we will generate this in 57 days, our per-year rate of return nets out to 24%, which is a solid rate of return given the low risk and discount valuation SPLS is trading at right now.
In the event shares are assigned, we will be buying the stock at a nice discount to the current market price (our net cost will be $10.60 when accounting for the option premium we receive), and we will be able to enjoy the 4.3% dividend yield. Investors can also create additional income from their position by selling covered calls. All in all, SPLS looks like an attractive value opportunity for income traders today.
Note: My colleague Amber Hestla has closed 52 straight winning trades using this strategy. You can see her entire track record and learn exactly how you can make the same winning trades yourself by following this link.