A Staples Setup

 | Aug 14, 2014 | 4:00 PM EDT
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Like most people, I can find many reasons not to buy shares of Staples (SPLS). It has missed earnings estimates in three of the last four quarters and is due to release second-quarter numbers in a week. With the office-supply chain facing competition not only from online retailers but also from big-box discount stores such as Wal-Mart (WMT), it's not surprising the stock is down more than 34% over the past year. That's just three of the most obvious factors. Even with all that, for those with a contrarian attitude and an appetite for risk, Staples sets up for a buy right now based on the prospect of a classic short squeeze

Markets, by definition, price in expectations, and it seems that the worst-case scenario is already priced into Staples. Yes, both revenue and earnings have been falling for over a year, but after that amount of time, significant continued declines are factored into analyst estimates. Even based on that gloomy outlook, Staples is trading at forward earnings per share below 11.5. That in and of itself doesn't make the stock worth buying -- it seems about right given the recent history and general market conditions, but it certainly doesn't appear that Staples is overvalued.

Value isn't really the point, though. What I see here is a trading, rather than investment, opportunity. When a lot of bad news and negative expectations are priced into a stock, the path of least resistance is up. That is especially true when it begins to look like almost all of those who are bearish are already positioned. Even bad news at that point will have a muted response; put simply, there are very few sellers left. There is evidence that Staples is at that point.

At the end of last month, short interest in the stock stood at more than 95 million shares, or a whopping 11.2 days to cover, up 5.4% from the previous two weeks. That positioning -- and the proximity to a 10-year low of $10.70 seen in June -- sets up the stock for a trade with limited downside. Even if next week's earnings disappoint again or management lowers guidance for the coming months, there will be plenty of shorts looking to take a profit, and that dynamic will, at worst, slow the descent of the stock.


Staples (SPLS)
Source: VectorVest


Of course, having a limited downside is of no use if there is no upside whatsoever. That potential upside comes from the prospect of a classic short squeeze. If results are even on a par with most analysts' gloomy expectations, then the short-term failure of the short play, combined with a relief rally of some kind, will result in upward pressure on the stock.

I would stress again that this is a trade rather than an investment, at least initially. A break to new lows can be guarded against with a stop loss below the previous $10.70 low, but I would suggest giving a little room. Somewhere around $10 should give the shorts room to come in and take a profit if results are a little disappointing but limits potential losses to around 12%. As for upside, any good news next week -- or even the absence of more bad news -- will see an initial pop in the price and a scramble to cover shorts; an ensuing 20% to 25% rally is distinctly possible.

I have said before that market positioning, particularly when exaggerated, often defines the price action following an earnings release more than the substance of the release itself. That is the case here. Given the dynamics of the retail sector and office supplies in particular, the weakness in Staples shares may be justified, but the large short interest makes buying the stock going into earnings a risk-controlled and potentially rewarding trade.

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