Editor's note: This column originally appeared on Real Money Pro on Thursday, Feb. 27, 2015. We have republished it on Real Money as a follow-up to a report on Lumber Liquidators by "60 Minutes" Sunday night.
One of the most prominent features of our real-time information world is that market news, good or bad, is factored into stock prices immediately. After-hours and premarket traders don't wait for a bell to move stocks once headlines break.
For instance, Hardwood flooring specialist Lumber Liquidators (LL) had been cruising along at almost $70 per share until slightly disappointing earnings, along with disclosure of legal problems concerning wood sourcing, conspired to knock the shares down. The stock plunged below $50 during Wednesday's session, bounced, but was still hovering in the $49 to $50 range the next day.
The stock typically has commanded a growth multiple. Its post-recession average price-to-earnings ratio has been north of 25x. The 2011 absolute low came at 14.4x that year's final profits. Last fall's nadir occurred at 20.7x actual 2014 earnings per share. Lumber Liquidators hit $47.76 last November before recovering in 2015 to $69.99. That made for a good trading opportunity.
Is the latest selloff another good entry point or a value trap?
Estimates of financial damages from the wood-sourcing investigation are hard to predict, and "60 Minutes" is scheduled to present a negatively slanted segment on Lumber Liquidators Sunday night. Those factors, though, appear priced into the shares already. Just to be safe, I passed on buying stock outright, but I did take advantage of its depressed price and increased volatility by selling long-term puts at juicy premiums.
Speculators paid as much as $5.86 and $8.50 on Thursday for LL Jan. 2017 $35 and $40 puts, respectively. Writing the more conservative $35 strike only commits to worst-case scenario buying at a net price of $29.14 ($35 strike, $5.86 put premium).
Lumber Liquidators hasn't actually changed hands that cheaply since the first half of 2012. Sales, cash flow, earnings and book value are all substantially higher today than they were three years ago.
The company is debt-free, has no defined benefit pension plan and no preferred stock. Survival is not in doubt.
The ultra-low break-even price on the $35 puts provides a better than 41% margin of safety from the trade inception price of $49.75. Barring other outrageously bad news, that should be more than enough cushion for those willing to shoulder the near-term headline risk.
The best-case scenario will play out as long as LL remains at $35 or better through the Jan. 20, 2017 expiration date. If the shares recover quickly, these 23-month options could probably be covered well before expiration while still locking in good profits.
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