Some Exciting Options in This Retailer

Timothy is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

In October I wrote about why I think that Best Buy (NYSE: BBY) being bought out by founder Richard Schulze makes sense in the article "Best Buy-Out: The Numbers DO Add Up!." Simply looking at common metrics like earnings per share or free cash flow hides the true profitability of Best Buy. In December false reports of an eminent buyout caused shares to jump nearly 16% only to lose all of that gain on news that Schulze's deadline had been pushed back to February. This allows Schulze to weigh the results of the holiday season before making a bid.

Although total holiday sales rose in 2012 sales of consumer electronics fell by 7% from 2011. Although this doesn't bode well for Best Buy, a survey done after Black Friday revealed that 86% of Best Buy stores were busy and that Best Buy had the third busiest retail website on Black Friday.

Best Buy is set to release holiday sales data on January 11. If Best Buy managed to convert the high traffic in stores into sales then these results could beat expectations. One result of all of this uncertainty surrounding Best Buy is that put option premiums are extremely lucrative. Selling put options offers a way to open a position in a stock at a set price while receiving a premium to do it. Put options can also be sold in an effort to generate income, and as we'll see, Best Buy puts offer exceptional returns.

Best Buy Puts

By selling a put option you give the buyer of the option the right, but not the obligation, to sell you shares of the underlying stock at the strike price on or before the expiration date. For this right you receive a premium. Best Buy trades at $12.21 per share as of close on 1/7/2013. Below is a table of possible put options which could be sold.

<table> <tbody> <tr> <td><strong>Expiration Date (Days Until Expir.)<br /></strong></td> <td><strong>Strike Price</strong></td> <td><strong>Premium</strong></td> <td><strong>Return</strong></td> <td><strong>Annualized Return</strong></td> </tr> <tr> <td> Jan 2013 (11 Days)</td> <td> $12</td> <td> $0.64</td> <td> 5.33%</td> <td> 176.97%</td> </tr> <tr> <td> Jan 2013 (11 Days)</td> <td> $11</td> <td> $0.27</td> <td> 2.45%</td> <td> 81.44%</td> </tr> <tr> <td> Jan 2013 (11 Days)</td> <td> $10</td> <td> $0.10</td> <td> 1.00%</td> <td> 33.18%</td> </tr> <tr> <td> Feb 2013 (39 Days)</td> <td> $12</td> <td> $1.04</td> <td> 8.67%</td> <td> 81.11%</td> </tr> <tr> <td> Feb 2013 (39 Days)</td> <td> $11 </td> <td> $0.60</td> <td> 5.45%</td> <td> 51.05%</td> </tr> <tr> <td> Feb 2013 (39 Days)</td> <td> $10</td> <td> $0.30</td> <td> 3.00%</td> <td> 28.08%</td> </tr> <tr> <td> Mar 2013 (67 Days)</td> <td> $12</td> <td> $1.43</td> <td> 11.92%</td> <td> 64.92%</td> </tr> <tr> <td> Mar 2013 (67 Days)</td> <td> $11</td> <td> $0.95</td> <td> 8.64%</td> <td> 47.05%</td> </tr> <tr> <td> Mar 2013 (67 Days)</td> <td> $10</td> <td> $0.58</td> <td> 5.80%</td> <td> 31.60%</td> </tr> </tbody> </table>

 

If You Want To Buy The Stock

If you're looking to use put options to buy the stock then the $12 strike price options are a good bet. The Jan $12 contract offers a premium of $0.64, knocking the purchase price if exercised down to $11.36 per share. If the option expires worthless then you'd realized a return of 5.33% in 11 days, or 176.97% annualized.

Going further out in time reduces your annualized yield, but even the Mar $12 contract offers an annualized yield of 64.92%. The premium would reduce your purchase price to $10.57 if the option is exercised.

If You Want To Generate Income

If you're looking to generate income from these options and avoid being forced to buy the shares, you most likely want to go out of the money. A $10 strike price gives you an 18% cushion, meaning that the stock would have to fall by 18% before expiration for the option to be exercised. The best option is the Jan $10 contract. This gives you a premium of $0.10 for a return of 1% in just 11 days, or an annualized return of 33.18%. And the stock would have to fall significantly for the option to be exercised.

Another Option...

If you're confident that the buyout will take place then you could sell a long-term put option. If the buyout occurs it will most likely be for at least $16 per share, possible much more, so you could sell the Jan 2014 $13 put option and receive a premium of $2.99. If the buyout occurs in February this option will become essentially worthless. Your return would be 23%, and depending on when the deal is finalized or if you choose to buy the option back at a much lower price your annualized return could be much higher.

Why The Buy Out May Not Happen

With the death of competitors such as Circuit City it appeared that Best Buy, the only remaining nationwide electronics chain, would reap the rewards. However, other brick and mortar stores such as Wal-mart (NYSE: WMT) and Target (NYSE: TGT) are increasingly encroaching on Best Buy's market share.

<img src="/media/images/user_13886/electronics-share_large.png" />

Along with this, Best Buy has suffered declining revenue in the current fiscal year. Another big competitor, Amazon (NASDAQ: AMZN), is driving the so called "showrooming" effect where consumers browse items in stores and then find a lower price online. This should be partially negated by Amazon starting to charge sales tax in many states, but it is still a big negative for Best Buy.

But I think the main reason for all the pessimism is that earnings and free cash flow have turned negative. This creates the illusion that Best Buy is losing money when, as I showed in my previous article on Best Buy, is just not the case. Hopefully those involved in the buy-out realize that Best Buy can easily be turned into a cash generating machine.

The Bottom Line

If you think that the buy out will happen or if you simply agree that Best Buy is undervalued, put options offer a way to purchase the stock at a discount and get paid a premium, in this case a substantial premium, to do it. You could also realize 30% annualized returns by generating income from the $10 strike price options. All of the uncertainty surrounding Best Buy has pushed option premiums into the stratosphere, and this is the perfect time to take advantage of it.


TheBargainBin owns shares of Best Buy. The Motley Fool recommends Amazon.com. The Motley Fool owns shares of Amazon.com. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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