This Beaten-Down Stock is a Screaming Bargain
Whole Foods Market (NASDAQ: WFM) isn’t winning any popularity contests lately. On top of being sardonically dubbed “Whole Paycheck,” the natural and organic foods grocery chain has seen its stock price nearly cut in half this year.
A pricing scandal, expansion costs, growing competition and slowing same-store sales have weighed on the stock. And last week, shares got hammered when the company reported earnings that missed analysts’ estimates and posted its first same-store quarterly sales decline since 2009.
The post-earnings headlines were dismal, and many investors probably wouldn’t touch Whole Foods with a 10-foot pole right now.
But based on its attractive valuation and two bullish catalysts, I think the stock is a screaming “buy.”
An Oversold Turnaround
Ironically, Whole Foods’ recent poor performance may be the key to the company’s success. This latest earnings miss really puts management in the hot seat. They must take dramatic action or face more retaliation from investors.
And management has already begun to take steps in the right direction. Last month, in an effort to cut costs, the company said it would eliminate 1,500 jobs, about 1.6% of its workforce. Then, on Wednesday, management announced a $1 billion share buyback program. Both of these efforts should help improve future earnings.
Plus, the company retains a dominant position in its industry. It is the largest and arguably most recognized natural and organic foods supermarket in the United States, and it also has locations in Canada and the U.K.
While revenues for the company’s fiscal fourth quarter were below expectations, they increased 6% to a record $3.4 billion. The company also posted record revenues and earnings for its full fiscal year, as well as a record $1.1 billion in cash flow from operations for the year.
Even after analysts revised their 2016 earnings estimates lower last week, Whole Foods trades with a forward P/E ratio of 17.6, well below its 10-year average of 30 and also near the lowest level in the stock’s 22-year history.
Recent earnings misses have set the bar quite low, shares are trading at bargain basement levels… and there are two catalysts on the horizon that could spark a rally in the stock.
2 Potential Growth Catalysts
Whole Foods has been the subject of takeover rumors for years. Recently, analysts speculated about a potential competitor or activist investor stepping up to the plate.
While this is far from guaranteed, Whole Foods’ low valuation and strong brand make it an attractive target. At its current beaten-down price, the prospect should be taken much more seriously, and sometimes even just rumors are enough to keep buyers in a stock and short sellers out.
The second catalyst is Whole Foods’ plan to open five lower-cost versions of its stores in the second half of 2016. Called “365,” these stores will target younger, less affluent shoppers. In addition to this strategy’s huge growth potential, it is a step in the right direction toward combatting its “Whole Paycheck” image.
While the company certainly has its work cut out for it, its low valuation and growth catalysts combine to make it a compelling opportunity. And judging by the rebound in shares following the initial post-earnings sell-off, it appears investors are looking to the future as well.
Trading buyout candidates or “turnaround” stocks can be tricky, though. Their movements are often volatile and can be hard to predict. So instead of purchasing shares of WFM outright, I have a trade that greatly increases our chances of success.
This trade will allow us to make money if Whole Foods stays flat or goes higher. It fact, it could even be profitable if the stock falls. All WFM has to do is remain above $29 — which is 6.8% below recent prices — through Jan. 15, and we will make a profit.
Make a Potential 19.3% on Whole Foods in 68 Days
The strategy is known as a bull call spread, and it involves simultaneously buying one call option and selling another with the same expiration date but a higher strike price. The option premium from the call sold decreases the cost of buying the long call.
For this trade, I am interested in buying one WFM Jan 24 Call and selling one WFM Jan 29 Call for a net debit of $4.15 or less ($415 per pair of contracts).
Note: Be sure to use limit orders when entering and exiting a bull call spread to get the desired prices.
The most this trade can be worth is the difference in the strikes. This is achieved as long as WFM stays above the strike of the short call ($29) through expiration in January.
Therefore, the maximum profit equals $5 ($29-$24) for a return of 20.5% over the $4.15 net debit paid to enter the trade.
However, I like to set my profit target slightly below the maximum profit to automate the trade and allow for an early exit if the stock continues to rally. When you enter the trade, place a good ’til canceled (GTC) limit order to sell (close) the spread at $4.95. This will result in a 19.3% profit in 68 days, or an annualized gain of 103%.
The breakeven for a bull call spread is the strike price of the long call ($24) plus the net debit paid ($4.14), or $28.15, which is 9.5% below WFM’s current price.
If the stock is below this level on Jan. 15, we will experience a loss. But no matter how low WFM goes, the maximum loss is limited to the amount paid to initiate the trade, or $4.15 in this case.
A bull call spread is the perfect strategy to reduce risk in this turnaround story while still profiting from potential strength due to the bullish catalysts I outlined above.
Recommended Trade Setup:
— Buy one WFM Jan 24 Call
— Sell one WFM Jan 29 Call
— Enter trade for a net debit of $4.15 or less
— Set GTC sell limit order at $4.95 for a potential 19.3% gain in 68 days
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