Option buyers are risk takers. They are often willing to bet relatively small amounts of cash on events that could pay off in a hugely leveraged fashion. In a worst case, they can lose up to 100% of their money. If things work out well, the sky is the limit.
The shares of fashion designer Michael Kors (KORS, Financial) have been a disaster since peaking at $101.04 in February of 2014. They bottomed on Aug. 4, 2015, at $38.16.
The price action would suggest KORS is a troubled company. In fact, the company posted record earnings of $4.28 per share in its latest fiscal year (ended March 28, 2015). The firm is debt-free and held almost a billion dollars in cash at the end of FY 2014.
KORS posted a great growth record from its 2011 IPO through the present. Recent problems have surfaced but appear temporary. Consensus views for FY 2015 and 2016 now center on $4.25 and $4.49 in EPS, respectively.
A single-digit P/E company with a pristine balance sheet makes a prime candidate for a leveraged buyout (LBO). That is especially true in a ZIRP environment where debt is easy to raise and cheap to finance.
At today's close of $39.63, KORS’ earnings yield, the inverse of its P/E, equals 10.75% even if EPS dips slightly in the current year, as expected. With inexpensive financing available, option action implies money is lying on the table, waiting to be picked up by an acquirer.
Wednesday saw almost 3,000 contracts of KORS November $47.50 strike price calls trade against an open interest of just 5,530. At a closing premium of $1.25, break-even for those call buyers is $48.75 ($47.50 strike + $1.25). The stock would need to rise by at least $9.12 per share, or plus 23%, over the next 107 days for those option buyers to get their money back.
4,488 of KORS’ November $50 strike price calls changed hands today as well. The final price was $0.80 taking break-even for those buyers to $50.80. They are betting on a greater than 28% increase not later than Nov. 20, 2015.
224 contracts of the $52.50 strike price traded on Aug. 5 and closed at $0.56. Call buyers can’t recoup all their money with anything under $53.06 on expiration day. That’s a cool 33.8% move from today’s 4 p.m. quote.
None of those call option buyers are taking positions simply hoping to break even.
If a take-over offer emerges at even 16 times FY 2015’s estimate, KORS would be a $68 stock in a flash. Those $47.50, $50.00 and $52.50 calls would have intrinsic values of $20.50, $18.00 and $15.50 respectively.
That is why those risk-takers are playing the game.
Why would anybody, then, be willing to sell those call options? Someone who purchased KORS in the $39 range and gets "called away" at net prcies of $48.75 to $53.06 would have made very nice percentage gains in a short period of time.
If KORS fails to break above the respective strike prices before Nov. 20, 2105, the call option premiums collected up front act as decent dividend substitutes. They are earned whether the options get exercised or not.
Anyone who "knows" a deal is coming, except maybe Bill Ackman (Trades, Portfolio), is not allowed to trade on that information. There is nothing, though, to prevent us from watching the action and guessing what might be on tap.
We’ll know for sure if they were geniuses or fools by Nov. 20.
KORS closed on Aug. 5 at $39.63, up 2.47% on the day.
Disclosure: Long KORS shares, short KORS options
