“In the stock market, the most important organ is the stomach. It's not the brain.” - Peter Lynch
Investors often associate taking risks in the stock market with high-multiple, high-flying stocks that capture market attention. Typically, those perceived as risk-takers debate whether a high-multiple stock can sustain earnings growth for decades. However, significant risks also exist in stocks teetering on the brink of bankruptcy, which can offer substantial rewards. Skillfully navigating bankruptcy scenarios can be highly lucrative.
Opportunities often arise in options markets with stocks that enjoy less attention than market favorites. While many recognize the potential in beaten-down stocks, combining these with affordably priced derivatives can significantly enhance returns.
Walgreens is not a stock that typically inspires confidence or enthusiasm, yet I see a significant opportunity to profit from its potential to avoid bankruptcy. The trade I'm suggesting will also allow time to exit if bankruptcy does occur.
The traditional value investing strategy involves finding beaten-down and undervalued stocks. However, a critical aspect of this strategy is avoiding the infamous value trap, where a stock appears increasingly appealing by valuation measures as it heads toward bankruptcy, drawing in hopeful value investors only to ultimately fail or restructure.
Walgreens Boots Alliance, a beleaguered pharmacy/retail giant, has experienced a sharp stock decline, dividend cuts, and a new shareholder lawsuit. Yet, within this dramatic fall and the uncertainty surrounding its future lies a substantial opportunity.
Once a revered dividend aristocrat, Walgreens has faced hard times following several failed strategic pivots. I won't try to convince you that this is a great stock with bright future prospects compared to market winners. It is not. The company faces numerous challenges, and pressure on profitability could lead to another dividend cut. However, the stock is undeniably undervalued and is experiencing revenue growth that should provide a temporary reprieve.
When a stock's financial viability is in doubt, it can present a significant opportunity for options traders. As share prices decline, the possibility of bankruptcy increases. With options, the market's underdogs can become advantageous. Here's why.
Owning large quantities of Walgreens shares could be risky given the serious threats and deteriorating financial condition. However, by foregoing stock ownership and dividend collection, which is one of its primary attractions, you can achieve substantial alpha by focusing on upside price action. If you're confident the company won't go bankrupt, they might still need to cut or suspend the dividend to avoid that outcome.
The stock is hovering near 52-week lows, and I don't foresee the price dropping much further unless bankruptcy prospects significantly increase. While Walgreens faces serious challenges, its bankruptcy risk isn't as high as the recent price drop suggests.
For a dividend aristocrat, much of the buying is driven by dividends, and losing this status was bound to result in severe repercussions. However, I believe this is overstated and partly due to the composition of Walgreens' investors. With the Fed's cutting cycle beginning and a recent report where the company lowered guidance, I think the risk/reward is starting to shift favorably.
This trade is bullish on Walgreens, but we wouldn't consider it without advantageous options pricing, which I believe offers a high probability of success. Many institutional derivatives traders focus on Theta decay strategies, benefiting from time value decreasing faster than intrinsic or extrinsic value can catch up with. Walgreens presents the opposite opportunity.
It offers an opportunity to acquire extremely cheap time value to observe Walgreens' developments. We can use LEAPS to give the stock time to recover from its current dismal range near lows, with high leverage since these options will essentially move 1 to 1 with the stock price. The downside is controlled because such a high proportion of the option's value is from intrinsic value rather than extrinsic value.
The contract we are suggesting is deeply in the money, meaning its value won't rapidly decline as time passes. Its value will only rapidly decline if Walgreens experiences significant price declines from here, which I currently view as unlikely given the depths of their recent fall. Based on the average sell-side price target, if the stock avoids financial calamity, it should result in a substantial appreciation for cheaply acquired LEAPS.
As shown above, the extrinsic value of the option, or the portion of the value that comes from not being ITM, is only $0.31 or about 5% of the option's contract value. The sell-side price targets on the stock further support this trade. This is a deeply contrarian call, but I believe it will be highly profitable.
Here is the trade:
Buy January 17th, 2025 $WBA call options at $2.50. The current price is around $6.35. You want to hold them long enough for the extreme malaise of the stock to wear off.
If you are bullish on Walgreens, I would also complement this position with a $15 call of the same expiry, January 26th, 2025. This will enhance returns if the stock recovers but will also increase risk. These last traded at $0.81.
Remember, the $15 calls have a far higher chance of expiring worthless since they have no intrinsic value.
Walgreens faces many risks, and the bears could ultimately be right. However, I believe the bankruptcy prospect is relatively low over the next year and a half, and we are at or near a low point of confidence in the stock. The last earnings report may have been a "kitchen sink" report, creating conditions for the company to start outperforming expectations and righting the ship. Furthermore, I have confidence in the economic backdrop, and Walgreens has some counter-cyclical healthcare attributes even if economic prospects materially decline in the short term.
