July 23 (Bloomberg) -- As PetSmart Inc. comes under pressure from activist investors to consider a sale, options traders are moving in to cash in on the buzz.
Calls to buy shares in the pet-care retailer trade close to the most expensive level in almost a decade relative to bearish puts, data compiled by Bloomberg show. Short interest, which rose to a record earlier this month, is declining as PetSmart extends a rally from a two-year low to 25 percent.
The company is considering ways to return more money to shareholders after Jana Partners LLC and Longview Asset Management LLC, which own almost 20 percent of PetSmart, called for a sale. The Phoenix-based operator of pet stores and pet hotels is in talks with investment banks about strategic alternatives, the Wall Street Journal reported last week. The review will boost the stock no matter what option is chosen, Erik Rubingh of F&C Asset Management said.
“We just want to get a good price,” Rubingh, head of systematic equity strategies at F&C, said by phone from London. “It doesn’t really matter to us what happens as long as it leads to a higher price. It is a company that is valued quite cheaply and that is showing good growth. This kind of activist investor activity usually helps unlock an upswing.”
EBay Inc. rallied 10 percent in February amid optimism that Carl Icahn’s efforts to split its PayPal unit and bring his nominees to the board will reinvigorate the company.
Shareholders pondered PetSmart’s future after the company reported a decline in same-store sales in the first quarter and cut its full-year profit forecast as competition with Amazon.com Inc. and other retailers intensified. It joined Target Corp. and American Eagle Outfitters Inc. in highlighting unusually cold weather and shaky consumer confidence.
Even so, its high free-cash-flow yield -- the proportion of cash flow to the stock price -- and low debt relative to earnings open up ways to boost returns, shareholder Olstein Funds said this month. PetSmart’s free-cash-flow yield is 6.5 percent, greater than the 3.9 percent yield for a gauge of Standard & Poor’s 500 Index retailers, data compiled by Bloomberg show.
Short interest in PetSmart rose to 16 percent of outstanding shares on July 7, up from 10 percent on June 3, according to Markit data. It fell back to 11 percent on July 21. In a short sale, traders sell borrowed stock in bets that the price will fall, allowing them to buy back the shares at a lower price and pocket the difference.
PetSmart trades at 16 times its projected earnings, lower than the multiple of 21.6 for S&P 500 retailers, data compiled by Bloomberg show. The stock suffered its worst monthly rout since 2008 in May. It rose 0.3 percent to $69.34 yesterday.
Calls betting on a 10 percent increase in PetSmart shares cost 0.9 point more than puts pricing in a similar-sized drop on June 30, data on three-month contracts showed. That was the highest level since Bloomberg began compiling the information in January 2005. Among the 10 options with the largest ownership, eight are bullish.
PetSmart’s media-relations team did not respond to phone and e-mail requests for comment.
The Chicago Board Options Exchange Volatility Index, a gauge of future S&P 500 volatility known as VIX, slipped 4.5 percent to 12.24 yesterday. Its European counterpart, the VStoxx Index, lost 2.5 percent to 15.29 at 10:50 a.m. in London today.
Skeptics remain. Aram Rubinson, an analyst at Wolfe Research, says online competition from the likes of Amazon is a bigger factor for the stock’s future than any deal talk.
“What’s changed? Nothing really,” Rubinson wrote in a client note this month. “Shareholders might agree that change is necessary, but it may be hard to prove numerically that PetSmart has mismanaged the business. It is facing increased competition from online retailers, among others.”
PetSmart said comparable sales dropped 0.6 percent in the first quarter. That was the first year-on-year decline since PetSmart’s initial public offering in 1993, according to Rubinson. The company predicted sales may slide again in the second quarter.
PetSmart’s strong free cash flow makes it an attractive target for private-equity bidders, said Albert Saporta at Makor Capital Ltd., who has a buy rating on the stock. The company generated $137 million in cash from operating activities in the first quarter.
“With big activist investors in PetSmart pushing for a sale, I think it could attract a bid from a private-equity firm, given it generates a significant free cash flow,” said Saporta, Makor’s head of research in Ramat Gan, Israel. “Our fair value is about $80 per share. Like a number of big-box retailers, the stock was and is still quite undervalued.”
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