Big Lots (BIG): Playing Deal Stocks with Option Spreads

There is no better feeling than being long call options and then having a takeover deal announced for your holding, resulting in huge gains, but sometimes potential deals are made public well before an official deal, and there are weeks, and often months, of large options trades positioning for an eventual deal. I am not talking about the every day takeover rumors that make the way around trading floors, chat rooms,twitter, and especially the laughable rumors cited on CNBC's Fast Money, as these never come to fruition 95% of the time. I am talking about when activist investors make it public that they are looking into an acquisition of a Company or a Company announces it is seeking a sale. A variety of strategies can be used to benefit from the price of the stock eventually surging on a deal, and also take advantage of the volatility and time decay in options. With some basic relative valuation analysis and looking at prior deal premiums, projecting a price is also not too difficult to allow for the construction of a profitable strategy.

In this particular case I am looking at Big Lots (BIG). While fellow discount retailer BJ's Wholesale (BJ) has often been mentioned in takeover reports lately with Leonard Green, famous for buyouts, releasing a 13D with a 9.5% stake in shares last July. The group is hot lately with Nelson Peltz's recent offer to buy Family Dollar (FDO) being rejected, so the value is seen in this group.

On February 7th, Bloomberg reported that Big Lots (BIG) is considering a sale, sending shares from $34 to up above $39. The Company was said to be working with Goldman Sachs on a sale. Raymond James feels that the Company could fetch a $54/share offer. Since the story on February 7th shares have been able to not only maintain gains, but climb to new highs with a $43.55 close on Friday. The price action dictates that an eventual sale is likely here.

Big Lots' shares trade 12.5X earnings, 0.66X sales and 14.2X cash flow. EV/EBITDA of 6.9, also a key metric looked at for potential takeover prices, is on par with BJ's Wholesale, but well below the 8.84 ratio at CostCo (COST).

Considering the recent move in shares since the report, it has hard to imagine a premium coming in for more than 20%, and a $50 price-tag seems most likely in my view.

There are plenty of opportunities in the options market to bet on an eventual deal occurring. On March 23rd I noticed one large opening trade that was a very interesting approach.

A trader bought 5,000 May $45 calls at $1.85 and sold 10,000 October $50 calls at $0.80, net $0.25 debit (small outlay), in the calendar ratio call spread. The same trade was put through for 975X1950 contracts earlier that day. This trade is looking for the deal to get done by May expiration, being long the May calls at the $45 strike, OTM, and not wanting to be left with 10,000 short October $50 calls after May expiration. The maximum profits of this trade comes with shares at $50, the perfect situation as the May calls are then worth $5 and the October $50 calls would be worth $0.00 (theoretically, although will hold some value until official closing of the deal and without another bidder coming in at a higher price). So, a deal at $50/share would result in the $0.25 outlay being worth $5, or a 1900% gain, turning $125,000 into $2.5 Million. The trade is also profitable above $45.25 all the way to around $55, where the spread would be worth $0 and the trader would lose the $125,000 outlay. A deal above $55 and the trader's losses would start to mount, but this seems unlikely given the valuation and average premiums paid in retail buyouts.

Another way to play for a buyout in the expected price range I have noted without needing a margin account (due to the naked short calls in the ratio spread) would be to buy the July $45/$50/$55 butterfly call spread at $1.20, a profit zone from $46.20 to $53.80, which would not have quite as big of a percentage gain, but still a great way to play the deal. The strategy view is provided below:



A riskier way to play that is also attractive is the May $47.50/$37.50 bull risk reversal, buying the $47.50 calls at $1.05 and selling the $37.50 puts at $0.95 for a $0.10 outlay, a leveraged long position.







***This is Not a Trade Recommendation***