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Morning Update

Yesterday there was unusual options activity in Sears Holdings. One traded made a large bullish bet on the long term performance of the stock by buying 10,000 January 2015 60/70 call spreads for a net debit of $2.50. This trade will profit if SHLD is above 62.50 in two years, and can return a total of $7.50 is SHLD is at or above 70 at expiration. The total risk is limited to $2.50 if SHLD is below 62.50, meaning that this trade has the potential to return 300% on investment. However, this definitely a speculative play considering that SHLD was trading 47.30 at the time of the trade which means the stock would have to rise 32% for this trade to be profitable.

The problem is that Sear’s is not a profitable company and does not expect to be anytime soon, which makes a 32% rally in the stock unlikely without a major change. Since its merger with Kmart in 2005 Sears has seen revenues and profitability decline. Free cash flow has been negative since 2010, and consensus expectations are for the losses to continue through fiscal 2015. CEO Lou D’Ambrosio was leading the turnaround attempt and made progress last year with the closure of 100 unprofitable stores and the spinoff of Sear’s Outlets. However he recently announced that he would be stepping down and will be replaced by Chairman of the Board Edward Lampert. This abrupt leadership change could stall the momentum the Sears turnaround recently gained and increases uncertainty over the company’s future.

Next Thursday Sears will report earnings, which will be the most important near term catalyst for the stock. It will also give the new CEO a chance to speak to investors and explain what the company’s strategy will be going forward. To put this trade on you must believe in Sears management and that they will return the company to profitability. Recent 13F’s show that the Fairholme Fund’s Bruce Berkowitz added to their long position in Sears, showing that there are believers out there.

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