New Trade $TGT – Target Practice

by Enis November 22, 2013 10:32 am • Commentary

Target posted its third straight earnings miss yesterday morning, and the stock was down 3.5% yesterday as a result.  The stock was downgraded this morning at BofA/ML, and is down again today.  Target’s woes have persisted all year.  It has missed earnings for the last 3 quarters, declining 3-4% in each instance, on big volume too:

TGT daily chart, 200 day ma in black, volume lower panel, Courtesy of Bloomberg
TGT daily chart, 200 day ma in black, volume lower panel, Courtesy of Bloomberg

I’ve circled each of the post-earnings moves in red, which are the 3 biggest volume days of the past year.  Yesterday’s earnings miss ($0.54 vs. $0.62 expected) was Target’s worst earnings miss in percentage terms in almost a decade.  For a company historically known for consistent execution (it beat earnings every quarter from May 2009 to November 2012), the last year has been quite the anomaly.

The company blamed yesterday’s miss on weakness in its Canadian segment.  Target entered Canada last year, and is on track to have opened 124 Canadian Target stores by the end of 2013.  It opened 23 stores in Canada in the third quarter, vs. only 9 in the U.S.  The Canadian launch has been very difficult.  Competitors in Canada have slashed prices as Target entered their market, and sales and margins have severely lagged management’s expectations.  However, Target management viewed the current problems as the growing pains of entering a new market, and struck an optimistic tone on the conference call about future Canadian growth, once current excess inventory was cleaned up.

Target’s stock is at interesting juncture here for several reasons:  

1)  The stock’s trailing 12 month P/E is now near 7 year highs, mainly due to the earnings drop of 20% over the last year (the company earned $4.52 in EPS in 2012, and is expected to earn $3.66 in EPS in 2013):

[caption id="attachment_32871" align="alignnone" width="600"]Trailing 12 month P/E in TGT, Courtesy of Bloomberg Trailing 12 month P/E in TGT, Courtesy of Bloomberg[/caption]

2)  While the P/E multiple has expanded as the E has dropped (P is actually unchanged in the past year), the TGT’s consensus earnings growth expectations over the next 3 years is actually around 20% per year.  TGT hasn’t achieved such earnings growth since the 2004-2006 period (the last time the P/E was above 20).  If earnings growth is 20%+ next year, then the stock’s 19x multiple all of a sudden looks quite cheap on an absolute basis and especially vs. the rest of the market.  Of course, that’s a big IF.

3)  Management has guided analysts to a robust 2014 operating environment as the company’s Canadian start-up costs subside and the business there starts to gain steam.  Whether that’s achievable is still quite uncertain, and could lead to dramatic shifts in the market’s expectations as a result.  Meanwhile, the U.S. business has been stable in a tough macro environment (1-2% sales growth), and management expects more of the same there.

At first glance, I was surprised that TGT was only down 3.5% yesterday on such a poor number.  But when you think about the future prospects vs. current valuation, the rationale of the buyers seems more reasonable.  TGT is certainly no quick turnaround story, but I view the potential value argument for the stock as much more appealing.

In the short run, the $60 level is the crucial support spot technically, while I think the $68 level support from earlier this year is now stout resistance:

[caption id="attachment_32874" align="alignnone" width="600"]TGT weekly, Courtesy of Bloomberg TGT weekly, Courtesy of Bloomberg[/caption]

In that vein, despite the recent weakness, I like playing for a rangebound situation with a slight upward bias over the next couple months:

TRADE:  TGT ($63.72) Bought Jan14 60/65/70 Call Fly for $2.32

-Buy 1 Jan14 60 Call for $4.21

-Sell 2 Jan14 65 Calls at $1.00

-Buy 1 Jan14 70 Call for $0.11

Break-Even on Jan14 Expiration:

Profits: Between 62.32 and 67.68 of up to 2.68, with max profit of 2.68 at 65

Losses: Up to 2.32 between 60 and 62.32, and between 67.68 and 70, with max loss of 2.32 below 60 and above 70.

Trade Rationale:  

TGT’s prior all-time high before this year was around $70 in 2007.  The stock’s failed breakout earlier this year above that level likely means that there are many ready sellers of the stock in the high 60’s.  Against that, the stock’s favorable valuation vs. growth outlook and strong execution history makes us think that buyers will be more aggressive in the low 60’s.  With that in mind, we like the call fly structure as a way to play for the 62 to 68 range in the coming months.