Name That Trade – Target Practice (TGT)

by Dan May 22, 2014 1:50 pm • Commentary

Target has had a tough year, with the fall out from their cyber troubles in Q4 reverberating through the C-Level suite with the company’s President and CEO resigning earlier in the month, and just this week reporting worse than expected Q1 results and lowering Q2 and  full year 2014 guidance.

The stock is down almost 5% on the week, now just 2% from the 52 week lows, and down 12% on the year.  The five year chart below shows just how important this coming test of the prior lows will be as it approaches the neckline of a textbook head and shoulders top formation, or as some may call it, “the Triangle of Death”.

Target 5 year chart from Bloomberg
Target 5 year chart from Bloomberg

The news sounds about as bad as it can get, with management shakeup, loss of consumer confidence, resulting in reduced sales, disappointing earnings and margins resulting from a weak consumer, a Canadian division that can’t get out of its own way and an under-performing online strategy hindered by continued share loss to Amazon.  Is sentiment so bad that it could maybe be could for a contrarian play?

The stock is not particularly cheap relative to larger competitor WMT, both trading about 14.5x this year’s expected earnings, though TGT’s long-term growth prospects are much better if new management can right the ship.  TGT is cheap relative to COST, which also is expected to grow sales and earnings in the middle single digits, and trades 24.5x current year’s expected eps.

The long-term bull case for TGT is that the restructuring going on in Canada as well as the management weakness in the U.S. has tarnished a brand that was once seen as the beacon for the American middle class shopper.  If those hiccups turn out to be short-term, and a turnaround starts to materialize, then the underlying business has plenty of room to capitalize on its impressive nationwide platform and long-term customer awareness.  Moreover, the discounted valuation in the stock as a result of the recent troubles offers decent downside protection if the bad news continues for the next few months.

In short, this is a turnaround play that might take some time, but the stock will bottom well before the news cycle turns.  If the stock tests and hold the prior lows we will look to play directional with long premium structures as implied vol is surprisingly low given the plethora of negative headlines.  Thirty day at the money IV is just above 16, not far off the 52 week lows of about 14.5, but down significantly from the recent 52 week highs of almost 25:

TGT 1yr chart of 30 day at the money IV from Blommberg
TGT 1yr chart of 30 day at the money IV from Bloomberg

HYPOTHETICAL TRADES:  If we were looking to put the trade on today we would likely give it atleast a couple months to play out and would consider outright call purchases like the Oct 57.5s about 1.55 with the stock $55.65, with an eye towards legging on a bounce by selling a higher strike call, or possibly the July 55/60 call spread for about 1.65 or the Oct 57.50/62.50 call spread for about 1.10.

Again, we want to see how the stock acts on a break of $55, but this is one we have a close eye on and would be far more inclined to play for a bounce on very bad sentiment, then press the short at 2 year lows.