New Trade – Opportunity $COST

by Dan August 13, 2014 3:25 pm • Commentary

The story in U.S. retail has remained fairly consistent with over the past year, consumers have had tight grips on their wallets and retailers have had to discount aggressively to maintain market-share.  This dynamic has taken its toll on profitability for most retailers. Just this morning best of breed department store Macy’s (M) showing they are not immune to such trends, missing analysts estimates in the quarter just ended and offering a fairly somber outlook for the balance of the year.  What’s interesting about the Macy’s miss is that there are no shortage of pundits who have suggested that the higher end of retail is fine and its the likes of FDO/ WMT /TGT /TJX that should be of a concern given where the weakness in long term unemployment and wage growth sits.  I guess the recent results from KORS, LULU and WFM should further dispel the notion that consumer weakness predominately lies at the low end.

Last week Costco (COST) reported July sales that were essentially in line with street consensus and the stock touched seven month highs.  COST is clearly best of breed as it relates to big box retailers, but its valuation reflects this, trading at  about 26x this years expected earnings, nearing 10 year highs:

COST P/E over last 10 years from Bloomberg
COST P/E over last 10 years from Bloomberg

From a comparative standpoint, COST’s valuation stands out a bit to WMT and TGT as their expected earnings growth of 4%, and sales growth of 7% in this year is just a tad better than that of WMT and TGT, while both trade well below a market multiple.  Investors have clearly picked their horse in the space, and it is overwhelmingly COST.  

That being said, Wall Street analysts remain fairly mixed on the stock with 18 buys, 15 holds and 1 serll with an avg 12 month price target of $122, or only 3.5% above current levels.

The next catalyst for the stock will be August sales to be reported between Sept 6th and 12th.  This will be a fairly important month as many retailers see a bump with back to school sales. I would say for many retailers this could be the make or break for Q3 and if August is week it will be a long few months until we get the all important holiday selling season.

From a technical standpoint, COST has a VERY interesting chart.  The stock’s 20% gains from the October lows, to the all time highs made in early December only to round-trip by early February.  The stock has traded in a fairly well defined range over the last 18 months, $110 has been meaningful support, where $120 on the upside (aside from the move in November of last year) has served as resistance:

[caption id="attachment_44169" align="aligncenter" width="600"]COST 18 month chart from Bloomberg COST 18 month chart from Bloomberg[/caption]

With the stock having just failed to break out above $120, and the backdrop of weak consumer sales, I am inclined to look for a defined risk way to play for a pull back towards $115, the mid point of the 2014 range.

Trade: COST ($118.37) Buy Sept 120/115/110 Put Fly for 1.45

-Bought 1 Sept 120 put for 2.80

-Sold 2 Sept 115 puts at .80 each or 1.50 total

-Bought 1 Sept 110 put for .25

Break-Even on Sept Expiration:

Profits: btwn 118.55 and 111.45 make up to 3.55 with max gain of 3.55 at 115

Losses: btwn 118.55 and 120 lose up to 1.45, btwn 110 and 111.45 lose up to 1.45, max loss of 1.45 below 110 and above 120


This is a mildly bearish structure that looks for a slight pullback in the stock. It is a net short premium trade so it doesn’t suffer from decay unless the stock goes higher than where it is now. The sweet spot is 115 which seems reasonable if the stock fails to break out higher here.