Trade Idea – $COST Center

by Dan December 7, 2015 12:50 pm • Commentary

Event: Costco (COST) reports fiscal Q1 results tomorrow before the open. The options market is implying about a 2.5% one day move, which is rich to the 4 qtr average of just 1%, and the ten year average of about 2%.  

Price Action / Techncials: COST is up 21% on the year, just this morning making a new all time intra-day high at $167.50.

The stock’s breakout to new all time highs last month has held the uptrend that has been in place since its August 24th closing low, which was also the closing low for 2015.

On the downside a pull back to the uptrend (which also corresponds with the breakout level from the prior high in February and also its 50 day moving average) looks like a reasonable target if the stock were to pull back. To the upside there is no overhead resistance:

[caption id="attachment_59019" align="aligncenter" width="600"]COST 1yr chart from Bloomberg COST 1yr chart from Bloomberg[/caption]

Sentiment:  Despite the stock’s strong ytd gains, and massive relative out-performance to big box retail peers Target (TGT) and Walmart (WMT) down 3% and 30% respectively on the year, Wall Street analysts are relatively mixed on the stock with 18 Buy ratings, 12 Holds, no Sells and a 12 month average price target of $169, just a tad above where the stock is trading.

Fundamentals / Valuation: On December 2nd the company released November same store sales that beat expectations, reflecting strong Black Friday Sales in Consumer Electronics.  The only real issue to poke at in COST is valuation, trading at about 30x expected fiscal 2016 earnings that consensus has growing 8% year over year, with 7% sales growth.  On a P/E basis, 30x current year earnings is a 13 year high:

[caption id="attachment_59020" align="aligncenter" width="554"]COST 20 year P/E from Bloomberg COST 20 year P/E from Bloomberg[/caption]

My View:  COST is clearly priced to perfection, but its been that way for the better part of the last year, despite headwinds of rising food prices, oil price deflation and the strength of the dollar. Investors appear comfortable with valuation given the stickiness of their model, strong execution and cost controls, in what appears to be a rapidly changing retail environment that has yet to inflict any damage on COST’s model.

The only scenario that I see a material out-sized move would be if the company were to miss and guide lower, but given the Nov comps, that seems unlikely.  An inline report and inline to slightly cautious guidance probably has the stock down 1-2%.

What’s the Trade?: Probably the best trade on the board is playing for consolidation this week, fading the move. But implied vol isn’t particularly high and risk reward of fading the move just isn’t that exciting (itm flies, condors etc)

But for those that are long or considering a new long for a breakout we don’t love the idea of doing so without defining risk. Here’s the options trade we prefer to long stock:

Stock Alt/Replacement (in lieu of 100 shares):

COST ($166.60) Buy the January 165/175/185 call fly for 3.00
  • Buy 1 January 165 call for 5.30
  • sell 2 January 175 calls at 1.20 (2.40 total)
  • buy 1 January 185 call for .10

Rationale – This trade defines risk in COST to 3.00 while offering a potential profit of 7.00 on a move to 175 on January expiration. The gains on a move high aren’t immediately realized but implied vol should come in some after the event, helping realize some of the profits. The breakeven on profitability is 168 so just slightly higher than where the stock is trading. Unlike stock, the most that can be lost on a move lower is 3.00.