Back on January 17, 2016 we suggested investors consider a bullish risk-reversal on Target Corp. (TGT), the general merchandise retailer. Our bullish call rested on a number of factors. (1) The company was trading at a modest multiple to trailing earnings, 15 versus a median market multiple of 22. (2) Enterprise value relative to cash flow was a modest 6.4. (3) While the share price traded sideways for 2 years as top line growth was non-existent, they were slowly but surely increasing their online sales to diversify their distribution channel and compete with the likes of Amazon.Com and other online retailers. (4) Sentiment was bad as the retail sector and this was reflected in the stock price, even as the company continued to perform well.
Turns out we got bullish too early, which is the risk one takes when buying stocks in company’s that are out of favor. Yesterday, TGT reported earnings for Q4 2016 and the full year. Investors did not like what the company had to say and they took the stock down a whopping 12.2% ($8.14) to 58.77. The following is the reported earnings for the quarter and the year, compared to the same period last year.
The average analyst expectation for EPS before one-time items (as reported by Thompson Reuters) for the quarter was $1.51. The company delivered $1.47 for a small miss. This is not what scared investors. The company provided earnings guidance of $3.80 to $4.20 a share for 2017. This is much lower than analyst’s expectation of $5.37.
The other area of concern was the company’s plan to compete in a rapidly changing retail environment. In the area of distribution, the company plans to make investments in both its physical and digital stores. In the area of product, it plans to launch at least 12 new brands over the next 2 years. In response to customer demands for value, the company is lower margins somewhat to maintain market share even as they expect small drop in comparable store sales.
There seems to be some controversy around this plan. Many believe the company needs to be more aggressive with online sales and suggest an acquisition in this space is in order. Some question the plan to freshen up and modernize stores. The wisdom of these moves remains to be seen. We think product is very important. If the company sells product people want, sales will follow. We think the 12 new brands to company plans to deliver will be a key element to success going forward.
Clearly, the street was caught by surprise, as were we. As you can see from the chart above, the share price decisively broke support and could fall another 10% or more. As a result, we are stopping ourselves out of this trade for a very painful loss.
| 1/17/2017 | 2/28/2017 | ||||||
| Action | Quantity | Exp. Date | Strike | Type | Net | Net | Loss |
| Buy | 1 | 4/21/17 | $72.50 | Put | $2.07 | $0.04 | |
| Sell | 1 | 4/21/17 | $67.50 | Put | -$2.35 | $8.75 | |
| -$0.28 | -$8.71 | -$8.43 |
When we placed the trade, TGT was trading at $70.18 and it closed yesterday at $58.77, for a loss of $11.41 or 16%. Since we were looking for a sharp rebound as sentiment reversed, we thought a risk-reversal, as a stock replacement strategy was the optimal way to play a turnaround. This position lost $8.46, out performing a pure stock position by $2.95.
In retrospect, we made 2 errors. The first is that we were too early in suggesting a bullish position. We thought a rebounding economy would help retailers in 2017 and that investors would recognize that TGT was underpriced and performing well in a difficult environment. Our second mistake was that we took too much risk on the trade. We should have chosen to buy a call spread. This would have limited our risk to the premium paid, just in case the ultimate bottom was not in place, which as it turns out. It clearly was not.
