This Retailer Should Be Sold

Target’s still running on turnaround hopes but the long term results may miss the mark.

Investors and economists had hoped and predicted that consumer spending would bounce back strongly this spring and following this past winter’s deep freeze and boosted by low fuel prices. But recent reports suggest the consumer is still in hibernation and that money saved on gas seems to have gone towards buying more gas or simply put into savings.

The damage has been widespread but soft goods and apparel have been particularly hard hit ; in the past few weeks companies ranging from high end specialty brands such as Michael Kors (KORS) getting slammed down following poor earnings and down 40% year to date, middle market Gap (GPS) down 18% in the past three months, to deep discount giant Wal-Mart (WMT) down 15% for the year to date.   Even best of breed Macy’s (M) posted disappointing results saying consumers spending has simply not improved as expected. There is also an underlying shift of millennial choosing electronics or experiences (such as food or travel) over apparel and home goods.

It is against this backdrop shares of Target (TGT) have somehow climbed some 33% over the past six months and despite a recent pullback to $77 now stand just shy of the 52-week high at $83 a share. At this point I think it’s running into multiple levels of resistance near the $81 level.

TGT chart 5.27.15

I think the stock is setting up as a good candidate for a short sale or creating a bearish option strategy.

Turnaround Will Be Limited

The recent rally has been built on turnaround efforts. Target struggled mightily through 2013 and most of 2014 due to some macro issues and consumers shift away from big box general merchandisers towards either online shopping or specialty shops.

But Target also faced several company specific challenges. These included the massive credit card data breach, a near non existent digital strategy and a complete failure of it’s expansion into Canada to the point it created a video apologizing to customers.

Target had also simply lost its cachet as an inexpensive place for somewhat hip products. Target pioneered the concept of getting high end designers to create mainstream lines for its stores. When it had names such Isaac Mizrahi’s in its stable Target, pronounced with French accent, was a shopping destination. Now its merchandise is just viewed as merely serviceable. Offering groceries has not helped drive traffic like it has for Wal-Mart.

But new management came in last December and made some swift bold moves. It ramped up digital sales which have now displayed 37% quarterly gains albeit from a very low base. It totally shut down the Canadian stores taking a $5.4 billion charge for that misadventure. It has recently signed designers such as Lilly Pulitzer for lower cost versions of her high dresses.

These things are all well and good. But that has all been priced in. Now the company faces the harsh reality that big box retailers and are simply not the destinations for shopping nor is anchoring a mall all that economically attractive.

For its most recent quarter reported May 20th the company posted 30% increase in bottom line to $1.10 a share thanks easy Year-over-Year comparisons.   But top line revenue and same store sales grew an anemic 2.1%.

Given the recent price gains the stock is no longer cheap trading at 17x forward earnings. That’s not only above Wal-Mart but also richer than TJ Max or Rost Stores which has genuine growth prospects.

Management still has their hands full and long road to home before the company can claim to get back to its glory days. In the very competitive retail environment expect will likely have to become more promotional especially as it heads into the crucial Back to School season. This will likely pinch margins.

Target may continue to turn itself around but it’s also possible it heads down the path Sears (SHLD) and JC Penney (JCP) have traveled.  I’m using options to establish a bearish position.

The Trade:

I’m using a basic vertical put spread with an expiration date out into January 2016.   The spread will keep my cost low. The long term date will allows over 7 months’ time for the investment thesis to play out over both the back to school and holiday shopping season.

Buy January $75 put/Sell the January $65 puts for a $2 net debit for the spread

TGT risk graph 5.27.15

As you can see the spread offers a very attractive 1:4 risk reward. Meaning the $200 cost per one contract spread could realize an $800 or 400% profit if shares are below $65 by the January 2016 expiration.

— Steve Smith

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About the Author: Steve Smith