Retail on Sale

Retailers have been crushed by a shift in spending patterns and preferences, the failure of lower gas prices to translate into increased spending and above average temperatures. But one of blue chip department store offers a compelling bargain ahead of its earnings report tomorrow.

Can fashion ever go out of fashion? It sure seems that way as more people, especially those millennials we keep hearing so much about, are choosing to spend their discretionary dollars on technology like iPhones and “experiences” such as food and travel.

When they do need clothing or want to keep up the current styles they are opting for “fast fashion” from places like H&M or Uniqlo. This has left traditional apparel retailers from the Gap (GPS), which just warned that sales would come in below previous estimates, to Kohl’s (KSS) to specialty teen such as Aeropostale (APO) and even high end such as Nordstrom (JWN) all suffering with share prices down from 25% to over 45% since their summertime highs.

Of course fashion comes and goes and I expect that at some point in the near future as people have all the gadgets they need they will once again turn to clothes to make a statement about themselves. But there is also the major secular shift towards online shopping that will not be reversed. In response to this trend we are seeing a round of store closings as it is becoming clear the U.S. remains “over stored.” This has included in just the last two months:

  • Macy’s will close 35 to 40 stores
  • C. Penney will close 40 stores
  • Target is closing 13 stores
  • Sears Holding has already closed 235 stores this year

This year will see the second largest number of physical store closings since the first wave during the financial crisis. And the number of locations doesn’t begin to show how the footprints are shrinking as many of the big box retailers such as Wal-Mart (WMT) and Target (TGT) are shifting to smaller store formats.

None of this seems to bode well for the traditional retailers.

Let’s Have a Parade

So given all the above one might wonder why I’m establishing a bullish position the Macy’s (M) the most traditional retailer of all. With its annual Thanksgiving Day parade and starring role in the Christmas classic “Miracle on 34th” street Macy’s is the iconic American department store. One could call it the McDonald’s of retail.

But unlike the purveyor of fast food which compounded headwinds of secular trends toward healthier fare by creating a confusing menu Macy’s management has been extremely forward looking.

Macy’s has been at forefront of creating the “omnichannel” which allows consumers to either shop and try on in person and the receive delivery, or order online and then pick up in store. This has not only boosted top line sales but helped the bottom line through improved margins.

The company is also seeking growth through focus is likely to be on its new off-price concept, Macy’s Backstage, as well as bluemercury, a cosmetic and spa specialty store. These smaller, more flexible stores can expand more quickly than a full line department store. So far 6 off-price stores have been opened and it is likely that additional stores will be announced soon given the concept is viable and productive.

Wash Out 

Shares of Macy’s are down some 35% from there summertime high and the chart shows no obvious support level. But yesterday’s 5% sell-off, which seemed to be precipitated by the above mentioned weather concerns, came on very high volume and suggests the shares are getting washed out.

M 111015

All of the above negatives are known and priced into the shares. This leaves room for a relief rally if the company doesn’t lower estimates further. The shares now trade at just 11x p/e despite expectations for 18% earnings growth in 2016. It also sports an attractive 3.3% dividend yield.

The Trade:

Due to the recent sell-off and upcoming earnings report implied volatility of the near term options is at a 52-week high. We can take advantage of the Post Earnings Premium Crush (PEPC) that will come following the report by using a diagonal calendar spread. I’m buying the December $45/November $48 call spread.   Specifically;

-Buy to Open 5 December $45 Calls

-Sell to open 5 November Week2 $48 Calls

For a $2.40 Net Debit (+/-0.10)

This is what the risk graph of the position looks like.

M risk 11.10.15

Winter will come and consumers will shop. And Macy’s shares should march higher from current levels.

— Steve Smith

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About the Author: Steve Smith