Today, a large and unusual volume of Target Corp (TGT) put options traded in a long-dated expiry period. This means investors' worries about Target may be overdone. Short-sellers of these puts made an 8% yield and a 20% lower breakeven.
TGT is down over 21.7% at $121.13 in midday trading after the company reported disappointing earnings this morning and was cautious about the upcoming holiday season.
The company said its comparable ("comp") sales were up just 0.3%, and its margins declined. Gross margins in Q3 fell by 0.2 percentage points year over year, and its operating margin fell from 5.3% of sales last year to 4.6%.
Moreover, for Q4 management said it expects flat comp sales. That is not good news for a market that wants growth and upside.
The market reacted harshly and dumped TGT stock by over 21%.
But has it been overdone? After all, the company did not issue a profit warning. This kind of drop happens when a company expects not to make a profit.
Moreover, a large and unusual volume of out-of-the-money (OTM) put options traded in an expiry period well over one year away. This is effectively a contrarian play by the sellers of these puts to the buyers.
Unusual OTM Put Options in Long-Dated Expiry Period
The trade occurred for put options that expire on Jan. 16, 2026, about a year and two months from now (422 days away). This can be seen in today's Barchart Unusual Stock Options Activity Report.
The report shows that over 7,500 put option contracts traded at the $105 strike price, which is $16.26 or 13.4% below today's already 21% lower price from yesterday. The midprice of these puts is $8.35.
In other words, the investor who bought these puts believes that TGT will fall below $100 over the next year to at least $96.65 (i.e., $105-8.35) in order to make a profit. That represents a total drop of over 20% from today's already depressed price.
This investor may have overreacted. For example, at that price, based on analysts' EPS projections of $10.45 next year, TGT will be on a multiple of just 9.3x earnings. That seems too cheap.
On the other hand, the short-sellers of these puts have made a great out-of-the-money (OTM) short trade. They received $8.35 for an investment of $105, or a short-put yield of almost 8% (i.e., $8.35/$105.00 = 7.952%).
That is a fantastic yield. There seems to be a good probability, given the low delta ratio of just -26%, that TGT stock will not end up at the $105 strike price.
TGT Looks Undervalued Here
So far this year Target has generated over $4 billion in operating cash flow. After deducting almost $2 billion in capex spending, its free cash flow (FCF) works out to $2.11 billion.
That represents a good portion of sales (2.84% of $74.39 billion in YTD sales) and nowhere near a loss.
Granted, FCF during Q3 was low, only $8.3 million. That could account for the huge drop, assuming that this continues going forward. But that does not seem likely, as capex spending is wholly controllable by management.
For example, if we assume the company can make a 2.0% FCF margin next year on analysts' forecasts of $110.08 billion in sales, FCF will reach $2.2 billion in 2025. That is close to the expected rate for this year.
And, using a conservative 3.0% FCF yield metric, implies Target's market cap will rise to $73.3 billion (i.e., $2.2b/0.03 = $73.33b). This is 30.9% higher than today's depressed $56 billion market valuation.
In fact, using a 3.33% FCF yield metric (i.e., 30x FCF) gives the stock a $66.1 billion market cap target, or 18% over today's price. In other words, TGT is worth at least 18% more or $143 per share.
So, no wonder short sellers are willing to sell puts at $105.00, given this high target price. The 8% yield available in long-dated short-put yields is a good play over the next year. In other words, the drop in TGT stock looks like an overreaction, at least in terms of valuation.
