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L Brands: Looking for Relative Underperformance

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Jill: Investors showed concern in consumer stocks heading into 2013. Whether it was the Euro zone economic crisis, sequestration or U.S. fiscal cliff, any of these factors could have put pressure on the group. One of the biggest surprises of the year has been the resiliency with consumer spend. We are seeing some improvement in U.S. economic indicators, and because of that the sector has not looked back. The sentiment was upbeat for the job and housing market, inflation remains contained, while fuel prices are below the year-ago level thanks to the strengthening of the dollar. All of these factors support why the SPDR S&P Retail ETF (XRT) is up 30.2% year to date.

As impressive as retail performance has been, I believe there is still room to go in many of the names like Gap (GPS), TJX Companies (TJX) and Costco (COST). But Skip and I want to shift gears and look at what we think will be an underperformer relative to the group.

Fair disclosure: I have shopped and extensively shop and just about every single division of L Brands (LTD). Emotionally, I don't want to be negative on the stock, but as a trader it is my job to identify opportunities whether bull or bear in sentiment. (Take a note Apple (AAPL) fan boys). Love of the products (emotion) cannot get in the way of the investment thesis.

Let's review same-store sales, a key volatility event that falls on the first Thursday of each month for the retail space. Lindsey Bell did an excellent job reviewing the latest numbers from last week. As she noted, LTD was the notable disappointment from last month.

A recovery in the housing market, stock prices gaining momentum, improving labor market, lower gas prices and favorable weather conditions played vital roles in raising consumer confidence. All of these factors led to fabulous June comps. However, LTD's less competitive pricing strategy led to a decline in clearance sales and impacted the results. Let's turn to Skip and look at some other factors that setup our trade.

Skip: LTD was known at Limited Brands until only a few months ago when the company decided to change its name (in March). Regardless LTD remains comprised of over 3000 retail stores such as Victoria's Secret; Bath & Body Works, Henri Bendel, La Senza, and Pink. This year is the 50th year that LTD has been in business.

Technically LTD hit an all-time high in early May, trading a bit above $53. Since then the stock has been what I call "backing and filling" as LTD has traded from the high $40s to the low $50s over the past eight weeks. The slow stochastic is rising which I think of as being bullish. The RSI has recently turned down which I think of as a red flag for any further price appreciation.

Fundamentally LTD is on course to grow earnings at a less than 10% rate of annual growth. In fact, for fiscal year 2013 ending in January, it could finish this fiscal year at a tepid 8% or less rate of growth. That is another red flag as LTD currently trades at a 20 P/E. Toss into the red flag mix this latest sales report: http://www.marketwatch.com/story/l-brands-reports-flat-5-week-same-store-sales-2013-07-11.

LTD does like to pay special dividends when it thinks it is prudent to do so based on earnings and earnings expectations. Thus, should earnings become suspect so should any potential special dividend. That potential special dividend is always in play for options traders, the questions being if, when and how much that dividend might be. The company also pays a regular $1.20 per share annual dividend, doing so on a regular quarterly basis. Early September should be the next regular-way dividend period.

The options trading tactic we prefer for LTD is the calendar diagonal call spread. This type of spread begins as biased to the bearish side. However if the underlying stock remains near the strike price as the short call expires, the spread morphs itself into being a bullishly biased long call. In fact, that long call could be somewhat, if not completely paid for, should the shorted call expire worthless.

Trades: Sell to open 3 LTD November 52.5 calls at $2.70 and buy to open 3 LTD January 54 calls for $2.70.

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