Preparing for More Retail Pain (Plus 1 Bonus Pick!)

Add AZO Puts, TSO Calls

PLAY: Buy the AZO January 100 Puts (AZO MT) at market, good for the day. Place a protective stop limit at $3.90 and implement our scaled-selling technique as your position achieves gains of 50% (and greater).

PLAY: Buy the TSO January 2011 5 Calls (ZGC AA) at market, good for the day. Due to the January 2011 expiration date, do not place a protective stop limit at this time. Implement our scaled-selling technique as your position achieves gains of 50% (and greater).

Dear Bottarelli Research Member,

Last week, I gave you a list of retail stocks that could experience weakness going into (what appears to be) the worst holiday shopping season in decades. To profit off this, we entered puts on Zale Corp. (ZLC – NYSE) and Toyota Motors (TM – NYSE). And over the last week, our ZLC February 20 Puts (ZLC ND) and our TM January 65 Puts (TM MM) traded higher by 31.48% and 13.10%.

Today, we’ll continue on this theme by adding another retailer that’s currently priced too high. And as an added bonus, I’ll also offer you an upside call LEAP going into January of 2011 that could hand you truly explosive returns. So let’s get started!

Starting on the put side, I’d like to enter puts on auto-parts retailer AutoZone (AZO – NYSE).The company operates 3,933 stores in the United States, Puerto Rico, and Mexico. As you probably know, they sell automotive replacement parts and accessories to do-it-yourself customers. Over the last 52-weeks, the stock has out-performed the market by losing only -16% versus the -41% loss in the S&P 500. This over-performance has been attributed to cash-strapped customers who have elected to fix up their current vehicles (using AZO’s parts) instead of buying new vehicles. This has helped AZO survive despite our current recession. But that’ll end soon.

Think about it like this. AZO attracts customers whose disposable incomes are dwindling by the day. In other words, if the standard AZO customer can’t even afford to buy (or lease) a new car, then how much money do they truly have available to spend on parts? As the recession lingers on, I believe AZO will begin to suffer. They can only combat the weak retail environment for so long. All it’ll take is a slight reduction in earnings and AZO’s $107.00 stock price will take a tumble. Not only that, but AZO currently carries a Price/Book ratio of 26.24, which is way too high in this retail environment. In comparison, Advance Auto Parts (AAP – NYSE), who is AZO’s top competitor, currently carries a Price/Book ratio of 2.33. This is far more appropriate in a recessionary environment.

Why has AZO held up? The answer, quite simply, is Eddie Lampert. As a “Director” of AZO, Mr. Lampert is notorious for throwing massive stockpiles of cash at the companies he’s involved with. On August 4^th, for example, he traded over 3.4 million shares of Sears Holdings Corporation (SHLD – NASDAQ). As you can see below, this temporarily offered SHLD a price boost. But when this temporary injection of cash gave out, SHLD quickly fell from $105 down to $60 in less than a month. I think the same fate will soon fall on AZO.

After all, on October 10^th, Eddie bought 143,200 shares of AZO for the total cost of $13,890,168. Just like the SHLD play, I think this purchase has offered a temporary boost to AZO shares. But going into November and December, this premium will wear off. When this happens, AZO could easily follow the pattern of SHLD and trade down around $60 per share. Therefore, let’s play this down-move using longer-dated puts. Here’s the play…

PLAY: Buy the AZO January 100 Puts (AZO MT) at market, good for the day. Place a protective stop limit at $3.90 and implement our scaled-selling technique as your position achieves gains of 50% (and greater).

Over on the call side, I’ve uncovered an opportunity that is simply too explosive to ignore. It comes to us in the form of oil refiner Tesoro (TSO – NYSE). As you know, oil prices have been rapidly falling. As of Thursday, crude oil was at $70.00 per barrel, down over 50% from the highs above $140.00 from earlier this year.

Without question, the beneficiary of falling oil prices are refiners like TSO. But in one of the strangest trading patterns I’ve seen in quite some time, oil refiners have continued to fall. Over the last year, Holly (HOC – NYSE) is down 58%, Valero (VLO – NYSE) is down 54%, and Western Refining (WNR — NYSE) is down 77%. The movements of TSO are even more stunning. Amazingly, in October of 2007, shares of Tesoro traded for $65.00 per share. Today, they can be yours for $10.00.

Why have refining stocks been so severely bludgeoned?

Well, Wall Street fears that the demand for gasoline will remain depressed for the next few years. At the same time, there is also fear that international refineries will put pressure on domestic margins. Perhaps there is some truth to these concerns. But at current levels, both of these issues are fully priced into shares of TSO by a magnitude of ten. The three-year chart (below) tells the whole story.

In other words, the worst-case scenario is fully priced into shares of TSO. And to be perfectly honest (and realistic), as much as we talk about electric cars or alternative fuels, the truth of the matter is that gasoline demand will remain consistent for years and years to come.

Not only that, but if you look at Tesoro’s earnings expectations, you’ll see that the stock’s current valuation represents a once in a lifetime buying opportunity. The company plans to release third-quarter results October 29^th, and according to the company, they expect to report earnings between $1.70 and $1.90 per share. But as it stands right now, analysts surveyed by Thomson Reuters are forecasting earnings of $0.64 per share. In other words, TSO is prepared to blow their numbers out of the water. That’s why it’s smart to get positioned now.

That’s the best part of this entire play.

Look at the TSO January 2011 5 calls (ZGC AA). As I write, they’re in-the-money by $5.00. But right now, you can own these calls for a grand total of $7.20. That means you’re paying $2.20 to carry this position for 24 months! We’re talking $0.10 per month of carry! It’s truly a steal, so let’s get positioned now!

PLAY: Buy the TSO January 2011 5 calls (ZGC AA) at market, good for the day. Due to the January 2011 expiration date, do not place a protective stop limit at this time. Implement our scaled-selling technique as your position achieves gains of 50% (and greater).

FUTURE PUT PLAYS: Below are some additional put-play candidates that could emerge as future LEAPS plays.

Chipotle Mexican Grill (CMG – NYSE): High commodity prices and rapidly falling consumer spending are starting to effect shares of CMG, which recently issued a profit warning. $25.00 per share looks like a realistic downside target.

Life Time Fitness (LTM – NYSE): Studies show that in times of recession, discretionary monthly expenses like gym memberships are the first to get eliminated. Therefore, I wouldn’t be surprised to see shares of LTM trading under $10.00 by January 2009. Not only that, but consider this: The recent dramatic falls in stock prices have forced a number of CEOs to sell off significant portions of their personal company holdings (which are held as collateral on loans to comply with margin requirements). Bob Simpson, CEO of Life Time Fitness, has to sell 30% of his entire LTM stake, which was 2.8 million shares, to unlock $101 million. This paints a bearish picture going forward.

PNC Financial Services Group (PNC – NYSE): Here’s a bank that operates 1,109 branch offices in New Jersey, Washington DC, Maryland, Virginia, Ohio, Kentucky, and Delaware. Last week, they reported net income of $248 million ($0.71 per share), which was down 39% from last year’s $407 million. Now, what intrigued me was this. If you listen to CEO James Rohr, you’ll hear many of the same things we’ve heard from other failed bank CEOs. He said, “During a time of great uncertainty, PNC posted solid third quarter results reflecting the quality of our balance sheet and maintained strong capital and liquidity positions. Our core business activities performed very well and we grew loans, deposits and customer relationships. Credit quality continued to be manageable as we adhered to our strategy of maintaining a moderate risk profile. Nonetheless, PNC was not immune to the effects of market dislocation on certain fair value assets. During these extraordinary times, we continue to believe our business model positions the company for growth.” From a chart perspective, the stock has some room to fall. The only threat is that the Fed could cut rates down to 1%, which would spark a rally in PNC. Therefore, I’ll continue to monitor this stock for an upcoming put-buying opportunity.

UPDATES

Zale ZLC February 20 Puts (ZLC ND): Our puts have already traded higher by 31.48% this week, and I expect more pain going into the holiday season.In the original buy alert, I mistakenly listed this as a January position, but this is indeed a February position. Sorry for any confusion. Hold.

Toyota Motors January 65 Puts (TM MM): Ford and General Motors are at 50-year lows. Toyota will be the next to feel the pain. Our puts have traded higher by 13.10% this week. More gains to come. Hold.

American Capital May 25 Calls (DQS EE): A surprise rate cut by the Fed could snap this position back into the black. Given the May expiration date, it’s my intention to hold this position throughout the market volatility. After all, I believe they’ll emerge as the winner in the financial crisis. Hold.

Excel Maritime March 15 Calls (EKN CC): We locked in half of our profits on Tuesday, which leaves us holding the remaining half for more upside. Hold.

Apex Silver Mines January 2010 2.5 Calls (YSB AZ): The explosive potential remains. Some members have asked why I recommended the option versus buying the stock outright? Either investment could pay off handsomely, so I would consider both recommendations strong plays. Hold.

Southern Peru Copper January 2010 25 Calls (YPV AE), Barrick Gold January 2010 40 Calls (WRX AH), & United States Natural Gas Fund January 40 Calls (UNG AN): Shares of metals remain volatile, as you can see by ABX’s move this week. But I remain bullish on all three positions, especially natural gas going into the winter months. Hold.

America Movil January 2009 70 Calls (AMX AN), Petroleo Brasileiro January 90 Calls (PMJ AR), & Entergy January 140 Calls (ODF AH): Still no signs of life for these three. Since they’re at such nominal values, we might as well hold for a miracle. Hold.

Sincerely,