Short-Term Out-of-the-Money Covered Calls

I periodically employ a conservative 'out-of-the-money covered call' option strategy when I think I can generate some option premium income and I have a strong probability of retaining the underlying security.

Summary

  • Despite BDX’s credit risk being higher than that to which I am accustomed I remain confident the company is on track to have its long-term credit rating upgrade to investment quality.
  • While the raising of additional equity has had the effect of diluting the ownership interest of equity investors I like that management continues to focus on improving the company’s Balance Sheet flexibility.
  • I continue to view BDX as an attractive long-term investment but am of the opinion shares are currently richly valued.
  • I am employing the use of short-term out-of-the-money covered calls in an effort to generate more cash flow from a portion of my BDX holdings.

Introduction

On May 4th I deemed Becton, Dickinson and Company (BDX) shares trading at ~$255 to be richly valued and wrote short-term out-of-the-money June 19th $280 covered calls on a portion of the BDX shares held in an account for which I do not disclose details; I disclosed this trade in this article.

These options have expired worthless meaning I retain 100% of the option premium I collected and I also retain the underlying shares.

In this article I revisit BDX to determine if I should deploy this same strategy so as to ‘skim’ additional income.

Q2 FY2020 Results

On May 7th, BDX released less than stellar Q2 results and also withdrew FY2020 guidance due to the COVID-19 pandemic; BDX’s Q2 investor presentation can be accessed here.

Recent Virtual Investor Conferences

The following are my key takeaways from BDX’s recent investor presentations at the Jefferies, Goldman Sachs, and William Blair virtual conferences.

BDX’s senior management reiterated that BDX is focused on the following 3 key goals:

  • Drive consistent durable revenue growth of 5%+ on a normalized basis;
  • Continued margin expansion of 10%+ EPS growth;
  • Continued improvement in Balance Sheet strength and flexibility.

These goals are to be achieved by focusing on the following 5 strategies:

  • Innovation in areas in which BDX is strongest and where disproportionate new growth opportunities exist which are aligned to key healthcare and technology trends. This will be accomplished through organic innovation, tuck-in M&A, collaborative R&D, and licensing. Management stressed BDX is NOT focused on large scale acquisitions at all for the next few years;
  • BDX will leverage its global footprint - ~40,000 of BDX’s ~65,000 employees are based outside the US and ~45% of revenue is generated outside the US;
  • Leverage/Invest in BDX’s extensive manufacturing and network. Scale and cost in production are extremely important and BDX will continue to invest in new cutting edge technologies and production. The plan is to invest ~$0.9B - $1B annually in capital across BDX’s plants.
  • Double digit EPS growth by focusing on simplifying the company. There are still many opportunities to improve efficiencies from the large Carefusion and C.R. Bard acquisitions. ‘Project Recode’, a comprehensive internal simplification initiative, has been created for this express purpose and expectations are that ~$0.3B in savings will be achieved over the next 4 years.
  • Disciplined capital allocation and increased Balance Sheet flexibility. The top priority over the past 6 years has been in the repayment of debt incurred for the purpose of acquiring Carefusion and C.R. Bard.

On these conference calls, management acknowledged that BDX investors have had a bumpy ride in recent years and, in particular, after the C.R. Bard acquisition.

There have been significant challenges over the past several months such as foreign exchange headwinds, the Alaris Pump Infusion Module issue I touched upon in my February 16th article, and the Chinese government volume based tendering process. Despite these challenges, BDX’s objective to be a leader in key healthcare areas has not changed.

Credit Ratings

BDX’s long-term unsecured debt credit ratings are:

  • Ba1 (Moody’s) which is the upper tier of 3 tiers in the non-investment grade category;
  • BBB (S&P) which is the middle tier of 3 tiers within the lower medium grade category;
  • BBB-(Fitch) which is the lowest of 3 tiers in the lower medium grade category.

As a relatively conservative investor, BDX’s current credit ratings are weaker than what I like to see from the companies in which I invest. I have held shares in BDX for over a decade and my decision to continue to invest in BDX despite its weak credit ratings is because management has stated that a key objective is to restore BDX’s credit rating to ‘investment grade’ and I see progress being made in this regard.

Looking at BDX’s short-term and long-term debt reflected in the 2019 10-K (see pages 97 - 98 of 138) we see $2.446B of debt due in 2020.

When I wrote my February 16th article I indicated that as at FYE2018 (September 30th), BDX’s gross leverage ratio was 3.9 times but as at FYE2019 this had been lowered 3.5 times.

On the Q1 2020 earnings call, BDX disclosed that it had repaid ~$0.9B of debt but the gross leverage ratio remained at 3.5 times; management reaffirmed the company was on track to achieve the commitment to de-lever to below 3 times by December 31, 2020.

On the Q2 2020 Earnings call, management indicated it had taken actions to reinforce BDX’s liquidity position and had successfully completed $1.9B of term loan funding at very favorable rates. This, however, resulted in an increase in BDX’s gross leverage to 3.9 times as at March 31 and may have alarmed some investors given management’s commitment to restore BDX’s credit rating to investment grade levels.

In this May 21st News Release, we see that BDX raised additional equity with the intent ‘to use the proceeds from the offerings for general corporate purposes, which may include, without limitation and in the Company's sole discretion, funding its growth through organic investments and acquisitions, working capital, capital expenditures and repayment of outstanding indebtedness.’

While issuing additional equity has diluted equity investors’ interests, I am of the opinion management has made the right decision given the current environment. BDX will continue to experience near-term pressure and given the company’s current focus on cash conservation and the importance of liquidity, it is imperative that BDX not place itself in a position where it needs to raise money at the most inopportune time.

Although BDX may not reach the deleverage target deadline it set following the acquisition of C.R. Bard, I am relieved that restoring BDX’s investment credit rating is still a priority…even if it takes a bit longer than the original December 31, 2020 target.

Dividends and Dividend Yield

BDX’s dividend and stock split history can be found here; we can expect another $0.79 quarterly dividend to be declared in the 2nd half of July for payment at the end of September.

BDX has limited its dividend increases in recent years to $0.02/quarter/share and I suspect a similar annual dividend increase will remain in effect until such time as BDX’s credit rating has been restored to investment grade.

If you are an existing BDX investor and are disillusioned by ~1.3% dividend yield generated from your BDX holdings, I present later in this article a reasonably conservative option strategy for the purpose of generating additional income.

Valuation

Management has withdrawn guidance making it more difficult to determine BDX’s current valuation. Having said this, I make a rudimentary attempt to determine FY2020 adjusted diluted EPS so as to determine BDX’s forward valuation.

NOTE: BDX’s adjusted diluted EPS results include several line items which result in a material change from reported diluted EPS. While Generally Accepted Accounting Principles (GAAP) offer uniformity in how a company reports its financial performance, income statements reported based on GAAP do not always reflect the ongoing performance of a company’s underlying operations. If, for example, a company writes-down an asset or restructures, there could be large one-time costs that distort earnings.

Although not every investor may agree, my personal observation is that adjusted earnings can overstate earnings but GAAP earnings can understate earnings.

Looking at BDX’s quarterly earnings presentations we see the degree to which BDX’s GAAP diluted EPS results differ from adjusted diluted EPS results.

When I wrote my November 6, 2019 article, BDX reported diluted EPS of $3.89 for FY2019 versus $11.68 of adjusted diluted EPS (see presentation). I disclosed the purchase of additional BDX shares at $248.655 giving us a PE of ~64 versus an adjusted PE of ~21.3. In addition, management’s FY2020 adjusted diluted EPS guidance was $12.50 - $12.65 ($12.575 mid-point) thus resulting in a forward adjusted diluted PE was ~19.77.

When I wrote my February 16, 2020 article, BDX had just reported Q1 2020 diluted EPS of $0.87 versus $2.65 of adjusted diluted EPS  and adjusted diluted EPS guidance for FY2020 had been lowered to $11.90 -$12.10 (see presentation). This lowered guidance was attributed to management’s latest view on FX and the impact of Alaris pumps. BDX’s share price dropped over 10% and I acquired additional shares at ~$249 giving BDX’s valuation range of ~20.58 - ~20.92 based on adjusted earnings guidance; management does not provide guidance on the basis of GAAP.

Looking at Q2 2020 results we see BDX reported diluted EPS of $0.53 versus $2.55 of adjusted diluted EPS for the quarter and diluted EPS of $1.40 versus adjusted diluted EPS of $5.20 for the first half of FY2020. We also see that guidance on an adjusted diluted EPS basis had been withdrawn.

COVID-19 was not declared a pandemic until mid March 2020 so BDX’s results for the first half of FY2020 might end up being slightly stronger than the second half of FY2020. We also have to take into account that BDX has raised additional equity to reduce debt. Although guidance has been withdrawn, I do not think it is totally unreasonable to expect BDX will generate ~$9.85 - $10.05 in adjusted diluted EPS for FY2020.

My adjusted diluted EPS range for FY2020 is certainly open for debate but until such time as I see Q3 results which are to be released in August I will use this range for my immediate purposes. With shares currently trading at ~$234.75, BDX’s forward adjusted diluted PE is ~23.4 – 23.84.

BDX’s valuation is trending up and has reached a level where I am not prepared to acquire additional shares other than through the automatic reinvestment of dividends. I do, however, wish to generate additional income while I wait for BDX’s valuation to retrace to a level at which I am prepared to acquire additional shares so…..

Covered Calls

I am employing the use of out-of-the-money short-term covered calls; I recently wrote out-of-the-money covered calls against some of my underlying BDX shares so as to ‘skim’ additional income. This strategy worked well as I was able to retain my underlying shares and 100% of the option premium I collected.

Now that BDX’s share price has pulled back from the ~$255 level when I wrote covered calls in early May, I have written July 17th $250 calls which has generated $ 1.85/share in option premium (before nominal commission).

In this current market environment it is entirely possible BDX’s share price could be bid up even though I think shares are currently richly valued. While I could have selected a strike price closer to the current strike price I do not want to retain my underlying shares. I am employing this option strategy merely to ‘skim’ additional income.

On the flip side, I could have selected a higher strike price but the option premiums are negligible at the $260 level and, currently, there is little open interest at the $255 level.

Final Thoughts

Although some investors might not agree with management’s decision to raise additional equity because that has the effect of diluting their ownership interest, I am pleased that management remains focused on debt repayment and positioning the company to withstand challenges which may come about during the current difficult business environment.

I continue to view BDX as an attractive long-term investment. I do not, however, think the current valuation is reasonable for me to acquire additional shares other than through automatic dividend reinvestment. Until such time as BDX’s valuation becomes attractive I am prepared to consider writing short-term out-of-the-money covered calls to increase my cash flow generated from my underlying shares.

I wish you much success on your journey to financial freedom.

Thanks for reading!

Note: I sincerely appreciate the time you took to read this article. Please send any feedback, corrections, or questions to [email protected].

Disclaimer: I have no knowledge of your individual circumstances and am not providing individualized advice or recommendations. I encourage you not to make any investment decision without conducting your own research and due diligence. You should also consult your financial advisor about your specific situation.

Disclosure: I am long BDX.

I wrote this article myself and it expresses my own opinions. I am not receiving compensation for it and have no business relationship with any company whose stock is mentioned in this article.