PEP covered call strategy

Summary

  • PEP released its Q1 2019 results on April 17, 2019 and the share price jumped to a new 52-week high.
  • I view PEP as richly valued considering it is a mature company in the low growth packaged foods industry.
  • My opinion is that an overall market pullback will occur within the next 6 months.
  • I think PEP’s share price will behave defensively but the share price will experience a modest pullback.

Introduction

Following PepsiCo, Inc.’s (PEP) release of its Q1 results on April 17th I initiated a conservative out-of-the-money covered call  option trade the morning of April 18th. My preference is to provide timely updates on my investment decisions but moments after placing my PEP covered call trade we left town to visit friends and family for the Easter weekend; we  returned home April 23rd.

The last time I reviewed PEP was in this February 17, 2018 post. In that post I discussed how PEP was rewarding shareholders despite its challenges and noted that:

  • PEP’s products are sold in 200+ countries and territories;
  • it has 22 billion-dollar brands;
  • it holds a low 20% market share.

North American carbonated soft drink consumption continues to be sluggish and ever increasing competition from niche players has presented PEP with recent volume challenges. Its brand strength, however, remains intact.

PEP is expanding its international presence and product portfolio. Significant investment is being made in developing e-commerce capabilities. In addition, PEP is spending heavily on R&D and it continues to innovate among its ancillary brands as evidenced by a host of new products.

At the time of my previous PEP post, shares were trading at ~$111. Fast forward to April 17, 2019 and PEP’s share price jumped $4.60/share to a new high of ~$127.

Based on management’s guidance, current market conditions, and my opinion on PEP’s valuation I decided to initiate a covered call on some of our underlying PEP shares. My rationale for writing covered calls was to:

  • collect cash income at the time of the trade;
  • get a small amount of downside protection if PEP’s stock price declines.

Covered calls do NOT protect me in the event PEP’s share price plunges.

Should PEP’s share price skyrocket prior to expiry of the options I wrote I will need to take appropriate action so my shares do not get called away.

Let's look at what are the possible outcomes using various stock prices.

Q1 2019 Financial Results

The supporting material related to PEP’s Q1 2019 Earnings Release can be accessed here.

Credit Ratings

Moody’s continues to assign an A1 rating to PEP’s long-term debt and Standard & Poor’s continues to rate PEP’s long-term debt A+. Both ratings are the top tier of the upper medium grade and are satisfactory for my purposes.

Dividend and Dividend Yield

PEP’s dividend history can be accessed here. As I compose this article I see PEP’s dividend history has not been updated to reflect the 15.2% increase in PEP’s quarterly dividend which was announced February 13, 2019.

The new $3.71 annual dividend currently provides investors with a ~2.93% dividend yield based on the current ~$127 stock price.

Valuation

As per the Q1 2019 Earnings Release, guidance calls for 2019 adjusted core EPS of $5.50 which is a 3% decrease compared to 2018 adjusted core EPS of $5.66. Reported diluted EPS for FY2018 was $8.78 but if you look at page 6 of 7 in this document you will see various adjustments.

I also note that the mean adjusted FY2019 EPS estimate based on estimates from 25 analysts is $5.52. Another source from which I access earnings estimates reflects a consensus estimate of $5.67.

If we use the current ~$127 share price and the consensus earnings estimate reflected above we arrive at a forward adjusted PE range of ~22.4 - ~23. Using management’s guidance we get a forward PE of ~23.

I view PEP as currently being fairly valued based on the above forward adjusted PE levels.

Covered Call Option Strategy

When employing covered calls you must own the underlying shares.

I sold October 2019 $130 calls as opposed to a shorter expiry because the further out I go on the calendar the more time premium I receive. Look at the option premiums for calls with expiry dates prior to October.

In addition, I chose the $130 strike price which is slightly higher than the current market price to allow for a potential slight uptick in PEP’s stock price. I could have written a covered call with a $135 strike price but I would have received less of an upfront premium.

In exchange for writing the October 2019 $130 covered calls I received $3.50/share or $350 per contract (excludes nominal service charges).

Although the book value of my PEP shares is less than half the current market value I look at my breakeven point at being the strike price plus the premium I received.

Let’s look at my outcome using different stock prices.

  • If shares are trading below $130 then I retain the premium I collected AND my shares. Nobody in their right mind would buy PEP shares at $130 if they could acquire shares on the open market for less than $130.
  • If shares are trading at $131 and the buyer of the calls exercises their right to buy shares from me at $130 then I would be ahead $2.50/share ($131 – ($130 + $3.50)).
  • If shares are trading at $132 and the buyer of the calls exercises their right to buy shares from me at $130 then I would be ahead $1.50/share ($132 – ($130 + $3.50)).
  • If shares are trading at $133.50 and the buyer of the calls exercises their right to buy shares from me at $130 then I breakeven ($133.5 – ($130 + $3.50)).
  • If shares are trading at $140 and the buyer of the calls exercises their right to buy shares from me at $130 then I would be down $6.50/share ($140 – ($130 + $3.50)).

I do not want to part with my shares so as we approach expiry I will need to determine what course of action I wish to take based on where PEP is trading.

I have written various articles in which the underlying shares have closed below my strike price. That investment decision is easy….let the options expire worthless.

Not all my covered calls, however, have worked out as planned. You can see what I have previously done with my BDX, NKE, and MA covered calls.

Final Thoughts

Covered calls can be employed when you own the underlying shares and wish to skim some additional income.

If you are unfamiliar with covered calls you may wish to read this article in which a good high level overview (including pros and cons) is provided.

In my opinion it is always prudent to run through ‘what if’ scenarios before employing ‘live’ option strategies.

I am fully cognizant that not every investment decision will pan out as planned. However, through the prudent use of option strategies (I prefer to use relatively conservative option strategies) you can improve your investment returns.

I hope you found this article helpful and 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 PEP.

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.