PepsiCo, Inc. (PEP) has just released Q2 2019 results and reaffirmed FY2019 guidance. In its July 9, 2019 Earnings Release, PEP's Chairman and CEO indicated efforts are being made to make PEP a faster, stronger and better company by building new capabilities, strengthening brands, adding capacity to grow and transforming the culture.

I view PEP as a company that will merely continue to plod along.

Summary

  • In my April 23rd article I disclosed that I had written October 2019 $130 covered calls and my reasons for such a decision.
  • I view PEP as a company which just 'plods' along and which is currently overvalued.
  • It is not my intent to liquidate my PEP holdings but I currently have no intention of adding to my position other than through the automatic reinvestment of dividends.

Introduction

With the release of PepsiCo, Inc.'s (PEP) Q2 results for the 24 week (just under a full half year)  period ending June 15, 2019 (the 15th is not a typo) and the surge in PEP's share price subsequent to me writing October 18, 2019 $130 covered calls I thought this would be an opportune time to quickly look at PEP; click on the following links to access my two previous PEP posts (February 17, 2018 post and April 23, 2019 post).

Interestingly, PEP's Chairman and CEO indicated in the July 9th Q2 2019 Earnings Release that:

'We are also pleased with the progress on our priorities to make PepsiCo a faster, stronger and better company by building new capabilities, strengthening our brands, adding capacity to grow and transforming our culture. Our performance for the first half and the progress we are making on our strategic priorities give us increased confidence in achieving the 2019 financial targets we communicated earlier this year.'

I understand his position given his leadership role in the company but when I look at PEP's brand portfolio and see how an increasing number of people are beginning to pay closer attention to the nutritional value of the products they consume, I can't say that I view PEP as a company that will do much more than 'plod' along.

I know PEP devotes a section of its website to 'Nutrition' but when I look at the products PEP deems to be nutritional it appears that we have a difference of opinion. I never buy PEP products but I will go down the aisles in the grocery stores where its products are displayed for interest sake. When I look at the 'expiry date' on PEP’s products I KNOW I don't even have to look at the list of ingredients to know that stuff is in PEP’s products are not on the 'good for you' list.

Having said this, I will readily admit that I am not the world’s 'most ethical investor'. Were I the 'world’s most ethical' investor I probably would not have retired in my mid 50s as I would have likely passed on investing in many companies within our portfolio; you can probably find something with just about every publicly traded company that a 'purely ethical investor' would deem as a reason not to invest. I have, in essence, tried to find a healthy balance….invest in decent companies that do their best not to run afoul of the law and which do what they can to make the world a little better.

I digress….

When I wrote my April 23, 2019 post, PEP shares were trading at ~$127. At the time of that article I wrote:

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.

Based on management's guidance, current market conditions, and my opinion on PEP's valuation at the time, 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;
  • generate a small amount of downside protection if PEP's stock price declined.

In the portion of the article viewable by subscribers I disclosed the covered call option strategy I had decided to employ. NOTE: When employing covered calls you must own the underlying shares.

I decided to sell 4 October 2019 $130 covered calls as opposed to a shorter expiry to generate more time premium. In addition, I chose the $130 strike price which was 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 always look at my breakeven point at being the strike price plus the premium I received.

In presenting potential outcomes regarding the covered call options I had sold, I provided the following outcomes 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 indicated that it was not my intent to part with my PEP shares so I indicated I would need to determine what course of action to take based on where PEP would be trading in mid-October 2018.

So….what has happened subsequent to my April 23, 2019 article? Well, in these crazy market conditions PEP's share price has appreciated and it briefly exceeded $135 (late June). The share price, however, has subsequently retraced slightly and as I compose this article I see shares are trading at ~$131. I still have over 3 months before the covered calls expire and anything can happen between now and then. As for now, however, my option trade is profitable.

For the sake of full disclosure, the last time I ranked all my holdings and the respective weighting of each holding within the overall portfolio, PEP was my 30th largest holding. I am not about to perform this exercise again at this time but following a brief review of all our holdings held in multiple accounts, it appears that PEP is no longer one of our top 30 holdings. (cont'd.)

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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 and KO.

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.