HSY - Option Strategy

The Hershey Company's (HSY) share price has appreciated rapidly in a very short timeframe for no justifiable reason.

A Bear Call Spread option strategy can be employed if you think HSY is overvalued and its share price will pullback.

Summary

  • HSY released Q1 2019 results on April 25, 2019 and its share price jumped $5.37 or 4.59% from the previous day’s close even though FY2019 guidance was reaffirmed.
  • HSY is not a high growth business but the recent behavior in its share price would suggest otherwise.
  • I view HSY as being overvalued and on this basis I initiated out-of-the-money covered calls toward the end of March.
  • I present a potential option trade for consideration if you think HSY’s share price will pullback and you do not wish to go long HSY.

Introduction

On March 26, 2019 I wrote an article in which I indicated that I was writing covered calls on 2 companies of which The Hershey Company (NYSE: HSY) was one.

At the time of that article, HSY was trading at ~$113. I knew HSY would be releasing Q1 results toward the end of April and purposely wrote calls with a $120 strike price as I thought this would give me a sufficient buffer in the event HSY’s share price popped following the earnings release.

Fast forward to April 25th and HSY’s share price has gone parabolic having closed at $122.44. I am now underwater on these covered calls but they do not expire until May 17th and I think HSY’s share price will pullback before expiry.

I have mentioned in previous articles that the behavior of some investors reminds me of the dot.com bubble. While some companies are producing record breaking results and exceeding earnings estimates, there are many companies whose stock prices are setting new highs for no apparent logical reason.

Case in point (my opinion)…HSY.

Here is a company which provided guidance at the end of January 2019 and was trading in the $105 range. Fast forward to mid March and it was trading at ~$110. Fast forward to the release of Q1 results where guidance has been reaffirmed (not raised!) and HSY is trading at over $17/share higher than late January.

I am of the opinion that HSY is richly valued and a share price pullback is highly likely following the recent rapid run-up.

If you are of a similar opinion and do not own the underlying shares yet want to profit from a potential pullback in HSY’s share price, I present a relatively low risk bearish option trade for your consideration.

Q1 2019 Results and Guidance

HSY’s Q1 2019 results can be accessed here.

HSY’s comprehensive February 20, 2019 CAGNY Conference presentation can be accessed here.

Valuation

I have calculated HSY’s valuation over the past several quarters using guidance provided in HSY’s quarterly earnings releases. The purpose of this exercise is to compare HSY’s current valuation based on the most recent guidance relative to valuation at the time guidance was provided for several recent previous quarters.

HSY Valuation

HSY’s valuation based on current guidance is similar to that of Q4 2016 – Q3 2017. I am of the opinion, however, that HSY was somewhat expensive during those 4 quarters.

NOTE: HSY’s valuation was distorted in 2016 when Mondelez proposed to merge with HSY in June 2016. This proposal was quickly declined by HSY and Mondelez dropped its offer in late August 2016.

I think we are currently witnessing a wave of irrational exuberance which has resulted in the surge of many a company’s share price; HSY appears to have been caught up in this wave.

HSY is certainly not a high growth company and a PE of ~20.5 seems to be more appropriate than just shy of 22 which is what we get if we use the mid-point of Full Year EPS Guidance. If I use projected diluted EPS of $5.66 and a ~20.5 PE then a price closer to $116 seems more reasonable than the current $122.44.

Credit Ratings

Moody’s continues to rate HSY’s long-term debt A1 and S&P Global continues to rate it A.

Moody’s rating is the top tier of the upper medium grade category while S&P’s rating is the middle tier of the upper medium grade category.

Both ratings are satisfactory for my purposes.

Recent Historical Performance

If you want to see the extent to which HSY’s share price has changed relative to the S&P500, click on this link and plug in a relatively recent start date. Choose October 1, 2018, for example, and you will see the extent to which HSY’s share price has appreciated relative to the broad index.

Dividend, Dividend Yield, and Dividend Payout Ratio

HSY’s dividend history can be found here and its stock split history can be found here.

In my October 2018 article I indicated that HSY’s $2.756 dividend as reported on HSY’s website provided investors with a yield of ~2.63% based on the $102.52 stock price. That was just shy of 0.5% lower than when I wrote my June 6, 2018 article.

With HSY having just closed at $122.44, the current $2.756 annual dividend provides investors with a dividend yield of ~2.25%.

HSY typically announces an increase in its dividend in Q2. Looking at the compound annual growth rate of HSY’s dividend I anticipate a ~8% increase to ~$2.98.

A $2.98 annual dividend would provide investors with a ~2.43% dividend yield. While an improvement from the current dividend yield it is still lower than what HSY investors were receiving a few quarters ago.

On the dividend payout ratio front, the current $2.756 annual dividend is ~49% of HSY’s $5.58 FY2019 projected EPS mid-point. This payout ratio increases to ~53.4% if we use my projected ~$2.98 annual dividend. This is not entirely out of line with the dividend payout ratio in previous years.

Option Strategies

Covered Call Option Strategy

Details of the $120 May 17, 2019 covered calls I wrote on HSY can be found in my March 26, 2019 article. At the time of that article HSY was trading at ~$113. I collected a $1.13/share premium (before nominal commission) giving me a ~$121.13/share breakeven. With HSY having just closed at $122.44 I am slightly underwater.

I am not about to take any action on these covered calls at this juncture as I think HSY’s share price will pullback below $120 between now and the May 17, 2019 expiry.

Should shares not pullback below my $120 strike price I will most likely close out my position before expiry and will write new covered calls with a higher strike price further out on the calendar.

Bear Call Spread Option Strategy

If you are of the opinion HSY is overvalued and you do not own the underlying shares you may wish to consider employing a Bear Call Spread. This provides you with the opportunity to profit from a neutral to bearish price action in HSY’s stock.

You can select from various expiry dates and strike prices but I provide this example for illustrative purposes.

Sell 1 HSY $125 August 16, 2019 call and receive $3.49/share or $349/contract

Buy 1 HSY $130 August 16, 2019 call and pay $1.93/share or $193/contract

When you place these two trades you will end up with $1.56/share or $156/contract credited to your brokerage account.

NOTE: Brokerage fees are excluded in these calculations

Breakeven Level

Your breakeven level is $125 + $1.56/share = $126.56/share.

Maximum Profit

You maximize your profit if HSY’s stock price is at or below $125 (the lower strike price) at expiration and both calls expire worthless.

No investor will exercise their right to acquire shares from you at $125 if HSY is trading below that level and you will not exercise your right to acquire shares at $130.

Your maximum profit is, therefore, the $156/contract you collected when you wrote the options.

Maximum Risk

This maximum risk is realized if the stock price is at or above $130 at expiration and is equal to the difference between the strike prices minus the net credit you received when you placed your option trades.

($125 - $130) plus ($3.49 - $1.93)

($5) + $1.56 = ($3.44)/share or ($344)/contract

Let’s assume HSY is trading at $140. Someone has purchased the right to acquire shares from you at $125. While you are down $15/share ($140 - $125) or $1500/contract, you purchased an option to acquire shares at $130 versus $140 so you are ahead $10/share or $1000/contract.

($15) + $10 + $1.56 = ($3.44)/share or ($344)/contract

Benefits

This strategy can be employed if you do not want to directly own HSY shares but want to profit from your bearish position on HSY. Spreads are attractive because you know ahead of time your:

  • Breakeven
  • Maximum profit
  • Maximum risk

Risks

I would, however, be remiss if I did not advise you of the potential risks you need to consider. This article explains Bear Call Spreads in a bit more detail and discloses the risks associated with the use of this option strategy.

Final Thoughts

I view HSY as a company which might appeal to investors who are looking to invest in a company which will exhibit a low level of volatility relative to many other publicly traded companies.

I think the recent surge in HSY’s stock price is overdone. If you are in agreement that a pullback is highly likely, you may wish to consider initiating a Bear Call Spread; I have provided one possible trade for your consideration.

There is always an element of risk when you trade equities and options, and therefore, I encourage you to weigh the risks of the option trade I have presented.

Although I present a Bear Call Spread strategy for your consideration, it is not my intent to initiate such a trade as I already have written covered calls to skim additional income from my HSY shares.

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 charles@financialfreedomisajourney.com.

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 HSY.

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.