Name That Trade – $KO: Pour Some Sugar On Me

by Dan June 11, 2015 1:27 pm • Commentary

To state the obvious, shares of Coca-Cola (KO) have under-performed in 2015, down 5% vs the S&P 500 (SPX ) up 2.5%.  This should not come as a surprise to most as there are no shortage of large cap U.S. multinationals, specifically consumer staples, that have not kept pace as their earnings and sales adjust to the new found strength of the U.S. dollar.

Interestingly, KO has rallied on days when it’s giving weaker than expected forward guidance (in early February and late April). But the stock is now flirting with new lows on the year, down almost 9% from the January highs:

KO 1yr chart from Bloomberg
KO 1yr chart from Bloomberg

To drive home the importance of the $40 support level, a 7 year chart (below) shows the stock this year breaking the uptrend that has been in place since the financial crisis lows:

KO yr chart from Bloomberg
KO yr chart from Bloomberg

Earnings and sales are expected to decline 2% this year, with analysts calling for a 6% increase in earnings in 2016 and a 3% rise in sales.  KO shares trade at 20x this year’s expected earnings of $2, which would be a penny below the 7 cent range of annual earnings over the prior 3 years.

The company has an aggressive commitment to capital return, in Q1 they doled out $1.8 billion in the form of buybacks and dividends, which is meaningful when you consider they generated $1.1 billion in free cash flow during the period. It’s not hard to imagine where stocks like KO would be trading if they were not actively managing earnings and putting a bid under the shares.

The next identifiable catalyst for KO will be their Q2 results, due in the last week of July (yet to be confirmed).  I suspect a miss is priced in the stock, but a meaningful guide down of forward guidance is not.

Options traders don’t seem to bothered by the poor technical set up and the challenged earnings picture, with 30 day at the money implied vol (the price of options, blue below) approaching 2015 lows, with the backdrop of realized volatility (how much the stock has been moving, white line) having just made 52 week lows:

KO 1yr chart of 30 day at the money implied vol (blue) vs 30 day realized vol (white) from Bloomberg
KO 1yr chart of 30 day at the money implied vol (blue) vs 30 day realized vol (white) from Bloomberg

If I thought the stock was very near breaking long term support, I would look for very near the money participation. The stock is a tad depressed at the moment, but on a bounce to $41 I might consider the following sort of trade:

Hypothetical Trade: KO ($40.18) Buy to open July 24th weekly 40 puts at .67

Break-Even on July 24th weekly Expiration:

Profits: below 39.33, down 2%

Losses: up to .67 between 39.33 and 40 with max loss of .67 at 40 or higher. Risking 1.7% of the underlying stock price.

Rationale:  One reason to wait for a bounce is to give a little more time so that the company can confirm their reporting date. While the likelihood is that the company reports by July 24th there are no guarantees. Owning July 24th options only to see the company announce their reporting date after that date would mean watching vol come in hard and premium erode in that expiration. We considered going out to August which is sure to capture earnings but the trade is meant to isolate earnings and there’s no need to spend more money for that extra time.

Short premium strategies make little sense here with vol as low as it is, and near the money options are very dollar cheap.

Stay tuned, this is a very interesting trade set up in our opinion.