Event: Pepsi (PEP) will report Q2 results tomorrow morning before the open. The options market is implying only a 2% one day post earnings move in either direction, which is rich to the 4 qtr average one day move of only 80 bps, but in line with the 10 year average.
Price Action / Techncials: Shares of PEP have outperformed the broad market in 2016, up 5.5% vs the SPX up 2.5%, but has lagged the Consumer Staples sector etf, the XLP, which is up 10.5% ytd. XLP has been propelled by heavy weightings in tobacco stocks.
PEP has been range-bound in 2016, while also making two higher all time highs. That’s very impressive considering all we’ve seen in the broader market during that time. The stock has found some technical resistance at the prior highs, and a good bit of support at the nice round number of $100:[caption id="attachment_64814" align="aligncenter" width="600"] PEP 1yr chart from Bloomberg[/caption]
Taking a longer term view, the stock is now at the tippy-top of the uptrend that has been in place since the stock’s 2009 lows, with a re-tracement back to the two year uptrend some where very near the mid $90s, with very healthy support at $90:[caption id="attachment_64815" align="aligncenter" width="600"] PEP since 2008 from Bloomberg[/caption]
My View into the Print: PEP is one of those stocks that confounds me. It’s a consumer staple, but its product line-up stills skews way too far to the wrong side of history as it relates to consumer health choices. PEP trades at 22.5x expected 2016 eps that should grow 3% yoy on flat sales growth, following 2015’s 5% decline.
With 45% of their sales coming from outside the U.S. currency movements will have a big effect on results, but likely a greater impact on forward guidance given the dramatic moves of late. Back on April 18th when the company reported Q1 results, they had the following to say about adverse currency effects for the balance of 2016:
Based on current foreign exchange market consensus rates, foreign exchange translation to negatively impact reported net revenue growth by 4 percentage points;
The day the company gave that guidance the U.S. Dollar index (DXY) closed at $94.50, down about 5% from its 2016 highs, a little less than 2% from today’s levels.
PEP has managed earnings fairly effectively given the recent sales malaise, guiding to $3 billion in share buybacks in 2016, using all of their expected $7 billion in free cash flow for capital return (including about $4 billion for dividends, with the stock sporting an annual div yield of 2.8%). So I get the capital return yield, but remember what investors are paying for that.
But consumer staples stocks have been working in this environment, the second best performing sector in the SPX behind utilities in 2016. The one year chart speaks to the potential for a breakout if the company is able to print upside guidance, while the long term chart shows potential for a pull back to $100 if the company were to guide lower. Which is why we think it makes sense to define one’s risk if looking to make a directional bet prior to tomorrow’s earnings.
So What’s the Trade?
For those looking to play PEP for a breakout but with defined risk we like looking to August and an in-the-money call butterfly:
PEP (106.20) Buy the August 105/110/115 call fly for for 1.70
- Buy 1 August 105 call for 3.05
- Sell 2 August 110 calls at .70 (1.40 total)
- Buy 1 August 115 call for .05
Break-even on August expiration:
Losses of up to 1.70 below 106.70 with max loss of 1.70 below 105.
Gains of up to 3.30 above 106.70 and below 113.30 with max gain of 3.30 at 110.
Rationale – This defines risk near the all time highs at just 1.6% of the underlying with potential gains about twice that. If the stock fails at the highs over the next few months the most that can be lost is 1.70 but you can participate like stock up to 110 on August expiration. Profits lessen above 110 but there’s a lot of room for this trade to work if the stock goes higher because it’s not the type to go parabolic or gap. 110 seems like a realistic area to target on a breakout, and if wrong, only risking 1.70 is safer than owning stock near the highs.