A Giant Stumbles and Sets Up a Giant Trade
Procter & Gamble Co. (NYSE: PG) reported a profit of nearly $2.9 billion for the first quarter of the company’s fiscal year. This was an increase of 5% over the same period the previous year. Earnings per share (EPS) were $1.09, up by 6% compared to a year ago.
EPS were also better than expected. Analysts had been expecting EPS of $1.08.
Revenue was also up compared to a year ago. Revenue of $16.65 billion was a 1% increase compared to the same three months a year ago. However, revenue came in slightly below analysts’ expectations which were for $16.7 billion in sales.
“First quarter sales and earnings results were in line with our going-in expectations and keep us on track to deliver our targets for the fiscal year,” CEO David Taylor said in a statement issued by P&G. He added, “We delivered organic sales growth in a decelerating global market and against a relatively strong base period.”
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But, Results Weren’t Good Enough for Some
P&G has been the target of activist investor Nelson Peltz, who led a proxy battle against the company’s current management. Peltz seemed to lose the vote for a board seat which was held on October 10 by a close margin, estimated to be about 0.3%. Results won’t be official for several weeks.
Despite the setback, Peltz who owns about $3.5 billion of PG stock through his firm, Trian Fund Management, remains focused on P&G’s financial performance. PG is the sixth largest investment in Train’s portfolio.
Peltz has pushed for changes he believes will drive the company’s profit margins up. Among his recommendations, according to Bloomberg, Peltz wants cost cutting at P&G to be redirected to ensure it improves earnings and sales growth.
He claims $10 billion in savings management achieved under a 2012 productivity drive has yet to improve the company’s operating results. Peltz believes the board will help ensure the current target of $12 billion to $13 billion in savings will be used more effectively.
Peltz explained his beliefs in a white paper which did show that P&G is trailing its peers in growth.
Source: Train Fund Management
Peltz also pointed out that he has experience helping companies grow, citing the track record of companies whose Board of Directors he served on. The chart below shows total shareholder returns (TSR) for those companies compared to PG.
Source: Train Fund Management
PG is not impressed and believes they can do better on their own. Jon Moeller, Procter & Gamble’s chief financial officer said that some big institutional investors told him they support the company’s turnaround plan but want P&G to speed it up.
Management also cited improvements in the most recent quarter. The biggest boost in revenue for the recently ended quarter was seen in P&G’s beauty division, which reported a 5% increase in organic sales versus a year ago.
Other results were less helpful to the company’s arguments. The grooming segment saw organic sales decline by 6%, which was attributed to lower sales in shave care. However, Braun electric shavers saw organic sales increase by double digits.
Results of other divisions were mixed. Fabric & home care organic sales rose 2%, while health care saw a 1% rise. Organic sales fell 1% for the baby, feminine & family care division of P&G.
Operating cash flow was $3.6 billion for the quarter. Free cash flow productivity was reported to be 87%. The company returned $4.3 billion of cash to shareholders through $1.8 billion in dividend payments and $2.5 billion through the buyback of shares of common stock.
Traders Sell on the News
After the earnings were released, sellers quickly took the upper hand in the market. The stock gapped down a little more than 2% on the open.
This continues a pattern of weakness seen in the stock for the past month.
As traders, the question is always “what’s next?” since that is where profits can be realized. In this case, there seems to be little chance that PG will recover to its old highs until major news is announced. This could take time.
The stock’s recent trend has been down, reflecting broad concerns about the company’s profit margins and growth compared to other companies in its industry. These issues were highlighted by Peltz and are now likely to remain in place until he concedes that he is satisfied with PG’s plans.
As the chart shows, PG is in a downtrend and its recent selloff led to increased volatility. The higher volatility seen after the news of the disappointing earnings increased options premiums even more. This is normal when a steep selloff occurs.
Now, put options are trading at high prices. Those high prices suggest an alternative strategy. The option premium is high because the expected volatility of the stock is high. Options that are based on selling an option can benefit from high volatility. In this case, with a bearish outlook, a call option should be sold.
Selling options can involve a great deal of risk. A spread options strategy can be used to limit the potential risk of the trade.
One strategy that is important to consider is the bear call spread. This trade uses two calls with the same expiration date but different exercise prices. Traders buy one call and sell another call. The exercise price of the call you sell will be below the exercise price of the long call, so this strategy will always generate a credit when it is opened.
The risk profile of this trading strategy is summarized in the diagram below.
Source: The Options Industry Council
The trade has limited up side potential and limited risk. But, this strategy will allow traders to generate potential gains in a stock they might otherwise find too risky to trade.
The maximum potential gain with this strategy is equal to the amount of premium received when the trade is opened. The maximum loss is equal to the difference between the exercise price of the options contracts less the premium received.
A Bear Call Spread in PG
For PG, we could sell a November 3 $89 call for about $0.30 and buy a November 3 $90 call for about $0.15. This trade generates a credit of $15, which is the difference in the amount of premium for the call that is sold and the call that is bought multiplied by 100 since each contract covers 100 shares.
The credit received when the trade is opened, $15 in this case, is the maximum potential profit on the trade.
The maximum risk on the trade is $85. The risk is found by subtracting the difference in the strike prices ($100 or $1.00 time 100 since each contract covers 100 shares) and then subtracting the premium received ($15).
This trade offers a return of about 17% for a holding period that is about two weeks. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if PG is below $89 when the options expire, a likely event given the stock’s trend.
Call spreads can be used to generate high returns on small amounts of capital several times a year, offering larger percentage gains for small investors willing to accept the risks of this strategy. Those risks, in dollar terms, are relatively small, about $85 for this trade in PG.
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