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Trades

A Contrarian Take on Coke’s Seemingly Great Quarter

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Investors are swarming all over shares of Coca-Cola (KO) today after it announced better than expected revenues and earnings in the first quarter of 2019. But that explosion of new investment capital could be misplaced.

There’s no doubt that beating Wall Street analyst estimates is a good way to boost your share price. But it is also taken as a sign that a company can do no wrong… and we all know that’s not true.

Coke is one of those companies that seemingly has always been great to own and offers nonstop price appreciation. While that’s often true, there are always times where you don’t necessarily want to be building up your position in the company. Now is one of those times.

Now, we’re not saying that Coke is a bad company to own. But right now, it is clearly overbought. Just take a look at the numbers.

Earnings grew to 48 cents in the first quarter, bringing its trailing 12 months’ total to $2.09. That gives the company a price to earnings ratio of 23. And that’s using only favorable adjusted earnings figures.

To put that in perspective, Apple – a growing tech company – has a P/E of just 17. Tech is supposed to be pricier than a slow-grow consumer staple like Coke. But it’s not.

You could easily argue that investors have been favoring the company because of its relative recession resistance. It is not the kind of company that would be affected by slower economic numbers like we’re seeing in major markets like Europe and Asia. But this still doesn’t paint the whole picture.

Coke blew away investors with a better than expected quarter. But in reality, it only grew its bottom line 2%… or just one penny per share. That’s not exactly exciting.

What’s more is the real issue with its financials. It has far too many expenses for what it actually brings in. Take its dividend for instance.

The company pays $6.6 billion in dividends each year – a number that will only ever go up. Yet it takes in just $6 billion in free cash flow. In fact, this quarter saw an actual decline in free cash flow. Meaning, it was already upside down on its dividend payments and only getting worse.

That’s not to say the company is suffering or won’t be able to find the cash to meet investors demand for steadily-rising dividends. But it makes the financials less comfortable.

The other issue the company noted that raise our eyebrows was over Brexit. The company noted four separate times in its press release this morning that it saw a favorable inventory build up at its bottling operations due to the timing of Brexit (which was ultimately delayed). In fact, it notes that more than one-third of its sales growth in the quarter came from this one situation.

That doesn’t bode well for a company this massive and global. Brexit shouldn’t really be making that kind of impact for this size of company before the country even leaves the EU.

All of this leads us to believe that the company is likely due for a slight correction after today’s analyst beat enthusiasm dies down. But, that’s not to say anyone should go out and short shares of the beverage giant. Coke, after all, is not a company going anywhere anytime soon. It is just due for a small pull back.

Fortunately, there’s a strategy for that.

A Strategy For Short Term Bears

A bear put spread is a type of options trade that involves buying one put option on a stock you believe is due for a correction and selling a second put on it with a lower strike price.

What this does is let you profit as share prices fall, but not need to put up as much capital at risk as simply buying the first put outright. The sold put option provides a small amount of income to help you reduce the total cost of the trade.

In exchange for that reduction of money at risk, the potential maximum profit is capped. But for a company like Coca-Cola, that’s a trade off definitely worth taking. After all, it’s not like shares of KO are likely to crash from here. But a retraction of a few dollars off its current rally price is likely.

You can see how this type of trade looks like on paper:

bearputspread

Source: The Options Industry Council

As you can see, the most you ever have at risk is known right up front… the entry cost of the trade. The profit is capped, but can still be larger than the amount at risk. For Coke, that’s the case.

Let’s look at a specific example.

A Specific Play on KO

A trader looking to use this strategy to play the expected slight correction in shares of KO could buy a June 21 $48 put for $1.01 per share and sell a June 21 $46 put for $0.39 per share for a net debit of $0.62 per share.

Since each of these put options are worth 100 shares of KO, that’s a total cost of just $62 for this trade. That’s the most the trader would have at risk for the whole duration of this investment. For it to turn to a profit, shares of Coke would only have to dip a small amount from here.

In fact, for this trade to maximize the trader’s profit, shares would only have to fall from their current $48 price tag to $46 – a move of just 4.2% over the next two months.

To find out how much that potential profit is, take the difference in strike prices ($48 – $46 = $2) and subtract the entry cost ($2 – $0.62 = $1.38). On 100 shares, that’s a potential return of $138.

Remember, this trade only cost $62 to get in. So, that works out to a potential return of 223% on the amount at risk. Very few places can you find an opportunity to triple your money using shares of Coke. And with its current rally, this is one of the best ways to take advantage of it.

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