When a Fortune 500 company’s best days in the market come during what would normally be a routine debt refinancing, you know things have gotten pretty bad. When investors are keener to see credit extended than to even expect any sort of profits, you know the company has fallen on hard times. For Kraft Heinz (KHC), that’s the case.
If you haven’t followed the saga of Kraft over the last year, I don’t blame you. It’s been a sad one. The company has dealt with accounting errors, significant multibillion-dollar asset writedowns and a surge of shareholder selling. And that doesn’t even touch on its dividend cut or its net income lapsing into red territory.
While other multinational food companies haven’t had a very good 12 or 18 months, Kraft’s story has been the worst. Now, its second-largest shareholder just reported it is selling KHC shares en masse.
Kraft is down 3.7%, as I write, on news that 3G Capital Partners continued to reduce its investment in it by more than 25 million shares over the last quarter. That sounds bad, and it is… but the real problem is that the private equity firm still holds a 20% stake in KHC. Meaning, if it is bearish now, just wait until it cashes out more… potentially one-fifth of Kraft’s shares.
The only real savior through this incredibly tough period for Kraft has been Warren Buffett’s Berkshire Hathaway. Berkshire is the largest shareholder with a 26.7% stake. And Buffett has been nothing but a cheerleader for the company.
While it is always nice to have the likes of the Oracle of Omaha in your corner, even his once-golden touch isn’t enough.
The company shares have had a devastating year, with all of this negative news coming out:
But note that recent rally, or at least bounce over the last few weeks. That is our opportunity today.
You see, last month, the company was able to successfully refinance a good portion of its debt, the very thing that has investors scared. Then, in a bit of a surprise, it announced it was able to refinance even more than expected.
That’s led some investors to either reenter their positions or to at least stop selling. That $6-per-share recovery should prove to be just a last gasp at life before shares continue on with their slide lower.
3G Capital’s disclosure of a 25 million share sale proves that the company has further to fall. When analysts discuss their full-year picture for Kraft, they aren’t even specific in just how far that bottom line is expected to fall. They are just saying high double-digit losses.
The company’s next earnings release comes in early November. That’s when the next round of selling from more than just 3G should start. And because of that recently little uptick, we have a chance to play it today…
A Strategy For Short Term Bears
A bear put spread is a type of options trade that involves buying one put option with a strike near the current trading price of a stock you believe will fall… and selling a second put with a lower strike price. What this does is reduce the amount of money at risk, while offer a target profit above and beyond that risk.
The income received from the sold put helps offset the cost of the bought one. This reduces both the entry cost and the total amount at risk, which are one in the same. In exchange for this offset cost, it does cap the total maximum profit potential of the overall trade. But it often leaves that potential profit ceiling high enough to make it worth the effort.
You can see this trade off here:
Source: The Options Industry Council
For Kraft, because of the recent bounce, traders looking to use a bear put strategy are able to lock in a great risk-to-reward balance… one that could pay out well over what the trader has at risk.
Let’s look at a specific example.
A Specific Trade On KHC
Right now, a trader could buy a November 15 $27.50 put for $1.20 per share and sell a November $25 put for $0.50 per share for a total cost of $0.70 per share. Since each contract is worth 100 shares of KHC, that’s a total entry price of $70.
That’s it. That $70 is all the trader would have at risk for the full duration of this trade, which doesn’t expire until late November.
As you recall, KHC is most likely going to report its next earnings results in early November. I say likely, because that is yet another problem the company has had this year… filing on time. And when it finally did, shares fell even though it beat estimates.
So, this time around, even if it does file on time and hit its already dismal analyst expectations, another fall is just as likely… especially with its second-largest shareholder weighing down those prices with large-scale selling of its own.
Back to the trade… that $70 is all that’s at risk. The trader would only lose it if shares remained above the $27.50 mark for the next eight weeks, which is highly unlikely. A slip back to at least where they were a few weeks ago is probable… and a fall even further is possible.
So, to find out how much this trade would make, take the difference between the strike prices ($27.50 – $25 = $2.50), and subtract the cost of entry ($2.50 – $0.70 = $1.80). On 100 shares, that’s a potential return of $180.
In other words, if shares slip at any point over the next two months – a very likely outcome – this trade would offer our trader a 257% return on the amount he has at risk. That’s more than triple his money back by simply trading on common sense.
Kraft isn’t turning this ship around. Even with Buffett’s loud cheerleading, it hasn’t been able to staunch the flow of blood. Now, with its number two investor bailing out, there’s nothing to stop another – or at least a continued – collapse.
There’s one final catalyst to watch out for, that could boost this trade along. A second dividend cut is likely. The timing of said cut is hard to judge. But if the company slashes its dividend yet again, those iron-stomached investors still onboard would surely flee.
With so much weighing down on KHC shares right now, this trade is a no-brainer way to play it.