Suck On This 198% Return…

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Smoking has never been as unpopular as it is these days. But vaping, that’s still on the rise.

Philip Morris Int’l (PM) announced its second quarter of earnings today, showing a decline in cigarette volumes of 3.6%… but heated tobacco volumes up 37%.

There are a few things to note here, however. PM is basically in charge of everything that isn’t the U.S. Altria is the company that sells to Americans. While tobacco use in Europe has fallen, it hasn’t suffered major declines in developing nations. That’s where a lot of PM’s business remains

It’s also important to note, before we get into the nitty gritty details of this earnings report and eventually today’s trade opportunity, that PM recently launched its heat-not-burn tobacco product… called IQOS.

This vape product is supposed to be less dangerous as it only heats the tobacco enough to release the flavor of it, rather than burning it which comes with all of the even more hazardous chemicals. Now, the FDA has approved this, but hasn’t declared it immune from future regulation in the industry.

So, these early sales in this first full quarter of sales might be a bit skewed.

During the first quarter, the company disappointed with lower IQOS volumes than expected in its key Eastern European market. So, these larger second quarter results have impressed analysts.

Shares are up 10% as we write, marking a current year-to-date gain of 28% in PM’s share price.

Screen Shot 2019-07-18 at 2.44.02 PM

During the quarter, Philip Morris blew away other analyst expectations. Revenue for the period hit $7.7 billion compared to the estimated $7.4 billion. And earnings per share jumped to $1.46 vs. the $1.33 analysts expected.

Company guidance also surpassed all hopes, for the most part. Management claims the company is on track to beat its previous volume estimates. Instead of 1.5% to 2% declines in total shipments, it now sees a drop of 1%. Earnings, despite a penny off analysts’ estimates, are forecast to come in at $5.14 per share – a tad higher than previously anticipated.

This would give the company a forward price-to-earnings ratio of 17.3. That puts PM right in the middle of the competition, with its US sister company (Altria) trading a bit cheaper and its large international competitor British American Tobacco trading a bit higher.

So, what does the rest of 2019 look like for the tobacco giant? Can it hold onto these gains in share price despite just an okay forecast?

Analysts believe so. In fact, right now out of 18 analysts covering its stock, not a single one rates Philip Morris a “sell.” That, to anyone sensible – a rarity in today’s insensible marketplace – sounds a lot like a red flag.

The company did beat earnings estimates. And it’s certainly not going anywhere with the seemingly successful launch of its heat-not-burn product. But is it really in that great of shape?

A quick glance at its numbers – those buried just a bit further in its earnings press release – show that the company has a large debt load. Right now, it carries a debt-to-EBITDA ratio of 2.4… a bit high for a company with relatively flat earnings and decreasing volumes.

But the real problem is its dividend. The company offers a handsome dividend of $4.56 per year yielding about 5.1%. But that large of a dividend represents a payout ratio of nearly 90%. Meaning it doesn’t have a lot of money left over after paying shareholders to pay down its debt or turn around its shrinking volumes.

Investors are hot about these recent numbers. But after the initial wave of early enthusiasm for PM shares passes, the company is due for a cool down. That’s where today’s opportunity comes from. This small window following such a large one-day jump, when shares retreat back to a more likely valuation.

Even better, because of today’s rally, there’s a trade opportunity that offers a very lucrative if rare return on risk chance.

Let’s get into it.

A Strategy For Short Term Bears

A bear put spread is a type of trade that involves buying a put option with a strike price near the current price of the underlying stock and selling a second put option with a lower strike. This results in a net debit, but a much lower one than the trader would pay if he just bought the put outright.

You see, the premium received from the second put option offsets much of the cost of the one the trader buys. This reduces the amount at risk. But it does cap the profit potential of the trade.

For a company like PM, which is unlikely to completely collapse overnight, that’s a tradeoff worth taking.

You can see how this kind of trade plays out here:


Source: The Options Industry Council

As you can see, that initial cost is the whole amount at risk for the duration of the trade. It is lost only if shares stay where they are or rise. If they do indeed fall, even a little bit, the trader can quickly turn that cost into a profit.

Let’s look at a specific example of a bear put spread trade on PM…

A Specific Trade For PM

Right now, a trader could buy a September 20 $90 put on PM for $3 per share and sell a September 20 $85 put for $1.32 per share for a net debit of $1.68. On 100 shares, that’s a total cost of $168.

That $168 is the total amount at risk for the two months this trade would be open. If shares of PM continue to climb without regard to its cash flow and balance sheet problems, that’s how much the trader would lose.

If they don’t continue to rally, however, the potential reward is much higher. To find that, take the difference in strike prices ($90 – $85 = $5), and subtract the cost ($5 – $1.68 = $3.32). On 100 shares, that’s a maximum profit potential of $332.

In other words, if today’s overenthusiastic rally in PM’s shares does dissipate and result in a small correction, the trader would be sitting on a 198% return on the amount of risk he took on.

For him to collect that full return, shares of PM would have to decline to just $85. With shares trading at $88.63 as we write, that represents a decline of just 4.1%. Considering they moved by more than 10% at one point today alone, that’s not a far drop over a two-month window.

This is a rare opportunity to get in on an obvious market overreaction. And a 198% potential return on risk is about as good as you’ll ever see in any PM trade.

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