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“Food” for Thought – Kraft Shares and Options

March 13, 2009 | About:
Kraft Foods, Inc. [NYSE:KFT] March 13, 2009 close: $22.53

52-Week Range: $20.81 (Mar. 5, 2009) - $34.97 (Sep. 19, 2008)

Dividend = $0.29 quarterly = 5.15% current yield


In a market where uncertainty is rampant it’s nice to have something with low volatility, better than average safety and high predictability. Kraft seems to nicely fit all those criteria. Value Line notes that Kraft has a Beta of just 0.65, an ‘A+’ financial strength, and it earns their highest ‘Safety’ ranking. This $43 billion (sales) company also falls into the top 1% in terms of ‘stock price stability’ and in the upper 20% in ‘earnings predictability’ compared with the 1700 company Value Line stock universe.

Berkshire Hathaway is a long time KFT owner with 9.41% of the outstanding shares as of the most recent proxy statement.

The only knock on this fine company has been its lack of earnings growth. EPS were $2.02 in 2002 and came in at $1.89 in 2008 despite a 72% rise in sales per share. Net profit margins peaked at 11.8% in 2002 but dropped to about 6.4% last year as raw material commodity prices rose.

The lack of growth and margin contraction has led to KFT’s multiple contracting from 19x to < 12x today. With 2009 estimates flat with last year’s I don’t expect more than a 13 - 14 P/E until 2010. Even a return to 13 times expected 2009 earnings would bring KFT shares back to $24.57.

Why am I excited about KFT then? While I don’t see big upside I also don’t see much risk of a further drop from the present quote of $22.53 due to the juicy 5.15% yield and the already historically low valuation.

Here is my buy/write combination play:

……………………………………........................…..... Cash Outlay ….......…. Cash Inflow

Buy 1000 KFT @ $22.53 ……………….......…..…….. $22,530

Sell 10 KFT Jan. 2010 $22.50 Calls @ $2.30 ……………………..........………. $2,300

Sell 10 KFT Jan. 2010 $22.50 Puts @ $3.20 ……………….........…………….. $3,200

Net Cash Out-of-Pocket ………………….....……….... $17,030

On expiration date (Jan. 15, 2010):

If KFT shares remain above $22.50/share (as they are right now):

Your $22.50 calls will be exercised.

The shares will be sold for $22,500.

You will have received $1,160 in dividends (at the current rate).

Your $22.50 puts will expire worthless (a good thing for you as a seller).

You will have shares left and no further option obligations.

You will have $23,660 cash from an initial cash outlay of $17,030 for

a cash-on-cash profit of $6,630 / $17,030 = 38.9%.

This excellent total return would be achieved over less than 10 months on shares that did not need to move up at all from the day this trade was started.

What’s the risk?

If Kraft shares are below $22.50 on expiration date:

Your $22.50 calls will expire worthless.

The $22.50 puts will be exercised.

You will be forced to buy an additional 1000 shares and lay out

$22,500 more cash.

You will now own 2000 shares of KFT.

You will have received $1,160 in dividends (at the current rate).

You will have no further option obligations.

Your total cash outlay for the 2000 shares will be the original $17,030

plus the $22,500 from the ‘put’ exercise = $39,530.

After subtracting the $1,160 in dividends you will have spent a net of

$38,370 for the 2000 shares = $19.185 /share all-in.

Your overall breakeven point is thus $19.19 share.

Unless Kraft shares are below that price you will have shown a profit.

While I can’t guarantee that KFT shares will not be under $19.19 by next January, I can say that since their June 2001 IPO, the all-time low was $20.81 (during the recent market panic). The previous share price nadir during the seven and a half years 2001 – 2008 was $24.80.

Your best case gain is a 38.9% profit if the shares stay unchanged or go up.

The worst case scenario requires an additional cash outlay but even a 14.8% decline in share price would not cause a loss.

Not the worst risk/reward I’ve come across lately.


Disclosure: Author is long KFT shares and short KFT options.

About the author:

Dr. Paul Price
http://www.RealMoneyPro.com
http://www.TalkMarkets.com

Visit Dr. Paul Price's Website


Rating: 2.6/5 (8 votes)

Comments

kfh227
Kfh227 premium member - 5 years ago
KFT ... I haven't looked at that one in a while. Thanks for pointing it out!
traderashish
Traderashish - 5 years ago


one risk with kraft is customers moving to cheaper private store labels to cut costs.

I myself recently ( for first time ever) bought a ralphs cream cheese for $1.5 instead of KFT cream cheese costing $2.5
Sivaram
Sivaram - 5 years ago
TraderAshish points out something that I have been worried about for a while now. I have a suspicion that a lot of branded consumer goods are going to suffer if the economy enters a long-term slump, as I think it will.

Similar to what happens in clothing--people move up to brand name clothes when they have money, but go down a notch or two when household finance deteriorates--I wonder if the same thing will happen with food, drinks, and so on. Historically, from what I can gather, Americans have never really cut back on food or drinks. But it might be different this time (yes, I realize I'm uttering the 5 most dangerous words in investing :)). Branded consumer goods companies have generally done well during recessions but it may be different this time.

GDP per capita (or Americans's disposable incomes) have largely gone up at a high rate for a long time. If that ever slows down, and I think it will, then I wonder if branded goods and services may come under pressure. THe moats of some branded companies may dissapear as quickly as branded department store market share has been lost to Wal-mart.

Anyway, this is just a wild macro view and I haven't looked at specific companies. I'm just throwing out a contrarian idea out there...


(On a bullish note, Japan went into a multi-decade slump, similar to what America may face in the worst case, but their consumers never cut back on branded goods from what I can tell. However, it is possible that this happened because Japanese consumers had a strong balance sheet whereas American consumers aren't in the same situation.)
batbeer2
Batbeer2 premium member - 5 years ago
...I myself recently ( for first time ever) bought a ralphs cream cheese for $1.5 instead of KFT cream cheese costing $2.5...

But what happens if KFT lowers it's price to 1.8

Most of the cost will be in transportation, packaging etc. The other guy may have a 15% cost advantage if he's good and doesn't try to sell a grossly inferior product.

On top of that the retailer just won't remove the KFT brand from the floor in a hurry. The other guy is competing for floor space with 400 other other guys. The KFT brand is allmost guaranteed floor space.

Are you willing to pay 50% more for the taste you have grown to like ? 35% ? 25% ?
roiguy
Roiguy - 5 years ago
Dirty little secret of super markets:

Many of the off brands are manufactured by the same makers of the premium brands. Not all, but a significant amount.

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