Don't Do It

By Chad Henage - July 31, 2012 | Tickers: KO, KRFT, PEP, SODA | 0 Comments

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I know it seems like a good idea, I know the numbers look good, but I'm begging you please don't do what you're thinking of doing. If you write covered call options, and you see the August $40 call option on SodaStream (NASDAQ: SODA) the numbers I'm sure are calling your name. The problem is, with the company due to report earnings before this option would expire, you're going to be mad at yourself for cutting off your gains.

The Basics of Covered Call Options:

A covered call option is one of the simplest option strategies there is. Here is the way it works. First, you have to own or buy 100 shares of a particular company. Then you have the option (pun intended) to write a covered call. A covered call option simply means that you are willing to accept money up front, for the possibility of selling your shares at a prearranged price. The great thing is, there is no way to lose money on this transaction. You already own the shares, and the worst thing that can happen is the share price goes down. However, you keep the upfront payment (premium) no matter what. Let me give you an example using SodaStream to show you how this works.

Let's say that you already own 100 shares of SodaStream. You go to your brokerage account, click on options trading, and type in the symbol. Normally what you're presented with is, a list of all the different options available on the stock. Since the shares trade currently around $38, you would normally write an option for a price above this. Since you get paid more for an option price that's closer to the market price, the most profitable choice is the August $40 call. Writing this option, says you're willing to sell your 100 shares at the preset price of $40. In exchange, you agree to be paid a premium of $1.90 per share. This works out to $190 minus whatever commission your broker charges. This premium is yours to keep no matter what happens with the stock. Assuming you use a discount broker, your net premium would probably be around $180. If we assume today's stock price as your cost basis, your total cost would be around $3,790 including commission. Writing this option, up front you'll receive the equivalent of a 4.75% return. Keep in mind this 4.75% return is being earned during just one month, or what would be the equivalent of a 57% annual return assuming you could keep rolling the options to earn similar premiums. The downside is, you've already committed to selling your shares at $40 no matter what. If the stock goes to $50, you're still getting $40 per share. This is the primary reason I'm suggesting investors hold off until after SodaStream reports earnings. I firmly believe that the company's upcoming earnings report will cause the stock price to jump, and writing a covered call at today's prices could actually cost you potential gains. What's the reason for my optimism?

There are multiple factors benefiting SodaStream at the current time. The first is, people who doubted the system originally are beginning to come around. One example is The Motley Fool's own Brian Stoffel. He penned an article saying that when it came to SodaStream, he was hesitant about the company. That was before he used the product. In his words after purchasing the machine, “I can say that my wife and I are thoroughly impressed.” He went on to say that while the company's soda flavors are not patented, their carbonators are. This gives the company some protection against competitors trying to duplicate the system. Another factor working in the company's favor is, SodaStream can make the claim to be a healthy alternative to traditional soda.

Another article from the Motley fool was written by Rick Munarriz who pointed out the huge calorie difference between a serving of SodaStream's Cola flavor versus Coca-Cola (NYSE: KO) or PepsiCo (NYSE: PEP) soda. In the example he gave, an 8 ounce serving of Coke or Pepsi both have 100 calories, 27 grams of carbs, 27 g of sugar, and between 25 and 35 mg of sodium. By comparison, the same serving by SodaStream has just 34 calories, 9 g of carbs, 9 g of sugar, and only 2 mg of sodium. For consumers looking for a healthier alternative to the top two soda brands, SodaStream seems like a good choice. Beyond this health advantage, the company is expanding its distribution and partnerships.

In addition, the company is expanding its partnership with Kraft (NASDAQ: KRFT). The two companies recently announced that Kraft's Kool-Aid brand would be available for SodaStream drink makers. Initially, the Cherry, Grape, and Tropical Punch flavors will be made available. Kraft said, “we are pleased with the early success of our Crystal Light and Country Time flavors and believe that adding Kool-Aid will attract even more people to enjoy our flavors with personally made carbonation.” This partnership benefits Kraft as their flavors get into more customers hands. SodaStream benefits because now the company has three major brand names to market for its soda makers. While it's true that SodaStream does not pay a dividend, or have the history of Coke or Pepsi, the company's growth trajectory is much more impressive.

At current prices, SodaStream sells for about 17 times 2012 full year earnings. This is for a company expected to grow earnings-per-share at 30% in the next few years. Compare this to Coca-Cola that sells for over 19 times its 2012 earnings estimates, and yet is slated to grow at about 7.5%. Though Coca-Cola pays a dividend with a current yield of 2.6%, this payout is not significant enough to make up for the huge difference in growth between the two companies. Comparing SodaStream to Pepsi makes the choice even more obvious. PepsiCo is expected to grow at just 4.5% over the next few years yet sells for the same 17 times 2012 earnings estimates. While Pepsi pays a dividend of over 3%, the gap in valuation is too large to ignore. While this seems like the perfect stock to write a short term covered call on, the shares are so cheap, and the growth rate is so large, that short-term trading just doesn't make sense. I know the numbers look good, but don't do it.

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