Food Is Essential, So Sell Naked Puts On Performance Food Group

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Summary

We get a lot of emails asking about selling puts on big momentum plays like Tesla (TSLA). We understand that there are tempting premiums associated with such a stock, but we cannot emphasize enough that this is a foolish strategy.

We believe selling naked puts is an income-generation strategy, especially for those who have lost that ability with record low interest rates. Since the risk is having to own a stock, it is only logical that you want that stock at a value price. If your goal is income generation, you don’t want to take on too much risk.

One area we really like right now is anything having to do with food, and especially logistics. Companies like Performance Food Group Company (PFGC) are what we are looking at.

Thesis

There is good news and bad news about this sector. The good news is that there is opportunity because there is a necessity for food and associated items all over the country. The bad news is that these deliveries are made to restaurants and other food service entities, and many of these are shut or operating at significantly reduced capacity.

So these companies are suffering right now, but that makes them value plays because they will recover and states are starting to open up.

Ultimately, this is the supply chain that we are considering an investment in, and the American supply chain is rock-solid. It has not been disrupted. It is also extremely well-established, it will never go away, and in fact, it will always be an essential part of the human experience. Remember, there is always a need for food distribution. Whereas the Sony PlayStation supply chain is not critical, food is.

Right now, the only thing that puts a company is jeopardy (as we’ve seen elsewhere) is debt that cannot be serviced. The big players are pretty well set, so this too shall pass and everyone will return fighting over market share and optimizing operations.

You may not have heard of PFGC, but have a look at the company's description and how broad its business is:

The company offers a range of frozen foods, including meats, fully prepared appetizers and entrees, fruits, vegetables, and desserts; canned and dry foods; fresh meats; dairy products; beverage products; beverage products; imported specialties; fresh produce; and candy, snack, and other products, as well as beef, seafood, shortenings and oils, baked goods, salad dressings, teas and cocoas, pork, and others. It also supplies various non-food items, such as paper products comprising pizza boxes, disposable napkins, plates, and cups; tableware that include china and silverware; cookware, which comprise pots, pans, and utensils; restaurant and kitchen equipment and supplies; cigarettes and other tobacco products; and cleaning supplies. In addition, the company offers value-added services related to foodservice distribution, including electronic order-taking, payment, and other Internet based services; various reports and other data, menu planning advice, food safety training, and assistance in inventory control, as well as access to various third-party services designed to add value to its customers' businesses. It serves street and chain restaurants, schools, business and industry locations, hospitals, vending distributors, office coffee service distributors, retailers, theaters, convenience stores, and hospitality providers, as well as franchises and other institutional customers. The company markets and distributes approximately 160,000 food and food-related products from 83 distribution centers to approximately 170,000 customer locations.

Valuation Rules

When it comes to value stocks, we generally look for a 5-year PEG ratio of 1.0 or less, which is a pretty standard metric. However, when it comes to a sector with limited players, we give that sector an allowable PEG ratio of up to 2.0.

There’s a reason for this. Limited players usually result in premiums being paid for those stocks because of the lack of competition. It’s simply the supply-demand curve basics at work. As long as the leader is generating free cash flow that is around half of its net margins, we will grant the higher PEG ratio.

We also are looking at FY19 earnings because we want to establish a baseline for where the company was at prior to the COVID-19 crisis.

PFGC stock trades at 12.4x TTM EPS of $1.90 per share, and its 5-year average annual growth rate is 7.6%. Thus, it has a PEG ratio of 1.65, which is below our value threshold.

Risks

Let’s be clear: there are risks to the food provider and distribution businesses. While the supply chain is critical, that doesn’t mean everything will always be hunky-dory.

We may be utterly wrong about how long the COVID-19 crisis will last and how it will impact clients of PFGC. Restaurant service will be slow to ramp up, and questions remain about whether that industry will even return to normal. So, while we expect a long ramp-back to previous levels, there may not be “previous levels”.

There is the possibility that supply chain workers at PFGC may contract the virus in a disproportional percentage, hobbling company service and impacting revenue. Also, this is a very low-margin business, and it may experience higher compliance costs should regulatory authorities institute additional protections for workers and recipients.

PFGC's client base may be disproportionately negatively affected by the virus' economic impacts, resulting in loss of both customers and market share.

Actionable Conclusion

What puts can we sell with PFGC stock at $26.27 as of Tuesday's close?

The July $25 puts are going for about $2 each. Earning nearly 8% in just 8 weeks is a traditionally very high premium, especially considering the strike price is more than 5% below the current price. If PFGC shares are put to you, you will be buying PFGC stock at the equivalent of $23 per share, which is about a 12% discount from even this low price.

For those who want to wait a little bit longer to see how the food distribution environment shakes out, the September $25 puts are going for about $3.35. If put to you, you will be buying PFGC stock at the equivalent of $21.65 per share, a discount of more than 17% from this already cheap price point, and you'll own PFGC stock at a low P/E of just 11x TTM earnings.

Finally, for the most conservative choice, December $22.5 puts sell for about $3.60 each. You first earn 16% on your money, and in the process, you'd be hedging your PFGC stock bet all the way down to $18.90 per share - and owning it at just 10x TTM earnings.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.