Use 'Coach' Options to Get First Class Returns

Shares of Coach (COH), the upscale designer, producer and marketer, have been hit hard by the economic slowdown and the stock market's year long collapse.

After touching an all-time high of $54 April 2007, COH dipped as low as $13.19 in the pre-Thanksgiving panic selloff.

How do the fundamentals look, though? Since being spun off from Sara Lee (SLE) in October 2000, the company has posted eight straight years of record, sales, cash flow, earnings and book value. Even its latest quarter (ended September) showed year-over-year improvement with EPS of $0.44 versus $0.40 in the same quarter of 2007.

As of September 30 Coach had total debt of just $2.5 million versus $409 million in cash assets. Here are its split-adjusted, per share numbers (as reported by Value Line) for the past eight fiscal years. Coach's FYs end June 30. The 2009 data below includes consensus estimates for the remainder of this FY.

FY ……... Sales ….. C/F ….. EPS ….. B/V ….... Avg. P/E

2001 …… 1.76 ….. 0.25 …. 0.19 ….. 0.42 ……. 18.7x

2002 …… 2.01 ….. 0.31 …. 0.24 ….. 0.73 ……. 22.1x

2003 …… 2.60 ….. 0.48 …. 0.40 ….. 1.17 ……. 21.4x

2004 …… 3.48 ….. 0.80 …. 0.68 ….. 2.06 ……. 26.5x

2005 …… 4.52 ….. 1.18 …. 1.00 ….. 2.73 ……. 25.8x

2006 …… 5.71 ….. 1.51 …. 1.27 ….. 3.21 ……. 26.2x

2007 …… 7.01 ….. 1.93 …. 1.69 ….. 5.13 ……. 24.7x

2008 …… 9.45 ….. 2.50 …. 2.06 ….. 4.50 ……. 17.7x

2009 ……10.80 …. 2.65 …. 2.21 ….. 5.70 ……. 13.0x

Do I expect the old growth rates to come back anytime soon? No. Do I think the old P/E levels between 18x – 26x are to be expected over the next year or two? No. Is this virtually debt-free, highly profitable company going to disappear? No way. What assumption would I think might be a conservative multiple for COH shares over the next couple of years? I'm using 12x earnings- a lower valuation than these shares have ever traded for excepting the past few months.

Twelve times this FY's already reduced estimate of $2.21 would bring the shares back to $26.52 or plus 31% from last week's close. Insiders appear confident in the company's prospects. The last five open market insider transactions have all been purchases with a total dollar value of $1,021,324.

How can you play COH with great upside but with reduced risk?

Here are two option combinations that make sense to me:

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

Buy 1000 shares COH @ $20.25 …… $20,250

Sell 10 Jan. 2010 $20 Calls @ $6.00 ……………………………$6,000

Sell 10 Jan. 2010 $20 Puts @ $5.60 ………………………….… $5,600

Net Cash Out-of-Pocket ……………....... $8,650

On expiration date (Jan. 15, 2010) if Coach shares are above $20 [where they are today in the midst of a horrendous stock market environment]:

Your shares will be 'called' [sold] for $20,000.

Your $20 'puts' will expire worthless [a good thing for you, the seller].

You will own no shares and have no further option obligations.

You will hold $20,000 for your original $8,650 cash investment.

What's the risk? In a worst case - if COH shares are below $20 on expiration date] you would be forced to buy an additional 1000 shares. You need to have at inception, and to maintain until expiration, the financial ability to pay for those extra 1000 shares either with cash or available margin.

What is the break-even point on this trade?

For the shares you bought originally at $20.25, it's that price less the $6 per share you received for the covered calls.

$20.25 - $6.00 = $14.25 [break even] or 29.6% under the starting price.

For the $20 puts you sold, it's the strike price less the $5.60 per share you received for the put premium.

$20 - $5.60 = $14.40 [break even] or 28.8% under the starting price.

Thus in a worst case you would own 2000 shares of Coach with an average price of $14.33 /share. That's 29.25% below last Friday's closing quote and just 6.9x the trailing 12 month actual EPS.

If you think it may take a bit longer for the economy to bounce back, then perhaps you'd rather do the same transaction but with an expiration date in January of 2011. Here are the numbers for that trade:

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

Buy 1000 shares COH @ $20.25 …… $20,250

Sell 10 Jan. 2011 $20 Calls @ $7.60 …………………………... $7,600

Sell 10 Jan. 2011 $20 Puts @ $6.90 …………………………… $6,900

Net Cash Out-of-Pocket ……….....…….. $5,750

On expiration date (January, 2011) if Coach shares are above $20 [where they are today in the midst of a horrendous stock market environment]:

Your shares will be 'called' [sold] for $20,000.

Your $20 'puts' will expire worthless [a good thing for you, the seller].

You will own no shares and have no further option obligations.

You will hold $20,000 for your original $5,750 cash investment.

What's the risk? In a worst case - if COH shares are below $20 on expiration date - you would be forced to buy an additional 1000 shares. You need to have at inception, and to maintain until expiration, the financial ability to pay for those extra 1000 shares either with cash or available margin.

What is the break-even point on this trade?

For the shares you bought originally at $20.25 it's that price less the $7.60 per share you received for the covered calls.

$20.25 - $7.60 = $12.65 [break even] or 37.5% under the starting price.

For the $20 puts you sold, it's the strike price less the $6.90 per share you received for the put premium.

$20 - $6.90 = $13.10 [break even] or 35.3% under the starting price.

In a worst case you would end up owning 2000 shares of Coach with an average price of $12.88 /share. That's 36.4% below last Friday's closing quote and just 6.2x the trailing 12 month actual EPS.

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

Comments

[wizuurd:]

Your comments are a bit misleading - you infer the 'best case' profit is $14,500 on a $20,250 investment (2011 options). The profit is actually on a $40,250 investment (the origingal investment plus the $20,000 you could not use in any way until the Option expiration. I agree if the reader uses margin, they would have higher return.) Therefore, this scenario (2011 options) is only roughly 10% per year - and many of us do better than that.

2008 Dec 15 10:44 AM

[Paul Price:]

The actual cash-on-cash return is $14,500 profit on a net outlay of $8,650 in the 13 month scenario. It is not a $20,250 or a $40,250 investment in either case as even if all puts were exercised your net cost would be reduced by both the 'call' and 'put' premiums received right up front.

If Coach shares remain above $20 that is all the cash you will ever put out of your pocket. Margin requirements can be met simply by having other [paid-up] marginable securities in the same account.

2008 Dec 15 02:12 PM

[dpf:]

Thanks Paul for all your great picks - I started out with options a couple of years ago by following one of your picks. You have made me a lot of money!!! Dan


On Dec 15 02:12 PM Paul Price wrote:

> The actual cash-on-cash return is $14,500 profit on a net outlay
> of $8,650 in the 13 month scenario. It is not a $20,250 or a $40,250
> investment in either case as even if all puts were exercised your
> net cost would be reduced by both the 'call' and 'put' premiums received
> right up front.
>
> If Coach shares remain above $20 that is all the cash you will ever
> put out of your pocket. Margin requirements can be met simply by
> having other [paid-up] marginable securities in the same account.
>
>

2008 Dec 16 05:54 PM

[Paul Price:]

R. Krakoff, President of Coach, reported a 16,000 share purchase
at $29.64 /share ($474,240) completed on August 11, 2009.

Aug 15 06:00 PM