Cruising for Carnival Options

Carnival Corporation (NYSE:CCL) May 17, 2009 - $25.00
52-week range: $14.85 (Nov. 21, 2008) - $42.39 (Sep. 19, 2008)

Carnival is the world’s largest cruise ship operator carrying almost half of all cruise passengers on its eleven brands and 89 ships. They operate Carnival, Princess, Holland America, Costa, P&O, Cunard, Yachts of Seabourn, Ocean Village, AIDA, Ibero and P&O Australia.

After posting record and near record results of $2.95 and $2.90 in FY 2007 and 2008 Carnival’s earnings this year are expected to be down to about $2.15 - $2.17 /share. CCL’s FYs end in November. The company has taken steps to address the weak economy and reduced cash flow. Most notably, the $1.60 annual dividend was eliminated to conserve about $1.26 billion per year for operational needs.

Here are Carnival’s per share numbers as reported by Value Line:

With Carnival shares now at $25 they trade at less than 11.7x this fiscal year’s already reduced expectation of $2.15 in EPS and right at one time book value. Those are extraordinarily low metrics for this industry leader.

Long-time Chairman, Micky Arison, continues to be a huge holder of CCL shares with a 30% stake as of the February 2009 proxy.

When times were better (in 2004 – 2007) CCL shares were hitting peak prices of $52.70 - $59.00.

I think the current quote already reflects the bad economy and the lack of yield support.

Accordingly I see little risk of a major drop over the next year or two.

Here are my eight month and twenty month plays with Carnival that can produce great returns even if the shares just ‘hang around’ today’s price:

On the Jan. 15, 2010 expiration date:

If Carnival still is $25 or higher…

The $25 calls will be exercised.
You will sell your shares for $25,000.
The $25 puts will expire worthless.
You will have no further option obligations.

You will end up with no shares and $25,000 for your $15,900 outlay.

That’s a net profit of $9,100 / $15,900 = 57%.

You will get this best-case scenario result if the shares go up or stay unchanged for the next eight months.

What’s the risk?

If Carnival shares finish below $25 on Jan. 15, 2010…

The $25 calls will expire worthless.
The $25 puts will be exercised.
You will be forced to buy an additional 1000 shares and to
lay out another $25,000 cash.
You will end up with 2000 shares of CCL.

What’s the break-even point on the whole trade?

On the first 1000 shares it’s the $25 purchase price less the $4.60 /share call premium = $20.40 /share.

On the ‘put’ shares it’s the $25 strike price less the $4.50 /share put premium = $20.50 /share.

Your break-even point is thus $20.45 /share.

Carnival could drop by up to $4.45 /share or (-17.8%) without causing a loss on this trade.

Here’s the same trade but out to January of 2011 …

On the Jan.2011 expiration date:

If Carnival still is $25 or higher…

The $25 calls will be exercised.
You will sell your shares for $25,000.
The $25 puts will expire worthless.
You will have no further option obligations.

You will end up with no shares and $25,000 for your $11,800 outlay.

That’s a net profit of $13,200 / $11,800 = 111.8%.

You will get this best-case scenario result if the shares go up or stay unchanged for the next twenty months.

What’s the risk?

If Carnival shares finish below $25 on expiration date in 2011 …

The $25 calls will expire worthless.
The $25 puts will be exercised.
You will be forced to buy an additional 1000 shares and to
lay out another $25,000 cash.
You will end up with 2000 shares of CCL.

What’s the break-even point on the whole trade?

On the first 1000 shares it’s the $25 purchase price less the $6.60 /share call premium = $18.40 /share.

On the ‘put’ shares it’s the $25 strike price less the $6.60 /share put premium = $18.40 /share.

Your break-even point is thus $18.40 /share.

Carnival could drop by up to $6.60 /share or (-26.4%) without causing a loss on this trade.

In Summary:

If you agree that Carnival shares are likely to hold their current level or go higher in the future, then these combination plays should look attractive. If you let the 2011 sequence run its course (and CCL stays above $25) you will have better than 111% profit and all taxes on the gains would be deferred until April of 2012 when you file your 2010 tax-year Schedule D.

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

Comments

[MILESCFA:]

Fundamentally, doing a "buy-write" (buy 1000 sh at $25, selling 10 calls $25 strike) and selling "naked puts" (selling 10 puts $25 strike) ARE THE SAME TRANSACTION... same risk, same return, blah, blah, blah...

I just don't understand any author that recommends this without explaining this equivalency. You would have the same transaction if you did "20" buy-writes at $25 or sold 20 naked puts at the $25 strike. It is a high risk, high return transaction that may mislead naive option investors with the "111% return" figure.

I don't know whether the author will be right or wrong, but whenever I see someone advocating this "duel strategy" of a buy-write and a naked put at the same time without noting the "two trades" are equivalent, and I see them often on SeekingAlpha, I get an uneasy feeling. I hate to say "the author wants me to take Sally and Sue" (because guys will get excited).... but guys, "there ain't no difference between the two".

May 19 12:47 PM

[socphd71:]

1. Carnival also owns Aida, which is a subsidiary of Costa.

2. The big problem for cruise lines is the large number of new, larger ships which were under construction when the recession / depression / financial panic hit. Many will be delivered in 2010. These ships will raise operating costs. If the number of passengers stays constant, or increases only slightly, the cruise lines will make less money. Their fixed costs will be increasing faster than their revenues:

Disclosure: I have cruised 5 times:
Empress of the North (I don't know which line, if any still operates this one.
Aidavita.
Costa Mediterrenea
Costa Atlantica
Serenade of the Seas (Royal Caribbean, stock symbol RCL)

May 19 07:27 PM

[Paul Price:]

Miles,

Covered calls and naked puts ARE functionally equivilent.

Shares held for over one year may qualify for long term gain treatment though, and they do draw dividends that short options do not.

Additionally, if qualified covered calls are written (and eventually exercised) then the call premiums, too, can turn into long-term capital gains. This can be quite valuable on an after-tax basis.

LEAP puts that expire after more than one year still are taxed as short-term gains as they have no 'holding period' for IRS purposes.

Since I recommend writing these combinations against marginable securities I often put my cash to work in the shares I'm using for the combinations.

Today's low interest rates on free credit balances make many of the dividends on my recommended stocks better than the return on T-bills that would otherwise secure my puts.

______________________...

socphd71,

The deliveries of new ships may turn out to be great or a drag on earnings depending on how the world economies play out. I believe the drop in CCL's share price from $50 - $60 to $25 already reflects the uncertainty on this count.

With break-even at $18.40 I'd be willing to hold the shares if neccessary waiting for the eventual recovery.

May 19 11:04 PM