I Keep Writing Put Options On Conagra Brands As The Stock Remains Cheap

Summary

• Conagra Brands is still generating very strong cash flows, but an inventory buildup is hiding this from the reported results.
• This seasonal effect will be reversed in the current semester, and I expect Conagra to report a sustaining free cash flow exceeding $3/share.
• That makes this company quite cheap, despite the high net debt on the balance sheet.
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Introduction

Since publishing my previous article on Conagra Brands (NYSE:CAG), I continued to write put options that were (and are) slightly out of the money. The option premiums are quite appealing, and I’d be happy to initiate a long position in the company as the strong financial results reduce the balance sheet risk.

Data by YCharts

Anyone expecting a post pantry-stocking blues was wrong

As I explained in the October article, Conagra’s financial performance in the first quarter of FY 2021 (which ended in August) remained pretty strong. Some readers thought this was mainly due to the pantry-stocking frenzy right after the outbreak of the COVID pandemic (Conagra’s Q1 runs from June to the end of August), but I’m happy to see the company’s Q2 performance confirms the trend. The revenue remains very strong while lower interest expenses help to increase the net income.

Source: SEC filings

As you can see in the image above, the H1 FY 2021 revenue came in at just over $5.67B, an increase of almost 9%. Meanwhile, the COGS increased by just 6% which means the gross profit (revenue minus COGS) came in at almost exactly $1.7B compared to $1.46B in the first half of FY 2020. The SG&A expenses also decreased although this was pretty much reverted during the second quarter. All in all, Conagra performed very well and thanks to the continuous effort to reduce the net debt and the lower yields on the debt markets, the interest expenses decreased by about 10% compared to the first half of 2020. The bottom line shows a net profit of $709.3M of which $707.8M was attributable to the shareholders of Conagra Brands. This works out to be approximately $1.45 per share.

That being said, my main investment thesis in October was based on the free cash flow rather than the net income, so I was very keen on checking up on Conagra’s free cash flow profile. After all, those incoming cash flows are more important than the paper profits to reduce the net debt as fast as possible.

Conagra reported an operating cash flow of $541M, but we still need to take the working capital changes into consideration. The total net investment in the working capital was approximately $400.7M. Adding this back to the reported operating cash flow results in an underlying adjusted operating cash flow of approximately $942M. I am also deducting the $13M in ‘payment of intangible asset financing arrangements’ and end up with $929M in operating cash flow.

Source: SEC filings

The total capex in H1 FY 2021 was about $282M. Much higher than the $184M in the first half of the preceding financial year, but even after taking the higher capex (which currently is trending at 1.5X the depreciation expenses) into account, the free cash flow result of $650M is quite impressive.

The current share count is just under 489M shares which means the free cash flow result is approximately $1.33 per share. That’s lower than the reported EPS, and that’s entirely attributable to the high capex which is substantially higher than the depreciation expenses. Conagra is still investing in growth which should result in additional operating cash flows going forward.

It’s also important to note the free cash flow guidance issued by Conagra includes growth capex, this was confirmed during the Q2 conference call.

Source: Press release

As the free cash flow guidance for FY2022 includes growth capex, the sustaining free cash flow will likely come in at in excess of $3/share.

What did Conagra do with the cash?

As Conagra still needs to focus on its balance sheet, it shouldn’t come as a surprise that’s what most of the cash inflow was spent on. First of all, while the underlying free cash flow was $650M, but a big chunk had to be reinvested in the working capital where the inventory build-up required a working capital investment of $247M.

This means Conagra’s net debt didn’t decrease by too much. As of the end of November, Conagra had $68M in cash, $980M in current debt and almost $8.3B in long-term debt for a net debt position of about $9.2B. That’s high, even for a company generating $2.6B in EBITDA using a trailing twelve month basis. This represents a debt ratio of just over 3.5 and that’s well within Conagra’s expectations.

Also keep in mind that as the investments in the working capital position are being released, the net debt will decrease again, so there will always be some seasonal fluctuations. In FY 2020 for instance, we saw a $230M investment in inventory levels during the first semester, but in the second semester there was a total $390M release from these inventories due to this seasonality.

Investment thesis

The market still seems to be underestimating Conagra’s underlying performance. The official guidance for FY2022 calls for a free cash flow per share of roughly $2.70 while filtering out the growth capex indicates an underlying free cash flow result exceeding $3/share. Rather than just writing put options, I will likely also just buy the stock on the open market while continuing to write put options. A P30 expiring in June for instance, has an option premium of $0.70, which I think is quite generous for a resilient company like Conagra Brands. Writing a similar P30 with an expiry date in January 2022 (the year wherein the reported FCFPS will be around $2.70 and the underlying FCFPS will exceed $3) would get you an option premium of in excess of $2.50, and I think that’s just too good to pass up on.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in CAG over 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.

Comments

[dugrov]

If I place a GTC buy order at 30, I will get it if the price dips below that. If I write a P30 and the price dips below 30 well before the expiry of the put, but then the price increases quickly and stays higher than 30 through the expiry of the put, might I have lost the opportunity to buy it for 30? When the price was briefly below 30, the put doesn't necessarily get exercised, does it, and it would be more expensive to close it at that point than what I wrote it for, wouldn't it? How do I mitigate that economically? Sorry about my ignorance.

[The Investment Doctor]

@dugrov It's not ignorance and a very valid question. What I tend to do in such a situation is buying the stock below 30, and trying to close the put option if it's affordable to do so.

However, what I usually do (if the position size allows it), is splitting my desired block up in 3 thirds: 1/3rd I buy on the market, 1/3rd will be acquired by writing a put option that's (relatively) deep in the money, and 1 put option that's out of the money.

For instance, in Conagra's case, this would be what I theoretically could do, if I'd want 300 shares (around $10,500).

* Buy 100 shares at $34.79
* Write 1P 40 September at around $7.00
* Write 1P 30 September at $1.25 (or I could pick a different date here)

If Conagra trades above $40 on expiration, I end up with 100 shares and $825 in option premiums.
If Conagra trades between $30-40, I end up with 200 shares at a total cost of $3479 + $4000 - $825 = $6654 or around $33.27/share
If Conagra trades below $30, I end up with 300 shares at $3479 + $4000 + $3000 - $825 = $9654 or $32.18/share.

There is no 'one correct strategy'. Determining which dates & strike prices work best should be determined by how keen one is to buy at a certain price while, as you correctly stated, one also needs to remain flexible and perhaps keep some cash on the side to buy more stock if it severely dips, or write another option.

[LOST99]

@dugrov That's the rub with writing puts. There is no way to mitigate missing the chance of buying the stock at the "$30 bargain price". If you are really determined to own CAG, the the only way is to potentially double your position in CAG. That is, when the price dips to the level that you want to own it at, buy CAG at a market limit price. But you have to be wary that on or before the expiry date of the put, you may be assigned for those shares as well, requiring additional expenditure of cash reserves.

I've found myself holding puts and missing out on buying shares that I wished I owned as the price continued to rise. Before you make the decision to sell a call or put option, you simply have to resolve yourself to the chance that you may be limiting your upside potential, accepting the 'stealth dividend payout' of the option premium, against the potential of the stock price capital gain.

[dugrov]

@The Investment Doctor Thanks to you and LOST99 for the additional information. I thought I must have been missing something. But I wasn’t.

[homerbart]

Totally agree with how “ lost 99” presents the way selling puts works. Great job

[homerbart]

I have been selling puts for income for as long as I can remember. And that’s a long time lol. No better way to fund a relaxing retirement

[Thomas4647]

Your article would benefit from a brief discussion of why you prefer selling puts to buying calls. I assume you did that analysis on your own but you didn’t mention it. Seems like you think the stock is going up, and in that scenario it is the typical move in options.

[The Investment Doctor]

@Thomas4647 The answer is simple, I like time to work in my favor. Not against me.

[Thomas4647]

@The Investment Doctor
I get it. I sell puts frequently as well!

[LOST99]

If you are thinking of getting into options, start small and I would strongly recommend first going with selling covered call options before getting into cash secured puts.

Think of selling a put as the equivalent of you being an insurance company. The buyer (ie the existing owner of CAG) is willing to pay you a premium for you taking on the obligation to pay him a fixed floor price on his CAG stock for a fixed term of time. He is willing to pay a higher premium for a longer term put, hence the difference between the June & January 2022 premiums. He continues to own the stock, so he is entitled to collecting the dividends. Now, if catastrophe hits, and the stock price crashes, you are obligated to buy CAG at the strike price, just like an insurance company is obligated to pay you on your insurance policy. And if he decides to collect on his put insurance policy, just like an insurance company, you better have enough cash on hand to buy those CAG shares from him! Now, you do have the option to buy back the puts at a lose just before expiry, or even roll the put to a future date, but that is not the intent of the strategy that the author is suggesting to you.

I started selling covered call options on stocks that I own over 25 years ago. It took me another 15 years before I built up enough nerve to sell puts. Now, that likely is because I was overly cautious, but I hope you get my point.

[The Investment Doctor]

@LOST99 Good advice for novices. Another one I'd like to add is 'write only puts on stocks you wànt to own'. In essence, there's no difference between putting in an order at $30 or writing a put with a strike price of $30. In both cases your loss can be 100%.

You seem to be referring to writing put options without having enough cash to effectively get assigned. That's obviously not recommended. But if you write a P30 and have $3000 readily available, then there's no problem.

[LOST99]

@The Investment Doctor As you outline in your article, writing puts on stocks that you want to own is a good way to get the shares at the price you want, and collecting the put premium as a bonus. I only write cash secured puts on stocks that I would be happy to own. One must bear in mind that the further out into the future that you write a put, means that you must tie up the cash reserves to protect against the eventuality of assignment. I typically write on expiry dates out 30 to 45 days on covered calls and up to 60 days on cash secured puts.

[Thayden]

@LOST99 is correct. I'm new to options & have successfully written one covered call. I'm in the middle of another that is going well. I also decided to buy a cash secured put on a stock trading at $10.02. Strike price was $10 (zoiks!). Closed today at $8.40 but I bought to close before the final bell, lost $150. At least I was starting small on purpose.

Covered calls are the training wheels of options trading and I clearly need one on each side of my tricycle. Breaking Buffet's #1 rule is a good teacher.

[gsgold]

Would someone be so kind as to flush out exactly what is being outlined here? (I'm trying to learn options trading.)
You are "writing" (selling) puts with strike prices about $4.15 below market (at $34.15 in the chart above), and pocketing that premium (100x $.70 or $2.50 in your two examples), while buying/holding the stock outright. Do I have that correct?

[The Investment Doctor]

@gsgold That is correct. As I write the put options OTM, I also want to end up with a position (as there's no guarantee the OTM options will end up ITM).

So perhaps this makes it easier: Let's say I buy 100 shares of CAG, write 1P 30 in June and 1P 30 in January, I'll end up with 100 shares of CAG and $3.20 in total option premiums if CAG expires above $30.

If it trades below $30 and my put options get assigned, I will end up with 100 shares +200 shares from the ITM puts, while keeping the $3.20 option premiums.

Just to single out the P30 for June:

* If CAG expires above $30 (technically options can be exercised at any time, not just on the expiry date): I end up with just $0.70

* If CAG trades below $30 on the expiry date, I'll have to buy the stock at $30 while keeping the $70 in option premium which means at that point my average purchase price will be $29.30.

[gsgold]

@The Investment Doctor Meanwhile, you could also be writing (I believe they are called) naked puts, aka without buying the stock up-front?

[The Investment Doctor]

I'm not sure what you mean.

Writing puts: entering into a commitment to BUY the stock upon assignment

Writing calls: entering into a commitment to SELL at the strike price, upon assignment.

You can write naked calls (by not having the stock to sell if assigned) but theoretically your 'naked' puts are always backed by cash. If you sell 1 P30 and have $3000 in cash in the account, you aren't writing naked. You'd be writing half-naked if you'd only have $1500 in cash in the account.

[svy]

as an options newbie it looks like you are selling otm puts $30 below market share price $34.12 @ time of comment (aka selling to open a put?); Your timeline appears to be 90 days to 320+ days; If that is the case do you have a volatility impact entry criteria to be selling (writing) puts e.g. IV Rank above 50?

[The Investment Doctor]

@svy Hi SVY, no I'm not a professional options trader. I just look at what makes sense in terms of premium/timeframe/strike price.