How do you profit with limited risk when a company is in trouble?
Over the past few weeks we’ve been documenting the problems at Papa John’s (PZZA - Free Report) , mostly centered around the resignation of company founder John Schnatter from his position as Chairman of the Board after it was reported that he had used a racial slur in a conference call with a public relations firm Papa John’s had hired.
It was Schnatter’s second public relations disaster in less than a year as Papa John’s had already lost a lucrative NFL endorsement deal over comments he made that were deemed culturally insensitive in November of 2017 about National Anthem protests at football games.
Talks with Wendy’s (WEN - Free Report) about a possible merger or acquisition were shelved in the wake of the most recent controversy.
Read about those issues here>> and here>>
A Wednesday headline on CNBC.com pondered whether the company was “beyond recovery.” In the article, a current multi-unit Papa John's franchisee was quoted as saying that sales were off between 5 and 20% since July 11th and that he was facing the possibility of closing one or more of his stores if the trend continues.
Since our last report, the situation at Papa John’s has deteriorated significantly and the board voted to adopt a “poison pill” defense against the possibility that Schnatter might amass a controlling interest in the company. In an 8-K filed with the SEC, the directors outlined the plan that would allow the board to issue one share purchase right to existing shareholders in the event that a single individual, and including the family and associates of that individual, acquired 15% of Papa John’s shares.
The additional purchase rights would not be granted to the individual or entity that had acquired the 15% interest. The intent is to dilute the interest of any party that seeks to acquire a controlling share of the company that would allow them to negotiate without the approval of the board.
Schnatter is specifically named in the SEC filing as having been “grandfathered” because he already owns between 29 and 30% of shares in Papa John’s. In the case of Schnatter, the poison pill would not be triggered unless he or his associates acquired 31% of outstanding shares.
The term of the poison pill provision is one year, which the board believes is enough time for them to carefully and thoroughly consider all options.
Even prior to the Schnatter controversy, Papa John’s had already been badly underperforming both the broad markets and its more adept competitor, Domino’s (DPZ - Free Report) , with declining same-store sales and a succession of downward earnings revisions. Papa John’s is currently a Zacks Ranks #5 (Strong Sell).
Shares in the company, which were already 42% off of their all-time highs – which were reached in December of 2016 - have declined an additional 13% just this week after news of the board’s poison pill resolution were made public.
The Low-Risk Way to Get Short
Simply selling shares of a public company short can be an uncomfortable and dangerous proposition. No matter how confident you are in your thesis for the trade, unlimited losses are always possible.
There’s also the additional complication that an individual investor is rarely alone when it comes to negative sentiment about a company that’s recently experienced a run of bad press. This can work against the shorts as any short-term rally causes financial and emotional pain and the shorts all tend to try to cut losses at the same time, driving share prices higher.
The following trade is definitely not the most complicated or sophisticated options strategy you’re going to read about in “Know Your Options”, but simplicity can definitely be an advantage. It offers limited risk and a healthy profit to loss ratio if we’re correct.
Buy a put vertical spread.
We’re going to choose longer dated options because of the length of the poison pill provision. The options expiring in January of 2019 have approximately 6 months left, at which point the situation at Papa John’s should be much clearer.
We’re going to buy one Jan 40 put and sell one Jan 30 put.
As of the close on Wednesday, the market prices of the options we’re going to trade are:
Jan 19 40 put 3.20 3.60
Jan 19 30 put 0.60 1.00
These markets are pretty wide - which is often the case in longer term options on stocks that have been experiencing high volatility. Even at $3, this spread offers us better than a 2 to 1 profit ratio if we’re correct and Papa John’s continues to slide, but let’s try to buy it a little cheaper. If we can pay 2.70, we’re very close to a 3 to 1 potential profit on the capital we’re putting at risk.
If we’re wrong and Papa John’s can pull out of the tailspin, we’ve only lost $270 per spread. If we’re correct, we can pick up $730.
It’s a spread with great potential, but we can also sleep easy at night. Options trades don’t have to be complicated. If you’ve got a strong sentiment on a stock – bullish or bearish – a simple vertical spread is often the best way to turn your ideas into profits.
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