Activist investors have the ability to influence significant changes in companies that they take an interest in, often leading to greater profits and investor confidence and ultimately driving stock prices higher.
Activists may take the form of institutional investors (such as mutual funds, hedge funds or endowments), or they may simply be one or more wealthy individuals. Whatever form they take, activist investors can be very motivated toward driving change in a company and unlocking shareholder value.
For this reason, it makes sense to keep track of the actions of successful activist investors, and to trade alongside these opportunists when possible. Today, I want to take a look at an income trade that does just that.
Darden Restaurants Pressured To Break Up
Our target today is Darden Restaurants (NYSE: DRI), owns and operates full-service restaurants chains such as the well-known Olive Garden and Red Lobster, as well as some relatively new chains like the Capital Grille and Yard House.
A consortium of activist investors, including Barington Capital, has taken an interest in the company because they think that Darden can unlock a significant amount of value by breaking the company into two separate entities.
According to these activist investors, DRI trades with a low price-to-earnings (P/E) multiple due to the fact that most investors are purchasing the stock because of the steady cash flows and reliable (but low-growth) profits that come from the Olive Garden and Red Lobster chains. Both of these restaurant concepts are cash cows, but they are also near market saturation and unlikely to grow significantly in the future.
As a general rule, stable investments with little growth potential trade at low multiples. Barington thinks investors are paying a low multiple for DRI because the stability of these two legacy brands overshadows the growth potential of the company's up-and-coming restaurant concepts.
Therefore, Barington is pushing Darden to break the company into two separate entities, believing the total value for the two companies will be much higher than the value for the single conglomerate.
Recently, Darden's management team said they were willing to spin off the Red Lobster brand but would still maintain the Olive Garden concept within the main company. The stock dropped significantly on the news as investors were disappointed with this half measure. However, the stock subsequently rallied when one of the activist investors, Jeffrey Smith, went public saying that the plan falls short of the actions required by the consortium.
At this point, it looks like the activist investors will continue to push for a full spin-off of the Olive Garden brand, which should unlock value for shareholders. I expect DRI to find support near its current level at $50.77. Meanwhile, the added volatility in the stock creates a put selling opportunity that should allow us to collect an attractive level of income.
Selling Puts on DRI to Generate 15% Per Year
My recommendation today is to sell the DRI March 50 Puts, which are currently trading near $1.50 per share. The put options may be trading a bit higher or lower when you look, but I would be willing to sell these puts with a limit order of $1.20 per share.
By selling the puts, we are obligating ourselves to buy shares at $50 should the stock trade below this level when the March puts expire. Given the changes the activist investors are pushing for, I would be willing to buy the stock at this level, as DRI looks like a great long-term investment. Meanwhile, if the stock does not drop below the $50 strike price, we can scoop up an attractive amount of income while waiting for our puts to expire.
Action to Take --> Since we would be obliged to buy the stock at $50, we must set aside the necessary capital in our account to cover this liability. We will be receiving at least $1.20 per share from selling the puts, so we will need to allocate an additional $48.80 per share ($4,880 per contract) of our own capital for the trade.
If DRI remains above $50, our net profit will be the $1.20 we receive from selling the puts. When you divide that by the $48.80 that we set aside, you get a nominal return of 2.46%. This will be booked over the course of 59 days, which nets out to a per-year rate of return of 15%.
If DRI trades back below $50, our net cost to buy the shares will be $48.80, a 4% discount to current prices. Keep in mind, the stock currently pays a $0.55 quarterly dividend, so if we are required to buy the stock, we can expect to receive an attractive dividend payment as it will go ex-dividend on or about April 8.
This article was originally published at ProfitableTrading.com:
Activist Investors' Push Could Help Income Traders Score a Big Payday