Recommendation No. 1: Diageo (NYSE: DEO)

“Sell to Open” Diageo October $110 Call

Option Symbol: DEO121020C110

Limit Order Price: $1.45 or more

Directional View for Underlying Stock: Neutral

Personal Finance Portfolio: Growth

• Income generated: $145 per options contract (representing 100 shares of stock)
• 64-day rate of return at current stock price of $107.57: 1.3 percent (7.7 percent annualized)
• Tell your broker:

“I want to sell a covered call against 100 shares of my Diageo (DEO) stock. Specifically, I want to ‘sell to open’ one October $110 call for a credit of $1.45 per share or more.”

• Remember: You should only sell one call option per 100 shares of stock purchased. The trade can only be done in 100-share increments (100, 200, 300, 400, 500, etc.).

Alternative Trade for Those Who Don’t Already Own Diageo:

Buy/Write on Diageo (NYSE: DEO): Buy the Stock and Simultaneously “Sell to Open” the October $110 Call

Option Symbol: DEO121020C110

Limit Order Price: $106.12 or less (stock is at $107.57 and October $110 call is at $1.45)

Directional View for Underlying Stock: Neutral

Personal Finance Portfolio: Growth

• Net cost of buy/write: $10,612 per 100 shares
• 64-day return if stock does not move: 1.3 percent (7.7 percent annualized)
• Brokers vary as to whether they call this trade a “buy/write” or a “covered stock” trade.
• Do the trade simultaneously at a single limit price, if possible. For example, if you want to buy 100 shares of stock, tell your broker:

“I want to do a buy/write trade. Specifically, I want to buy 100 shares of Diageo (DEO) and ‘sell to open’ one October $110 call for a net debit of $106.12 per share or less.”

• Some brokers require that you buy the stock and sell the call in separate trades. If your broker is one of these, always buy the stock first and sell the call against it second:

Trade No. 1:

“I want to buy 100 shares of Diageo (DEO) for $107.57 per share or less.”

Trade No. 2:

“I want to sell a covered call against 100 shares of my Diageo (DEO) stock. Specifically, I want to ‘sell to open’ one October $110 call for a credit of $1.45 per share or more.”

Please note: When doing a buy/write trade in two steps rather than in one simultaneous trade, the important thing is limiting the net cost of the buy/write to $106.12 per share. The specific limit prices of the individual “buy stock” and “sell covered call” trades are just starting points and should be adjusted as needed, keeping the net cost of the overall buy/write in mind.

• Ex-Dividend Date: The stock’s next semi-annual ex-dividend date is around September 5th. If the October $110 call is in the money at that time, there is a chance that the call owner will opt to exercise the option early in order to capture the estimated $1.65 “final” dividend for 2012. In such a case, an early roll of the covered call may be warranted.
• Why the October $110 Strike?: Personal Finance lead advisor Elliott Gue has set a “buy below” target for Diageo of $105 per share. With Diageo trading 2.4 percent above that target level at $107.57, the stock has gotten ahead of its fundamentals and more upside is unlikely. About 60 percent of the company’s sales come from North America and Europe. Diageo management recently concluded that “these devel­oped markets will be unable to drive substantial, long-term growth.” Consequently, additional stock appreciation may be delayed until the company can further expand into higher-growth emerging markets like China, Latin America and Turkey.

Price Adjustments Regarding This Trade

Stock prices are currently fluctuating and option prices fluctuate with them. Consequently, the limit prices recommended in this trade alert may no longer be immediately fillable by the time the alert has been released. The alerts are valid for seven days, so be patient and place your limit orders as “good ‘til canceled” (GTC) for seven days.

Investment Rationale for Underlying Stock:

Diageo (NYSE: DEO, London: DGE), the world’s biggest producer of al­coholic drinks, boasts an impressive lineup of premium brands that reads like the contents of a fully stocked bar: Guinness, Red Stripe, Tusker, Johnny Walker, Bushmills, Crown Royal, Cap­tain Morgan, Tanqueray, Baileys, Smirnoff, and Ciroc. Thanks to attentive brand control, these well-established names carry a reputation for quality that attracts aspirational consumers in both developed and developing markets.

London-based Diageo’s performance has been as heady as its spirits. The company reported in April that first-half fiscal 2012 earnings increased 16 percent to $2.2 billion. The strong performance of Johnnie Walker in all markets, coupled with accelerated expansion of the company into emerging markets around the world, helped offset sales declines in troubled Southern Europe­an markets.

Net revenue (i.e., total revenue minus excise duties) reached $9.2 billion in the first half of fiscal 2012, up from $8.3 billion a year ago. Gross prof­it climbed 11.7 percent year over year to $5.7 billion, from $5.1 billion a year ago.

The company said consumer trends continued to be “robust” in Latin Amer­ica, matched by price increases and consumers choosing more expensive products. Management expects to widen its operating profit from $2.8 billion in 2011 to $3.2 billion in 2012. It also expects earnings per share of $3.92 in 2012, up from $3.11 in 2011, in line with analysts’ estimates.

Diageo is pursuing an aggressive strategy of expansion in developing markets. Notably, it plans to penetrate Brazil’s $4.4 billion alcohol market by purchasing Brazil-based Ypioca for $453 million. Ypioca is Brazil’s third-largest producer of cachaca, which is distilled from sugar cane and accounts for four out of every five spirits sold in this vast country. Management said this acquisition won’t affect its earnings during the first year of ownership.

Latin American and Caribbean markets represented Diageo’s fastest grow­ing segments during the past nine months, at roughly 18 percent sales growth com­bined. The company is now in talks to purchase the world’s biggest tequila brand Jose Cuervo for more than $2 billion from its family owners.

The company recently announced that it had bought Cabin Fever Maple Flavored Whiskey, allowing the company to tap growing demand for fla­vored whiskey. Diageo plans to start selling Cabin Fever Whiskey this fall.

The company also announced a $1.2 billion investment program in Scotch whiskey production over the next five years. Already the world’s largest Scotch producer with 29 distilleries, the firm plans to construct a new malt distillery and warehouses, as well as expand existing ones. The company also has contingency plans for additional distilleries, depending on global demand.

This investment is expected to increase whiskey production by 30 percent to 40 percent over the next five years to satisfy a predicted global demand growth of about 50 percent.
Driven by demand in emerging markets such as Asia, Latin America and Africa, sales of Diageo’s Scotch brands grew by 50 percent over the past five years to $4.6 billion in 2011–roughly one-third of the company’s total $13.2 billion in sales in 2011.

In another bid to fuel growth, the company this year launched a major marketing push toward women.