Options Players Toast Constellation

04/15/2010 12:00 pm EST

Focus: STOCKS

Jocelynn Drake

Financial Analyst, Schaeffer's Investment Research

Jocelynn Drake of Schaeffer’s Investment Research says the leading wine maker gets little respect on Wall Street, but options traders have a much sunnier view.

Wine and spirits maker Constellation Brands (NYSE: STZ) disappointed investors with its recent weak earnings forecast. STZ forecast adjusted earnings of $1.53 a share to $1.68 a share for fiscal 2011, which started March 1st, well below the Street's consensus estimate of $1.78 a share.

An article in Barrons.com (“Is Constellation Brands Worth a Shot?" April 9th) takes a pessimistic view following the forecast. The article acknowledges that the shares trade at just 9.1x forward earnings, cheaper than most rivals, but argues that the discount seems justified due to the company's poor margins and returns on equity, more than $4 billion in debt, little free cash, and no dividend.

Meanwhile, KDP Advisors analyst Thomas Ferguson reiterated his Hold rating on the stock, noting that despite his optimism about certain areas of the company, 2011 estimates do not yet reflect "ongoing economic challenges and management's guidance."

Furthermore, Morningstar analyst Philip Gorham agreed that [last week’s] announcement "support(s) our thesis that despite the company's scale, stiff competition in the wine industry will restrict Constellation's pricing power." Reducing its debt in 2011 could also be an issue, due to "a challenging competitive environment and rising costs restrain[ing] Constellation's profitability."

The article concludes that market leader Diageo (NYSE: DEO) and even Molson Coors (NYSE: TAP) look more attractive [than Constellation].

Overall, despite the negative tone of the article, options players are extremely optimistic toward STZ. The International Securities Exchange (ISE) and Chicago Board Options Exchange (CBOE) have seen an increase in call trading, as nearly four calls have been purchased to open for every one put purchased to open during the past 50 trading sessions. This ratio of calls to puts is higher than 73% of all those taken during the past year, pointing to a growing optimism.

Furthermore, the Schaeffer's put/call open interest ratio comes in at 0.45, as call open interest doubles put open interest among options slated to expire in less than three months.

Even short sellers are shedding their bearish bets. During the past month, the number of STZ shares sold short dropped by 12% to 2.9 million. This accumulation of pessimistic positions now accounts for only 1.5% of the company's float, leaving the stock with little potential short-covering pressure.

Technically speaking, the stock has gained only 3% since the beginning of the year, [and] it is struggling to stay above its ten-day moving average. A fall below this key level (below $17—Editor) could shake loose the remaining bulls, pushing the stock even lower. (It closed above $17 Wednesday—Editor.)

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