Albertson's Rally Overdone? Overwrite.


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Albertson's Rally Overdone? Overwrite.

  1. 1. EQUITY RESEARCHOctober 10, 2005 North America Investment Strategy & MacroEquity Derivatives Strategy Equity Derivatives Strategy Ryan RenickerMarket CommentaryStrategy 1.212.526.9425Albertsons Rally Overdone? Overwrite. rrenicke@lehman.comSector View:New: 0-Not RatedOld: 0-Not RatedInvestment conclusionq Option market participants are pricing in elevated risk expectations for Albertsons (ABS) shares, as implied volatilities on ABS options are trading high versus their own history, the stocks realized volatility, as well as the market and sector. Given the recent run-up in ABS shares and the companys relatively low break-up value, investors should consider hedging against a possible retracement in the stock by writing ABS Dec. 05 out-of-the-money calls struck at $27.50 against their long position in the underlying.We are seeing signs that risk expectations for ABS shares have continued to climb since early September, when the board announcedplans to explore its strategic options, such as pruning underperforming assets. This corresponded with a rally in ABS shares, which hadbeen under pressure for most of the year. Figure 1: ABS 3-Month Implied Volatility, Stock Price (LTM) 38% $27 ABS 3-Month Implied Volatility ABS Stock Price 36% $26 34% $25 32% $24 Implied Volatility Stock Price 30% $23 28% $22 26% $21 24% 22% $20 20% $19 5 -05 5 5 05 5 4 5 5 4 5 4 5 r-0 b-0 n-0 l-0 g-0 t-0 t-0 v-0 n-0 c-0 p-0 ar- ay Ap Ju Oc Oc Fe Ju No Au Ja De Se M M Source: Lehman BrothersHowever, Lehman Brothers Food & Drug Retailing analyst Meredith Adler estimates that the current break-up value of the company couldbe equal to $20 per share, which is roughly 20% below ABS’s stock price as of Friday’s close ($25.09). Based on the stock’s currentvaluation, Adler today downgraded ABS to “3-Underweight” from “2-Equal Weight”.Lehman Brothers does and seeks to do business with companies covered in its research reports. As a result, investors shouldbe aware that the firm may have a conflict of interest that could affect the objectivity of this report.Customers of Lehman Brothers in the United States can receive independent, third-party research on the company or companiescovered in this report, at no cost to them, where such research is available. Customers can access this independent research or can call 1-800-2LEHMAN to request a copy of this research.Investors should consider this report as only a single factor in making their investment decision. PLEASE SEE ANALYST(S) CERTIFICATION(S) ON PAGE 3 AND IMPORTANT DISCLOSURES BEGINNING ON PAGE 4 1
  2. 2. EQUITY RESEARCHABS: High Embedded Risk ExpectationsFrom the options market’s perspective, the spread of ABS 3-month implied minus 90-day realized volatility is currently trading at ahigher level than where it had been 78% of the time during the past year. Additionally, ABS 3-month implied volatility spreads versusthe S&P 500 Index and the S&P 500 Consumer Staples sector stand nearly 4 standard deviations above the average of where eachof these spreads has traded during the past year. This indicates that traders in ABS options are pricing in elevated risk expectations overthe next few months (Figures 2 and 3).Figure 2: ABS 3M – 90-Day Realized Vol. Spread Figure 3: ABS vs. SPX 3M Implied Vol. Spread 8% 25% 6% 23% ABS - S&P500 3M IVOL SpreadABS Implied - Realized Vol. Spread 3% 20% 1% 18% -2% 15% -5% 13% -7% 10% 5 5 5 4 5 4 5 5 4 5 5 5 5 5 5 5 5 5 n-0 r-0 4 5 y-0 v-0 l-0 t-0 t-0 5 g-0 5 5 c-0 p-0 b-0 r-0 n-0 t-04 4 5 l-0 n-0 r-0 t-0 g-0 c-0 p-0 y-0 b-0 r-0 v-0 n-0 Ju Ap Oc Oc Ma Ma Ja No Au De Ju Se Oc Ap Fe Ju Oc Ma Ma Ja Au De No Se Fe JuSource: Lehman Brothers. Source: Lehman Brothers.Given the possibility that ABS’s break-up driven rally could be overextended due to the relatively low fundamental equity valuation,investors holding ABS shares should consider selling (the relatively "rich") out-of-the-money calls to hedge against a possible retracement.For example, investors can write ABS December 05 $27.50 calls and collect about $0.65, which is approximately 2.6% of ABSs stockprice (based on Friday’s close). This strategy outperforms a long-only position in ABS shares , unless the stock rallies above $28.15 as ofthe December 16th expiration date (~ 12.2% above Friday’s close).Figure 4: Payoff Diagram: ABS Dec. $27.50 Overwrite Figure 5: Stock Price vs. Overwrite Outperform Range $4 $30 Overwrite Payoff Stock-Only Payoff $29 $3 $28 Payoff at Expiration $27 Overwrite Outperforms $2 Stock-Only Strategy ABS (Closing Price) $26 $25 $1 $24 Outperform Long-Only... $- $23 $22 Current Stock Price $(1) $21 $20 $(2) $19 0 5 0 5 0 5 2.5 3.7 5.0 6.2 7.5 8.7 05 -05 4 4 5 4 5 5 $2 $2 $2 $2 $2 $2 5 5 5 5 5 5 5 t-0 v-0 v-0 c-0 n-0 l-0 n-0 r-0 y-0 g-0 p-0 t-0 c-0 b- ar Ju Oc Ap Oc Fe Ma Ju No No Ja Au De De Se M Stock Price at ExpirySource: Lehman Brothers. Source: Lehman Brothers. 2
  3. 3. EQUITY RESEARCHOptions are not suitable for all investors and the risks of option trading should be weighed against the potential rewards.Supporting documents that form the basis of the recommendations are available on request. Please note that the trade ideaswithin this report in no way relate to the fundamental ratings applied to European stocks by Lehman Brothers Equity Research.Analyst Certification:I, Ryan Renicker, hereby certify (1) that the views expressed in this research Industry Note accurately reflect my personal views about any orall of the subject securities or issuers referred to in this Industry Note and (2) no part of my compensation was, is or will be directly orindirectly related to the specific recommendations or views expressed in this Industry Note.Other Team Members:Mallick, Devapriya 1.212.526.5429 3
  4. 4. EQUITY RESEARCHImportant Disclosures:Albertsons Inc. (ABS) $ 24.99 (05-Oct-2005) 2-Equal weight / 2-NeutralRating and Price Target Chart: ALBERTSONS INC. As of 05-Oct-2005 Currency = USD 32.00 30.00 28.00 26.00 24.00 22.00 20.00 18.00 16.00 10-02 1-03 4-03 7-03 10-03 1-04 4-04 7-04 10-04 1-05 4-05 7-05 10-05 Closing Price Price Target Recommendation Change Drop Coverage Source: FactSetCurrency=$Date Closing Price Rating Price Target Date Closing Price Rating Price Target05-Sep-05 23.05 21.00 05-Sep-03 22.92 21.0015-Mar-05 19.97 19.00 06-Jun-03 19.20 18.0028-Feb-05 22.39 23.00 31-Oct-02 22.31 23.0003-Dec-04 23.66 25.00 29-Oct-02 27.35 30.0029-Apr-04 23.31 26.00 29-Oct-02 27.35 2-Equal weight23-Mar-04 22.60 24.00 FOR EXPLANATIONS OF RATINGS REFER TO THE STOCK RATING KEYS LOCATED ON THE PAGE FOLLOWING THE LAST PRICE CHART.Lehman Brothers Inc. and/or its affiliates beneficially owns 1% or m ore of any class of common equity securities of Albertsons Inc. as of theend of last month.Lehman Brothers Inc and/or an affiliate trade regularly in the shares of Albertsons Inc..Risks Which May Impede the Achievement of the Price Target: We see risks of a slower sales environment, in part due to deflation,leading to a much "hotter" promotional environment in manymarkets, thereby significantly reducing earnings growth. We also think that the weak employment climate has caused customers to shop fordeals at other retail channels, especially value-oriented retailers such as discounters, clubs and dollar stores, and there is a potential thatthese customers will not return to supermarkets once the employment outlook improves. Moreover, if the recent inflationary trends beingexperienced within the industry were to continue for a number of months, or become more severe, Albertsons earnings could come underpressure. In the past Albertson’s has been negatively impacted by the entry of Wal-Mart supercenters into markets where its market shareor price image was weak. Thus, we view ABS as particularly vulnerable to Wal-Mart’s expansion into the Pacific Northwest, and continuedexpansion in Denver and Phoenix. Wal-Mart could continue to lower its prices aggressively, forcing Albertsons to match Wal-Mart withoutthe same ability to lower its cost structure. 4
  5. 5. EQUITY RESEARCHImportant Disclosures Continued:The analysts responsible for preparing this report have received compensation based upon various factors including the firms totalrevenues, a portion of which is generated by investment banking activitiesCompany Name Ticker Price (05-Oct-2005) Stock / Sector RatingAlbertsons Inc. ABS $ 24.99 2-Equal weight / 2-NeutralSector Coverage UniverseNot applicable.Guide to Lehman Brothers Equity Research Rating System:Our coverage analysts use a relative rating system in which they rate stocks as 1-Overweight, 2-Equal weight or 3-Underweight (seedefinitions below) relative to other companies covered by the analyst or a team of analysts that are deemed to be in the same industrysector (the “sector coverage universe”). To see a list of the companies that comprise a particular sector coverage universe, please go addition to the stock rating, we provide sector views which rate the outlook for the sector coverage universe as 1-Positive, 2-Neutral or 3-Negative (see definitions below). A rating system using terms such as buy, hold and sell is not the equivalent of our rating system.Investors should carefully read the entire research report including the definitions of all ratings and not infer its contents from ratings alone.Stock Rating1-Overweight - The stock is expected to outperform the unweighted expected total return of the sector coverage universe over a 12-monthinvestment horizon.2-Equal weight - The stock is expected to perform in line with the unweighted expected total return of the sector coverage universe over a12- month investment horizon.3-Underweight - The stock is expected to underperform the unweighted expected total return of the sector coverage universe over a 12-month investment horizon.RS-Rating Suspended - The rating and target price have been suspended temporarily to comply with applicable regulations and/or firmpolicies in certain circumstances including when Lehman Brothers is acting in a n advisory capacity in a merger or strategic transactioninvolving the company.Sector View1-Positive - sector coverage universe fundamentals/valuations are improving.2-Neutral - sector coverage universe fundamentals /valuations are steady, neither improving nor deteriorating.3-Negative - sector coverage universe fundamentals/valuations are deteriorating.Distribution of Ratings:Lehman Brothers Equity Research has 1759 companies under coverage.42% have been assigned a 1-Overweight rating which, for purposes of mandatory regulatory disclosures, is classified as Buy rating, 35% ofcompanies with this rating are investment banking clients of the Firm.41% have been assigned a 2-Equal weight rating which, for purposes of mandatory regulatory disclosures, is classified as Hold rating, 7%of companies with this rating are investment banking clients of the Firm.17% have been assigned a 3-Underweight rating which, for purposes of mandatory regulatory disclosures, is classified as Sell rating, 85%of companies with this rating are investment banking clients of the Firm.This material has been prepared and/or issued by Lehman Brothers Inc., member SIPC, and/or one of its affiliates (“Lehman Brothers”) and has beenapproved by Lehman Brothers International (Europe), authorized and regulated by the Financial Services Authority, in connection with its distribution in theEuropean Economic Area. 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