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Stutland: Is Whole Foods Wholly Valued?

This is a Guest Blog from CNBC Contributor Brian Stutland.

Donna Mcwilliam

Yesterday, one option trader placed a big bet for the rest of 2013, by buying 86,200 shares of Whole Foods at $89.82, and selling 862 January 2014 98-strike calls for $6.50.

This covered call position will break even as long as Whole Foods is above 83.32 one year from now (that would be a 7 percent move lower).

If Whole Foods rallies 9% to $98 by next January, this trade will return 16%, because of the call premium collected. This is a conservatively bullish trade that at hedges downside risk while leaving room for growth. From a risk/reward perspective, this is a great trade: it offers 7% downside protection and 16% potential upside appreciation. Additionally, holding a long-dated short call against a stock reduces the day-to-day price fluctuations of the overall position, and makes it easier to stick with the original trade thesis for the entire year – even during whippy, volatile markets.

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That said, while I do like the risk/reward of this trade, in order to justify putting it on, I would also need to like the underlying company.

Whole Foods is a brand name I love, but think its stock is a bit pricey to buy here. Currently, Whole Foods trades at 4.4 times book value, a 35.5 price-to-earnings ratio, and 1.4 times sales. This is not an astronomically high valuation for a growth company, but certainly shows that the stock is not cheap.

What I do like is that Whole Foods consistently posts higher gross margins (currently 36%) than its competitors like Safeway (27%) and Kroger (21%). The company also has a strong history of growth, and offers a 0.9% dividend yield. The company's growth has come from its ability to use free cash flow to open new stores in new markets. In doing so, it has capitalized on the American trend of eating higher-quality organic food, and the newfound willingness to pay a premium for it.

All in all, I like Whole Foods, but would not buy the stock without downside protection, because of its full valuation at the moment. As a longer-term investment, I think Whole Foods has room to run, and would be happy to capture a 16% return in a year. The seven percent downside protection that this trader's call sale call offers makes it easier to buy the stock at these levels, and on a sell-off I would look to accumulate a few more shares for the long-term.

Disclosures: I do not yet have a position in the stock.

Brian Stutland is Managing Member of Stutland Equities and a contributor to CNBC's "Options Action."

Watch "Options Action" on CNBC Fridays 5:00 p.m. ET, Saturdays at 6 a.m. ET and on Sundays at 6 a.m. ET.

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