An Earnings Warning Sets Up An Income Opportunity
Some companies warn investors before releasing bad news. An example, as reported by Business Wire, Domtar Corporation (NYSE: UFS) recently provided an update on its financial performance for the fourth quarter 2019.
Domtar Corporation designs, manufactures, markets, and distributes various communication papers, specialty and packaging papers, and absorbent hygiene products in the United States, Canada, Europe, Asia, and internationally.
The company’s products include Xerox Paper and Specialty Media, EarthChoice Office Paper and Husky paper brands.
Domtar’s management expects fourth quarter 2019 sales to be $1.2 billion and the operating loss to be between $15 and $19 million. EBITDA before items is expected to be between $74 and $78 million.
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The expected operating loss in the fourth quarter 2019 includes closure and restructuring costs of approximately $19 million and depreciation and amortization of $74 million. Adjusting the estimated operating loss for these two amounts yields EBITDA before items.
During the fourth quarter, the Company repurchased 2.1 million shares for a total cost of approximately $75 million under our stock repurchase program.
“Our fourth quarter results fell short of expectations. We increased market-related downtime to better balance our supply with our customer demand and to accelerate our inventory reduction plan,” said John D. Williams, President and Chief Executive Officer. “Our inventories are now at optimal levels and our expectation is that our business will return to a balanced level in early 2020 given recent capacity closures.”
The stock was lower on the news as investors were expecting revenue of $1.28 billion and earnings per share of $0.25, which was still significantly below last year’s level of $1.63 for the same quarter.
The announcement confirmed a warning from Zacks which came a week earlier and noted,
UFS is being weighed down by higher maintenance costs, competitive pressure and volatile demand for softwood and pulp. Weak price performance and lowered earnings estimates do not instill investor confidence in the stock.
The company, with a market capitalization of $2.3 billion, carries a Zacks Rank #5 (Strong Sell) at present. In the past six months, the company’s shares have fallen 2.5% against the industry’s growth of 11%.
The company faces tremendous competitive pressure from local, and some global producers, which often possess relatively greater financial resources and lower production costs.
As such, Domtar has to make continued investments in value drivers, which act as a hedge against stiff competition but reduce its profitability to some extent. Also, given its international presence, the company often faces unfavorable foreign currency movements, impacting its top-line growth.
The ongoing slowdown in the manufacturing industry continues to have an adverse impact on business.”
These negatives could explain the stock’s recent down trend.
A Trading Strategy To Benefit From Weakness
A price decline often results in higher than average options premiums. That means option buyers will be forced to pay higher than average prices for trades, But, sellers could benefit from the higher premiums.
In this case, with a bearish outlook for the short term, a call option should be sold. The call should decline in value if the stock declines and sellers of calls benefit from this decline.
Selling options can involve a great deal of risk. A spread options strategy can be used to limit the potential risk of the trade.
One strategy that traders can consider is the bear call spread. This is a trade that uses two calls with the same expiration date but different exercise prices.
Traders buy one call and sell another call. The exercise price of the call you sell will be below the exercise price of the long call. The call is sold to limit the risk of the trade. So, this strategy will always generate a credit when it is opened and will always have limited risk.
The risk profile of this trading strategy is summarized in the diagram below which shows the limited risk and reward.
Source: The Options Industry Council
While risks and rewards are limited, this strategy will allow traders to generate potential gains in a stock they might otherwise find too risky to trade. Many individuals ignore bearish strategies because of the risks.
You’ll know the maximum potential gain with this strategy as soon as it’s opened. It is equal to the amount of premium received when the trade is opened. The maximum loss is equal to the difference between the exercise price of the options contracts less the premium received and is also known.
Every day, we scan the markets looking for trades that carry low risk and high potential rewards. These trades are available almost every day and we share them with you as we find them. Now, it’s important to remember these are trading opportunities in volatile stocks.
When we find a potential opportunity, we evaluate it with real market data. But because the trades are volatile, the opportunities may differ by the time you read this. To help you evaluate the current opportunity, we show our math and explain the strategy.
A Bear Call Spread in UFS
For UFS, we could sell a February 21 $35 call for about $3.71 and buy a February 21 $40 call for about $1.43. This trade generates a credit of $2.28, which is the difference in the amount of premium for the call that is sold and the call.
Remember that each contract covers 100 shares, opening this position results in immediate income of $228. The credit received when the trade is opened, $228 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $272. The risk can be found by subtracting the difference in the strike prices ($500 or $5.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($228).
This trade offers a potential return of about 83% of the amount risked for a holding period that is relatively brief. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if UFS is below $35 when the options expire, a likely event given the stock’s trend.
Call spreads can be used to generate high returns on small amounts of capital several times a year, offering larger percentage gains for small investors willing to accept the risks of this strategy. Those risks, in dollar terms, are relatively small, about $272 for this trade in UFS.