Earnings Sets Up a Possible Gain of 63%
In earnings season there are often trading opportunities in the news. An example, as Benzinga reported,
“Record revenues helped Kansas City Southern (NYSE: KSU) generate a 3% increase in third-quarter profit compared with the same period in 2018.”
The stock jumped on the news.
Kansas City Southern has domestic and international rail operations in North America that are focused on the north/south freight corridor connecting commercial and industrial markets in the central United States with industrial cities in Mexico.
The company’s subsidiaries include The Kansas City Southern Railway Company (KCSR) and Kansas City Southern de Mexico, S.A. de C.V. (KCSM).
KCSR serves a 10-state region in the midwest and southeast regions of the United States and has the north/south rail route between Kansas City, Missouri and various ports along the Gulf of Mexico in Alabama, Louisiana, Mississippi and Texas.
KCSM operates a corridor of the Mexican railroad system. KCSM’s rail lines provide rail access to the United States and Mexico border crossing at Nuevo Laredo, Tamaulipas. KCSM also provides rail access to the Port of Lazaro Cardenas on the Pacific Ocean.
Benzinga continued, “Reported net income for the third quarter was $180.6 million, or $1.81/diluted share, compared with $174 million, or $1.70/diluted share in the third quarter of 2018.
Adjusted diluted earnings per share were $1.94, 24% higher than the same period in 2018.
The company said investors should consider the adjusted earnings because they take into account factors such as foreign exchange currency rates, the impact of adjustments to the 2017
provisional income tax benefit for the Tax Cuts and Jobs Act and other items that are not directly related to ongoing operations.
Meanwhile, operating ratio (OR) in the third quarter was 62.3%, while the adjusted OR was 60.7%. In the third quarter of 2018, the OR was 62%, while the adjusted OR was 63.4%.
Investors sometimes use OR as an indicator or profitability, with a lower OR implying greater profitability. Kansas City Southern defines OR as dividing operating expenses by revenues.
Third-quarter revenue rose 7% to $747.7 million even though carloads were flat year-over-year. Among the notable gains, increased refined fuel products and liquid petroleum gas shipments to Mexico helped fuel a 21% revenue increase in KSU’s chemicals and petroleum segment, while improved cycle times helped the minerals segment’s third-quarter increase by 15%.
Reported operating expenses were $465.7 million in the third quarter of 2019, compared with $433.6 million in the third quarter of 2018. But KSU said investors should consider adjusted operating expenses of $453.7 million.
“We are very pleased with our progress towards implementing PSR [precision scheduled railroading] principles. Notwithstanding this exceptional performance, we expect to continue optimizing our cost profile while delivering superior customer service and shareholder value,” said KSU Chief Executive Officer Patrick J. Ottensmeyer.
While the stock jumped on the news, the chart shows the rally was a breakout and additional gains are possible.
A Trade for Short Term Bulls
As with the ownership of any stock, buying KSU could require a significant amount of capital and exposes the investor to standard risks of owning a stock.
To reduce the risks of a trade, an investor could purchase a call option. This allows them to benefit from upside moves in the stock while limiting risk to the amount paid for the options. However, buying a call option can also require a significant amount of capital and includes the risk of a 100% loss.
Whenever an option is bought, the maximum risk is always equal to 100% of the amount of spent to purchase the option. Since options cost significantly less than a stock, the risk in dollar terms will usually be relatively small to own an option.
To further limit the risks of the trade, an investor could use a bull call spread. This strategy consists of buying one call option and selling another at a higher strike price to help pay for the cost of buying the first call. The spread strategy always reduces the risk of an options trade.
This strategy is designed to profit from a gain in the underlying stock’s price but has the benefit of avoiding the large up-front capital outlay and downside risk of outright stock ownership. The potential risks and rewards of this strategy are summarized in the chart below.
Source: The Options Industry Council
Both the potential profit and loss for the bull call spread are limited. The maximum loss is equal to the net premium paid when the trade is opened. The maximum profit is limited to the difference between the strike prices, less the debit paid to put on the position.
This strategy could be especially appealing with high priced stocks where the share price and options premiums are often a significant commitment of capital for smaller investors.
A Specific Trade for KSU
Every day, we scan the markets looking for trades with 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.
For KSU, the December 20 options allow a trader to gain exposure to the stock.
A December 20 $145 call option can be bought for about $5.10 and the December 20 $150 call could be sold for about $3.20 his trade would cost $1.90 to open, or $190 since each contract covers 100 shares of stock.
The amount paid to enter the trade is the largest possible loss on the trade. This is generally true whenever a trader is creating a debit to enter an options trade. “Creating a debit” means there is a cost to enter the trade. You could create a debit by simply buying puts or calls to open a directional trade.
In this trade, the maximum loss would be equal to the amount spent to open the trade, or $190.
The maximum gain on the trade is equal to the difference in exercise prices less the amount of the premium paid to open the trade.
For this trade in KSU the maximum gain is $3.10 ($150 – $145= $5; $5 – $1.90 = $3.10). This represents $310 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $190 to open this trade.
That is a potential gain of about 63% based on the amount risked in the trade. The trade could be closed early if the maximum gain is realized before the options expire.