Government Action Could Help This Company Deliver for Investors
Tax reform is on every analyst’s mind right now. Changes in the corporate tax rate are a significant development. Many analysts are revising their earnings models to reflect the lower rates. In many cases, this will result in higher earnings per share.
But, the changes to the tax rules will have effects beyond the rate that companies pay. The reforms will also change business plans. Some companies made headlines within an hour of the bill becoming law by announcing bonuses for all workers.
Other companies announced new wage policies. There is little doubt that more companies are preparing plans in private. One area that is likely to see changes is capital spending.
Capital spending involves the purchase of large items or new buildings. The tax code changes the facts behind many decisions.
For example, in the past it might have been profitable for a company to build a factory overseas. Lower wages would offset the higher shipping costs and higher taxes. But, now, with lower taxes, the math might change. It could be best to pay higher wages to save shipping costs with low taxes.
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A Winner Could Be a Company That Doesn’t Pay High Taxes
Just like capital spending decisions are indirectly influenced by the passage of tax reform, some companies will be indirectly affected even though they pay relatively low tax rates already. One of the companies this could affect is U.S. Steel (NYSE: X).
X pays just a small amount of taxes. In the last full year, the company paid just 0.2% of its revenue in income taxes. Labor expenses, the cost of raw materials and depreciation account for more than 90% of revenue. That’s unlikely to change.
What is likely to change is the company’s customers’ tax bills. It’s true that many manufacturers show income statements that are similar to U.S. Steel’s. But, analysts still expect a benefit from the new law.
Manufacturers already benefit from a relatively low effective tax rate, but it will likely drop more under the plan — about six or seven points in 2018 — according to a new financial report from the Penn Wharton Budget Model.
Plus, government does do more than set tax rates. They also implement trade policies and on this front, it seems that U.S. Steel could receive a boost next month.
A Trade Ruling Is Due
U.S. Steel has a major catalyst coming in January that could potentially drive the stock’s share price much higher.
An analyst with Axiom noted “The reason why we got out of the way now is because you have a Section 232 case that is going to be determined by January 15, 2018—Trump is going to make a decision,” according to the analyst.
A section 232 investigation “focuses on whether the importation of the article in question is in such quantities or under such circumstances as to threaten to impair the national security.” It is conducted by the Secretary of Commerce who makes a recommendation to the President.
The President can concur or not with the Secretary’s recommendations, and take action to “adjust the imports of an article and its derivatives” or other non-trade related actions as deemed necessary.
President Trump has ordered an investigation into the potential risk that U.S. steel imports pose to national security. A decision could allow him to implement what are known as “Section 232 powers” to restrict steel imports.
The research report advised investors that the underlying fundamentals of the U.S. steel market remain weak, but there’s too much Section 232 upside risk at the moment to sell the stock.
“We want to get clarity on this Section 232 case…and I think then we’ll be in a better position to reevaluate how we feel on the stock,” according to the report.
The stock price has been rallying, perhaps in anticipation of a favorable decision.
The daily chart, shown next, confirms the up trend.
That indicates traders should consider strategies that provide bullish exposure to the stock.
To benefit from potential gains in X that are expected over the next few weeks to months, an investor could buy shares of the company. This requires 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.
A Specific Trade for U.S. Steel
For X, the January 19 options allow a trader to gain exposure to the stock through the expected period of seasonal strength.
A January 19 $35 call option can be bought for about $1.80 and the January 19 $37.50 call could be sold for about $0.80. This trade would cost $1,00 to open, or $100 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 $100.
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 X the maximum gain is $1.50 ($37.50 – $35 = $2.50; $2.50 – $1.00 = $1.50). This represents $150 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $100 to open this trade.
That is a potential gain of about 67% based on the amount risked in the trade. The trade could be closed early, immediately after the earnings announcement, if the maximum gain is realized before the options expire.
In this trade, options provide income and defined risk. These are the type of strategies that are explained and used Trading Tips
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