Stock Buybacks Can Still Do What They Once Did
Stock buyback programs have been available to companies for decades. They can be an important tool as they were in October 1987 when many companies announced buybacks to help boost their stock after that historic market crash.
“Companies buy back shares for a number of reasons, such as to increase the value of remaining shares available by reducing the supply or to prevent other shareholders from taking a controlling stake.
A buyback allows companies to invest in themselves. Reducing the number of shares outstanding on the market increases the proportion of shares owned by investors. A company may feel its shares are undervalued and do a buyback to provide investors with a return.
And because the company is bullish on its current operations, a buyback also boosts the proportion of earnings that a share is allocated. This will raise the stock price if the same price-to-earnings (P/E) ratio is maintained.”
Another example of a company using a buyback in an effort to counter bad news was recently seen in the market.
A Buyback Announcement Follows a Negative Analyst Report
Deutsche Bank (DB) analyst Amit Mehrota, meanwhile, has placed a buy rating on the company’s stock, as has Stifel, following a negative research note from noted short-seller Spruce Point Capital Management.
Both actions seemed to combine to push the price of the stock up.
“To be sure, we are not forensic accountants, but there are enough inaccuracies in the report, and highly misleading analysis – especially with respect to the cash flow – to make us feel today’s sell-off could ultimately be seen as one of the great buying opportunities,” Mehrota wrote.
“We understand the difficulty in timing, given broader macro concern and lackluster guidance, but ultimately, we feel this short report will be remembered for its inaccuracies rather than its soundness.”
XPO did not elaborate on the share repurchase program or whether it had been in the works prior to the Spruce Point report. In a release, the company said it would fund the repurchase through a variety of methods, including “existing cash, borrowings on XPO’s revolving credit facility and/or other financing sources.”
Mehrota’s research note included counter arguments to the main points of the Spruce Point report, saying that DB had found no “smoking gun” that would lead to the conclusion of Spruce Point’s Ben Axler that XPO was providing no “tangible financial return” to investors.
On a point-by-point basis, Mehrota attacked Axler’s main points, including his claim that XPO was overstating its total enterprise value.
“It appears the report is double counting secured debt of $2.1B… implying EV under its own definition is $15.1B vs. $17.2B as stated in the presentation. This error translates to over 1 turn of valuation, which would directly counter the conclusion that ‘XPO is more expensive than it appears.'”
Axler also claimed that free cash flow was only $73 million on over $6.1 billion in capital deployed. This fails to include proceeds from asset sales, Mehrota said, which is standard in trucking-related companies.
“This would add $79M to FCF in ’17 and $69M in 2016, and more than triple the report’s estimate of ‘cumulative free cash flow,'” Mehrota noted.
Mehrota went on to point out that Spruce Point compares leveraged free cash flow to enterprise value and it ignores inflows expected in the fourth quarter of 2018.
“This … is most indicative of our overall impression of the report, which cherry picks cash flows to reach misleading conclusions together with calculation errors,” Mehrota said.
Traders could expect a bounce in XPO after the extreme selling pressure seen in recent weeks.
A Trade for Short Term Bulls
As with the ownership of any stock, buying XPO 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 XPO
For XPO, the January 18 options allow a trader to gain exposure to the stock.
A January 18 $52.50 call option can be bought for about $4.30 and the January 18 $55 call could be sold for about $3.20. This trade would cost $1.10 to open, or $110 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 $110.
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 XPO the maximum gain is $1.40 ($55 – $52.50 = $2.50; $2.50 – $1.10 = $1.40). This represents $140 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $110 to open this trade.
That is a potential gain of about 127% based on the amount risked in the trade. The trade could be closed early 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 in TradingTips.com’s Extreme Profits Calendar service. This service uses seasonals as one indicator in its trade selection process. To learn more about how options can be used to meet your goals, click here for details on Extreme Profits Calendar.