This 115-Year-Old Company Could Deliver a 184% Gain
Trade summary: A bull call spread in Badger Meter, Inc. (NYSE: BMI) using the November $80 call option which can be bought for about $3.20 and the November $85 call could be sold for about $1.90. This trade would cost $1.30 to open, or $130 since each contract covers 100 shares of stock.
In this trade, the maximum loss would be equal to the amount spent to open the trade, or $130. The maximum gain is $370 per contract. That is a potential gain of about 184% based on the amount risked in the trade.
Now, let’s look at the details.
Badger Meter, Inc. manufactures and markets flow measurement, control, and communication solutions in the United States, Asia, Canada, Europe, Mexico, the Middle East, and internationally.
It offers mechanical or static water meters, and related radio and software technologies and services to municipal water utilities.
The company also provides flow instrumentation products, including meters and valves to measure and control fluids going through a pipe or pipeline, including water, air, steam, oil, and other liquids and gases to original equipment manufacturers as the primary flow measurement device within a product or system, as well as through manufacturers’ representatives.
Badger Meter has been in this business for more than a century since its founding in 1905.
BMI recently reported results for the third quarter ended September 30, 2020.
Business Wire reported, resiliency of municipal water market evident with consolidated third quarter 2020 sales of $113.6 million, an increase of 5% compared to $108.6 million in the comparable prior year quarter; municipal water sales grew 11% year-over-year.
Strong incremental profitability with a 210 basis point increase in operating profit margins.
Net earnings and diluted earnings per share (EPS) were $14.9 million and $0.51, respectively, compared to $12.7 million and $0.44 in the comparable prior year period.
Generated $21 million of cash provided by operations representing strong earnings conversion, ending the quarter with $94 million in cash on the balance sheet.
“During the quarter, we continued to effectively serve customers while protecting the health, safety and well-being of our employees and communities. We were pleased with the stability of municipal water order rates from the second quarter trough, and with the performance of our manufacturing operations which recovered productivity and output. My thanks go to all the Badger Meter employees who continue to adeptly serve our customers and keep our operations running safely and efficiently,” said Kenneth C. Bockhorst, Chairman, President and CEO of Badger Meter.
“As we look ahead, we will continue to adapt to and execute through the far-reaching implications of the pandemic. While there have been sporadic, short-term award delays, we have not experienced cancellations and our backlog and bid funnel of attractive opportunities remains solid.
Unsettled market conditions and related customer budget uncertainty, primarily in North America, could impact a portion of our large and diverse customer base, however, we anticipate the critical municipal water industry in general will be more resilient, on a relative basis.
End markets and product applications served by the flow instrumentation product line are expected to remain challenged.
While we cannot control the cadence of orders, we can and will build on our successes from the first nine months of the year and leverage those in the fourth quarter and into 2021. Our strong cash generation and balance sheet allow us to nimbly execute our capital allocation strategy.
This involves investing to grow our business organically and through acquisitions that are consistent with our vision and objectives, as well as returning cash to shareholders via dividends, with this past August marking the 28th consecutive year of increased dividends.”
The stock jumped on the news.
BMI broke out of a base and could continue higher although there are risks of a pullback.
A Specific Trade for BMI
For BMI, the November options allow a trader to gain exposure to the stock. This trade will be open for about six weeks and allows for traders to turn over capital quickly, potentially compounding gains several times a year.
A November $80 call option can be bought for about $3.20 and the November $85 call could be sold for about $1.90. This trade would cost $1.30 to open, or $130 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 $130.
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 BMI, the maximum gain is $370 ($85- $80= $5; 5- $1.30 = $3.70). This represents $370 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $130 to open this trade.
That is a potential gain of about 184% based on the amount risked in the trade. The trade could be closed early if the maximum gain is realized before the options expire.
A Trade for Short Term Bulls
As with the ownership of any stock, buying BMI 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 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 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.