This Company Might be buying GE’s Problems
General Electric has been challenged in the past few years and some analysts expect the company to restructure in order to save itself. That restructuring might be underway with GE selling off some assets. However, selling assets may not solve all problems.
Even companies that are buying the assets are facing questions about the strength of GE’s businesses. That’s why analysts believe Wabtec (NYSE: WAB) sold off recently.
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Barron’s explained that worries about General Electric’s financial situation spilled over to Wabtec recently, as the latter prepares to close its acquisition of GE Transportation early next year.
Yet analysts still think the deal makes sense. Wabtec management agrees and recently reiterated its financial targets from the GE Transportation transaction, saying that it expects adjusted earnings before interest, taxes, depreciation and amortization to increase between $900 million and $1 billion.
But, there are signs the estimates could be optimistic. Wabtec did say that a minor adjustment to account for GE Transportation’s financials would lead to a $63 million decrease in the consolidated net revenue and Ebit expected from the combined company in 2019.
Looking ahead, management doesn’t expect there to be any significant effect in future years.
Looking Ahead, the Stock Could Rebound
The company expects the transaction to close in the first quarter of next year and is optimistic, “Upon completion of the merger, we believe we will be poised to drive strong growth in 2019 and beyond and well-positioned to serve customers as industry demand continues to improve.”
Wells Fargo’s Allison Poliniak-Cusic agrees and reiterated an Outperform rating and $120 price target on Wabtec, writing GE’s financial troubles are no secret at this point, and Wabtec is “absorbing some of that pain,” but the transaction ultimately still makes sense.
She writes that the variance in free cash flow and leverage is the main sticking point with bears. While she agrees that debt is an issue, Poliniak-Cusic believes that Wabtec’s limited cash outlay and easy access to low-interest-rate financing means that it still makes strategic sense for the company.
Margin “choppiness” may occur, but that ultimately Wabetc will benefit from the merger. Moreover, the demand side of the equation for freight markets has improved a good deal since the deal was first announced in May.
“As such, it is clear to us that the trough has been reached most notably on locomotive orders and deliveries giving us increased confidence in 2019 estimates expectations,” she concludes. “When the transaction is complete, we believe Wabtec will be well-positioned to benefit from the volume growth in addition to the captured content on delivered locomotives going forward.”
William Blair’s Nicholas Heymann is also still bullish on Wabtec, reiterating an Outperform rating on the shares today.
He writes that he hasn’t moved his adjusted earnings per share estimates for the stock going out to 2020, although the company has also noted that North American freight rail business has been performing above expectations of late.
That means the recent market action could be a pullback within an up trend.
A Trade for Short Term Bulls
As with the ownership of any stock, buying WAB 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 WAB
For WAB, the October 19 options allow a trader to gain exposure to the stock.
An October 19 $105 call option can be bought for about $3.80 and the October 19 $110 call could be sold for about $1.72. This trade would cost $2.60 to open, or $260 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 $260.
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 WAB the maximum gain is $2.40 ($110 – $105 = $5.00; $5.00 – $2.60 = $2.40). This represents $240 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $260 to open this trade.
That is a gain of about 92% 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.