This Xerox Trade Could Make You Real Money

Investors have flown into shares of Xerox (XRX) after it announced a better-than-expected quarter. The company brought in $1.14 in earnings per share – a full 10 cents higher than expected.

It also blew away analysts’ 2019 projections announcing a target EPS range of $3.70-$3.80… 17-27 cents above estimates.

This news comes as many in the market have struggled to meet expectations this quarter, manly on news from the ongoing struggles with the slumping Chinese market. Xerox doesn’t have much exposure there, giving it a leg up this quarter.

Shares are up 11%, as we write.

This is a remarkable turnaround just a month after the company lost its investment-grade credit rating from Moody’s. In December, the company’s unsecured debt was downgraded from Baa3 to Ba1, or junk status.

Shares have been in a freefall ever since that downgrade… bottoming out at $19. At $26.90, they are back to pre-downgrade levels.

There’s a clear path they should head from here. But before we get to that, let’s back up and look at what Xerox actually does these days.

While the 113-year-old former Wall Street titan has made plenty of moves to modernize as the world has evolved over the last century, it is still a printing company at its core.

It has its hands in other forms of printing, like digital and packaging. It has even dipped a toe into digital security. But the largest chunk of its revenue still comes from copiers and printers of all sizes and servicing those machines.

This isn’t to say Xerox is exactly like betting on horse-drawn carriages during the era of automobiles. But it isn’t that far off.

Now, that might seems like a contradiction. How can a company beat earnings estimates and guidance, yet still perform so poor overall? The answer is simple: analysts really had low expectations.

Those earnings “beats” still represent declines from previous periods. Revenue is even worse with an unbroken string of declines for far too long. Business is still slowing for the copy king.

Now, there’s another catalyst coming up for the company… but likely not a good one.

On February 5, Xerox is going to host its Investor Day. Nearly all companies do this in some form or another. It’s a chance to share goals, plans and forecasts for the year with shareholders. Unfortunately, those attendees this year will include the credit rating agencies.

Moody’s in its December downgrade noted that it will use the February Investor Day to fully review the company’s financial prospects. And it probably won’t like what it finds.

As of December 31, Xerox had $1.1 billion in cash and another $818 million in inventories. However, it is also sitting on more than $5 billion in debt – nearly $1 billion of which is due very soon. To top things off, it also has pension liabilities totaling $1.5 billion.

These numbers just aren’t very sustainable. It does have positive cash flows… but only when those pension problems don’t take too large of a cut.

So, we’re looking at a bit of a contrarian play. The market has reacted strongly to the company’s better than expected earnings. But we can clearly see that these numbers mask the real problems at Xerox. And more credit agency scrutiny won’t help much either in a week’s time.

This gives us a chance to take advantage of market overreaction. And we have the perfect way to do just that…

A Strategy For Short Term Bears

It’s always been far easier to profit when you believe a stock is going to rise is value. Profiting from a decline can be challenging. But it doesn’t have to be.

One way would be to simply short the stock. But that involves margin, borrowing the shares from your broker and the risk of falling into a short squeeze.

Another would be to buy put options. These work well, especially when a stock hasn’t moved too much yet and option premiums aren’t too high. The problem there is that there’s almost an equal amount of risk that you’d lose your whole bet and that it pays off. More like gambling that many of us prefer.

There is another option here. By using a bear call spread, a trader is able to collect income right up front. If the stock goes down, he or she keeps that full upfront payment. But it gets better, if shares don’t fall… but simply stay where they are, the trader can still keep that income.

The way a bear call works is by selling a near-to-the-money call option on a stock that should remain weak for a time. Then, buying a second call option with a higher strike price.

Here’s how that looks:

bearcall

Source: The Options Industry Council

The maximum profit is the amount received right at the beginning of the trade. That’s found by taking the difference in option premiums between the two calls.

Because of the second call option, the total risk too is known right up front. To find it, simply take the difference in strike prices and subtract the amount received at the beginning of the trade.

Let’s look at a real example for Xerox.

A Specific Trade For Bearish Xerox Traders

To enter a bear call spread trade, you could sell a March 15 $27 call for $1.50 per share and buy a March 15 $28 call for $0.90 per share for a net credit of $0.60 per share. Since each call is worth 100 XRX shares, that’s a total income payment of $60 right up front to enter this trade.

That’s the maximum profit potential. The full amount is yours to keep as long as shares don’t rise from where they are. With a too-high bounce today and a nerve-wracking analyst day with credit scorers coming up, this might just be the highest it goes for quite some time.

The risk, as noted above, is also known right up front. If shares do rise… and rise all the way past $28 each, the maximum risk is only $40. That’s found by taking the difference in strike prices ($28 – $27 = $1), subtracting the upfront credit ($1 – $0.60 = $0.40) and multiplying by shares per contract ($0.40 x 100 shares = $40).

So, for this trade, the upfront and max profit potential is $60. The max risk is $40. And shares don’t even have to move to keep the full entry amount. That’s a rare opportunity in a company that has many challenges ahead of it.

 

— The Option Specialist

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About the Author: The Option Specialist