The Value Line Daily Options Survey
The Weekly Option Strategist, October 6, 2011

Options on Xerox Corp (XRX)

This week, we kick off a new series of spotlights on option opportunities on individual stocks, starting with Xerox Corp (XRX). With the stock down 33% from end-June levels, and with a P/E ratio this is less than half the market’s, Xerox is steeply undervalued, according to our analysis.  In looking at Xerox options, we see opportunities for covered call writes, cash-covered put writes, and outright longer-term call purchases.

Stock Overview

Xerox Corp (XRX) develops, manufactures, markets, finances, and services a wide range of copiers, laser printers, and document publishing equipment. The company has had to deal with some strong headwinds recently, caused in part by the effects of the Tsunami on sales in Japan and by costs incurred by some sizable project awards received by Affiliated Computer Services (ACS; acquired in February, 2010). On the other hand, ACS accounts for most of 2011's estimated 6% revenue gain, and further consolidation savings are more than offsetting the impact of the aforementioned challenges.

11_11_11 Options on Xerox Corp 1

We believe that bullish positions in Xerox are attractive at this time.  The stock’s common rank (i.e., Timeliness rank in the Investment Survey) was raised to a 2 (above average) on 7/08/2011, and its technical rank was raised to a 2 on 9/16/2011.  Adjusted earnings are on track to advance almost 20% this year, and a low-double-digit percentage gain appears to be in the cards for next year. Moreover, following a share-price decline of about 33% since June, the P/E ratio, based on this year’s estimate of $1.10 a share, of 6.2 is about one-half the average market level of the past five years.  In addition, the stock is selling at only 3.8 times its 2011 likely cash flow per share. The current dividend yield is a decent 2.32%.

Xerox greatly broadened the scope of its offerings with the February, 2010 purchase of Affiliated Computer Services (ACS), the largest business outsourcing company in the United States. Thanks to cross-selling opportunities and global expansion, the subsidiary’s backlog has increased considerably over the past year. Meanwhile, Xerox’s research program, which is now focused on color output printers/copiers, has been quite fruitful lately. Thanks to this program, the company has the leading market share for digital publishing in the U.S. and Europe.  Over the three to five year horizon, we see the stock appreciating by between 85% to165% based on a projected 60% increase in share earnings and a reversion to a P/E ratio that is much closer to that of the stock market.

Options on Xerox

Because of Xerox’s low stock price ($7.13 at the time of this writing) and because the strike price intervals are usually $1.00, there are only limited option choices.  However, the few close-to-the-money Xerox options that there are tend to show good liquidity and reasonably narrow bid/ask spreads.

Investors might consider the January 2012 $7.50 call with a bid price of $0.61 and an asking price of $0.62.  It offers a 33.65% per annum return, with 9.25% downside protection, and maximum profit potential of 15.72%.

11_11_11 Options on Xerox Corp 2

A more protected short-term trade might be the November $6.00 cash-covered put. The stock would have to fall 18.30% to $5.83 before the investor would lose money.  Note that the 12-month trading range for XRZ has been $6.55 to $12.08 a share. The position offers a per annum yield of 23.64%. However, its maximum profit potential is limited to the 2.98% un-annualized return from the premium received.

11_11_11 Options on Xerox 3

More aggressive investors might consider buying the April 2012 call at $0.66.  This call is 27.37% underpriced, according to our model, and offers nearly 5 to 1 upside leverage if the stock were to score a 10% gain in the near future.

11_11_11 Options on Xerox Corp 4

Prepared by David Cohen, vloptions@valueline.com

At the time of this writing, the author had no positions in the stocks mentioned above.