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Dresser-Rand (NYSE:DRC) May 1, 2009 $25.20 (2:45 PM EST)
52-week range: $11.70 (Nov. 21, 2008) - $42.41 (June 6, 2008)

Dresser-Rand is among the largest suppliers of rotating equipment solutions to the worldwide oil, gas, petrochemical, and process industries. The Company operates manufacturing facilities in the United States, France, United Kingdom, Germany, Norway, India, and China, and maintains a network of 33 service and support centers covering more than 140 countries. DRC was created on December 31, 1986 and came public in August of 2005.

DRC reported March quarter results this Wednesday and posted excellent numbers. EPS were $0.42 versus $0.32 even though 2008’s quarter included a positive 6 cent a share non-recurring gain. Revenues surged by 39.9% year-over-year.

Despite the drop in oil and gas prices, DRC is expected to post full year results of $2.40 /share making their current multiple just over 10.1x this year’s earnings.

Here are their per share numbers as reported by Value Line since their IPO:

Year ….. Sales ….. C/F …. EPS .….. B/V ….. Avg. P/E
2005 …. 14.14 ….. 1.15 …. 0.56 ….. 6.02 ……..41.3x
2006 …. 17.57 ….. 1.42 …. 0.83 ….. 7.39 ……..27.9x
2007 …. 19.40 ….. 1.82 …. 1.25 ….. 9.38 ……..27.6x
2008 …. 26.78 ….. 3.01 …. 2.36 …..11.65 …….13.4x

Dresser-Rand shares were flying high when energy prices were going through the roof. They touched a high of $44 in 2007 and $42.41 in June 2008. They bottomed with the market last November 21st before rebounding to today’s $25.20 level.

It doesn’t seem far fetched to look for these shares to command at least a 13 multiple again. That would bring DRC back to a $31.20 target before year end.

Here’s a nice buy/write combination play that can generate excellent returns even if DRC shares don’t do anything at all between now and next January.

__________________________Cash Out_______Cash In
Buy 1000 DRC @$25.20________$25,200
Sell 10 Jan. $25 calls @$4.50 _________________$4,500
Sell 10 Jan. $25 puts @$4.30 _________________$4,300
Net Cash Out-of-Pocket ________$16,400

If Dresser-Rand stays above $25 (as it is right now) through the expiration date of January 16, 2010:

  • Your $25 calls will be exercised.
  • You will sell your shares for $25,000.
  • Your $25 puts will expire worthless.
  • You will have no further option obligations.

You will own no shares and hold $25,000 cash for your original outlay of $16,400.

That’s a net profit of $8,600 / $16,550 = 52.4 % cash-on-cash.

Not too bad considering the underlying DRC shares did not need to move up at all to achieve this best-case profit. That total return would have occurred in just 8.5 months.

What’s the Risk?

If Dresser-Rand shares go below $25 and remain there on expiration date:

  • Your $25 calls will expire worthless.
  • Your $25 puts will be exercised.
  • You will be forced to buy another 1000 shares of DRC and to lay out an additional $25,000 cash.
  • You will end up owning 2000 shares of DRC.

What’s the break-even on the whole trade?

On the original 1000 shares it’s the purchase price of $25.20 less the $4.50 /share call premium = $20.70 /share.

On the ‘put’ shares it’s the $25 strike price less the $4.30 /share put premium = $20.70 /share.

Just coincidentally the average break-even price would be identical at $20.70 for each batch of shares.

Thus, DRC shares could drop by up to $4.50 /share or (-17.8%) without causing a loss on the whole trade.

Summary:

If Dresser-Rand shares:

  • Go up.
  • Stay unchanged.
  • Go down to $25.

You will make the maximum profit of 52% in about 8.5 months.

If Dresser-Rand shares decline to below $25:

  • You will hold 2000 shares.
  • You would still be in profit unless the price declined to less than $20.71.

Barring another major melt-down, I don’t see these shares hurting you from the $20.70 /share break-even price.

Disclosure: Author is long DRC shares and short DRC options.

Source: Dresser-Rand Group: A Backdoor Play on Oil and Gas