Markets March On But Caution Could Be Key

As I pointed out last week, I am personally in a cautious mood with regards the markets right now. Despite this caution and despite an early week hit to the markets on the crises in Egypt, the Dow still managed to break through 12,000. I am more comfortable with the larger cap value stocks here than their smaller counterparts but whilst markets may appear overbought on my daily and technical indicators, there is no restriction on the length of time these markets may stay in overbought condition. Therefore, don’t be over-surprised if the market continues it’s movement forward but it is vital in these situations to remain vigilant if you are considering participating. Always look to the quality and valuation amongst other things when looking to invest.

Whilst the media might be rejoicing at the economic recovery in the US right now, lets call a spade a spade. The recovery is due to the quantitative easing measures of the Fed and low-interest rates. We are yet to see if this recovery is sustainable without such stimulus and it is quite clear that the stubborn unemployment rate doesn’t look like decreasing dramatically any time soon. For this reason, and due to the relatively higher than average P/E ratios of the US indexes, I believe a correction is overdue (but not a complete collapse). The economy is recovering but it is going to take a long, long time and the markets certainly seem to have gotten ahead of themselves.

As for the portfolio, we had a few earnings results and despite my caution, I actually entered into an options position with a short term view. Long term value investors might night like the thought of this short term “trading” but I comfortable with this and have to admit, I think there is role for technical analysis to play in value investing. Legends such as Buffett, Graham, Lynch and more might have me hung for such a statement though! Despite this short-term view, the basic fundamental analysis comes back to the same question……Is the company trading at a cheap price? I believe so.



The group delivered slightly weaker than expected Revenue of $6.9bln but Operating Margin was resilient at 11.7% due to strong cost controls and volume increases in certain segments. Reported earnings per share, adjusted for pension expenses, were $1.37 while the company generated strong operating cash flow of $861 million, bringing the yearly total to $1.9 billion. Raytheon continues to take advantage of what they believe is a currently undervalued share price (as I too believe), by using $1.45 billion to repurchase 28.9 billion shares during 2010, a figure which represents 7% of shares outstanding.

As for 2011, Raytheon forecasts revenue of $25.5-$26.3 billion, compared to the average analyst expectation of $26.2 billion. Meanwhile, EPS is forecast to be $4.83-$4.98, which compares to the average analyst call of $4.88. The tax rate is expected to increase to approximately 30.5% but the shares outstanding should decline to 353-359 million form the current figure of 377 million.
I am currently updating my numbers to determine if my fair value estimate needs to be adjusted but from reading through the earnings transcript, I doubt there is anything here that is going to move the needle too much. I continue to be impressed by the cash flow generating ability of the business and should EPS come in even at the lower end of managements forecast of $4.83, Raytheon still only trades at a P/E of 10.4, which seems undervalued to me. Furthermore, we can afford the stock to trade at $45 and still achieve our 61% return. A $45 share price reflects a P/E range of 9.3-9.0, based on the company forecasts for 2011. None of this looks expensive but I will update again during the week to determine if any changes need to be made.

Exelon reported fourth-quarter operating earnings of $0.96 per share, up 4% year over year, and full-year earnings of $4.06 per share, down 1.5% from 2009. Travis Miller of Mornignstar produced this insightful summary:

The key positive in Exelon’s quarterly disclosures was its hedging activity during the quarter at Exelon Generation, boosting management’s projections for 2011-13 gross margins. Exelon focused most of its hedging activity during the quarter in the Midwest, where it contracted an additional 3%-8% of its expected generation and raised its projected generation output for 2011-13. Its hedge positions in the Mid-Atlantic remained mostly the same during the quarter. The uptick in expected generation and a slight boost in hedged realized pricing for 2013 led management to raise the midpoint of its projected gross margin range by $50 million for 2011, $100 million for 2012, and $300 million for 2013. Our 2011 and 2012 gross margin estimates are in line with management’s new midpoints. We expect our 2013 gross margin estimate to be within management’s new range when we roll forward our long-term commodity price projections to 2014 and incorporate actual forward prices for 2013.
In the quarter, Exelon Generation benefited from a 28% drop in nuclear outage days and higher Pennsylvania power prices to earn $0.81 per share compared with $0.66 per share in the fourth quarter of 2009. However, a 1% drop in generation margins for the full year and higher depreciation and interest expenses offset the positives from fewer outage days and lower operating expenses, resulting in an 8.5% drop in full-year Generation earnings to $2.91 per share. We expected this drop and foresee continued earnings contraction at Generation at least through 2012.
ComEd ($0.13 per share) and PECO ($0.03 per share) both realized lower earnings in the fourth quarter from a drop in weather-normalized demand and higher operating expenses offset by slightly more favorable (colder) weather than during the fourth quarter of 2009. Adjusting for the $0.10 per share drop in earnings at PECO due to higher power prices that was offset by higher margins at Generation, PECO earnings rose by $0.01 per share in the fourth quarter. Both regulated units posted significantly higher full-year income after adjusting for the higher PECO power prices, helped by a big swing in weather-related usage. We expect the recent rate increase approved for PECO and expected for ComEd later this year should boost earnings at both utilities in 2011.

I continue to think that natural gas prices have upside rather than further downside potential and am confident that Exelon will benefit as a result. Regardless, it’s ability to produce low cost electricity whilst at the same time emitting minimal greenhouse gas emissions is enviable and should mitigate the effect of volatile power prices. There is still the prospect of Exelon making acquisitions which may hinder growth in the short term but encouragingly for investors in my view, Exelon has walked away from potential acquisitions over the few years that exceeded the price they were willing to pay. It is refreshing to some across management which doesn’t succumb to the “growth at all” cost syndrome. Looking at average analyst expectations for 2011, Exelon trades at an attractive P/E of 10.8. I am confident Exelon can achieve this target and therefore is an inexpensive call option to hold at this stage.