Tom Armistead's  Instablog

Many pundits have opined that the American consumer is on the ropes, so far in debt that he will be unable to contribute to the economic recovery. Because consumer spending has recently been about 70% of GDP, this has led many to declare that the recovery cannot proceed until a lengthy de-leveraging process has been completed. Factual information is available to assist in quantifying this concern: here is a link to the Federal Reserve's Household Debt Service and Financial Obligations Ratios. After downloading and studying this information, a plausible case can be made for the possibility that this process can be completed in a one or two year time frame, after which a strong and sustainable economic recovery would be possible.

The household debt service ratio - DSR - is an estimate of the ratio of debt payments to disposable personal income. Debt payments consist of the estimated required payments on outstanding mortgage and consumer debt. The Fed provides information going back to 1980, so it gives us a look at a number of troughs/recessions which preceded strong recoveries.



How much debt is too much? - The average ratio from 1980 to the present is 12.06%, with a max of 13.90% in 3Q 2007 and a min of 10.60% in 1Q 1983. My impression, after eyeballing the data, is that a DSR of less than 11% is optimal as a prelude to a strong economic growth spurt. Consumers are not over-extended and can safely handle more debt and drive the economy. This condition was present in the early 80's and again in the early 90's, when strong recoveries resulted. In the early 2000's and subsequent, DSR was not meaningfully reduced, which may be attributed to the extremely lenient monetary policies in place at the time. Very possibly this de-leveraging was not avoided but only deferred, and is taking place now.

DSR as of 2Q 2009, the last data point available, stood at 13.11%, and has been declining since the high of 13.90 % in 3Q 2007. Is it possible for DSR to be brought down as far as 11%, and if so, how long would that take? How about 12%, a little below average?

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Eric Dinallo was on Bloomberg recently, talking about CDS and other regulatory issues.  This clip www.youtube.com/watch is worth watching: he is the only politician or regulator who understands the dangers posed by CDS and inadequate regulation and is willing to talk about realistic solutions.

Dinallo, as former NY State Superintendent of Insurance has first hand knowledge of the issues involved, due to the problems he dealt with on AIG, MBIA, Ambac and other financial guarantors.  He and NY Governor Paterson attempted to bring the CDS issue to a head by offering to regulate them as insurance, if the Federal government did not step in and do something.  At the time, it seemed that Congress would be doing something, but more than a year later CDS regulation is still being debated and in the process whatever we get is going to be too watered down to resolve the issues.  Dinallo makes some excellent points: 

CDS should be regulated - as either the insurance products they are or the gambling products they are.  Approximately 20% of CDS are supported by an insurable interest: they should be regulated as insurance with requirements for adequate capital.  The other 80% of CDS are gambling contracts and should be regulated as such.  

These views are in sharp distinction from those we see in Congress, where there is considerable weight given to the input from Goldman Sachs (GS), Bank of America (BAC), Morgan Stanley (MS), JP Morgan (JPM) and CItigroup (C).  All of these "banks" make good money trading and steadfastly resist any efforts to regulate CDS in such a way as to prevent a recurrence of the debacle that required their rescue on the backs of over-burdened taxpayers. 

CFMA, Graham-Leach-Bliley, Glass-Steagall - CFMA was the legislation that exempted CDS from regulation by either the CFTC or the SEC.  Glass-Steagall enforced the separation of banks from other financial activities such as insurance, and Graham-Leach Bliley removed these important protections from the regulatory arsenal.  

Dinallo's common sense analysis: depositary institutions must not be permitted to indulge in leveraged financial bets.  That would include insurance companies such as AIG. Basically we need to repeal CFMA and Graham-Leach-Bliley, restoring the legal basis for adequate regulation of financial firms.   

Compensation for TARP recipients - after noting that Wall St. seems to have trouble grasping the implications of the compensation issue, Dinallo adds that it's not just about the top executives.  There are many operating employees (traders) making the big bucks.  Obviously their compensation schemes motivate extreme risk taking, inappropriate with taxpayer support.  

But he sees the solution as being improved regulation, not setting arbitrary limits on compensation.  If CDS are limited to their proper function as insurance, issued by institutions that have adequate capital, the problem of excessive compensation will go away.  If banks and insurance companies that are entrusted with people's savings and financial security are prohibited from gambling, the high rollers will go elsewhere, where they can't endanger the system, and their compensation will be paid by their gambling adersaries rather than taxpayers.  

NY Attorney General - DInallo is a candidate for this position.  Noting that Elliot Spitzer was able to act as the "Sheriff of Wall Street" while serving as NY AG, and that DInallo makes sense on a lot of regulatory issues, there is potential for some reduction in Wild West capitalism.  

Disclosure -  No position in the firms mentioned.  
 

Sigma Designs (SIGM) recently announced the acquisition of CopperGate for 160 million, to be paid by 92 million cash plus the issuance of an estimated 4 million shares. Boards of both companies have approved the deal. As has been happening lately, shares of the acquiring company traded down. Sigma closed Tuesday at 13.46, down about 6% on the day. After reviewing the slides that accompany the conference call, I regard the acquisition as a favorable development, based on a good strategic fit and the ability to fund it without incurring debt.

I wrote SIGM up favorably on 9/14 at 15.67, with my case resting on the possibility of renewed growth by expanding its IPTV expertise from telcom into the cable area, together with margin of security due to the excess cash on the balance sheet. A number of commenters questioned the pick, and the discussion got to be about whether management would dissipate the cash trove by high price buybacks or by overpaying for a series of ill-conceived acquisitions. A recent article on SA suggested SIGM would be a good target for an activist shakedown, adding a special dividend to the mix of possibilities. The acquisition of CopperGate answers these questions.

The Deal – from the press release:

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KB Homes (KBH) recently announced that the SEC is investigating their accounting.  I have been long the stock, beleiving that the company's ability to appeal to the entry level buyer and generate revenue in today's markets was reason to expect them to do well when housing would recover. 

Commentators have questioned my position, citing KBH's trouble with Chinese drywall, bad practices in their mortgage subsidiary, and the difficulty of improving margins to where they could make a profit.

Possibly the SEC is doing their usual thing, going after some kind of insider thing on options, while more serious offenses go unchecked and unprosecuted.  Years ago I kept the books for a sleazeball contractor, there was some stuff that didn't add up very well, or make a lot of sense, but the CPA on the case always seemed to find a way to do something with retained earnings and it would go away. 

I really don't want to find out any more on this situation, I sold the bulk of my position yesterday in the pre-market and the remainder is scheduled to go this week. 

ConocoPhillips (COP) released its 3^rd quarter interim results on 10/2, followed on 10/7 by an announcement of a dividend hike, together with plans to rationalize their portfolio and grow production. Shares closed Friday at 50.84, up 13% so far in October. Shiv Kapoor drew a lot of comments with his October 1^st article, suggesting COP may be a multi-bagger. Warren Buffett uncharacteristically admitted a mistake and took large losses on the company, a fact which seemed to distract some of the commentators from the fundamentals.

I have owned COP off and on for years, reliably extracting profits via covered calls at the lower end of its value range, and mentioned a recently added long position in a September article focused on changes in portfolio emphasis. However, I did not look that carefully at the selection when I made it, and I must confess to being a little surprised at the rapid price movement. Studying the 10/7 press release, what I see is management's tacit admission of strategic errors, followed by corrective action, which is winning market support.

Symptoms – COP is difficult to evaluate by my usual methods, which rely on historical average multiples and an expectation of mean reversion. In part, this is caused by dramatic fluctuations in earnings and asset values: the company reported its best and worst quarters back to back in the 3^rd and 4^th quarters of 2008. This reflected their heavy participation in the huge spike and crash of energy prices that year and the first quarter of this year. Looking at Price/5 year average EPS, Price/Sales and Price/Tangible Book, I get mid point targets of 48, 52 and 81, respectively. Anytime these values vary by that large a margin, analysis is required.

These variations in value according to different metrics are consistent with the criticisms of the Burlington Resources acquisition, which made COP the largest North American producer of natural gas. As this has progressed, the company's debt to equity has increased, cash flow was negative in 2008 and nowhere near covered capital expansion, and substantial write-downs were incurred.

Diagnosis - basically the company has too much debt supporting assets which are not generating cash or EPS consistent with their historical performance.

Corrective action – from the 10/7 press release:

Capital expenditures in 2010 are expected to be approximately $11 billion, down from $12.5 billion in 2009. At this level of funding, the company will support exploration, production and reserve replacement, while preserving its project portfolio for future development. Further details of the company's 2010 capital program will be announced near the end of 2009. The company intends to achieve its objective of replacing reserves through organic growth. Upstream production growth will occur from a reduced base, as a result of the asset rationalizations.

To improve its financial position and strengthen its balance sheet, ConocoPhillips intends to sell approximately $10 billion of assets over the next two years. The dispositions will occur across the company's Exploration & Production and Refining & Marketing portfolio. Proceeds from dispositions will be targeted to debt reduction, accelerating the company's return to its stated target debt-to-capital ratio of 20 percent to 25 percent.

Mr. Market hates negative cash flow, and despises capex that can't be paid from operating cash flow. Obviously, by selling assets to generate cash and reducing capex year over year, ConocoPhillips is toeing the line. Upstream production growth would mean finding and pumping more oil, increasing revenues and EPS.

Presentation – Here is a link to a presentation given on 9/9 at the Barclays Capital 2009 Energy & Power Conference. What I saw was increased emphasis on “Big E,” higher impact wildcat opportunities to test new plays. That and the assertion that “Deepwater GOM (Gulf of Mexico) has legs, steep creaming curve suggests material running room in Paleogene.” This sounds almost as good as tech companies talking about “ramping.” Seriously, a more aggressive approach to exploration should contribute to upstream production growth.

 

Target Price and Time Frame – COP says the makeover will take two years. Doing the math on the 10 billion of asset sales, that would bring debt/capitalization in line with COP's target and historical norms. Subject to market conditions, production growth will increase revenue and EPS.

What Graham called the vexed question, whether to look past the horrible Q4 08, will be answered in the affirmative, so 5 year average EPS can be ignored or adjusted. The market will look forward. Price/Sales ratios are difficult to interpret in an environment where oil goes from a peak of 147 to less than 30 in a matter of months.

That would leave book value: with the assets written down, and with energy prices recovering from their low point, but with 10 billion identified as “non-core.” or whatever they choose to call it. The point is, some of the assets are good, and some are not so good. Working off tangible book value, and assuming they get 70 cents on the dollar for the 10 billion of non-core assets, I apply a historic average Price/tangible book ratio of 2.2 and get a target price of 72, within two years when the makeover will be complete. From Friday's 50.84 close, that implies a 20% return annualized, not too shabby for a large cap dividend stock.

Disclosure – Long OJPAF, COP Jan2011 30 Calls; short COPAI, COP Jan2010 45 calls

 

 

 

 

 

 

Jim Cramer commented favorably on electric utility Exelon (EXC) on 9/30, after the stock closed at 49.62. I was not listening (a little bit goes a long way) but according to Miriam Metzinger, he said that the cap-and-trade bill should benefit Exelon, which has nuclear power exposure. Investors have a good entry point because the "stock is way off." I mentioned Exelon as a recent portfolio addition on 9/1, without providing any analysis of the individual stock, since my focus at the time was on strategy and positioning. Now would be a good time to go over the basics on the company and assess the possible implications of cap-and-trade for its future earnings and stock price.

Overview – From the 10-K:

Exelon, a utility services holding company, operates through its principal subsidiaries—Generation, ComEd and PECO.... Generation’s business consists of its owned and contracted electric generating facilities, its wholesale energy marketing operations and its competitive retail supply operations. ComEd’s energy delivery business consists of the purchase and regulated retail sale of electricity and the provision of distribution and transmission services to retail customers in northern Illinois, including the City of Chicago. PECO’s energy delivery business consists of the purchase and regulated retail sale of electricity and the provision of transmission and distribution services to retail customers in southeastern Pennsylvania, including the City of Philadelphia, as well as the purchase and regulated retail sale of natural gas and the provision of distribution services to retail customers in the Pennsylvania counties surrounding the City of Philadelphia.

Generation produces 68% of the power it generates from nuclear plants, 25% from fossil fuels, and the remainder from hydroelectric. They generate 80% of their power, the rest is purchased under long term contracts. Here is a link to their most recent presentation, which provides a good understanding of their operation and strategy.

Cap-and-trade – legislation has been passed by the house and a Senate bill is under review. Exelon is on the record as supporting this legislation and has adopted a plan of compliance and begun implementation. The act, if it becomes law, will create another layer of regulation for an already heavily-regulated industry. My take: global warming caused by green house gases is scientific fact, something has to be done, and cap-and trade is a start. Now, who is going to pay for this?

Logically, the beneficiaries of any environmentally harmful activity should pay the costs of remediation. In the case of electricity generation, that would be rate-payers. Politically rate-payers are tax-payers and voters, leading to the conclusion that attempts to place the cost elsewhere will pressure utility earnings and harm shareholders. Exelon, due to its large nuclear fleet, and preemptive adoption of various actions to reduce its carbon footprint, has distanced itself from the fray.

The legislation under consideration calls for a 17% reduction of green house gases by 2020. Large utilities will be required to produce 20% of their energy from renewable sources by 2020. The actual effects on earnings of any utility are many quarters away, and passage is not guaranteed. As Cramer's bullish remarks demonstrate, the positive perceptions of a low carbon foot-print can come up any time cap-and-trade is in the news. Very possibly the poor 2009 market performance of the utility sector reflects concerns for the harmful effects of new legislation.

Capex – Exelon does have one new nuclear plant on the drawing board, to be located in Victoria, Texas. Because the approval process is so slow, this is strictly a back-burner project.

The company is systematically availing itself of the opportunity to uprate its nuclear plants, a schedule is included in their recent presentations. The net result will be the addition of 1,300 to 1,500 MW of capacity, roughly the equivalent of a new nuclear plant. This type of capex is predictable and low risk. The process of securing regulatory approval, where needed, has been proceeding successfully. Expansions from this source are approximately 5% of total capacity.

They have been successful in extending the operating licenses, originally issued for 40 years, by means of 20 year increments. A schedule of expirations is included in the presentation.

Regulation – Exelon is regulated by numerous State and Federal authorities. Profits have been steady, suggesting that rate regulation has not been hurting them. There is no indication they have got on the wrong side of any of their regulators.

Energy trading – an unregulated activity, performed by the Power Team within the Generation company. Their positions are hedged by various derivatives, leading to counter-party risks and potential exposure to collateral posting requirements and liquidity issues in the event of a credit downgrade of sufficient severity.

In discussing the company's repurchase plan, CEO John Rowe mentioned that there would be little activity on that front, just being prudent to stay on the right side of the rating agencies.

Energy trading has in the past created difficulties for electric utilities: Allegheny (AYE) comes to mind, it was a while ago. There was also Enron, a very bad mix of predatory trading and accounting fraud. Exelon describes their limits and controls on this activity as stringent, backed by a Risk Management Committee. My impression is that trading is pursued in a manner that is supportive of primary activities - generation and distribution.

Valuation – EXC is another situation where a 5 year average EPS makes sense. Over the past five years, the stock has traded in a range of 12.8 to 30.9 on that metric, with the mid point coming in at 20. Projecting to the end of 2010, 3.72 X 20 equals 74 as a target price within the next two years. It reached a high of 92.13 during 2008, when the market seemed to perceive it as a growth utility, something of an oxymoron. It is indeed “way off” that price; however, that price was “way out.” A historical average line of reasoning applied to book value or revenue produces 66 and 55, respectively. Net income as a percentage of revenue has been consistently high in recent years, and may not be sustainable.

The dividend at 2.10 yields 4.2% with shares trading just under 50.

Taking all of this together, I plan to invest on the basis that shares will be fairly valued at 66. If that target is achieved within two years, annualized returns will be 15%, excellent for a low risk situation.

Investment strategy - EXC is a defensive stock, suitable for buy-and-hold or dividend investing. It has been mentioned twice on Seeking Alpha in articles on safe dividend stocks. Those who prefer something with a little more pop could consider substituting LEAPs for share ownership. The Jan11 35 calls make sense to me, the time premiums are not excessive and the sale of shorter expiration calls at 55 could provide current income and an exit point at a conservative valuation. In addition to the perennial attraction of cheap leverage, the options would have the benefit of limiting the downside in the unlikely event of a nuclear accident or rogue trader incident.

Disclosure – long VFRAG, EXC Jan11 35 calls, short EXCAK, EXC Jan10 55 calls, no position in AYE