Tom Armistead's  Instablog

Procter & Gamble (PG) filed an 8-K today, summarizing the contents of a presentation made to a conference of institutional investors. The tone was positive, including a statement that the company expects to see a resumption of organic growth during its second quarter, ending December 2009. Organic growth is projected in a range of 1 to 4%. The CFO, Jon Moeller, noted that comparisons will get easier going into the second quarter. The stock was up 4%, closing at 56.04.

I included PG in a bullish series of diagonal spreads I did during August, and wrote up here on Seeking Alpha, the reasoning being that large, well-capitalized companies with strong brands can be expected to perform well as the safety and reliability of their earnings streams is better appreciated during what may prove to be a slow recovery.

Target - My valuation methods for companies of this type rely on 5 year average earnings, with consideration given to margins and growth. Based on historical Price/5 year average earnings ratios, PG is trading at a discount, primarily due to loss of growth and expected pressure on margins. If growth can be restored and margins maintained, a target of 69 is well within reach, by year end 2010. The projected return of organic growth is a positive indication, strengthening the rebuttable assumption that management, having ample resources, will address the company's issues effectively.

Issues – management has been active over the past 5 years, acquiring Gillette in 2005, selling Folger's in 2008, and most recently announcing the sale of the company's pharmaceutical operations to Warner Chilcutt for 3.1 billion. All of this has opened to the door for critical analysts second guessing management's strategic direction. Slumping revenue has added fuel to the fire. A few years ago there was speculation that the Gillette acquisition was being impeded by culture clash, presenting a decent buying opportunity. Dividends4Life did a good job discussing some of the more recent concerns in an article earlier this month.

As a general rule, when a company has problems with growth or margins, I check to see if management is aware of the situation and has a plan to address them, as well as the resources to execute effectively. PG has ample resources, management is very well aware of the sales decline, and has plans to turn things around. Today's announcement is the first evidence that these efforts are bearing fruit.

Strategy – my options position, long the Jan11 45 call and short the Jan10 55 call, is developing favorably, but regretfully there is no upside potential beyond 55, assuming shares continue to rise. I spent some time earlier this week working on the risk and return for this strategy, developing the analysis that follows:

 

Now that the company is projecting a return to organic growth, I regard the risk of a return to the 52 week low as remote, and consider the risk reward profile of this strategy as very favorable. I added a few more Jan11 45 calls but did not sell any shorter expiration calls over them, leaving room for share price appreciation. Here is a chart showing why I see support at 50:

Monitoring – this situation has a way to go. I plan to review the company quarterly, including the conference calls, paying special attention to organic growth. I regard the sale of the pharmaceutical operation as a plus, and would like to see that come to fruition in November as planned before making any more additions to my position.

Disclosure: net long PG as described

 

 

 

 

Exxon Mobil (XOM) is attractive based on valuation at Monday's close of 69.15, but low beta and implied volatility suggest it will not make rapid price moves. For those who seek higher returns, the use of options to provide leverage makes the situation more interesting. XOM needs no introduction: the company is well known and heavily followed by professional analysts. I think a diagonal spread, long in-the-money LEAPs and short out-of-the-money calls makes good sense here. I will briefly state a simple case for going long the stock, followed by a longer discussion of the options strategy I am using on it, including an analysis of downside risk.

10 Year Average EPS – Noting that XOM has a history of buying back their own shares, consider a 10 year average EPS. The computation is, I add up ten years of net income, divide by ten, and then divide by current shares outstanding, arriving at a figure of 5.28 for the ten years ending in December 2008. Dividing this into a recent share price of 69.15, I get a P/E of 13, fairly low in my opinion. A midpoint price for XOM is about 15 X long term average EPS.

Is there any reason not to expect that the future will proceed along the same trajectory as the past? With demand from China and India picking up energy prices will probably go higher over the next ten years, so XOM should logically do better too. A conventional multiple of 15, applied to 5.28 gives a target of 79, with the shares trading around 69 the most likely path is upward. Beta here is .5, implied volatility is 26.8% - XOM is a slow mover. But it should slowly and surely wend its way upward. When last I owned the stock, I sold it for 89.48, so getting up to 79 seems doable.

Options for leverage – in order to receive higher returns, an investor/speculator might consider a diagonal call spread. This is similar to a covered call, but a long term option has been substituted for the underlying. Here is my analysis of the position:

 

Buying the Jan11 55 Call, the time value is very affordable, because of the low volatility. Long calls are cheaper when there is a dividend involved. I compute the time value as hypothetical interest on the additional 55 per share that would be required to buy rather than controlling by the use of options.

Selling the Jan10 70 call, the time value is higher when annualized, and can be looked at as 48.68% interest on the 14.50 expended to buy the long call which is serving as the underlying.

The projected option prices were developed by means of an options estimator tool provided by CBOE on their website. Projecting options prices is necessarily a guess because volatility cannot be known in advance.

If at the first expiration in January 2010 the stock is over 70, for example, 75, then a one contract position will have a gain of 555, on a net investment of 1,159, returning 115.7% annualized. If the stock is unchanged at expiration, the short call expires worthless, for an estimated profit of 204 after allowing for the time decay of the Jan11 55 call. The return is 42.5% annualized.

Break-even would be approximately 62.83 as of the first expiration date.

Looking at downside risk, the 52 week low is 56.51. If the stock hit that price in January 2010, one year before the expiration of the Jan11 55 call, the value of that option would be 7.43, according to the CBOE estimator. While this is serious compared to the original investment of 11.59, in order to put that 52 week low in perspective, here is a 1 year chart:



Eyeballing the chart I see support at 65, again according to CBOE's estimator if the stock was at 65 in January 2010 the Jan2011 55 strike should be worth 13.19, and the position's return at that point would be 33.4% annualized.

Assuming there has been no change in XOM's fundamentals, if in January 2010 this position has turned badly against the investor it would be reasonable to hold looking for the stock to recover to the 65 area which is credible support. Rolling down would also make sense, since it would cost about 3 to roll down to the 50 strike, positioning for some additional salvage in the event the share price recovers.

At some point another call could be sold, maybe 90-180 days out, the 70 strike is attractive as there seems to be resistance at 70-72.

Summary – XOM is undervalued based on 10 year average EPS. Based on the past year's price history and projections of this option position's value at multiple share prices as of the Jan2011 expiration of the call sold, the overall risk/reward ratio is attractive.

Disclosure – Net Long XOM as described.

Mr. Market was not impressed by Baker Hughes' (BHI) acquisition of BJ Services (BJS). BHI was down 10% on the day of the announcement, closing at 34.45. BJS was up only slightly, closing at 16.06. Commentators noted that the combination was a good strategic fit, giving BHI a position in pressure pumping similar to that enjoyed by Schlumberger (SLB) and Halliburton (HAL), at the same time compensating for BJS' lack of a strong international presence. Based on the strategic fit, the combination is worth more than the two companies separately.

A three or four way comparison is necessarily complex, but a simple analysis in terms of 5 year average EPS suggests that Mr. Market is getting it wrong:



I did some math on the merger, finding that it is fair to BJS shareholders in that the value received in BHI shares is equal to the value of the BJS shares to be relinquished, using the 5 year earning histories for comparison. Computing a five year average EPS for the combined entity, I arrived at a figure of 4.42.

BHI has said the expense savings in 2011 will be 150 million, or .35 per share after allowing for the shares to be issued in connection with the acquisition. So a proforma 5 yr average EPS, including the projected expense reduction, would be 4.77.

If the global economy and with it the Energy Sector are in recovery by 2011, as seems increasingly likely, then earnings should tend back toward the long term averages. Applying a multiple of 12 to the 4.77 proforma for BHI+BJS, the shares would be worth 57, 65% above yesterday's close.

Disclosure: Long BJS