Following on from our previous post on Raytheon, where we provided an initial overview of the business itself, today I want to focus on the valuation process involved before deciding on whether or not to buy. I also want to talk a little on technical indicators, which although sometimes ignored by value investors, need to be incorporated into our investment strategy considering the approximately 14 month time horizon. Finally, I will walk through the details of the Put Spread strategy I have adopted and the potential profits/losses that I stand to make between now and expiration date.
Valuation
Source: www.Morningstar.com
I briefly touched on Valuation in the last post, but lets briefly run through the above table. As you can see, Raytheon trades at very attractive price ratios relative to the Industry average, the S&P 500 and their 5 year average. The current P/E of 9.8 looks particularly cheap and with a 3% dividend yield to boot, one would imagine that Raytheon is on the investment radar of both value and dividend orientated investors.
Source: www.Morningstar.com
When we compare Raytheon to it’s industry peers, it is clear that not only Raytheon looks like they are currently trading at attractive multiples right now. Whilst I debated Lockheed Martin as a potential alternative, the lower Interest Coverage and significantly higher debt/equity multiple led me to turn instead to Raytheon. Whats more, underfunded pensions are a serious issue going forward for this industry and Raytheon, although still exposed, is in better shape than its rival Lockheed Martin.
Looking at analyst estimates for 2010 and 2011, we see the average is 4.57 and 4.88 respectively. At a current price of $47.70 (i.e. the price of Raytheon was $47.70 when I made the investment), that would suggest the company currently trades at a FY10 multiple of 10.43 and FY11 multiple of 9.77. Certainly not expensive considering the Cash Flow generating ability of a company like Raytheon. Even applying analyst low estimates for 2010 and 2011, Raytheon trades at a respectable 11x and 1.0.6x earnings.
Morningstar currently place a Fair Value of $61 on Raytheon and a Recommended Buying Price of $42.70. When I conduct my Fair Value estimates, I generally first look for the worst case scenario, especially when entering into a Put Spread investment. In the case of Raytheon, even when I assumed FY11 estimates 15% lower than the lowest analyst figure, 0% revenue growth over the next 5 years (2.59% is the 5 year average) and a FCF/Sales average ratio of 6.4% (compared to 5 year average of 8.52%), I was still able to only forecast an absolute Low Fair Value of $41.41.
With regards my base case scenario, which I put most weight on, I concluded that the average analyst estimates for 2010 and 2011 would be in line and that Revenue Growth would continue at a 2.7% average annual rate for the coming 5 years. This is in line with the current 2.59% 5 year average. Assuming Gross and Net Margins in line also with 5 year averages and a FCF/Sales ratio of 7.8 going forward, I finally came to the conclusion that $61.66 was a fair value for Raytheon. At this price, and assuming earnings of $4.57 for 2010, this suggests Raytheon should trade closer to 13.8x earnings, still some bit below that 16+x average over the past 5 years.
When all the calculations were complete, I went back and compared them to some of the other brokers out there. Interesting, my Fair Value of $61.66, Recommended Buying Price of $43.25 and Recommended Selling Price of $86.32 was very much in line with Morningstar’s estimates. While this may not mean much, I guess it is somewhat reassuring to know that when I read their research going forward, I know we are broadly thinking along the same lines.
Strategy
With the stock currently trading at $47.70 and my fair value at $61.66, I would realistically expect to make a 29% return over the life of my investment. If the stock reached my Recommended Selling Price of 86.32, that would result in an 80% return. What’s more, a 3% dividend yield makes it a little easier to sit and wait for the market to take advantage of the current low valuation. However, I am more aggressive and therefore, I want to potentially achieve these results in a shorter time frame, without having to put a large amount of capital at risk. Bearing this in mind, the Put Spread strategy works for me.
The first leg in this strategy is to sell someone the right, but not the obligation, to sell me their shares on the 3rd Friday of January 2012, at $45 (6% lower than the current price). In return for providing what is effectively insurance to someone else’s stock holding, I receive a tidy Premium as a result. In this case, it was $4.56 per share. Mindful that the market could deteriorate and quality companies like Raytheon get hammered as a result, I want to protect that however by taking out my own insurance. With the premium I received, I therefore purchased the right, but not the obligation, to sell those same shares if put to me, at $40 on the 3rd Friday of January 2012 (19% below the current price). I paid $2.66 for this insurance.
So, lets summarize. I have received $4.56 per share and paid out $2.66 per share for a $45/$40 Bullish Put Spread. My total return therefore will be those proceeds ($4.56 – $2.66 = $1.90 per share), provided the stock trades above $45 on the 3rd Friday of January 2012. My max loss occurs if the stock trades below $40 on the 3rd Friday of January 2012. in this instance, the stock would be sold to me at $45 and I would in turn sell the stock at $40, for a $5 loss. Therefore, my broker will require this max loss amount as upfront capital. Considering I have already received the $1.90 in proceeds, my capital requirement is reduced to $3.10 (i.e. $5 – $$1.90 = $3.10). My total return potential is therefore, my proceeds divide by the capital required to fund the investment. In this case, it is a very attractive 61% ($1.90/$3.10 = 61.29%). What’s more, even if the stock were to drop as much as 5%, but still traded above $45 in 14 months time, I would still realize this 61% gain. Finally, and probably my favorite part, is that I not only have a Margin of Safety with regards my perceived valuation of Raytheon, I also benefit from a substantially lower Breakeven point than what I would if I invested in the stock itself. My breakeven point is calculated by subtracting the proceeds/premium I received ($1.90) from the price I have agreed to buy the shares at ($45). That equates to a Breakeven price of $43.10, over 10% lower than the price Raytheon currently trades at.
Rayhtheon Current Price: $47.70
Margin Of Safety: 29%
Max Profit Point: If Stock trades > $45 on 3rd Friday, January 2012
Max Loss Point: If Stock trades < $40 on 3rd Friday, January 2012
Profit Potential Return: 61%
Breakeven Safety Net: 10%
Technical
Now onto probably the most debated issue with Options investing, and that is timing. Value investors will mostly argue against the use of technical analysis when investing because they do not believe timing should have anything to do with investing. However, with Options, I need to at least be aware of important support and resistance levels in a stock because there is no guarantee that the market will behave rationally and according price securities rationally over the lifetime of my option investment. Therefore, I have identified some area’s where I would need to review my Option Investment in Raytheon.
Source: www.FreeStockCharts.com
The stock currently trades in an upward channel and importantly for me, above the 50 and 100 day Moving Averages. Key technical areas I am watching however are the $45.68, $44.39 and the $42.70. If Raytheon’s stock price were to break down through the 100 day Moving Average and in turn breach the $42.70 level, I would be concerned the stock would be caught in a new downward trend. If this was confirmed with momentum indicators, I would have to seriously consider my investment position. Although I would be forced to take a loss, it could nevertheless be potentially smaller than if I waited for expiration.
