With the end of the first quarter approaching, it is time to adjust the names in our Watch Lists. We will price all the new lists as of the close on Friday, March 30. Today we present our planned updates to the Large Cap Watch List (Track at Marketocracy).

Though less than the Small Cap Watch List and Mid Cap Watch List (Track at Marketocracy), there was still relatively high turnover in this list. 14 of the original 33 names made the cut for the new list (which was trimmed to just 26 names.) Part of the reason for the turnover was to reduce overlap between the lists. One third of the Mid Cap Watch List (Track at Marketocracy) names appear on each of the Small Cap and Large Cap Watch List (Track at Marketocracy)s, but there is no longer any overlap between small and large.
So without further ado, the names on the chopping block from the previous list are:

3M (MMM); Continental (CTTAY.PK); Mitsui (MITSY); Anheuser-Busch (BUD); ConocoPhillips (COP); Helix Energy (HELX); IndyMac Bancorp (NDE - Annual Report); Barr Pharmaceutical (BRL - Annual Report); Quest Diagnostics (DGX); Public Storage (PSA); ITT Educational Services (ESI); Equifax (EFX); Rent-a-Center (RCII); Kroger (KR); Ricoh (RICOY); First Data Corp. (FDC); Expeditors International (EXPD); and Keyspan (KSE).

The new list is:

Large Cap Watch List (Track at Marketocracy) member PG&E (PCG), through its Pacific Gas & Electric subsidiary, is the largest power utility in California. With a 2.9% yield and the revenue and earnings stability of a regulated utility, it would seem to be an interesting diversifier in current market conditions. That thesis, in fact, is borne out by recent market activity. Given that the benefits of a utility are fairly well known, we focused our 10K review on the issues that may fall below the radar screens of many investors. We are not presenting these as reasons not to buy the stock, so much as things investors should be aware of when making a decision.

Risk Factors (as we see them) for PG&E:

Pensions are $1 billion underfunded. Expense reported on the income statement is based on an assumed return on $640 million, whereas the actual return was just $154 in 2006. Given that 2006 was generally a decent year for investments, the assumed return may be aggressive.

Doubtful accounts – company has consistently been underreserving (see image) for doubtful accounts, depleting the existing reserve. The difference was approximately 2% of net income, which equates to perhaps $0.05 per share.

The regulation of the utility industry is a two edged sword. Against the benefit of earnings predictability investors should weigh the regulatory risks. FERC, Nuclear Regulatory Commission and State regulators all have a say. In addition, the power generation business is subject to extensive current and potential regulations over air and water quality, including possible regulation of greenhouse gases. The company is engaged in lawsuits over cooling water discharge at Diablo Canyon nuclear plant, its holding company structure and faces possible penalties for missing records related to California Air Resources Board.

Finally, while the price/earnings multiple is in line with that of the overall market, and the company generates strong cash flow from operations, most of the cash flow is consumed by additional investments in plant. On an enterprise value to free cash flow basis, the company appears somewhat expensive.

Large Cap Watch List (Track at Marketocracy) member PG&E CORP (PCG) filed a Form: 8-K detailing changes to its credit facilities:

The Restated Utility Credit Agreement increases the aggregate amount available under this agreement by $650 million to a total of $2.0 billion. Subject to obtaining commitments from existing or new lenders and satisfying other conditions specified in the Restated Utility Credit Agreement, the Utility may increase the aggregate commitments under this credit agreement to $3.0 billion. The Restated Utility Credit Agreement has an initial term of five years and, unless extended, all amounts will be due and payable on February 26, 2012. At the Utility’s request and at the sole discretion of each lender, the Restated Utility Credit Agreement may be extended for additional periods.Under the Restated Utility Credit Agreement, the Utility will pay reduced fees and interest rate spreads.

The new agreement is unlikely to have a huge impact on the company’s earnings, as there were no outstanding borrowings under the old facility. But it does give them extra access to capital and at lower cost for any instances that they might need it, and that is always a good thing.

Most advisors recommend some exposure to utilities for the dividend and earnings stability they tend to offer in a portfolio. However, the earnings report from Large Cap Watch List (Track at Marketocracy) member PG&E CORP (PCG) shows they have potential for earnings surprises and capital gains as well.

§ Year-end net income was $991 million, compared with $917 million in 2005.§ Earnings from operations for 2006 were $2.57 per share, compared with $2.34 for 2005.

§ The company is increasing guidance for 2007 earnings from operations by $0.05 per share to a range of $2.70-$2.80 per share.

Consensus estimates were for $2.54 in 2006 and $2.72 in 2007. The year-over-year increase in earnings per share predominantly reflects the positive effects of share repurchases in 2005, which resulted in fewer shares outstanding in 2006. The shares are up half a percent in a flat market on the news, in addition to offering the aforementioned dividend yield of nearly 3%.

We asked, but no one answered. So we are taking our own counsel and breaking our Watch List into three portfolios: Small Cap, Mid Cap and Large Cap. Each will be tracked against the relevant S&P index going forward from their collective inception date of January 31 (priced at the close of market trading that day.)

For your viewing pleasure, the Large Cap Watch List (Track at Marketocracy) (to be measured against the S&P 500) follows.

Astute observers will notice less overlap between this watch list and the names in the Small Cap Watch List and Mid Cap Watch List. This was not for lack of overlap, as the smallest S&P 500 name has a market capitalization of $600 million, which would allow for complete overlap with the Mid Caps if we chose. Instead we selected an arbitrary low of $2 billion for large-cap names, which cuts off five names that are actually in the S&P 500.
In addition, we will provide a “quick and dirty” analysis of each name, with a goal of one such analysis per day. As the name implies, the quick and dirty analysis will be incomplete. We are hoping you will join in the debate and fill the gaps in our analysis.