"When everyone thinks alike, everyone is likely to be wrong."
- Humphrey Neill
We discuss a broad range of issues that are often investment-related, but not always so. We call it a 'thought blog'. Sagacious: Having or showing keen discernment, sound judgment, and farsightedness.
Quality of Earnings Deteriorating?
In what might be a sign that corporate earnings quality may not be as good in the near future as in the recent past, a recent WSJ article mentioned that the difference between GAAP and “pro forma” earnings has widened over the last two quarters. This is the second-largest percentage move in two years, according to the article, which sources information from a strategist at Merrill Lynch.
Why could this be worrisome? Well, a difference between GAAP earnings and pro forma earnings indicates the use of below the line, one-time “nonrecurring” charges that are often ignored when comparing period-over-period changes in earnings. Some analysts will simply back out the one time charge, adding it back to earnings (pro forma) since the charge is supposed to be non-recurring, unusual or extraordinary. The problem is, sometimes these charges should not be ignored and actually should, at least in part, be considered part of a company’s ongoing operations, despite their apparent one-time or unusual nature.
To see how these one-time charges affect economic value, watch the cash flow statement and read the footnotes. These charges, though one-time from a GAAP perspective, will continue to show up in cash flow as companies pay for severance packages or restructuring costs, for instance. Or they may be non-cash in nature, such as asset writedowns, which won’t affect cash flows until the asset is sold, or goodwill impairment.
Note that these “nonrecurring” charges can also be used to manipulate earnings. Taking the hit in the current quarter may benefit GAAP earnings in the next. Sometimes this will occur in the form of a “big bath” where, when times are tough, a company might “move” all of the next few periods’ plant shutdown costs into the current period, so that future “earnings” are not crippled by these expenses. It’s the “Let’s get all the bad stuff out of the way now” idea. This can come in the form of asset writedowns, layoffs, restructurings, etc., whose actual economic effects are not really confined to a single period.
If this widening continues into the third quarter, it could lead to a troubling trend. Stick with companies that have high quality earnings and where cash flows and earnings tend to approximate one another. If there is a persistent sharp disconnect, the company may be trying to hide trouble.
Why could this be worrisome? Well, a difference between GAAP earnings and pro forma earnings indicates the use of below the line, one-time “nonrecurring” charges that are often ignored when comparing period-over-period changes in earnings. Some analysts will simply back out the one time charge, adding it back to earnings (pro forma) since the charge is supposed to be non-recurring, unusual or extraordinary. The problem is, sometimes these charges should not be ignored and actually should, at least in part, be considered part of a company’s ongoing operations, despite their apparent one-time or unusual nature.
To see how these one-time charges affect economic value, watch the cash flow statement and read the footnotes. These charges, though one-time from a GAAP perspective, will continue to show up in cash flow as companies pay for severance packages or restructuring costs, for instance. Or they may be non-cash in nature, such as asset writedowns, which won’t affect cash flows until the asset is sold, or goodwill impairment.
Note that these “nonrecurring” charges can also be used to manipulate earnings. Taking the hit in the current quarter may benefit GAAP earnings in the next. Sometimes this will occur in the form of a “big bath” where, when times are tough, a company might “move” all of the next few periods’ plant shutdown costs into the current period, so that future “earnings” are not crippled by these expenses. It’s the “Let’s get all the bad stuff out of the way now” idea. This can come in the form of asset writedowns, layoffs, restructurings, etc., whose actual economic effects are not really confined to a single period.
If this widening continues into the third quarter, it could lead to a troubling trend. Stick with companies that have high quality earnings and where cash flows and earnings tend to approximate one another. If there is a persistent sharp disconnect, the company may be trying to hide trouble.
More on Dow Chemical
(continued from previous post)
The 4% dividend yield is a nice pad to total return. Over at least the past 17 years, the company hasn’t cut or reduced its dividend, which has grown at an annual rate of a little over 3%. The company is watching costs, having shut down more than 50 manufacturing facilities across the globe over the last three years amidst record profitability. And they’re using cash to pay down debt and buy back shares. Yet this has happened before, most recently from about 1994 through 1998, and from there debt levels and share count grew again.
We know the third quarter is likely to be a little rough, as the company will be taking about $600 million in charges for severance and asset writedowns as a result of plant closings. Look for earnings to be boosted in future periods, as this writedown will hit earnings in the third quarter of this year and not affect them in future periods. Don’t be fooled, though, as actual severance and plant shutdown costs will continue to impact the company’s cash flows into the future.
Let’s look at another metric, the current forward price-to-sales (P/S) ratio, which is around 0.75. This is near the lows of the past 10 years and most similar to the lowest forward multiples experienced in 1995-96 for the expansion years of 1996-97. Coincidentally (or not), the period most similar to now in level of margins and ROE was 95-96. The average forward P/S multiple during those years was under 0.90 (since 1995 Dow’s average P/S ratio is 1.00) , while Dow’s P/E ratio averaged 9.5, which looks strikingly similar to now. What does all this mean?
Purchased at the low prices of 1995-96, Dow would have returned about 8.6% annually to date (including the 10-yr average dividend yield of 2.6%). The S&P 500’s total return over that period is around 10% annually.
Historically, it has been more profitable to buy cyclical companies when P/Es are high and profits are bottoming. In this case, Dow has a low P/E ratio and its profits are (probably) at or near a peak.
If you think the stock has upside between now and January but don’t want to invest the cash, write a Jan 40 put and buy a Jan 40 call. Based on current prices, you’ll effectively own the stock at a little over $39 (slightly over market) but without any cash outlay. Be aware that you’ll need to have the cash to cover the trade in the event the stock is put to you come January.
A Look at Dow Chemical
Is Dow Chemical undervalued at $38 and change? At 9.5 times forward earnings, about 0.75 times sales, and a 4% dividend yield, on the surface it looks like a value.
This is a cyclical company that lacks an economic moat. In other words, it is largely not in control of its own destiny. It has high returns during economic expansion (when demand exceeds supply) and experiences poor returns during contractions (when demand weakens, or supply brought on during expansions exceeds demand). Roughly 50% of revenues come from specialty chemicals and plastics. These businesses are less cyclical than other, basic chemical lines but all segments remain sensitive to the economic cycle.
Especially in its North American operations, the company has little control over its resource costs and is only able to pass cost increases along to customers when demand is high. Thus, when economic activity slows and costs in increase the company’s margins get squeezed. Of course, this works both ways. Both oil and gas, which comprised almost half of Dow’s total costs in 2005, are down dramatically in price as of late. This is likely to lead to some margin gains and maybe even to an upside earnings surprise in Q4, perhaps even in Q3. But these gains may be fleeting.
Operating and net margins appear to be at cyclical highs (18.5% and 9.5%, respectively, versus a 14% and 5.2% 7 year average), as does return on equity (ROE), at about 26% currently, versus a seven-year average of 15%. The current numbers are direct evidence of pricing power during a period of high demand. Looking back as recently as 2001 and 2002 (recessionary conditions), Dow’s operating margins were near 10% and net margins were negative.
The market doesn't capitalize peak earnings, so let’s use the above numbers to “normalize” Dow’s earnings over an economic cycle. That is, average out the swings in profitability that result from the cyclical nature of the business. Using the 7-year average ROE of 15% times the current (2Q 2006) book value of $17.52, I get a “normal” net income number of $2.63. Using the normalized net profit margin based on projected 2006 sales we arrive at about the same number. At today's price, this puts Dow at nearly 15 times normalized forward earnings. This happens to be right around Dow’s average P/E since 1990.
(look for more on Dow in coming days)
This is a cyclical company that lacks an economic moat. In other words, it is largely not in control of its own destiny. It has high returns during economic expansion (when demand exceeds supply) and experiences poor returns during contractions (when demand weakens, or supply brought on during expansions exceeds demand). Roughly 50% of revenues come from specialty chemicals and plastics. These businesses are less cyclical than other, basic chemical lines but all segments remain sensitive to the economic cycle.
Especially in its North American operations, the company has little control over its resource costs and is only able to pass cost increases along to customers when demand is high. Thus, when economic activity slows and costs in increase the company’s margins get squeezed. Of course, this works both ways. Both oil and gas, which comprised almost half of Dow’s total costs in 2005, are down dramatically in price as of late. This is likely to lead to some margin gains and maybe even to an upside earnings surprise in Q4, perhaps even in Q3. But these gains may be fleeting.
Operating and net margins appear to be at cyclical highs (18.5% and 9.5%, respectively, versus a 14% and 5.2% 7 year average), as does return on equity (ROE), at about 26% currently, versus a seven-year average of 15%. The current numbers are direct evidence of pricing power during a period of high demand. Looking back as recently as 2001 and 2002 (recessionary conditions), Dow’s operating margins were near 10% and net margins were negative.
The market doesn't capitalize peak earnings, so let’s use the above numbers to “normalize” Dow’s earnings over an economic cycle. That is, average out the swings in profitability that result from the cyclical nature of the business. Using the 7-year average ROE of 15% times the current (2Q 2006) book value of $17.52, I get a “normal” net income number of $2.63. Using the normalized net profit margin based on projected 2006 sales we arrive at about the same number. At today's price, this puts Dow at nearly 15 times normalized forward earnings. This happens to be right around Dow’s average P/E since 1990.
(look for more on Dow in coming days)
A Contrarian Thought for (another) Record DJIA High
"Follow the course opposite to custom and you will almost always do well."
- Jean Jacques Rousseau
- Jean Jacques Rousseau
A New High - Now Let's Move On
As oil falls below a key psychological level of $60/barrel, the Dow Jones Industrial Average hits a new intraday high! If you've read previous posts, this is not something that gets me too excited, since at these levels on the Dow, the S&P 500 is still 12% below its all-time high. Let’s do a brief analysis of just how the prices of the stocks in the average can affect the DJIA’s overall returns.
General Motors (GM) is the average’s top performer year-to-date, up 74% and responsible for about 1.7% of the DJIA’s YTD performance. Looking deeper at the Dow’s YTD performance, we can see how the price-weighted average calculation method can affect its returns. Merck (MRK), now a $42 stock, is the second highest contributor after GM – up over 32% year-to-date and responsible for about 0.9% of the DJIA returns. The third largest contributor, Boeing (BA), an $82 stock, is up only about 17%, yet has contributed the same amount as MRK (about 0.9%) to the Dow’s returns. Despite Merck's returns exceeding those of Boeing by almost double, the effect on the DJIA is the same.
Note that the index in no way tries to overweight undervalued stocks or underweight the overvalued stocks. I don't know many money managers who determine a stock's weighting in a portfolio based solely on price.
General Motors (GM) is the average’s top performer year-to-date, up 74% and responsible for about 1.7% of the DJIA’s YTD performance. Looking deeper at the Dow’s YTD performance, we can see how the price-weighted average calculation method can affect its returns. Merck (MRK), now a $42 stock, is the second highest contributor after GM – up over 32% year-to-date and responsible for about 0.9% of the DJIA returns. The third largest contributor, Boeing (BA), an $82 stock, is up only about 17%, yet has contributed the same amount as MRK (about 0.9%) to the Dow’s returns. Despite Merck's returns exceeding those of Boeing by almost double, the effect on the DJIA is the same.
Note that the index in no way tries to overweight undervalued stocks or underweight the overvalued stocks. I don't know many money managers who determine a stock's weighting in a portfolio based solely on price.
Private Equity's Newest Bet
Harrah’s Entertainment (HET) shares got a big boost today, up about 14%, having received an $81/share buyout proposal from two private-equity firms. That price values Harrah’s at 20 times forward earnings and about 10 times operating cash flow. At market close, the shares were still trading about 7% under the deal price. Does the market not think this deal will consummate?
It’s a cash deal, which means that the newly private firm will be saddled with large amounts of new debt (Harrah’s market cap at the deal price is $15 billion) while assuming over $10 billion of existing debt. Interest expense currently totals around 25% of EBITDA. My primary worry in the near-term is that adding significantly to its debt load would limit its flexibility during a downturn.
True, at this point Harrah’s generates a healthy amount of operating cash flow that could service additional debt, but in recent years that cash flow has been used to fund considerable capital expenditures. Could more debt meaningfully restrict their ability, for instance, to develop their properties on the Vegas Strip to better compete with MGM’s upcoming City Center?
Typically, these private equity deals work out the best when a firm can slash costs, wringing out extra cash to pay down the new debt. Yet this could be detrimental to Harrah's, where capital spending is vital not only to maintain its growth track, but also to keep its casinos relevant and its competitive position in place.
It’ll be interesting to watch. With insiders owning over 4% of the shares, shareholders can bet the board has their interests in mind. Feel like a gamble? Go long Harrah’s shares and bet the deal goes through.
It’s a cash deal, which means that the newly private firm will be saddled with large amounts of new debt (Harrah’s market cap at the deal price is $15 billion) while assuming over $10 billion of existing debt. Interest expense currently totals around 25% of EBITDA. My primary worry in the near-term is that adding significantly to its debt load would limit its flexibility during a downturn.
True, at this point Harrah’s generates a healthy amount of operating cash flow that could service additional debt, but in recent years that cash flow has been used to fund considerable capital expenditures. Could more debt meaningfully restrict their ability, for instance, to develop their properties on the Vegas Strip to better compete with MGM’s upcoming City Center?
Typically, these private equity deals work out the best when a firm can slash costs, wringing out extra cash to pay down the new debt. Yet this could be detrimental to Harrah's, where capital spending is vital not only to maintain its growth track, but also to keep its casinos relevant and its competitive position in place.
It’ll be interesting to watch. With insiders owning over 4% of the shares, shareholders can bet the board has their interests in mind. Feel like a gamble? Go long Harrah’s shares and bet the deal goes through.
DJIA Flirts with a Record Close
If you’re like me, you watch CNBC for individual company and stock market news. It can prove valuable when news is breaking and for real-time market data. Yet despite its virtues, CNBC has a short-term focus which is why it is almost equally as valuable while muted. It is arguably the most-watched financial network and this position gives it considerable influence on investors of all types, both professionals and novices. Yet this kind of short-term thinking can be dangerous in a game that is best played over the long-term.
This week, even on mute, it seemed like they were covering a horse race, not the stock market, as the Dow Jones Industrial Average (DJIA) neared its record close set back in 2000 (the S&P 500, by the way, has over 14% higher to go to best its all-time closing high of 1527.46). Case in point, CNBC added along the top of the screen a “DJIA within X pts of record close” banner and had the “breaking news” alert going during market hours. Meanwhile, guests were asked if and when we’ll get to that record close.
So what if the Dow nears its record close?! It accounts for only 25% of the broad market (as measured by the Wilshire 5000) and is composed of just 30 companies in the form of a price-weighted average. To calculate it, the 30 companies' stock prices are literally added together and divided by, as of today, 0.12493117. That gives us the index value seen every day. This means companies with the largest absolute prices in the index have the largest relative impact on performance. For instance, IBM, with an $82 price would have a larger impact for each percent move than Intel, with a $20 price. A 5% move for IBM is $4.10, but just $1.00 for Intel. Similar problems exist for market-value weighted indexes, such as the S&P 500 (which is now float-weighted). These types of indexes tend to underweight undervalued stocks and overweight overvalued stocks, the exact opposite of what should be done.
Forgetting all that for a minute, the DJIA has had a strong run in recent months. Over the longer-term the performance of the DJIA tends to approximate the broader markets, but year-to-date the Dow is above the S&P 500 by nearly 2 percentage points, and has had its best quarter since the third quarter of 1995. How to play this recent run-up? If you own Diamonds (DIA), now might be a good time to sell at-the-money or slightly out-of-the-money call options on your shares. Going out to December or January, you’ll earn a decent premium and are likely to have the chance to buy them back at cheaper prices before expiration.
This week, even on mute, it seemed like they were covering a horse race, not the stock market, as the Dow Jones Industrial Average (DJIA) neared its record close set back in 2000 (the S&P 500, by the way, has over 14% higher to go to best its all-time closing high of 1527.46). Case in point, CNBC added along the top of the screen a “DJIA within X pts of record close” banner and had the “breaking news” alert going during market hours. Meanwhile, guests were asked if and when we’ll get to that record close.
So what if the Dow nears its record close?! It accounts for only 25% of the broad market (as measured by the Wilshire 5000) and is composed of just 30 companies in the form of a price-weighted average. To calculate it, the 30 companies' stock prices are literally added together and divided by, as of today, 0.12493117. That gives us the index value seen every day. This means companies with the largest absolute prices in the index have the largest relative impact on performance. For instance, IBM, with an $82 price would have a larger impact for each percent move than Intel, with a $20 price. A 5% move for IBM is $4.10, but just $1.00 for Intel. Similar problems exist for market-value weighted indexes, such as the S&P 500 (which is now float-weighted). These types of indexes tend to underweight undervalued stocks and overweight overvalued stocks, the exact opposite of what should be done.
Forgetting all that for a minute, the DJIA has had a strong run in recent months. Over the longer-term the performance of the DJIA tends to approximate the broader markets, but year-to-date the Dow is above the S&P 500 by nearly 2 percentage points, and has had its best quarter since the third quarter of 1995. How to play this recent run-up? If you own Diamonds (DIA), now might be a good time to sell at-the-money or slightly out-of-the-money call options on your shares. Going out to December or January, you’ll earn a decent premium and are likely to have the chance to buy them back at cheaper prices before expiration.
Chesapeake's Smart Move
Today Chesapeake Energy (CHK) announced the reduction of about 6% of its daily production volume that is unhedged because of low natural gas prices.
It's not often that you see a company sacrifice short-term numbers for the benefit of long-term wealth creation. With NYMEX natural gas prices hitting $4.20 (front month) Wednesday, CHK would still realize an over 100% cash operating margin (given cash costs are only about $2/mcfe). Yet management knows NG prices are on the low-end and that Mr. Market is likely to provide them with higher prices in the near future.
Meanwhile, today's press release updated us on their hedging position, which is even better than reported at year-end:
"The Oklahoma City-based company has locked-in prices averaging $9.24 per thousand cubic feet for about 92 percent of its expected production in the second half of the year. About 80 percent of Chesapeake's anticipated 2007 production is hedged at $9.92, and about 60 percent of 2008 production is contracted at $9.44." An enviable position to be in.
Great company. Buy it; the CEO has been doing so at prices higher than today's.
Disclosure: The author owns shares for clients as well as personally.
It's not often that you see a company sacrifice short-term numbers for the benefit of long-term wealth creation. With NYMEX natural gas prices hitting $4.20 (front month) Wednesday, CHK would still realize an over 100% cash operating margin (given cash costs are only about $2/mcfe). Yet management knows NG prices are on the low-end and that Mr. Market is likely to provide them with higher prices in the near future.
Meanwhile, today's press release updated us on their hedging position, which is even better than reported at year-end:
"The Oklahoma City-based company has locked-in prices averaging $9.24 per thousand cubic feet for about 92 percent of its expected production in the second half of the year. About 80 percent of Chesapeake's anticipated 2007 production is hedged at $9.92, and about 60 percent of 2008 production is contracted at $9.44." An enviable position to be in.
Great company. Buy it; the CEO has been doing so at prices higher than today's.
Disclosure: The author owns shares for clients as well as personally.
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