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Keeping Your Feet on the Ground but What a Rally!

(Guest Commentary by Rick Konrad – April 16, 2009)

Dear Subscribers and Readers,

For those who had wanted to learn more about picking stocks, evaluating companies, and other issues related to the stock market, we have again brought in one of our regular guest commentators, Mr. Rick Konrad for a guest commentary.  Rick is a regular guest commentator and usually writes for us every third Wednesday of the month.  We highly appreciate your investment insights and general wisdom, Rick!

In this commentary, Rick will again focus on stocks that he believes are cheap, growing, and have high free cash flows.  Rick believes that while this is the time to buy stocks, it is still imperative to avoid stocks that are highly leveraged or have little to no access to liquidity, given the ongoing deleveraging environment.  Without further ado, following is a biography of Rick:

Rick is author of the excellent investment blog “Value Discipline,” founder of “Value Architects Asset Management”, and is a regular guest commentator of MarketThoughts (please see “Techonomics and the ATM” for his last guest commentary).  Prior to his current role, Rick has been a professional portfolio manager for institutional investors for over 25 years.  You can view a more complete profile of Rick on his blog.  You can also email Rick at the following address should you have any questions or thoughts for Rick after reading his commentary.  Rick is a very genuine teacher of the financial markets and treats it very seriously.  Case in point: Rick has also been responsible for running the education program for the CFA Society in Toronto (which is the third largest CFA society in the world besides the New York and London Societies) and had also been responsible for grading CFA papers.

Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice.  Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.


What a rally! Who can blame the skeptics for their doubting Thomas attitude after all that we have been through? Though the economic backdrop provides sketchy evidence of recovery as of yet, the equity market's heady performance against a crowd of doubters is how this usually happens.

Waiting for earnings expectations to turn up has been a “Waiting for Godot” strategy. Instead, companies who after all, have been in a recession since the end of 2007 have had some chance to respond to this environment.

First, a look at WW Grainger (GWW) results reported April 14th. Sales were rather miserable, down 11% in the US and 18% in Canada (but up 2% in local currency.) As per the Grainger podcast:

  • Commercial and retail were down in the high single digits.
  • Light manufacturing was down low double digits.
  • Within this, sales to food processing customers were up mid-single digits and to furniture companies down 30%.
  • Contractor and reseller sales were down low teens.
  • Heavy manufacturing customers showed sales down mid 20's.

Despite what sounds like a fairly austere revenue results, here is where analysts got it wrong. Wall Street estimates were $1.07 for the quarter. Whisper numbers averaged $1.11. The company reported $1.25. Why such a positive surprise?

In short, management. Operating margins declined by only 10 basis points to 13.2% versus 13.3%. Gross margins lifted by 230 basis points driven by positive inflation recovery and close attention to pricing. Operating expenses such as payroll, benefits, and travel were reduced. On a trailing four quarters basis, ROA has actually improved to 23.5% from trailing four quarters results a year ago at 22.6%. Here is a graphical depiction of Grainger's returns on assets in this “tough” environment (chart courtesy of my friends at Cash Flow Analytics)

GRAINGER (W W) INC (GWW)

Slowing growth or declining growth has a profound effect on a business. Sales at Grainger dropped by 11%, operating earnings were down 14% and net earnings were down 16%. Largely due to share buybacks, which returned capital of $128 Million to shareholders, earnings per share fell by 11%.

Many financial analysts look for companies that are adept at growing revenue and earnings. Indeed, earnings growth is at the heart of many stock valuation models. However, earnings growth does not necessarily translate into cash flow growth. We need to analyze whether a company can be expected to provide or to consume cash as it grows. The usual focus on just the headlines as provided by CNBC or Investors Business Daily provide only a superficial perspective.

Here's a look at GWW from a free cash flow generation perspective:

GRAINGER (W W) INC (GWW)

Quite a different perspective from the perspective provided by a quarterly earnings report. Free cash flow growth can be the result of improvements in the core operating growth including changes in working capital management, not just reductions in capex.

One of the screens that I like to begin analysis with is this one where free cash flow exceeds earnings. I have also limited my screen by insisting on return on assets over the trailing four quarters that exceeds 12% and is improving versus the year ago metric. In order to maintain a semblance of balance sheet quality, I have also insisted on EBITDA being at least five times the interest paid.

FCF Exceeds Earnings with Improving ROA GT 12: http://tinyurl.com/cblx9x

This screen includes companies such as Alliant Tech (ATK), Brown-Forman (BF.a), Cooper Industries (CBE), Ecolab (ECL), Emerson (EMR), IBM (IBM), Pall (PLL), Sigma-Aldrich (SIAL), Snap-On (SNA) and Sysco (SYY) . These companies sell at an EV/EBITDA averaging about 7 times.

I have also provided a screen of companies which at the margin are showing improvement in their ability to generate both free cash flow as well as improvements in operating cash flow.

Improving Op, CF and FCF: http://tinyurl.com/d2fdvb

Though we continue to find a lot of companies that are interesting, cheap, and are providing comfortable fundamentals, this is not the time to be reaching too far up the risk ladder. An example of high roller risk, appropriately enough is MGM Mirage (MGM) which has rallied from under $2.00 to a current $6.60. MGM has violated debt covenants, has liquidity issues in 2009 to meet its obligations, its debt is trading at 40-50%, and has yet to resolve the financing issue for City Center, its mega-project JV in Las Vegas. Dubai World has sued MGM over City Center financing because "going concern" language in its SEC documents is considered breach of agreement. Deutsche Bank considered providing bank financing but backed out. Colony Capital stepped away from a loan / investment agreement with MGM. A complete crapshoot, in my opinion, if ever there was one. It seems to me that $1.8 Billion in equity market cap under at least $13 Billion in debt, if not more depending on the outcome of the Dubai lawsuit, is an awfully rich price for hope. But it is Las Vegas…let's hope it is not the city of broken dreams for MGM shareholders.

As always, half of the battle in the investment war is avoiding trouble. In this environment, that is so very important.

Disclaimer: I, my clients and family may own securities that are mentioned in this post or in the screens provided. Please bear in mind that ALL ideas, opinions, and/or forecasts are for informational or entertainment value ONLY and should NOT be construed as a recommendation to invest, trade, or speculate in the stock market.

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