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Cyclical or Not?

(Guest Commentary by Rick Konrad – September 23, 2010)

Dear Subscribers and Readers,

For those who want to learn more about picking stocks, evaluating companies, industry trends, and other issues related to the stock market, we have brought in Mr. Rick Konrad to pen a guest commentary.  Rick has been a regular guest commentator for several years and offers his unique insights to us in his twice-a-month mid-week commentaries.  We highly appreciate your investment insights and general wisdom, Rick!

In this commentary, Rick starts with a discussion of the cyclicality and current status of the steel industry (revolving around U.S. Steel and Nucor), and what stock he currently prefers.  However, Rick sees a more attractive opportunity in a company that operates in a less cyclical industry.  You would have to scroll down for more details!  Without further ado, following is Rick's biography:

Rick is author of the excellent investment blog “Value Discipline,” founder of “Value Architects Asset Management”, and is a regular guest commentator on (please see “The Death of Equities Revisited” for his last commentary).  Prior to his founding Value Architects, Rick was a professional portfolio manager for institutional investors for over 25 years.  A more complete profile of Rick is available on his blog.  You can also email Rick at the following address if you have any questions or thoughts after reading his commentary.  Rick is a very genuine teacher of the financial markets and treats it very seriously.  Rick has also run 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 graded CFA examinations.

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.

Investors continue to focus on "blurbs" as signposts for the direction of the economy. The recent Fed pronouncement that the pace of economic activities as well as employment generation has “slowed down in recent months”, should come as no great surprise to most of us. Yet, most economists seemed to rethink their forecasts based on subtle semantic shifts. It seems to me that too many of us are looking for subtleties rather than realities and looking backward rather than forward.

Is the shift in language to “prepared to provide additional accommodation if needed” from the previous wording of “will employ its tools as necessary" truly indicative of a weaker economy?

Perceived cyclicality finds itself in unusual places nowadays. Historically, when one thought of a typical cyclical industry, we thought of heavy industries such as the iron and steel industries. When we look at a company like US Steel (X), the financials read as one would expect. Operating cash flow was negative for the trailing twelve months (-$770 million) though starting to improve over the previous quarter. Nucor (NUE) has shown better operating cash flow which remained positive over the last twelve months (+$256 million) and also showing significant improvement versus the previous quarter. But the returns on invested capital remain dreary reading, with those of X still quite negative and NUE showing a miserable 1% return on invested capital at this stage. Nucor continues to paint a relatively weak picture, having taken street guidance down in its most recent conference call. NUE's comment that it is having difficulty passing higher scrap metal costs through suggests that competition remains robust and the demand environment remains weak.

Both X and NUE have performed rather poorly this year, down about 18% and 17% respectively. Valuations for both companies are "down in the dirt" with X trading at 40% of sales and NUE at 90% of sales, both in the lower half of their valuation ranges for the last decade.

When we look at peak returns on invested capital for the last decade, NUE wins by far with peak profitability at 27% as compared to X at 17%. Obviously, both have a very high degree of operating leverage, which clearly works in both the up and the downturns. X has one important advantage--its self-sufficiency in iron ore and near self-sufficiency in coke whereas mini-mills can get squeezed by scrap metal prices from time to time. If the cycle firms, there is likely decent upside in both companies but NUE should get the nod based on a stronger ability to manage its capital effectively.

There may be some hope in terms of steel prices improving internationally based on this Wall Street Journal article:

Of greater interest to me and hopefully to you are the less obvious cyclical companies. One that I believe is particularly cheap is AmSurg Corporation (AMSG).

AmSurg develops, acquires, and manages practice based ambulatory surgery centers. These tend to be single specialty focused operations, which are located adjacent to a physician's practice. These tend to be higher volume, lower risk surgical procedures such as endoscopy (colonoscopies), ophthalmology procedures such as cataract, orthopedic, and urological procedures

There is a cost advantage to AmSurg—generally, these centers can undercut the prices charged by the hospitals. The service also tends to be superior (or at least friendlier and faster) than that offered in most hospitals. Convenience, being located frequently next to the physicians' office is also an important advantage.

Not surprisingly, many of these procedures tend to be somewhat discretionary particularly for procedures such as screening colonoscopies or cataract surgeries. At a time of high unemployment, many patients are simply out of the "market." High levels of unemployment lead to fewer individuals with company-provided insurance. Even employed patients may be reluctant to take time off of work just in case their productivity is "not missed." Nevertheless, AMSG has a fairly large percentage of non-discretionary procedures as well as those covered by Medicare.

Volumes have moved down slightly over the last couple of quarters in response to the economic weakness. Lower Medicare reimbursement has also impacted margins by about 100 basis points.

AMSG is continually seeking physician partners for expansion, generally paying acquisition prices of some seven times cash flow. The business model has AMSG generally owning 51% of the partnerships or limited liability companies, and acts as the general partner in each limited partnership and the chief manager in each limited liability company. The agreements generally provide that AMSG will oversee the business office, marketing, financial reporting, accreditation and administrative operations of the surgery center. The physician group partner provides the center with a medical director and certain other specified services such as billing and collections, and accounts payable processing. With this partnership arrangement, AmSurg aligns the financial interests of partner-doctors with the company's and hence, shareholders. Physicians who partner with AmSurg have a strong incentive to refer their well-insured patients to the company's facilities, thus mitigating the bad debt problem that is so nettlesome to most hospitals.

The stock has been a poor performer this year, down some 22% YTD, significantly underperforming more traditionally cyclical businesses such as the afore-mentioned steels.

Operating cash flow for the trailing twelve months is down less than 1%, quarter over quarter is down 3%...doesn't feel very cyclical does it?

There is significant goodwill on the balance sheet as a result of growth by these numerous acquisitions. Nevertheless, trading at less than 4 times EV/EBITDA, the stock seems to be discounting a fairly moribund future. Market cap is about $530 million and there is about $440 million in debt and only about $26 million in cash. No worries, though. Interest coverage is more than 20 times.

Free cash flow is about 11% of revenues over the last twelve months whereas both Nucor and US Steel are running negative free cash flow over this same time period.

Disclaimer: I, my family and clients do not currently own a position in any of the securities mentioned in this post.

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