Ever wonder why a company’s stock price sometimes falls after bang-up earnings are announced? Or why the sudden death or incapacitation of a CEO can lead to a celebratory romp by the company’s shares?
Both situations are matters of expectations. In the former case, stock market participants already had factored superlative earnings into the share price, so the release of merely good earnings proved a disappointment. In the case of the suddenly departed top dog, investors had not considered the possibility that a new leader would come in and possibly maximize shareholder value more quickly, perhaps through the sale of the company.
“The question an investor needs to ask himself is, ‘Do I agree or disagree with the market’s prediction for the financial future of a company?’” says David Trainer, pres- ident of Nashville-based New Con- structs LLC. “If I agree, then there’s no reason to buy it because investment opportunities arise only when the investor has different expectations for future profits than the market.”
That being the case, knowledge of exactly what the market is expecting from companies should be quite valuable. The most compelling opportunities come when an investor uncovers greater promise in a company versus what’s expected by Wall Street.
To increase the odds that Business Tennessee readers successfully identify the opportunities and risks in investing, we asked the folks at New Constructs to put under their microscope 50 publicly traded companies headquartered in Tennessee. (New Constructs has received funding from several Tennessee investors, including Solidus Co., which is majority owner of Business Tennessee.) After a thorough scrubbing of publicly available financial statements, the institutional stock research shop reported back with some fairly eye-catching results.
While valued in line with U.S. stocks generally, Tennessee companies include 15 that could be considered downright cheap. Another 13 sport prices that would require investors to have faith in more than 100 years of profit growth to justify meaningful price appreciation—not a thrilling prospect.
The chart on page 46 depicts the results. Investors’ expectations compared to their March 31, 2004 prices are the most modest for AmSurg, CTI Molecular and Pinnacle Airlines. In the case of AmSurg, a Nashville operator of single-specialty surgery centers, the shares are priced so inexpensively it implies the current level of profitability is expected to decline. “Of course they could be cheap for a reason,” Trainer notes.
But the margin of safety embedded in AmSurg shares confers less risk of under-performance than any other Tennessee public company. In fact, at a recent $22, AmSurg shares are priced below New Construct’s calculation of economic book value at $26.
Third cheapest on the list is Pinnacle Airlines. The Memphis-based provider of Northwest Airlink service needs only to maintain 7.7% average annual revenue growth and a tiny 0.1% economic profit margin for four years to justify its recent price of $13.50. What makes this finding especially significant is the positive review of company fundamentals presented in the March issue of Business Tennessee. That article (“Northwest’s 10% Solution”) unwrapped a very complex business plan and income statement to find a company poised for solid performance. Pairing the cheap valuation of its shares (based on the work of New Constructs) with a positive review of Pinnacle Airlines’ management and financial future suggests a stock likely to reward investors.
AutoZone, First Horizon Financial (formerly First Tennessee) and Caremark can thank their high levels of profitability and returns on capital for their comparatively modest valuations. Even HCA, currently battling a surge in bad debt expense, improved its bottom line enough in recent years so that it once again produces true economic profits.
Confidence in such cheap valuations hinges on understanding the basis of appraisal. New Constructs begins by “scrubbing” the annual 10-K filings publicly traded
companies submit to the Securities & Exchange Commission. Trainer and crew look for distortions embedded in generally accepted accounting principles (GAAP), the financial reporting protocols all public companies follow. While consistent, the GAAP rules are badly flawed in presenting the true economic picture of companies, New Constructs argues.
Buttressing this point of view is a paragraph excerpted from Enron’s in-house risk management manual, as cited in 2003’s The Smartest Guys in the Room: “Reported earnings follow the rules and principles of accounting. The results do not always create measures consistent with the underlying economics. How- ever, corporate management’s performance is generally measured by accounting income, not underlying economics. Therefore, risk management strategies are directed at accounting, rather than economic, performance.”
For example, employee stock options are an alternate form of compensation that does not show up on income statements under GAAP. New Constructs deducts from earnings a calculated cost of employee stock options. For many companies, especially those of the high technology persuasion, this adjustment is all that’s needed to turn seeming financial profits into actual economic losses.
Also, to determine economic profit margin, Trainer backs out an estimated cost of capital from a company’s actual return on invested capital. While the price a company pays for borrowing is obviously embodied in the interest payments, the costs of equity funding are less obvious. Maybe less conspicuous, but equity carries a cost nonetheless—actually more of an opportunity cost in the form of other investments foregone.
With financial statements scrub- bed for at least 12 major disagreements with GAAP treatment, New Constructs is better able to quantify the future financial performance required to justify the current market price. Trainer says his analysis is inspired by John Burr Williams’ The Theory of Investment Value (1938), which suggests using a discounted cash flow model to reverse-engineer the future cash flows required to generate a value equal to the current market price.
This exercise for the Standard & Poor’s 500 Index, a list that includes most of the largest corporations in America, suggests a very rich current valuation on stocks. Investors owning the S&P 500 at recent prices should expect the index companies to grow an average seven percent annually and generate an unprecedented 13.6% economic profit margin for 80 years.
Sound unlikely? Then how about the Tennessee companies needing more than 80 years to justify their stock prices? At a minimum, they must do something to jack up the cash flow they’re generating if they are to avoid disappointing shareholders. FedEx, the state’s largest publicly traded corporation with $23.5 billion in annual revenue, is in that category. The disconnect for FedEx, according to a dissection of its financial statements, stems primarily from one big adjustment – bringing off-balance sheet financing used to pay for capital equipment back on the balance sheet. The impact of this adjustment, which converts operating leases into capital leases, is to boost capital invested in the business by over 100%. This change, plus adjustments for deferred tax liabilities and employee stock options, means FedEx “has never been as cheap as it may appear because it doesn’t make any economic profits,” Trainer reckons. Nonetheless, according to GAAP standards, the Memphis company earned $706 million, or $2.33 a share, in the trailing 12-month period.
This take on the profitability of FedEx and 49 other corporations should be only a starting point. Armed with a more sober financial picture of Tennessee-based companies, investors should next apply their imaginations to exploring such matters as strategy and competition. An investor who then reasonably concludes that a company will exceed the market’s expectation has all the justification needed to become a shareholder of Tennessee Inc.
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