Recap from February Picks
Most Attractive Large Cap stock Cisco Systems (CSCO) gained 10% last month. Most Attractive Small Cap stock The Goldfield Corp (GV) was up 21%. Overall, 7 out of the 40 Most Attractive stocks outperformed the S&P 500 in February and 22 had positive returns.
Our Most Dangerous Stocks (+1.4%) outperformed the S&P 500 (+3.6%) last month. Most Dangerous Large Cap stock Integrated Device Technology (IDTI) fell by 4%. Most Dangerous Small Cap Stock Matrix Service Company (MTRX) fell by 25%. Overall, 17 out of the 40 Most Dangerous stocks outperformed the S&P 500 in February.
The successes of the Most Attractive and Most Dangerous stocks highlight the value of our forensic accounting research (featured in Barron’s). Our research helps clients fulfill fiduciary duties when making investment decisions.
33 new stocks make our Most Attractive list this month and 14 new stocks fall onto the Most Dangerous list this month. March’s Most Attractive and Most Dangerous stocks were made available to members on 3/2/17.
Our Most Attractive stocks have high and rising returns on invested capital (ROIC) and low price to economic book value ratios. Most Dangerous stocks have misleading earnings and long growth appreciation periods implied by their market valuations.
Most Attractive Stocks Feature for March: Hawaiian Holdings, Inc. (HA: $48/share)
Hawaiian Holdings, Inc. (HA) is one of the additions to our Most Attractive stocks for March.
Over the past decade, Hawaiian Holdings has grown after-tax profit (NOPAT) by 30% compounded annually to $347 million in 2016. Per Figure 1, Hawaiian Holdings has also improved its NOPAT margin from 3% in 2006 to 14% in 2016.
Figure 1: Hawaiian Holdings’ Improving NOPAT & NOPAT Margin
Sources: New Constructs, LLC and company filings
Hawaiian Holdings currently earns a top-quintile 15% return on invested capital (ROIC), which is up from 2% in 2006. Hawaiian Holdings has generated a cumulative $381 million (15% of market cap) in free cash flow over the past decade.
HA Valuation Has Significant Upside
Despite solid fundamentals, HA is down 15% year to date while the S&P is up 6%. This price decline has left shares significantly undervalued. At its current price of $48/share, Hawaiian Holdings has a price to economic book value (PEBV) ratio of 0.6. This ratio means the market expects Hawaiian Holdings’ profits to permanently decrease by 40%. This expectation seems rather pessimistic for a company that has grown NOPAT by 30% compounded annually over the past decade.
If Hawaiian Holdings can achieve a 12% NOPAT margin (compared to 14% in 2016) and grow NOPAT by just 3% compounded annually for the next five years, the stock is worth $87/share today – an 81% upside.
Impacts of Footnotes Adjustments and Forensic Accounting
Our robo-analyst technology enables us to perform forensic accounting with scale and provide the research needed to fulfill fiduciary duties.
In order to derive the true recurring cash flows, an accurate invested capital, and an accurate shareholder value, we made the following adjustments to HA’s 2016 10-K:
Income Statement: we made $350 million of adjustments, with a net effect of removing $111 million in non-operating expense (5% of revenue). We removed $119 million in non-operating income and $231 million in non-operating expenses. You can see all the adjustments made to HA’s income statement here.
Balance Sheet: we made $1.5 billion of adjustments to calculate invested capital with a net increase of $365 million. One of the largest adjustments was $704 million due to off-balance sheet operating leases. This adjustment represented 37% of reported net assets. You can see all the adjustments made to HA’s balance sheet here.
Valuation: we made $2.3 billion of adjustments with a net effect of decreasing shareholder value by $1.3 billion. Apart from total debt, which includes $704 million in operating leases noted above, the largest adjustment to shareholder value was $360 million in underfunded pensions. This adjustment represents 14% of Hawaiian Holding’s market cap. Despite these claims on shareholder value, HA remains undervalued.
Most Dangerous Stocks Feature: CIRCOR International, Inc. (CIR: $63/share)
CIRCOR International, Inc. (CIR) is one of the additions to our Most Dangerous stocks for March.
Since 2013, CIRCOR’s NOPAT has declined 29% compounded annually, per Figure 1. This deterioration in profits coincides with NOPAT margins falling from 7% in 2013 to 4% in 2016.
Figure 2: CIR’s Declining NOPAT
Sources: New Constructs, LLC and company filings
CIRCOR’s ROIC has fallen from 10% in 2013 to a bottom-quintile 3% in 2016. The company has also burned through a cumulative $63 million (6% of market cap) in FCF over the past five years.
CIR Is Priced For Perfection
CIR is up 54% over the past year while the S&P is up 19%. This price appreciation amidst deteriorating fundamentals makes CIR significantly overvalued. To justify its current price of $63/share, CIR must grow NOPAT by 15% compounded annually for the next 12 years. This scenario seems overly optimistic given CIRCOR’s NOPAT has declined by 29% compounded annually since 2013.
Even if
CIRCOR International
can grow NOPAT at a more reasonable, yet still optimistic, 10% compounded annually for the next decade, the stock is worth $31/share today – a 51% downside.
Each of these scenarios assumes CIRCOR is able to grow revenue and NOPAT/free cash flow without spending on working capital or fixed assets. This assumption is unlikely but allows us to create very optimistic scenarios that demonstrate how high expectations in the current valuation are. For reference, CIR’s invested capital has grown on average $61 million (10% of 2016 revenue) per year over the last five years.
Impacts of Footnotes Adjustments and Forensic Accounting
Our robo-analyst technology enables us to perform forensic accounting with scale and provide the research needed to fulfill fiduciary duties.
In order to derive the true recurring cash flows, an accurate invested capital, and an accurate shareholder value, we made the following adjustments to CIRCOR’s 2016 10-K:
Income Statement: we made $51 million of adjustments, with a net effect of removing $12 million in non-operating expense (2% of revenue). We removed $19 million in non-operating income and $32 million in non-operating expenses. You can see all the adjustments made to CIR’s income statement here.
Balance Sheet: we made $470 million of adjustments to calculate invested capital with a net increase of $76 million. One of the largest adjustments was $155 million due to midyear acquisitions. This adjustment represented 22% of reported net assets. You can see all the adjustments made to CIR’s balance sheet here.
Valuation: we made $343 million of adjustments with a net effect of decreasing shareholder value by $285 million. One of the most notable adjustments to shareholder value was the removal of $278 million in total debt, which includes $27 million in operating leases. This lease adjustment represents 3% of CIRCOR’s market cap.
This article originally published here on March 9, 2017.
Disclosure: David Trainer, Kyle Guske II, and Kyle Martone receive no compensation to write about any specific stock, style, or theme.
Article by Kyle Martone, New Constructs
