Earnings Power Value: A Supplemental Measure Of Finding Competitive Strength

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Speak to any “value investor” and they will undoubtedly have certain metrics of choice which they will use to move an idea into the “further research”, “pass” or “too hard” pile. These preliminary metrics generally focus on determining whether a stock is trading at a reasonably attractive price. Some of the most common include forward P/E ratio, PEG ratio, P/FCF, EV/EBIT or even EV/Revenue. Most of these metrics are never used in isolation: typically, they are used to compare individual stocks against their respective industries and competitors. For example, investors may evaluate a grocery chain trading at 0.6x sales versus an industry average of 0.8x and a large competitor at 0.7x and conclude, amongst other factors such as projected earnings growth, that the stock is an attractive investment candidate.

Despite the myriad of metrics an investor can rely upon, all of them have limitations and should not be used in isolation but rather to complement stock analysis. One measure that we consider when researching a stock which we often find useful is the spread between Earnings Power Value or EPV and tangible book value. The rule is simple: the wider the spread, the greater the value of the franchise (and thus competitive strength). It must be noted that book value isn’t perfect as many businesses will have inflated goodwill or other assets on their balance sheet which would make the reproduction costs of their assets not equal to true book value, but we use the spread as a soft measure.

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In their book, Value Investing From Graham to Buffett and Beyond, Greenwald et al. accurately address the importance of Earnings Power Value as reliable measure of intrinsic value, competitive strength and why growth, as a variable for this particular metric, does not matter:

“We have ignored…the value of future growth of earnings…we are justified in paying no attention to it because in evaluating companies operating on a level playing field, with no competitive advantages or barriers to entry, growth has no value. The return these companies earn on the capital invested in them just equals the cost of acquiring the capital, and there is nothing left over for previous investors. Thus, the Earnings Power Value that equals the asset value defines the intrinsic value of the company, regardless of its growth rate in the future…if EPV, properly calculated, is significantly higher than the reproduction costs of the assets, then we are looking at an industry setting in which there must be strong barriers to entry.”(p.41)

At Logos LP, we will use Earnings Power Value to supplement our own estimates of how strong a business is within its industry setting. We will also look at several other metrics, even some that were mentioned above, when holistically evaluating a stock as a potential investment. Although high performing businesses will not usually find the spread between EPV and tangible book value (or book value) below their current stock price (although it does happen), the widening gap does give us a glimpse into how attractive the company is within their respective markets during large selloffs.  As such, we wanted to provide a few names high on our conviction list that also have large EPV values over tangible book:

  1. Lassonde Industries Inc. (TSX: LAS.A): The company is one of the largest private label juice companies in North America and operates in an effective oligopoly in the private label shelf stable juice market. Unlike Europe where a large portion of food and beverage sales are in large grocery chains are private label products, the private label juice market is still underdeveloped in North America. Moreover, this market has very attractive unit economics contracts for private label products are locked in at large grocers, big box, foodservice or e-commerce companies for a longer period in a highly stable and predictable market, creating very strong cash flows. The company has a 4-pronged growth strategy: rollup of regional shelf stable juice brands in North America (including Mexico); invest in innovative beverage products for clients and for regional brands (i.e. juice + carbonation, low calorie, hydration focused products); expansion into private label foods (i.e. sauces); expansion of cider and wine segment. Considering the long-term growth strategy and reduced inflationary risks (transportation and resin costs) we believe the company will continue to grow earnings in the low-double digits for some time.

Current Share Price = $203.40; Spread between Earnings Power Value and Tangible Book = $126; Logos LP 2-Year Price Target = $298.10

  1. Huntington Ingalls Industries (NYSE: HII): This company was a spin-off from Northrop Grumman and is the largest shipbuilder for the US Navy. If anyone will be touching US Navy ships, it will be Huntington. A recent paper from the US government in October made the case for significantly increasing government funds towards the US Navy over the next 30 years, which will create the largest shipbuilding pipeline seen since Reagan. Already HII has a $22 billion backlog (and growing) and they are utilizing project cash flows to grow their Technical Advisory business unit (which currently sports nearly $1 billion in revenue with 21% EBIT margin). This business unit provides strategic IT services such as cybersecurity software development, IT consulting and development, big data engineering, simulations, networking and other professional services to the US Navy, government departments and large multinationals such as Exxon and Boeing. We believe the stock is offering a very interesting entry point at 12.5x cash flow, 1x sales and 12x earnings. The company spits out nearly $1 billion in EBIT (and growing) despite a market cap of $8.4bn.

Current Share Price = $196.61; Spread between Earnings Power Value and Tangible Book = $67; Logos LP 2-Year Price Target = $303.91

  1. CGI (NYSE or TSX: GIB): CGI is a dominant player in government IT consulting and has 20+ year tailwinds given the complexity and spend of enterprise IT. The company’s total addressable market is near $1 trillion (and growing) and it holds a very small slice of it, giving it ample room to grow. The company is also transitioning to higher margin proprietary software development which enhances the stickiness of its services to its global clientele. They are excellent consolidators of IT contractors around the globe and we suspect this trend to continue. The company generates very high ROIC with tons of free cash flow, and they are excellent at keeping a lean shop while growing margins. The stock did not decline too much during the December selloff but it is not unreasonably priced (16.6x cash flow, 2.2x sales) given it’s leading position in enterprise IT consulting, which is somewhat oligopolistic (Accenture and Cognizant are the other two players, although Cognizant is more development focused). We think the company surpasses $100 billion market cap in the long-term.

Current Share Price = $64.62 (USD); Spread between Earnings Power Value and Tangible Book = $66 (USD); Logos LP 2-Year Price Target = $84.42 (USD)

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