Tuesday, July 14, 2009

Two Stocks That Have Shrugged Off Bad News

The following two stocks are ones that have had bad press recently. The first one lowered its earnings guidance for the first half of 2009; the second had its earnings estimate slashed. Both have shrugged off the news, although the first has had more time between the bad news' release and now than the second has had:

One week ago, CRH plc issued a warning that its 1H '09 earnings were going to be worse than expected. After hitting a one-month low on the previous day, in which it closed at $21.68, CRH's ADR leapt up to open at $22.65. The next day saw another leap-up, which held until last Friday, when the price stayed between slightly below $22 and $22.25. It rallied to above $23 on Monday, backtracked a bit, and closed today at $22.74.

Yesterday, before the bell, Barnes Group was panned by an analyst because it makes some components for the still-delayed Boeing 787. Also: the analyst doesn't expect the auto market to recover soon, which leaves Barnes with no major fallback to cushion the Boeing delay's impact on its earnings. After market opened, Barnes dropped to below $10.90. After about 10:15, though, it leapt up to over $11.10. Since that time, both today and yesterday, it's drifted between $10.90 and about $11.10; today, it closed at $11.09. It's stayed in a trading range that's held for more than a week as of now.

Given the expected earnings drops for both, CRH and Barnes Group can be viewed as turnarounds. CRH's 10-year average EPS is 1.63 euros. For 2008, it declared 2.32 euros in earnings. (Google's converted it to $3.22.) Its 10-year return on equity, as calcuated by ([sum of net income over 10 years] / [sum of shareholders' equities over 10 years]), is 15.90%. Its EPS growth, as calculated by logarithmic regression, is 11.15%: not very rapid, but it beat the S&P's. [Both calcuations are in euros, as I wanted to isolate the underlying trend from currency effects.] Converting CRH's current share price into euros, its price per 10-year-average-earnings is 9.98. That figure's not that expensive, but it isn't a bargain hunter's dream either.

The Euro-equivalent price for CRH is 16.26 euros. Of its 8.087 billion-euro shareholders' equity, slightly more than half is in intangible assets. CRH's book value per share is about 7.25 euros, which means that its shares are selling at 2.24 times book. Its 10-year trend of earnings shows no dip at all. CRH got closest to an earnings dip in the years 2001 and 2003, when earnings for the year were two hundredths of a Euro more then in the previous year: EPS growth of 1.78% and 1.68% respectively. Barring that guidance-lowering, this trend would be reassuring. With it, though, CRH is a company whose 10+ year trend of earnings growth is going to be broken unless the second half of 2009 is a darn sight better than 1H '08. As noted above, there's no compelling valuation in CRH to point to.

Earnings-wise, near-term, Barnes Group doesn't have a lot to recommend it. Its 1Q '09 diluted earnings per share dropped about 63% from 1Q '08's. Its free cash flow for 1Q '09 was negative, even if less negative than 1Q '08's. Over the longer term, Barnes' annual free cash flow over the last four years was more than sufficient to cover its dividend payments for the year. Other investing cash flow items tended to swallow up the free cash flow, as did retirement of stock, which made Barnes a regular net borrower. However: cutting out both items in 2008, and not borrowing an additional dollar, would have left the dividend with a 120% free-cash-flow cover. That's not much of a margin of safety, but there is one with respect to free cash flow. Capex spending, of course, is not set in stone - and depreciation increased in '08, suggesting that some of Barnes' investing-cash-flow spending was for expansion.

If that analyst's prediction for 2009 earnings is correct, then '09's earnings will be below '08's by 58.6%. Assuming that cash flow from operations drops by the same percentage, the company will have more than 40 million in cash flow from operations. If the dividend is kept as is, Barnes will once again have to spend 33 million. This leaves only 7 million for capex, other investment cash flow spending, and share buybacks without borrowing or dipping into cash. As of March 31st, Barnes has only $20.96 million in cash and equivalents. This rote calculation suggests that, if Barnes wanted to keep its dividend level for this year, it will have to borrow more for its capex spending...perhaps for its capex needs. Although the company's borrowing has proceeded unimpeded through the credit crisis, I can give no assurance that Barnes' dividend will stay at its present 16 cents/quarter. Its 5.77% yield does represent some uncertainty about a dividend cut.

Earnings-wise, long term, Barnes' 10-year-average EPS is 99 cents. So, its price per 10-year-average-earnings ratio is 11.2. Its 10-year return on equity is 13.14%, and its 10-year EPS growth rate is only 7.06%. The last time its earnings got cold-decked, in 2001, it took three additional years for its earnings to get back above 2000's level. 2001's cold-decking took earnings down by 47.3% - but net cash flow from operations was actually up in the same year, as was free cash flow. I can't suggest that 2009 will be like 2001, but 1Q '09's operations cash flow was less negative than 1Q '08. That being said, I remind the reader that the 2008 free-cash-flow margin of safety with respect to the dividend payment was only 120%.

The balance sheet is actually to its credit, in terms of liquidity. As of Mar. 31st, Barnes' current ratio is a safe 2.70. Its quick ratio is 1.45. Given these metrics, it's no wonder that Barnes can still borrow. Its additional borrowings show up under long-term, not short-term, debt, because its revolving-credit facilities don't mature this year. It has to pay off $24.072 million in long-term debt this year, but there's more than enough room in its credit facilities to use that means to refinance. [2008 borrowings on its line of credit: $251.4 million, out of a $400 million limit.] Given its curent and quick ratios, Barnes will not be in any debt squeeze even if its earnings are crimped in line with that analyst's forecast. Bear in mind, though, that paying off 2009's maturing debt without borrowing any more will crimp 2009's cash flow by almost $25 million. If that $40 million operations cash flow guesstimate proves to be correct, then the company would not have enough operations cash flow for the dividend without a cut in the latter.

In addition, Barnes' net tangible equity per share is below zero. So, in terms of book value, the balance sheet ain't that hot. Counting goodwill and intangibles, though, Barnes's common equity per share is $11.15. Its debt-to-equity ratio is $1.43 in debt to every dollar in equity. These figure may satisfy the bank, but it won't satisfy a value investor.


Both of these companies present a less-than-compelling set of financials. Some readers may be interested in the fact that they shrugged off their respective bad news, but their underlying financials suggest turnaround processes that have yet to be completed. Barnes may look interesting from a paid-to-wait perspective, but there's no compelling reason to label it a bargain as it is now. CRH may succeed in keeping their 10-year rising-earning trend intact due to cost cuts, but it might be in for some real trouble if it doesn't.

So, from a strict Ben Graham perspective, I would have to say that going into either at this point would be a speculation.

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