The following is my RealMoney column from December 6, 2006.
YRCW shares are pricing in a much lower EPS outlook than the consensus. Does that signal a buying opportunity?
Nobody believes trucking company YRC Worldwide (YRCW) will earn the consensus estimate of $2.52 per share in 2008. If they did, the stock would be trading significantly higher than $17.50 per share.
After all, the company earned $5.00 per share in 2006 and is expected to pull in $2.40 this year. If this year is really “the bottom” for earnings investors should be willing to pay at least $30, which equates to the company’s 5-year average P/E of 12x.
So investors clearly think YRC will earn less – probably much less – than $2.52. The questions then become:
- How much less will they earn?
- Does the current price reflect the worst case scenario?
- If nobody believes YRC will earn $2.52 how did it become the consensus estimate?
I’ll leave the last question to philosophers, but I think I can take a stab at the first two.
How Low Can They Go?
To get a feel for the potential earnings bottom, I looked at the history available from Zacks Research Wizard.
Source: Zacks Research Wizard
Clearly the earnings per share can be much lower than $2.52. In fact, the last economic slowdown included one year that wiped out the peak year, the subsequent down year and a good part of the next year’s recovery. Furthermore, the late 1990’s also indicate that several down years can wipe out a good deal of the positive earnings in up years. All of which goes to show why I prefer the non-asset based transportation companies like Landstar (LSTR - Annual Report) and CH Robinson (CHRW - Annual Report).
So one approach to valuation would be to take a page from Ben Graham’s Intelligent Investor (page 313 in my edition) and use a longer-term average of earnings per share. I chose five years, giving me the following chart.
Sources: Zacks Research Wizard, William A. Trent
Right away, I see two useful take-aways from this chart. One is that the trough-peak pattern from 1999-2001 looks very similar to the one in 2004-2005. This gives me some confidence that this cyclical relationship may represent the next cycle as well. The other is that the cumulative peak-peak growth rate from 2001-2006 is about 25%.
Applying 25% growth from the 2004 trough gives me a target for the average EPS in the next trough – about $0.44. This helps me answer the first question (as well as some indication of how severe the negative earnings year(s) will have to be in order to push the 5-year average that low.)
Is the worst case priced in?
An old rule of thumb is to buy cyclical stocks when the P/E is high and sell when it is low. This is because the P/E is high when earnings are at their lowest and about to recover. Just looking at the estimates, though, the current P/E is low.
But we already established that the estimates aren’t believed. If the five-year average earnings per share is about to drop to $0.44, the stock is currently trading at about 40x trough earnings. That is starting to sound like the “high P/E” that would signal a buy.
And whaddya know? It looks from this chart that as YRC started to pull out of the last earnings trough it was getting a multiple of about 40x earnings. Furthermore, the stock is now trading below its levels five years ago even though the general EPS trend has been up.
This doesn’t, of course, imply that the worst is priced in. Nobody can really know that for sure. But it sure looks like we’re getting close.
Cash Flow Talks
Of course, I always prefer to look at companies on a cash flow basis rather than an earnings basis. Free cash flow (cash from operations less capital expenditures) has been negative for the last three quarters. Over the trailing 12 months it comes to $68 million – a 3% yield on the $2.3 billion enterprise value.
Ideally, in exchange for accepting the risk related to a stock like YRCW I would to get a higher return than I would from other investments like a 3.3% 5-year Treasury bond. Although the current free cash flow yield for YRC is less than the Treasury yield, if the risk is mostly reflected then proximity to the risk-free rate isn’t necessarily bad.
Once again turning to a full-cycle perspective, the five-year average free cash flow for YRC is $152 million, and the current yield based on that figure is 6.6% – twice the Treasury yield.
Twice the Treasury yield would normally justify the investment, particularly for investors who are either more optimistic or more risk-tolerant than I am. But given that Landstar is yielding even more and has less risk (in my opinion) over the full cycle it isn’t enough to make me switch.
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