Deal Dead? Express Scripts Has 28% Upside to Cigna Buyout Offer Price

With AT&T (T) and Time Warner (TWX) currently fighting in court to prevail over the federal government in its anti-trust lawsuit, all eyes in the merger arbitrage world are focused on whether so-called “vertical” mergers will be endangered in the Trump Administration. Typically, lawsuits to block M&A transactions have centered on competitors trying to get together to reduce competition and increase pricing power post-combination, but the current fight puts vertical integration in the crosshairs, as the infrastructure company is trying to add content to diversify its business. Given how low sentiment is on Wall Street for paid television content production, investors clearly don’t believe a simple merger would give the content producers monopolistic power, but we will have to see what judges think.

One of the more interesting cases is Express Scripts (ESRX), the large pharmacy benefits management company that was recently (March 8th) offered a 31% premium to be acquired by health insurer Cigna (CI). Many believed that ESRX was in play after becoming the lone major PBM to not have a dance partner. And after CVS Health (CVS) — which owns another large PBM in Caremark — made a bid for Aetna (AET), it was clear that insurance and pharmacy benefits management were consolidating to the point where ESRX as a standalone business was becoming obsolete.

Express Scripts stock was trading at $73 when the $96 deal price was announced, and the stock jumped initially… for a few hours. It now fetches around $70, as investors bet that vertical mergers, even if allowed in the media business, have a steeper hill to climb, in part because multiple deals are pending and allowing all of them to go unchallenged, could be seen as risky by the government.

With ESRX having 28% upside if the deal is allowed, it might seem like a no-brainer risk/reward situation to go long the stock. After all, at current prices the shares trade for just 10x 2017 earnings per share, with that multiple falling to just 7.5x if you believe the mid-point of the company’s 2018 earnings guidance ($9.37), which is getting a big boost from a new, lower corporate tax rate.

The headwind in this case is that Express Scripts is slated to lose one of its biggest customers (Anthem), in 2020. Interestingly, Anthem sold its PBM unit to ESRX in 2009, which paved the way for the current client relationship. However, Anthem is regretting the contract terms (they claim they are being overcharged, whereas ESRX says they are simply abiding by the terms of their contract) and will shift its business to CVS in 2020, while ironically starting their own PBM business internally (again). If only Anthem had kept the business in-house all along…

It does appear that Anthem is getting the short end of the deal. Express Scripts earned EBITDA of $5.29 per prescription claim in 2017 across its entire business, but with Anthem it is making over $10 per claim. So you can see why Anthem is upset and wants a new partner. ESRX will make good money for the next two years — through 2019 — and then will see 1/3 of their EBITDA vanish. And that explains why the stock trades at 7.5x 2018 earnings. Assuming the Cigna deal is blocked, earnings in 2020 are likely to be in the $6.50 per share ballpark, giving the stock an “adjusted P/E” of around 11x, and making Cigna’s offer worth about 14x.

While I have not completed all of my due diligence on Express Scripts, it appears to be worth a look. Absent a buyout from Cigna, the company faces mounting criticism as a middleman in the pharmaceutical sector that supposedly drives up costs for consumers, despite existing for the purposes of negotiating discounts for its corporate clients. The way I see it, if ESRX was not earning its cut, its customers would fire them. Anthem aside, ESRX will see a client retention rate in 2018 of between 96 and 98 percent, according to the company. Without ESRX, employers would have to move their pharmacy plan management in-house, which would probably mean worse results (due to lack of experience), and higher costs (the point of outsourcing in the first place is to save money and resources). If corporations could do what PBMs do, internally and for the same or less money, why would companies like Express Scripts exist at all?

 

Big Question Mark for Facebook: Profit Margins (Not Advertiser Behavior or User Engagement)

There has been a lot of commentary in recent days about how user engagement will change, if at all, in the wake of Facebook’s user data privacy hiccups, as well as how advertisers will react and whether they will shift dollars to other social media platforms. I actually do not think either one of those metrics will materially change in the coming months. What is more important in my eyes is how Facebook’s margin structure could be permanently different in 2018 and beyond.

Sure, there will be some users who stop using Facebook and blame the recent issues, but those users were probably not using the platform much to begin with, and as with most things, people tend to have a short memory. Diners typically return to restaurant chains even after illness outbreaks and shoppers did not abandon Target or Home Depot after massive credit card data breaches.

I also would not expect material advertiser migration. It reminds me of the NFL ratings drama over the last season or two of professional football. Television ratings have declined, in part due to an abundance of games (Monday, Thursday, Sunday), more viewing options that are not easily tracked by Nielsen (streaming services, mobile apps, etc), and more competition for eyeballs (Netflix, etc), but the NFL is quick to point out that despite lower ratings, NFL telecasts still get more viewers than most every other television program. As a result, if you want to allocate ad dollars to TV, the NFL will remain one of the best ways of doing so.

The same should be true with Facebook. If both the user base and the average time per day spent on the app drop a few percentage points, Facebook will not lose its spot as one of the best ways to reach consumers on social media.

The bigger question from an investor standpoint is what Facebook’s margin structure looks like going forward. More specifically, how much expenses are going to rise and whether those costs are on-time or permanent. I suspect they will rise dramatically and will be permanent. After all, up until recently the company really just built the platform, turned it on, and let anybody do pretty much whatever they wanted with users and their data. It is obvious now that in order to maintain trust and their dominant position in the marketplace, they are going to have to [police the platform on an ongoing basis and limit the exposure to bad actors. This will cost money, lots of it, and will not bring in any incremental revenue. As a result, profit margins will fall and stay there, in my view.

This is critical for investors because the stock’s massive run-up in recent years has been due to a growing user base leveraging a scalable cost base. Facebook’s EBITDA margins grew from 48% in 2013 to 57% in 2017, and the stock price more than tripled. That margin expansion is likely to reverse beginning this year, to what extent remains unknown. Could those 9 points of margin leverage be recaptured by rising expenses of running the platform? I don’t see why not.

In that scenario, investors may no longer be willing to pay 10-11x forward 12-month projected revenue for the stock, which has been the recent range. If that metric instead drops to 8x (~$149 per share), it will have implications for the stock (currently fetching $160) even if advertisers and users stay completely engaged with the platform.

Full Disclosure: No position in FB at the time of writing, but that may change at any time

Facebook Could Become Solid GARP Play If Near-Term Pressures Continue

Facebook (FB) stock debuted less than six years ago at $38 per share and went through two very distinct sentiment shifts. The current environment, as the company faces pressure from multiple sides to better control use of its massive platform, could very well mark yet another shift.

In May 2012, Facebook IPO’d and flooded the market with stock, so much so that anyone could buy shares at the offer price. Investors were skittish that the company could move quickly to capitalize on the move from desktop to mobile usage and the stock quickly fell into the teens. That turned out to be one of the best growth stock investment opportunities in recent memory, because back then very few people understood just how much money the company would earn in just a few short years.

For instance, what if you knew that Facebook would grow revenue from $5 billion in 2012 to $27.6 billion by 2016, and that free cash flow would go from negative to $4 per share that year? Well, the stock probably never would have traded under $20 and I would bet that investors would have gobbled up every IPO share they could at $38 each.

That was very reminiscent of the Google IPO, which many people thought was wildly overpriced, only to be shocked a few years later when the company’s profits made the IPO price look like an enormous bargain (in hindsight only, of course).

As a result of huge profit growth, sentiment in Facebook has shifted dramatically in recent years and the stock had surged to $176 per share by the end of 2017, as free cash flow reached nearly $6 per share last year. While not overpriced necessarily, the bar has certainly been reset quite high, and therefore Facebook is more susceptible to near-term problems, such as how they are controlling the use of their user data and advertising platform.

The chart above shows the entire history of Facebook’s public stock performance and therefore the recent decline barely registers as a blip. If we look at the last year, we see that the shares have largely been moving sideways, and the recent drop is only about 15% from the highs:

So are the shares getting close to an attractive level? It likely depends on two factors; what valuation methodology you use, and whether you think the company can continue to grow per-share cash flow, or if future growth will be hampered by user base maturation and increased costs associated with policing the platform more heavily.

My base case is that they grow, but at materially slower rates, and margins come down some but remain quite high. As far as valuation, I prefer to use free cash flow per share, but I deduct non-cash, stock-based compensation. That metric for 2017 came out to roughly $4.65 per share (versus $5.91 if you ignore SBC). My estimate for 2018 is roughly $6.50 per share, but I realize there is risk in this figure because we really don’t know how much expenses are going to increase in the face of current political and social pressures.

For Facebook to get into the sweet spot as a GARP (growth at a reasonable price) investment, I would have to see a multiple of 20-25x free cash flow less stock-based compensation. On my 2018 estimates, it equates to $131-$164 per share. The current quote, after a 5% drop today, is $163 per share. In other words, FB stock is arguably now finding itself in GARP territory.

Given that near-term sentiment could very well accelerate to the downside, and considering that modeling 2018 growth rates of 35% in both revenue and free cash flow (the current consensus) are probably skewed to the aggressive end of the spectrum, I would probably want to pay less than the current price. However, if the stock reaches the midpoint of my 2018 range ($150-ish), it could very well make for a strong GARP investment from my vantage point.

Full Disclosure: No position in FB at the time of writing, but positions may change at any time 

 

New CEO Moving Quickly To Stabilize Wynn Resorts Shares

In the three months since my last post on Wynn Resorts (WYNN) a lot has happened. Steve Wynn has resigned as CEO and Chairman of the Board amid sexual misconduct allegations, long-time executive Matt Maddox has taken over the CEO role, two other directors of the company have vacated their positions, the board increased the annual common stock dividend by 50% (to $3.00 per share), and the company announced a settlement agreement to bring to a close a long-time litigation.

As you can see from the chart below, WYNN shares have found some support and are in the midst of climbing back, as Mr. Maddox settles into his new role and tries to turn the page:

In what turns out to be fortuitous timing, I began to trim back my WYNN positions in late January (around $195) as the stock approached my conservative $200 fair value estimate. Just days later the Steve Wynn news broke, which complicated matters with what to do with the rest of the shares.

Since then I have been sitting tight, waiting for more clarity as to the company’s next steps. Recent days has brought some insight on that front, but two big questions remain in my mind. One, how are Wynn Las Vegas bookings shaping up in the weeks since the news reports made national headlines? And two, what is the fate of the under construction Boston Harbor project?

Although I do not think the company’s Macau business will be impacted, the U.S. market is a different story. As long as Steve Wynn’s name is on the door, even if he is no longer with the company, I could see convention business contract materially, as well as tourist bookings. As far as Boston goes, it would be surprising to me if they put the Wynn name on that property when it opens in the middle of next year. So that begs the question, will they sell it, or get to keep their gaming license and simply rebrand the property?

The answers to these questions are likely to take several quarters to be crystallized. Wynn reported 2017 free cash flow of $942 million, which included roughly $650 million of construction costs for the Boston project. If the company can really generate free cash flow of $1.6 billion from its existing three properties, the stock today remains a great value ($19.3 billion equity value) and could easily fetch $230 per share (15x normalized free cash flow). And that does not even include Boston (the worst case scenario there would probably be them having to offload it at cost). Of course, that assumes that the Las Vegas business stays strong despite the negative headlines, which is a big unknown. I will be watching the data closely on that front in the coming quarters.

There has been speculation that the company may be up for sale, or that Steve Wynn might try to take it private. I think it really depends on whether he plans on holding onto his shares or not. He is 76 years old and could very well decide to retire from the business. If he was open to selling his shares I think the company would look to maximize value for shareholders and auction off the entire business to the highest bidder (and there would be plenty of interest).

If Mr. Wynn wants to hold onto the stock, then Mr. Maddox will have to figure out how to preserve the business value. That would possibly mean taking the Wynn name off of the door (if business does suffer here in the U.S.), or maybe even a more bold move (selling the U.S. assets and focusing on Macau and future growth opportunities like Japan).

In either case it looks like there are plenty of levers for the company to pull to realize full intrinsic value for the business. In that scenario, holding the stock and waiting for even more clarity will probably work out quite nicely. Heads we win (the company is sold and the resorts rebranded), tails we win (they rebrand it themselves with Steve Wynn nowhere to be seen).

Full Disclosure: Long shares of WYNN at the time of writing, but positions may change at any time

 

What Are Typical S&P 500 P/E Multiples Under More Normal Interest Rate Environments?

The U.S. stock market has been skittish lately, largely on fears of higher interest rates. As new Fed Chairman Jerome Powell takes over for Janet Yellen, and Congress passes multiple pieces of legislation that will swell the budget deficit, investors are getting more nervous about higher rates.

What is amazing about this dialogue is that a 3% yield on the 10-year bond is scaring some people, whereas throughout history 3% would look like a dream come true for equity investors. The issue, of course, is that a 3% 10-year yield is only problematic when the market’s valuation has been elevated due to such low rates. It does not really matter if 3% is still low, but rather, if 3% is higher than the 1.5-2.5% range we have seen for many years now.

So let’s assume that rates are heading higher and a sub-3% 10-year bond will become a thing of the past over the next year or two (I will not even hazard a guess as to exact timing). The S&P 500 ended 2017 trading at more than 21x trailing 12-month earnings, so that multiple will need to come down as rates rise. But by how much?

Fortunately, we do not have to go back very far in time to find instances of the 10-year bond trading in the 3-5% range. In fact, from 2002 through 2010, it traded in that range most of the time:

During that near-decade long period of time the S&P 500 index traded for between 13 and 20x trailing earnings, with the mean and median both coming out to around 17x. If we use price-to-peak earnings ratios (to smooth out earnings volatility due to the economic cycle (P/E ratios are artificially high during earnings recessions), the mean and medians are around 16x.

So it is fair to say that a more normalized interest rate environment could bring P/E ratios down to around 16.5x, on average, with the 10-year bond yielding 5% or less, but more than it does today. Well, that tells is a lot about where stock prices could trend in coming years. Consider the table below:

The consensus forecast for 2018 S&P 500 earnings is about $155 but that could prove a bit optimistic (companies are always very positive about their go-forward prospects when a new year begins). Above I showed a range of $145-$155, which would still represent strong year-over-year growth of 20% at the midpoint (due largely to the recently enacted tax cuts).

You can see that if P/E ratios were to come back down to the 16-17x range, assuming the 10-year yield moved towards 4% by year-end 2018 on the back of 3-4 Fed rate hikes), the U.S. market could be in for some sideways to slightly down price action. Today the market trades for about 19x the current $155 earnings projection.

The good news is that valuation and interest rate normalization should not, in and of itself, be hugely detrimental to stock prices as long as earnings hold firm. Assuming no recession, my worst case scenario would probably be a 16x multiple on $145 of earnings (S&P 500 at 2,320), which while not a fun path to take, would only represent about 8.5% additional downside relative to the market’s recent low earlier this month.  That is not exactly a super-scary outcome, and it probably is not even the most likely base case scenario. Buyers could easily come in at 17x earnings and if profits reached $150 this year, that would mean we have already seen the low point for the S&P 500 this year.

 

Possible Catalysts for Bottom in GE: Equity Raise and Getting Booted from the Dow

Saying that shares of one-time market bellwether General Electric (GE) have fallen upon hard times lately is surely an understatement. To see a member of the 30-component Dow Jones Industrial Average get cut in half in a year hardly ever happens, but that is exactly what has happened after the company fired its CEO, cut its dividend by half and projected that their long-time goal of earning $2 per share in 2018 was out of reach (profits this year will likely be around half that level):

 The big question now is whether GE is a screaming buy and a contrarian value investor’s dream. Normally it would not be overly difficult to answer this question, but the company’s financial services unit shares little information with investors, making it essentially a black box. Aggressive accounting metrics, having been carried over all the way back from the Jack Welch era, make it hard for investors to feel comfortable with the business outlook, as reported “earnings” more often than not differ wildly from actual GAAP cash flow.

That said, at $14 per share (and a dividend yield above 3% after the recent cut) the stock could very well be forming a bottom. Two announcements could very bring out nearly most every possible remaining seller; removal from the Dow and an equity raise to sure up their balance sheet.

The former seems like a forgone conclusion, though the timing is unknowable. As a price-weighted index, GE already represents the small of the 30 components by far. The next lowest priced stock in the Dow is Pfizer, which fetches more than double GE’s share price. Other components such as Boeing, Goldman Sachs, and 3M are anywhere from 15 times to 24 times more heavily weighted in the index even when GE’s market value is roughly the same as 3M and higher than Goldman. It is hard to imagine GE staying in the Dow for another 12 months, and when a change is made, plenty of index fund selling will occur.

Although less certain, there is a decent chance GE seeks to shore up its balance sheet by issuing more common shares in order to reduce debt. Dilutive transactions like that typically are priced below the market price of the stock at the time, and folks like Warren Buffett would likely be interested in scooping up some GE stock 5-10% below market prices. Such a move could also signal to the market that most of the bad news that could occur is behind the company.

Of course, the stock may very well be low enough that even these announcements would barely move the stock down at all, but that too would indicate that the selling has mostly passed.

All of that said, I have yet to start buying GE shares aggressively, mainly because I cannot yet get comfortable with the accounting games they play. The company has said that 2018 earnings should be the trough and that roughly $1 of earnings per share is a very conservative forecast for the year. If I felt strongly that $1 was “trough earnings” I would have little problem paying 14-15x given how many headwinds the company is facing right now. But the big question is what $1 of earnings really means to GE management.

As the company seeks to shore up its balance sheet and sell off some smaller divisions, we may get more clarity about their financial condition. Getting booted from the Dow would unleash some of the last remaining sellers (passive index funds) and raising equity could be the first step in stabilizing the capital surprises. While GE is not the ideal contrarian investment, the situation is worth watching closely as sentiment has turned severely negative and a few last shows could be getting ready to drop soon.

 

Momentum Trading Cuts Both Directions

Back on Monday October 19, 1987, the Dow fell 508 points, which was a decline of more than 22% in a single day. Today that same decline equates to roughly 2%. With the Dow trading at such high levels, in absolute point terms, a large decline might seem scary if not presented in percentage terms. The same is true when the financial media likes to focus on every 1,000 Dow points, as if a move from 25,000 to 26,000 is anything more than a simple 4% gain that historically takes less than 6 months, on average.

So rather than care about “a 1,000 point Dow decline!” let’s look at a one-year chart of the S&P 500 for some perspective:

As you can see, all we have done over the last two days, when the Dow has dropped 1,600 points, is give back the gains booked in January! When I look at this chart, I don’t see the mother load of all buying opportunities yet. I probably would not get even a little bit giddy about buying U.S. stocks unless we got back down to 2,400 or 2,500. That does not mean it will get there, or that I think it might (I — like anybody else — have no clue).

Momentum markets work in both directions, and when computerized algorithms conduct much of the daily trading in the stock market, moves like we see today can happen with ease, and most importantly, without tangible “reasons” behind them.

Most of the time I wish we could go back to the days when stocks were less volatile, a 10% correction occurred about once a year, on average, and the media did not over-hype days like today. It will make for good, scary headlines, but that’s about it.

Amazon Shares Pierce $1,430 And Sit Firmly Above 3x 2018 Forecasted Revenue

Valuing shares of Amazon (AMZN) has always been a difficult task since the company does not at all care about short-term profit margins. Investors are left with trying to estimate, based on the company’s various businesses, how large each will get and what type of margins will likely be achieved once each reaches maturity.

Of course, such an approach becomes nearly impossible when you have no sense of which businesses Amazon will choose to enter over time (or maybe the better question is which they will “not” enter). Traditional retail was one thing, but now with cloud services and advertising revenue, margins are going to be all over the map.

I recently trimmed many of my clients’ positions, as I have done once or twice since I made the investments beginning in 2014. My methodology has been inexact, to account for the aforementioned issues regarding Amazon’s various ventures, but it generally involves looking at AMZN on a price-to-sales basis and then seeing what margin/multiple assumptions are baked into such valuations. For instance, if you think they will ultimately earn a 10% profit margin at maturity, you might be willing to pay 20 or 30 times normalized profits, which would equate to 2-3 times annual revenue.

Given the company’s growth, my personal view is that anything up to 3x revenue is at least somewhat reasonable, as I don’t see margins going above 10% given the company’s desire to remain value-based in the eyes of consumers, and anything over 30x profits for a growth company makes me nervous. And if someone argued that they will never reach 10% margins and a 30x multiple is too high, I can totally understand that view. I just think some valuation flexibility is warranted given that Bezos might actually get as close as anyone in business to total world domination.

So below I have posted updated graphs that show Amazon’s stock price over the last two decades or so (not very helpful when trying to evaluate the valuation), as well as their year-end price to trailing 12-month revenue ratio (far more helpful in doing so). Note: the 2018 data points are based on today’s stock price and consensus 2018 sales estimates.

As you can see, AMZN stock hovered around the 2.0x price-to-sales ratio level between 2004 and 2014, with a range of 1.5x-2.5x or so. In recent years, as momentum stocks have led the market higher, that number has surpassed 3x and currently sits around 3.2x.

Given that position sizing in portfolios is always important to me, this graph tells me that now is not a bad time to trim AMZN. Trading above 3x revenue would seem to indicate that investor sentiment is quite high. There may be good reasons for that, of course, but as the company gets bigger and bigger, its growth rate is sure to slow. In fact, in order to grow by the 29% rate that Wall Street analysts are expecting in 2018, total sales need to rise by a stunning $51.5 billion. That very well might happen (and acquisitions like Whole Foods will only help), but when growth slows to only 10 or 15%, investors might not want to pay 3.2x revenue any longer. In my mind, anything above 3.0x tells me to tread carefully.

What do you all think? What kind of profit margins do you think AMZN will earn at maturity (i.e. when its growth rate is in-line with the average company)? What multiple of revenue seems right to you?

Full Disclosure: Long shares of Amazon at the time of writing (even after selling a chunk at $1,400 recently), but positions may change at any time

What A Difference A Strong Holiday Season Makes: Retailing Stocks Back From The Dead

Back in the second quarter of 2017 I wrote a four-part series of posts on the bricks and mortar retailing sector (Part 1: department stores – DDS & KSS | Part 2: mall owners – SKT & SPG | Part 3: balance sheet strength | Part 4: possible LBOs – JWN, DDS, URBN) focused on how Wall Street was pricing many companies as if they were essentially finished as profitable businesses.

Here we are after a strong holiday shopping season where online and bricks and mortar stores shared in the cheer and investor sentiment has shifted dramatically. This is notable because the businesses are the same today as they were back in May and June.

While the mall operators are largely unchanged, aside from above-average dividend payouts, profitable retailers with strong balance sheets have been on a tear. For example, Kohl’s (KSS) is up nearly 100%, hitting $67 today on an analyst upgrade. Similarly, Urban Outfitters (URBN) has doubled from $17 to $34 and Dillards (DDS) has jumped nearly 50% from $48 to $70.

The Kohl’s situation is interesting because the stock is jumping $2 today after a Jefferies analyst raised his price target by a whopping 50% to $100 per share (from $66). If that sounds like a crazy number, it is. While I was positive on the company in the $35-$45 area, after a move into the 60’s it warrants a skeptical eye going forward.

I had been using a $60 fair value estimate, based on 6x EV/EBITDA and 10x free cash flow. After all, this is a department store chain that will report lower revenue in 2017 ($19.0 billion) than it had five years ago in 2012 ($19.3 billion) and I wanted to use conservative estimates. Profitable and stable off-mall retailer? Check. Solid balance sheet with lots of owned properties to offer a margin of safety? Check. Growth company that stands to take market share? Not so much.

Slow/no growth department stores (JCP, DDS, M, KSS) have traditionally traded for 6x EBITDA. Unless you believe KSS can grow their business materially, a $100 stock price seems overly aggressive at 9x EBITDA and 17x free cash flow.

Although retail sales will continue to rise in the low single digits thanks to inflation and population growth, department stores will likely still cede market share slowly over time to online channels, as well as new store concepts. That trend likely explains KSS’s flattish five-year sales performance.

After a huge run, investors now believe that these companies will survive and do decently well, which is a huge shift in sentiment from 6-12 months ago. I consider many of the stocks trading at/near a fair price today, especially considering that revenue growth will still be hard to come by. In addition, the odds are low that media headlines focusing on the Amazon  threat, dead malls across the country, and bricks and mortar bankruptcies are a permanent thing of the past. Like many trends in the financial markets, I suspect we will get another good entry point in traditional retailers down the line when sentiment shifts yet again.

As for riding KSS from $67 to $100, I will leave that bet for Jefferies to make, as the stock is far less attractive today from a risk-reward perspective than it was at $36 last year. Most of these stocks seems like contrarian, sentiment-timed intermediate term trading vehicles more than multi-year, buy-and-hold investments.

Full Disclosure: Long shares of AMZN common, DDS debt, JWN common, KSS common, and SKT common at the time of writing, but positions may change at any time.I have been selling down existing positions in KSS recently, although not every share has been sold yet.

 

With Boeing Trading For 28x Earnings, Is The Bull Market In A Melt-Up Phase?

I do not spend a lot of time on cyclical stocks and the industrials and materials sectors are not well represented in portfolios I manage. Lack of expertise is one reason, but another tricky part of investing in cyclical companies is that you need to have a decent sense of their business cycles and that is not easy unless you have some specific experience in the industry.

That said, sometimes I dabble when I can get comfortable enough with the company and stock price simultaneously. In early 2016 that combination was staring me in the face after a sell-off in Boeing (BA) prompted me to buy at prices as low as $105 per share. I do not even recall what the particular short-term Wall Street worry was at the time regarding Boeing’s prospects, but if you are going to feel good about the competitive positioning of a large U.S. manufacturer, BA has got to be near the top of the list (nearly impenetrable market share, minimal competition, and fairly predictable product demand).

In 2015 Boeing had posted GAAP EPS of $7.44 per share, up modestly from 2014 and a new company record. At $105 each, the beaten down stock in early 2016 was trading at a trailing P/E of 14x and had posted free cash flow in excess of GAAP earnings for four straight years. It was a classic situation of getting a great business for a very reasonable price.

Boeing shares snapped back quickly, reaching $135 in less than two months. Earnings for 2016 were estimated to rise modestly again, which put the stock at 18x current year earnings, or nearly a market multiple for a cyclical business that was on pace for a fourth consecutive year of record earnings per share. As a result, I rang the register and was pleased with a 20% gain in a very short period of time (the IRR on the trade was over 1,000%).

Today, nearly two years later, Boeing stock closed at $320 per share:

 

 

 

 

 

 

 

 

What on earth is going on here?

Company management projects GAAP EPS of $11.30 for 2017 (fourth quarter results are due out later this month), which would be 48% above 2016’s record level. Boeing is trading for 28x trailing earnings, versus the S&P 500 at 22x.

Since when do cyclical stocks earning peak margins trade at premiums to the overall market? Isn’t it usually the other way around? Don’t investors in cyclicals typically pay high multiples on depressed earnings and lower multiples well into the upswing of a business cycle?

Other cyclical companies have seen steep share price climbs lately as well:

This bull market is producing some oddities no doubt. Not too many people would believe that nearly a decade into this economic expansion Boeing would fetch a higher valuation than Google (based on 2018 earnings estimates – CB 1/12/18), but that is exactly the case today. What does it mean? It is hard to say.

Maybe investors truly believe we are in the early innings of the economic cycle and Boeing’s earnings are set to soar more than they already have. Maybe the computer algorithms have taken over and just bid up every momentum-driven stock, regardless of what history would tell you about investing in cyclical companies. Maybe we are entering a melt-up/bubble phase and this market will ultimately hit a P/E ratio of 25 or 30x, with the biggest companies benefiting most due to huge index fund inflows. Maybe putting on a long Google/short Boeing paired trade today will look brilliant five years from now.

Thoughts on Boeing’s valuation? Please share.

Full Disclosure: No position in Boeing at the time of writing, but positions may change at any time