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Home / US Business / Seek Strong ROICs in Turbulent Markets, Part 2

Seek Strong ROICs in Turbulent Markets, Part 2



In declining markets, strong ROICs are the only liferafts. As we have shown, stocks for companies with higher ROICs performed best during and after the financial crisis.

Almost all stocks suffer in a bear market, but those with high ROICs tend to suffer less and rise faster in recovery. If you want more confidence in your portfolio, you can own companies with high ROICs.

[1] We recently highlighted these companies with strong ROICs, rising profits and undervalued stock prices: AutoZone (AZO), SYSCO Corporation (SYY), Best Buy (BBY), NVR Inc. (NVR) and Omnicom Group (OMC). We introduced AutoZone and Best Buy last week. We focus on NVR Inc. and SYSCO Corporation as this week's long ideas.

Using ROIC to find value

We have long argued (and proven empirically) that there is a strong correlation between improving ROIC and increasing shareholder value. We have also shown that winners, both during and after a market crash, tend to be companies that earn a high ROIC. Chart 1 shows that changes in ROIC explain 67% of changes in company value divided by invested capital (a cleaner version of the price book) for the S&P 500. It also highlights five shares that trade well below fair value based on ROIC.

Figure 1: Five undervalued S&P 500 shares

Sources: New Constructs, LLC and company filings.

These five stocks are not only undervalued relative to the S&P 500, the underlying businesses are strong:

  • All companies have positive and increasing core earnings [2] and financial earnings
  • All companies have increased ROIC the year before (YoY ) for the last period
  • All companies have earned positive financial revenue in each of the last 10 years
  • All shares earn our Very Attractive Rating

NVR Inc. (NVR) – Very Attractive Rating

We Made NVR Inc. came up with a long idea in April 2017 and repeated our call for the stock in February 2019. Since our original report, the stock is up 37% (S&P 500 + 12%), and since our 2019 report, the stock is up 14% (S&P 500 -6%). This outperformance is guaranteed given the company's improved fundamentals, but shares remain significantly undervalued.

Over the past decade, NVR has increased revenue by 10% compounded annually and core revenues by 16% compounded annually, per Chart 2. The company has increased its core earnings margin year over year for seven of the past 10 years, and TTM core earnings margin of 11% is up from 7% in 2009. NVR has improved ROIC from 24% in 2009 to a top quintile of 32% TTM and has generated $ 2.2 billion (21% of market capital) in cumulative free cash flow over the last five the years.

Figure 2: NVR Revenues and Core Revenues Since 2009

Sources: New Constructs, LLC and Company Submissions

Improve Financial Revenue also

Core revenues account for unusual gains and expenses included in GAAP net income. In order to get a complete picture of the company's business and to hold management accountable for capital allocation, we also analyze balance sheets to calculate accurate ROIC and financial earnings.

Some notable adjustments to NVR's balance sheet include:

  • Removed $ 740 million in excess cash
  • Added $ 396 million in accumulated asset write-downs
  • Added $ 87 million in operating leases

After all adjustments find We show that NVR's financial earnings grew by 16% annually over the past decade, according to Chart 3. NVR's financial earnings have grown 12% compounded annually over the past two decades.

Figure 3: NVR's financial income and ROIC since 2009

Sources: New Constructs, LLC and Company Submissions

Building on a ROIC Advantage

As mentioned in our original report, NVR's success has not only been the result of a rising tide (housing market) that lifts all boats (homebuilders) . Instead, our research indicates that NVR has improved the ROIC at a faster rate than the 15 home builders under coverage, per Figure 4. Equals include Beazer Homes (BZH), KB Home (KBH), Lennar Corporation (LEN), PulteGroup (PHM) , Taylor Morrison Home Corp (TMHC), and more. None of the peers who have coverage earn a higher ROIC than NVR.

Figure 4: NVR's growing ROIC and profitability over peers

Sources: New Constructs, LLC and company filings

NVR has upside potential

At the current price of $ 2,941 / share, NVR has a price-to -beconomic book value (PEBV) of 0.5. This means that the market expects NVR's profit after tax (NOPAT) to decline permanently by 50%. This expectation seems extremely pessimistic and short-term. Even at the depths of the 2008/2009 recession, NVR's NOPAT YoY declined for three consecutive years, before rebounding and growing 16% compounded annually over the next decade. In the longer term, NVR has grown NOPAT by 11% annually over the past two decades.

If NVR were trading at the level suggested by the trend line in Chart 1, it would be worth $ 5,135 / share today, 75% above today's price. NVR's current price means that the ROIC will permanently decline to ~ 19%, a level that has not been seen since 2014.

NVR's current financial book value, or no share price growth, is $ 4690 / share – a 59% upside to the current price. When we analyze expected cash flows that are baked into the stock price using our reverse DCF model, we find that NVR has significantly more potential for the upside.

Although NVR's NOPAT margin drops to 9% (three-year average, compared with 11% in 2019) and NOPAT grows by only 4% added annually for the next decade. The stock is worth $ 6272 / share today – a 113% upside. See the math behind this reverse DCF scenario.

Compensation plan incentivizes managers

In our original 2017 report, we pointed out NVR's overall compensation plan for executive agencies. NVR added a return on capital to its executive compensation plan in 2014 and good corporate governance is still in place today.

In its latest proxy statement, NVR revealed that 50% of the vesting of the managers' stock options is subject to return on capital development over a three-year period. NVR's Compensation Committee believes return on capital is an important metric for the firm because of the "capital-intensive nature of the home building industry." NVR's executive compensation plan reduces the risk of investing in this company because we know that managers are incentivized to create true shareholder value.

This compensation plan, together with strong basic conditions, earned NVR a spot in March Exec Comp Allined with ROIC Model Portfolio.

SYSCO Corporation (SYY) – Very Attractive Ranking

We made SYSCO a long idea in December 2017. Since then, the stock is down 13% while the S&P 500 is down 1%. However, the company's basic relationship has become stronger during this time.

Over the past decade, SYY has grown revenue and core revenue by 5% overall annually per Chart 5. The company has increased its core YoY earnings margin in each of the past four years and its 3% core earnings margin is up from 2% in 2015 SYY earned a ROIC of 14% in 2019, which is above the 10-year average (13%) and improved significantly from 10% in 2015. SYY also generated $ 3.5 billion (20% of market capital) in cumulative free cash flow for the last five years.

Figure 5: SYY's revenues and core revenues since 2009

Sources: New Constructs, LLC and company filings

Financial revenue grows even faster

We made the following adjustments to SYY's balance sheet to calculate accurate ROIC and financial earnings:

  • Added $ 1.6 Billion in accumulated other comprehensive losses
  • Added $ 505 million in operating leases
  • Added $ 170 million in accumulated impairment of assets
  • Added $ 140 million in accumulated goodwill amortization
  • Removed $ 118 million in deferred assets tax benefit

After all adjustments, we find that SYY's financial earnings increased by 14% annually compounded over the past five years, 5% compounded annually over the past decade, and 10% compounded annually over the past two decades.

Figure 6: SYY's financial revenue and ROIC since 2014

Sources: New Constructs, LLC and company filings

Higher ROIC stations competing benefits

SYSCO has leveraged its global distribution network and customer relationship to maintain competitive advantage over peers. According to Figure 7, SYSCO improved its ROIC from 10% in 2015 to 14% TTM. The weighted average of the 14 Food Retail & Distribution companies under cover fell from 11% to 9% at the same time. Colleagues include US Foods Holding Corp (USFD), United Natural Foods (UNFI), SpartanNash Co. (SPTN), and Core-Mark Holding Co. (CORE) and more.

Chart 7: SYY's ROIC and profitability lead to competition [19659059] Sources: New Constructs, LLC and company filings

Shares look significantly undervalued

SYY now has a $ 53 / share price, to book value (PEBV) of 0.4. This means that the market expects SYY's NOPAT to decline permanently by 60%. This expectation seems overly pessimistic and an overreaction to the current economic uncertainty given that SYY actually outperformed NOPAT YoY in 2007, 2008 and 2009 (the latest long-term economic downturn). Furthermore, SYY has grown NOPAT by 6% compounded annually over the past decade and 9% compounded annually over the past two decades.

If SYY was trading at the level suggested by the trend line in Chart 1, it would be worth ~ $ 76 / share today, 43% above today's price. SYY's current price means that the ROIC will permanently decline to ~ 10%, well below the 14% TTM ROIC.

SYY's current financial book value is $ 88 / share – up 66% at today's price. Even in a conservative growth scenario, SYY has greater potential.

If SYY can maintain its 2019 NOPAT margin (3%) and grow NOPAT by only 4% compounded annually for the next decade, its stock is worth $ 114 / share today – more than twice its current price. See the math behind this reverse DCF scenario.

Compensation plan rewards managers for creating value

SYY's executive compensation plan incentivizes managers to create shareholder value. In the 2019 financial year, one-third of SYY's profit shares were allocated based on the firm's three-year average adjusted ROIC. SYY has included ROIC as a performance metric in its executive compensation plan since 2012.

This focus on ROIC holds managers accountable for sound asset management and aligns managers 'interests with shareholders' interests.

The Importance of Basic and Quantifying Expectations

In unstable markets, it is worthwhile to include accurate foundations in the investment decision. Basics need not be 100% of your process, but they should not be 0%. And if you depend on basic conditions at some level, it pays to make sure you have accurate basic conditions. Investors should not make decisions based on incomplete or less accurate data than is available. Our business valuation models include all financial filing data to really assess whether a company is under or overvalued and to accurately represent the risk / reward of a stock. For NVR and SYY, the risk / reward looks good.

Disclosure: David Trainer, Kyle Guske II and Matt Shuler receive no compensation for writing about any specific stock, sector, style or theme.

[1] Robo-Analyst Technology. Harvard Business School has our research automation technology in the case of New Constructs: Disrupting Fundamental Analysis with Robo-Analysts.

[2] Our core revenue is a measure of profit, as shown in Core Earnings: New Data & Evidence, a paper from professors at Harvard Business School (HBS) & MIT Sloan. The thesis shows that our data is better than IBES "Street Earnings", owned by Blackstone and Thomson Reuters] and "Income Before Special Items" from Compustat, owned by S&P Global.

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Disclosure: I / We have no positions in any of the listed shares, and no plans to take up any positions over the next 72 hours.


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