Look Beyond Usual Suspects

7/31/2017


Investors focus on companies that grow sales and earnings, and with good reason. But in the search for high-potential stocks, smart investors key on the underlying characteristics that help drive growth. For this story, we cover crucial characteristics and related metrics that help sustain sales and profits. It's rare that stocks possess all of these qualities. And while the importance we place on them varies, these often-overlooked metrics help isolate attractive picks.

Cost control

Companies must spend money to make money. But keeping a lid on costs boosts earnings, particularly when sales growth is hard to come by. Too little spending, say, on marketing, can hamper future growth. But well-managed companies make prudent cost-cutting a priority. A major component of operating costs is selling, general, and administrative (SG&A) expense, which includes advertising costs, rent, commissions, and salaries. We screened for companies with declining SG&A as a percentage of revenue. Standouts include Amgen ($176; AMGN), Lowe's ($76; LOW), and Snap-On ($150; SNA).

Snap-on said total revenue advanced 6% in the June quarter, outpacing operating expenses, up 5%. As a result, earnings per share climbed 10% to $2.60, easing past the consensus by $0.04. Snap-on has topped the consensus in at least 28 straight quarters, dating all the way back to the September 2010 quarter. Sales growth was driven by Snap-on's most profitable unit, repair systems and information, up 15%. Organic sales rose 3%.

Operating profit margin expanded in the first half of 2017, putting the company on pace to post wider annual margins for an eighth consecutive year. Although Snap-on faced headwinds in its tools group, management continues to view the auto-repair market as "robust." Shares fell on the report, but Snap-on remains a Long-Term Buy due to its solid operating growth and cheap valuation.

Cash conversion

Companies that quickly convert sales into cash enjoy a leg up on competitors. To gauge speed, consider the cash-conversion cycle. The metric adds the number of days needed to sell inventory and days to collect receivables, then subtracts days allowed to pay bills. The shorter the cycle the better. Efficient companies turn over inventory quickly and collect money from customers faster than they pay suppliers. Companies with improving cash-conversion trends include D.R. Horton ($36; DHI), FedEx ($214; FDX), and Owens Corning ($68; OC).

With a Quadrix Overall score of 99, FedEx ranks in the top quarter of our research universe for Momentum, Value, Quality, Earnings Estimates, and Performance. Its cash-conversion cycle has steadily declined in recent quarters, meaning FedEx is receiving payment for its services at an increasingly faster rate. Additionally, days sales outstanding fell sharply in the May quarter, indicating that unpaid receivables account for a smaller portion of the company's sales.

Earlier this month, FedEx warned that a hacking attack on its TNT Express unit would hurt full-year results. But TNT generated just 2% of FedEx's operating income and 12% of revenue in fiscal 2017 ended May. The shares are also unusually cheap. At 17 times trailing earnings, FedEx trades near its lowest level since 2014 and 11% below the median for S&P 1500 air-freight and logistics stocks. FedEx is a Long-Term Buy.

Order outlook

A growing order backlog helps drive sales and cash flow. Moreover, a sizable backlog can improve the visibility of future earnings. Of course, orders can often be cancelled without penalty, and a rising backlog could suggest production problems or inefficiencies. Still, in general we see a rising backlog as a positive. Forecasts stocks with growing backlogs include Applied Materials ($47; AMAT), Lam Research ($168; LRCX), and Ingersoll-Rand ($87; IR).

Applied Materials ended fiscal 2016 with a backlog of $4.6 billion, up 46% from a year earlier and the highest since 2008. Orders have grown at a 14% annualized rate over the last five years. To be sure, changes in customer delivery schedules and currency fluctuations can impact orders. But robust demand, market-share gains, and product launches should help sustain those backlog gains. Applied Materials earns an impressive Overall score of 99.

The world's largest semiconductor-equipment maker, Applied Materials is benefiting from enormous global investments to advance chip and display technology and boost production. Sales of semiconductors have soared, fueled by increased usage in mobile devices to support improved cameras and virtual-reality applications. The need for high-performance storage at data centers and the spread of NAND hard drives, or flash memory, also drives demand. Applied Materials is a Buy and a Long-Term Buy.

Debt coverage

Fiscally fit companies have room to leverage their balance sheet and expand their business, which is especially important in a rising-interest-rate environment. The interest coverage ratio, calculated by dividing earnings before interest and taxes (EBIT) by interest expense, measures a company's ability to make its debt payments. The current ratio measures the ability to meet short-term obligations. It divides current assets (cash, inventory, and accounts receivable) by current liabilities (short-term debt and accounts payable). Stocks with interest coverage ratios above 5.0 and current ratios above 1.5 include CBS ($67; CBS), Celgene ($138; CELG), and Juniper Networks ($28; JNPR).

With $8.9 billion in long-term debt, CBS doesn't have a pristine balance sheet. But its finances are improving, which helps support dividend hikes, stock repurchases, and business expansion. In the March quarter, the interest coverage ratio was 6.4, up from 4.5 at the end of 2016. The current ratio was 1.6, up slightly and above the five-year average of 1.5. During the quarter, the company repurchased 7.6 million shares for $500 million. Yielding 1.1%, CBS has increased its dividend in five consecutive years.

To bolster its news business and global footprint, CBS and BBC News entered into a partnership to share reporting resources around the world. June-quarter results should be announced on Aug. 7. Analysts expect per-share earnings to advance 5% to $0.98. The company has exceeded consensus profit estimates in four consecutive quarters, with an average surprise of $0.06, or 7%. The stock is a Focus List Buy and a Long-Term Buy.  

Profitability

Well-managed firms squeeze the most profits from assets. One untraditional but handy metric is gross profitability, calculated by dividing trailing 12-month gross profit (revenue minus cost of goods sold) by total assets.

Unlike return on assets (ROA), gross profitability doesn't rely on net income, which is impacted by interest expense and tax rates. And gross profitability doesn't penalize companies spending on research and development and marketing. Stocks in the top 20% of our Quadrix universe for gross profitability include Citrix Systems ($82; CTXS), Facebook ($166; FB), and VMware ($92; VMW).

Citrix sports a gross profitability ratio (gross profit divided by total assets) of 55%, up from 52% a year ago, ranking it near the top 10% of stocks in our research universe. For comparison, the average software and services company in the S&P 1500 Index has a gross profitability ratio of 38%. Over the last 12 months, Citrix's gross profit has risen more than 2% while assets have shrunk nearly 3%. The company provides software and services that help deliver data over computer and cloud networks.

Look for June-quarter results on Aug. 2. The consensus targets per-share profits of $0.99, down from $1.20 a year earlier, reflecting the spin-off of the company's GoTo unit in February. Citrix has topped the consensus profit estimate in 16 consecutive quarters. The stock is a Buy and a Long-Term Buy.


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