Return on Capital Jumps – Some Stretched Expectations

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

September 26th, 2013

Return on Capital Jumps – Some Stretched Expectations

  • We have taken a top down look at the return on capital improvements implied in forward earnings estimates for the Industrials and Materials sectors. Not surprisingly, almost all estimates call for an increase in returns on capital, despite the aggregate 30 year trend which shows no growth and the fact that in 2013 we are already well above trend.
  • In Exhibit 1 we show the companies for which forward estimates suggest more than a 1 standard deviation move in terms of return on capital improvement. We have corrected the last 12 month data to account for any one time charges and events that might have depressed the number for the last 12 months.
  • The Chemical sector is well represented and the high expectations are reflected in current valuation for many. We highlighted FUL as a company that we thought was discounting too much in our recent piece on Chemicals (also see note below).
  • In aggregate the data suggests as much as a 200 basis point improvement in return on capital for the overall Industrials and Materials sector in 2014, which would put the aggregate return close to an all time high. While possible, history would suggest that you should bet otherwise, and if achieved, it would be a very brave man who assumed that it could improve further.
  • If 2014 estimates prove correct, UNP, LECO, BWC and HTZ will have all time high returns on capital. HTZ may come off the list if today’s earnings warning triggers a material negative revision to 2014 estimates.

Exhibit 1

Source: Capital IQ and SSR Analysis

Overview

We all struggle to forecast company earnings for the next year and there are hundreds (probably thousands) of people trying to perfect the process (and generally failing) everyday. Company guidance is a critical element but
as we have written about
there are some companies that consistently over estimate their earnings potential and the stocks of these companies suffer relative to those companies that have a tendency to under-promise and over-deliver. The issue of accuracy in forecasting also permeates into the corporate management and use of capital. Companies that have a better ability to forecast earnings generally have a better return on capital as they allocate capital more appropriately.

However in this analysis we chose to look at earnings estimates from the top down across the Industrials and Materials sectors to see if there were any stark anomalies relative to historical trends. Analyst estimates are deep rooted in bottom up analysis but do they make sense? Has the company ever shown this level of jump or fall in earnings in the past and where do we see potential vulnerabilities and conversely where are the estimates possibly overly pessimistic?

We looked at the implied change in return on capital in earnings estimates for each company over the next 12 months and compared this with the trailing 12 months. This delta change was then compared to the minimum and maximum change the company has historically seen (since 1990) as well as the standard deviation of the volatility. We appreciate that there may be fundamental cyclical or company specific reasons for the outliers but we wanted to highlight the list of companies at each end of the spectrum to provide a list that might be worthy of a second look in terms of expectations – both good and bad. We did not expect to find too many examples of what look like optimistic forecasts: and this was the case. Also, as expected, we find no expectations that look low, only ones that look high. The findings are summarized in Exhibit 1.

Note on FUL: clearly there is the effect of a portfolio shift at play here (confirmed in this quarter’s earnings release) and if we give the company the benefit of the doubt in terms of a permanent change in both the current “normal” return on capital and trajectory, we can make a case that the stock is fairly valued rather than expensive.

Average Returns on Capital Not Improving

Our initial piece of research at SSR focused on return on capital and while we concluded that there were some sub sectors that had shown an improving trend over time, there were others that showed the reverse and the average for the industry was close to zero (but actually declining slightly) – Exhibit 2. Best and worst sectors are shown in Exhibits 3 and 4.

Exhibit 2

Source: Capital IQ and SSR Analysis

Exhibit 3

Source: Capital IQ and SSR Analysis

Exhibit 4

Source: Capital IQ and SSR Analysis

While average change in return on capital from one year to the next has been essentially zero across the Industrials and Materials sectors over the last 30+ years, there has been some variation by sector, as illustrated above.

Returns have however been volatile and the volatility has varied across the group, as expected given the greater volatility in earnings of some of the industries. On average the annual volatility (as measured by the standard deviation) has been 1.7% but this has ranged from 1.7% for Conglomerates to 4.1% for Metals. See Exhibit 5. (The increased sample size explains the similar volatility for the group in aggregate to the best sub-sector.)

Exhibit 5

Source: Capital IQ and SSR Analysis

When we drill down into the company data we find that there are several companies that are outside their historical trends. In Exhibit 1 we showed those companies that are expected to exceed a 1.0 and 1.5 standard deviation jump in return on capital based on estimates for the next 12 months. In Exhibit 6 we show more detail for each company.

Exhibit 6

Source: Capital IQ and SSR Analysis

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