This article is the fifth in a series that examines a portion of the one-hundred stocks underlying the S&P Buyback Index. Readers have been receptive to my first four articles in this series with good reason; the index tripled the cumulative performance of the S&P 500 (SPY) over the trailing twenty years as graphed below:
The S&P Buyback Index has also strongly outperformed the broad market gauge this year, besting the S&P 500 by over twelve percent in 2013 (graphed below) with only four of the one hundred constituents posting negative year-to-date returns.
Source: Bloomberg, Standard and Poor's
Below is a table of key financial and return metrics for the ten constituents discussed in this fifth version of the article:
Financial information is as of trading close on Friday, August 9th
Goldman Sachs (GS)
Goldman Sachs, a bank holding company, is a global investment banking and securities firm specializing in investment banking, M&A advisory services, trading and principal investments, asset management, and securities services. The company provides services to corporations, financial institutions, governments, and high net-worth individuals around the globe.
While Goldman Sachs allocates capital as part of its business model, returning capital to shareholders in the form of share repurchases or dividend increases is now highly regulated by the company's chief regulator, the Federal Reserve. Despite the increased regulation coming from its crisis-era transition to a bank holding company, Goldman Sachs has still been a top quintile repurchaser of its shares over the past year.
Second quarter earnings announced a month ago doubled as the firm saw a surge in debt underwriting revenue and gains from the firm's own investments. Part of the earnings beat was due to the five percentage point drop in the firm's tax rate (32% to 27%) as the company chose to permanently reinvest some international earnings outside of the United States, a move likely to inflame the ire of a very vocal opposition group to the workings of the nation's top investment bank.
Strong earnings and cash flow generation led the company to repurchase $1.6 billion of share in the quarter, or just over two percent of the company's market capitalization. The company's return on common equity in the first half of the year was 11.5%, which makes the share repurchases attractive against my view of domestic annual equity returns over the intermediate term that will be lower than that hurdle rate. With the stock price now at above tangible book value; however, I would expect share repurchases to slow in the second half of the year.
The stock continues to trade with a bit of post-crisis taint, producing a beta of 1.35, and with trailing ninety day volatility nearly twice the level of the S&P 500. Since 2007, the company has reduced its assets by nearly $200 billion while increasing its equity base by over eighty percent. The firm is generating higher amounts of its earnings from fee-based businesses rather than earnings on its own invested capital. The company has reduced expenses, meaningfully lowering its ratio of employee compensation to revenues. I believe that the stock trades with too high of volatility for the aforementioned factors, and while I believe that the company will market perform at current levels, this volatility may provide an opportunity to buy shares at more attractive levels in the event of a dip.
H&R Block (HRB)
H&R Block, founded in the 1950s in Kansas City, Missouri by brothers Henry and Richard Bloch, provides a wide range of financial products and services through its subsidiaries. The company provides tax services to the general public, accounting and consulting services, and consumer financial and personal productivity software. H&R Block handles roughly one in seven tax returns in the United States.
The company has been under pressure in recent years, fighting a very public battle against Intuit (INTU) and that company's do-it-yourself TurboTax software. Revenue is down by roughly thirty percent from four years ago due to market share erosion and the end of refund-anticipation loans amidst regulatory pressure.
The company announced in October 2012 that it was shuttering its six-year-old banking unit given increased regulatory pressures on bank holding companies instituted by the Federal Reserve. The stock has responded positively, returning nearly ninety percent since the announcement. In mid-July, the company agreed to sell its bank assets to Kentucky's Republic Bancorp. The stock's outperformance since the original announcement of the bank divestiture has likely been a function of the removal of uncertainty from the shuttering of the bank and its subprime lender, Option One Mortgage, and the increased likelihood that the company could become a takeover target absent the required Fed oversight from its regulated bank.
While the business is facing secular headwinds, there are some definite positives to the story. The company's balance sheet and liquidity remains strong with $1.7 billion of unrestricted cash and only $907 million of long-term debt as of the end of the fiscal year in April. During the last fiscal year, the company repurchased 21.3 million shares at more than a fifty percent discount to the current share price. While the company does not give forward guidance on share repurchases, excess cash likely keeps management in the market.
At nearly twenty times trailing earnings, and with a free cash flow yield that now trails the broader market given the sharp increase in value, the company appears fully valued. Given the company's diverse geographic footprint, H.R. Block could make a good target for another financial services firm, which appear to be the next potential value driver for the stock.
Illinois Tool Works (ITW)
Operating globally, Illinois Tool Works designs and manufactures fasteners and components, equipment and consumable systems, and a variety of specialty products and equipment. The company is divided into seven different business segments: Transportation, Power Systems & Electronics, Industrial Packaging, Food Equipment, Construction Products, Polymers Fluids, and All Other/Test & Measurement.
The company has been under pressure from activist investor Relational Investors, which took a stake in the industrial firm last year and began pushing for a reduction in business units and cost cuts that could boost shareholder returns. Illinois Tool Works responded by authorizing a share buyback plan of up to $6 billion in shares, or roughly eighteen percent of current market capitalization, and increasing its quarterly dividend by roughly ten percent. The company still had $1.2 billion under its current authorization as of mid-year.
The CEO stated in a press release accompanying the share repurchase announcement that "the company is strongly committed to capital allocation priorities that emphasize both organic investments as well as the return of free operating cash flow to investors."
The company has roughly a third of its long-term debt coming due in 2014. Look for the company to satisfy these maturities and then modestly re-lever the balance sheet in order to complete this large scale share buyback plan. For a company that may look to take on more debt, increasing future financing costs, the company fortunately printed a $1.1 billion thirty year bond deal late last year that garnered a 3.9% coupon as the firm nearly top ticked the corporate bond market. With the stock trading at multiples atop the index and with a market equivalent performance year-to-date, look for Illinois Tool Works to modestly outperform the S&P 500 over the intermediate term driven by its enhanced shareholder focus.
Ingersoll-Rand is a diversified, global company that provides a diverse range of products and services for a wide range of industries. Like Illinois Tool Works, Ingersoll Rand has also been the recent target of activist investors. The company announced in December 2012 plans to spin off its commercial and residential security businesses within the next year after Nelson Peltz's Trian Fund Management LP pressed for a breakup, stock buyback, and dividend boost to drive value for stockholders. Ingersoll Rand's CEO, Mike Lamach, estimated in July 2013 that the spun-off seller of residential and commercial door locks might fetch a market capitalization of $4 billion when it begins trading. Proceeds will in part be used to complete the company's $2 billion share repurchase plan targeted for completion by the end of 2014. While the benefit of aggressive shareholder activism is best realized through identifying the opportunity and getting into the stock before the new large holder, I believe that IR, like ITW, will modestly outperform the S&P 500 over the intermediate term driven by its enhanced shareholder focus. I would favor ITW to IR for the simple reason that the former company has a greater amount of balance sheet capacity to reward shareholders prospectively.
International Game Technology (IGT)
Headquartered in Sin City, International Game Technology designs and manufactures computerized casino gaming systems. The company also develops and manufactures slot machine, track player activity, and wide area progressive systems.
With total returns in 2010, 2011, and 2012 of -4%, -1%, and -16%, International Game Technology was also ripe to invite activist shareholders to shake up the company, and that is exactly what has happened over the last several quarters. The company elected a nominee from dissident shareholder, the Ader Group, to the board in March. In a February letter to shareholders, the Ader Group laid out plans to increase shareholder value through improved capital allocation and expense savings. Since the date of the letter, IGT has arrested its stock price declines and produced a total return of 22%.
For years the stock has been punished by its inability to successfully transition to the internet where gaming's young consumers are now found. The company's $500 million acquisition of Double Down Interactive in March 2012 was panned by analysts. Now? The internet application is accounting for over ten percent of revenues, and more than doubled year-over-year revenues. DoubleDown Casino is Facebook's (FB) third highest grossing app, and the company hopes it can parlay users into virtual casinos if states ultimately approve internet gaming.
IGT's bread-and-butter is its status as the world's largest slot machine maker, but Double Down gives the stock a growth story. Competitor Bally Technologies (BYI) paid 16x EBITDA to acquire SHFL Entertainment last month. At 7.5x EV/EBTDA, IGT looks comparatively cheap. The company is likely to produce a free cash flow yield approaching ten percent for the fiscal year, and can use this strong cash generation to invest in organic growth in high margin products or repurchase shares. This company had a $15 billion enterprise value as recently as fiscal year 2007. EBITDA has fallen by twenty percent since this peak, but the valuation has fallen by sixty percent. Margins remain high, and I expect the stock to outperform the S&P 500 aided by its current relatively attractive valuation and discipline imposed from the new activist in the boardroom.
Interpublic Group of Cos Inc (IPG)
The Interpublic Group of Companies is an organization of advertising agencies and marketing service companies. The company operates globally in the sectors of advertising, independent media buying, direct marketing, healthcare communications, interactive consulting services, marketing research, promotions, experiential marketing, public relations, and sports marketing.
The big news in the advertising space was the July combination of Publicis Groupe SA and Omnicom (OMC) in a deal that created a $35 billion advertising giant. WPP Plc, the former industry leader with a $24 billion market capitalization, could seek to add additional scale, and IPG might be a potential tie-up. This speculation sent IPG's stock to a recent nine-year high.
The Publicis/Omnicom deal was in part conceived to better position the company for the transition to digital media, and I am not sure that increased scale is a necessary avenue especially when cash-rich and technology savvy companies in adjacent industries like Google (GOOG) and Facebook are already much larger.
The valuation on IPG now looks rich, pricing in the likelihood of a takeover which is far from a certainty. Given that the Publicis/Omnicom deal will face intense regulatory scrutiny, this seems a bridge too far at this moment. At 26x trailing earnings, 10x EV/EBITDA, and with limited free cash flow generation, I believe that the stock will underperform in the intermediate term.
Johnson & Johnson (JNJ)
Johnson & Johnson manufactures health care products and provides related services for the consumer, pharmaceutical, and medical devices and diagnostic markets. The company is the world's most comprehensive and broadly based manufacturer of healthcare products from its more than 250 operating companies.
Johnson & Johnson remains a rarity - a company whose balance sheet warrants AAA credit ratings. This strong balance sheet and consistent return of capital to shareholders from its strong product franchise has the company in another rare category as one of only five companies that are a member of the Buyback Index, the Dividend Aristocrats, and the Low Volatilty Index. I have demonstrated in past articles that each index has outperformed the S&P 500 over the trailing twenty years.
Despite the company's tremendous long-run performance, the company has hit some stumbling blocks in recent years from patent expirations, product recalls, and lawsuit losses. However, the company is believed to have a strong pharma pipeline that could drive future value prospectively. The stock has market performed over the past five years, and I would expect that the company will continue to market perform prospectively. However, I believe that JNJ will produce market-like returns with less than market-like volatility (current beta of 0.67), which is still alpha in my book.
Kimco Realty (KIM)
Kimco Realty Corporation is a real estate investment trust (REIT) that owns and operates over eight hundred neighborhood and community shopping centers with locations in the U.S. and Canada and a portfolio of Latin American properties it is looking to divest. The company provides management services for shopping centers owned by affiliated entities and various real estate joint ventures.
Kimco is generating above market rates of growth from its high quality shopping center portfolio, benefiting from favorable supply/demand dynamics, and spread expansion as the company's legacy leases are reset at more favorable market returns. The company has focused on capital allocation, jettisoning non-core assets to expand interests in joint ventures involving high growth assets.
The company has now generated thirteen straight quarters of same-store net operating income growth. Expect future gains to be driven by this favorable trend, but do not expect the gains to be driven by increased share repurchases as the company repurchased zero shares in the first half of the calendar year.
The stock like other real estate investment trusts has underperformed in 2013 given the year-to-date increase in interest rates, but this is a best in breed stock that will a steady and increasing payer of dividends to shareholders over time.
Kohl's Corp (KSS)
Kohl's Corporation operates a chain of family-oriented department stores. The company's stores feature apparel, footwear, soft home products, and housewares targeted to middle income customers. Kohl's also offers online shopping as well as store credit cards.
Kohl's has been an aggressive repurchaser of its own shares in recent periods as the company spent half the cash on its balance sheet in 2012 pursuing buybacks even as earnings weakened. This effort has failed to produce gains for shareholders as the market capitalization is roughly flat to its level at year-end 2009.
On a positive note, while the company has bought back $4.6bn of shares over the last three years adjusted leverage has increased from just 1.9x to 2.2x. The company has seen sluggish sales growth, losing share to value retailers like T.J. Maxx (TJX) and Ross Stores (ROST), which have seen thirty to forty percent cumulative revenue growth over the trailing three years.
With the stock treading water, there is the potential for a leveraged buyout given the company's low multiple, high level of unencumbered real estate assets, and still impressive cash flow generation. While M&A remains a low probability, high return possibility, the company has focused on its own infrastructure to improve its supply chain, inventory management, and e-commerce platforms that should continue to support its capital return plan. If the company is able to produce its targeted $1 billion of free cash over the next three years, the stock will outperform. Big box retailing is a tricky business, and we have seen meteoric rises - Best Buy (BBY) +162%, Gamestop (GME) +99%, and Staples (SPLS) +51% and flameouts - J.C. Penney (JCP) -35% thus far in 2013. I believe that Kohl's will ultimately prove to be a successful story for shareholders over the intermediate term.
Kroger Co (KR)
Kroger operates supermarkets and convenience stores in the United States, and operates an arm that manufactures and processes some of the food sold in its supermarkets under its own private labels.
The largest grocery chain in the United States is not just buying back its own shares, it is buying other grocers. The company acquired Harris Teeter Supermarkets and its 212 stores in the southeastern United States in early July for $4.5 billion.
Private equity was circling Harris Teeter when Kroger made its bid, and Kroger will need to pay down the acquisition loan before returning to future share repurchases. The company's leverage ratio has not drifted above 3x since 1998, and this consistency has given Kroger favorable treatment in the debt markets for a mid-BBB company in a competitive business with low margins.
Harris-Teeter is a solid, high-end banner in a complementary footprint, but the multiple at 7.9x EBITDA is pricey for the business, and I would not expect Kroger to outperform as it integrates this business and seeks synergies to justify the premium.
As I featured in the first four versions of this article, and will further detail over five additional articles introducing the remainder of the S&P Buyback Index constituents, collectively this is a group that trades at a slight earnings discount to the broader market while generating higher cash flow per share and more readily returning that cash to its investors. The Buyback Index is both underweight utility and consumer staples companies that have come under pressure recently due to higher interest rates while also underweight underperforming materials stocks hampered by falling commodity prices.
Readers who stick through the remainder of these articles will see a listing of companies bent towards healthcare, financial, and consumer discretionary stocks with stable business profiles. These companies also are collectively smaller than the broader index constituents with an average market capitalization roughly three quarters of the size of the average S&P 500 constituent. While there is currently not an exchange traded fund that replicates this particular index, readers of the first version of this article pointed me to the PowerShares Buyback Achievers Portfolio ETF (PKW), which tracks U.S. companies that have repurchased at least five percent or more of their shares over the trailing twelve months. As seen below, the Buyback Achievers Index has bested the S&P 500 by roughly five percent per annum over the trailing five years.
Collectively, the ten companies listed in this article are a group of stocks that have produced an equal-weighted return of thirty-four percent thus far in 2013, so much of the value has been wrung out of these shares. While this listing of companies trades at market-equivalent multiples on average, this list of companies features names with high levels of shareholder activism that could lead to shareholder-friendly actions over the intermediate term that could potentially further boost value. As I said in the third version of this article, the trick will be finding the companies that have these favorable characteristics but still trade at reasonable multiples that portend above market future returns. At the end of this ten article series, I will be offering my pick of ten companies that I believe will produce risk-adjusted returns in excess of the broader market over the next twelve months. At readers' suggestion, I will also author an article with ten stocks from this list that I believe that have become overextended.
Please offer your own feedback on the merits of the companies in this article, and stay tuned for the remainder of the series.