This article is the sixth 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 five articles in this series with good reason; the index has more than tripled the cumulative performance of the S&P 500 (SPY) over the trailing twenty years as graphed below:
Source: Bloomberg, Standard and Poor's
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 a handful of the one hundred constituents posting negative year-to-date returns.
Source: Bloomberg, Standard and Poor's
Key statistics on the ten companies chronicled in this version of the article are tabled below:
L-3 Communications Holdings (LLL)
L-3 Communications is a prime contractor in Command, Control, Communications, Intelligence, Surveillance and Reconnaissance (C3ISR) systems, aircraft modernization and maintenance, and government services. The company is also a provider of electronic systems used on military and commercial platforms.
L-3 Communications, like its defense contracting peers, trades at a low double digit multiple of earnings, roughly a discount of one-third to the broad market index. This multiple compression has caused the stock to produce nearly a zero total return over the last five-plus years as graphed below.
The table below shows that since year-end 2007, the company is producing only slightly lower revenue and profits, but that the company is valued at roughly a third less than pre-crisis.
Despite the wind-down of two wars and defense sequestration, the company is still producing over a billion of free cash flow. You will notice that one figure on the table above is materially higher - earnings per share - which is now spread over a much smaller share base given the firm's continued share repurchases. Expect the company's free cash flow generation to be deployed through $500 million of share buybacks, $200 million of dividends, and roughly $300 million of debt paydowns or pension funding. LLL may not be a growth stock given the reduction in defense spending anticipated in future federal budgets of the United States and its chief developed world allies, but at current multiples the stock looks relatively attractive to other defensive stocks like pharmaceutical and consumer staples names that trade at much higher multiples.
Lam Research (LRCX)
Lam Research manufactures, markets, and services semiconductor processing equipment used in the making of integrated circuits. Lam's broad portfolio of market-leading etch, deposition, strip and wafer cleaning solutions help enable devices that are smaller, faster, and more efficient. Lam's solutions are used in the removal of unwanted materials from the wafer in the production of the interconnect layer of the semiconductor device.
Analysts are bullish on the company's opportunities as the memory industry transitions more to 3D devices (NAND) that the product portfolio more readily supports. However, I think that strong revenue growth foreshadowed by the company's forward shipment numbers is already embedded into the company's valuation. Lam Research is trading with a market capitalization of roughly $7bn, which is $1bn more than in 2006 when the company produced roughly the same trailing twelve month EBITDA. At an EV/EBITDA multiple of over 14x, the stock is pricing in either tremendous earnings growth or extreme stability, neither of which this industry typically affords for long intervals.
Legg Mason (LM)
Headquartered in Baltimore, Legg Mason is a global asset management company. The company provides investment management and related services to institutional and individual clients, mutual funds, and other pooled investment vehicles across multiple manager platforms. The company's affiliates include fixed income manager Western Asset Management Company and equity managers ClearBridge and Royce & Associates.
The financial crisis still has not ended for Legg Mason as the asset manager seeks to reverse five years of client redemptions. Assets under management peaked at one trillion in 2007 led by top-ranked equity manager Bill Miller, who had beaten the S&P 500 for fifteen consecutive years. Assets at the manager have fallen by a third since driven by poor fund performance during the financial crisis, and a move by investors from mutual funds to exchange traded funds.
Nelson Peltz's Trian holds more than a ten percent stake in the firm, and I am favorable on this activist investor's stance. Flows are stabilizing, and the company's fee-based businesses generate stable and repeatable cash flow. Management has indicated that they will use up to 65% of operating cash flow, or $80 million to $90 million per quarter, for buybacks with the stock trading at a meaningful discount to book value.
Life Technologies (LIFE)
Life Technologies Corporation is a global biotechnology company that provides innovative products and services to leading customers in the fields of scientific research, genetic analysis and applied sciences. The company offers a broad range of products and services, including the company's gene-sequencing machines, as well as additional systems, instruments, reagents, and custom services.
Life Technologies will fall off this list after the closing of its acquisition by Thermo Fisher Scientific (TMO), which agreed to buy Life Technologies for $13.6 billion in cash and $2.2 billion in assumed debt to expand its reach in medical testing. Before a strategic buyer emerged, there was interest from a buyout group comprised of Blackstone, Carlyle, TPG, and Temasek. Steady growth and strong free cash flow generation are key ingredients to spark the interest of financial buyers, and could drive value elsewhere in the Buyback Index.
Lincoln National Corp. (LNC)
Lincoln National is a holding company that operates life accumulation, wealth accumulation and protection businesses. The company sells a wide range of insurance, annuities, mutual funds, and managed accounts.
While the S&P 500 is off to a strong start to 2013, the S&P 500 Life & Health Index has more than doubled the return of the broad market index year-to-date, producing a 43% total return thus far. Six of the seven constituents have produced returns more than double the S&P 500 with Lincoln leading the charge. The subindex is comprised of Lincoln National (73%), Principal Financial Group (PFG, 50%), Prudential Financial (PRU, 50%), MetLife (MET, 49%), Unum (UNM, 47%), Torchmark (TMK, 39%), and the laggard Aflac (AFL 15%).
These strong gains are driven by the leverage inherent in an insurer's business model, and how it relates to distributable earnings in the typical life insurer holding company model. Lincoln's flagship operating company, Lincoln National Life Insurance, had $82 billion of assets at year-end 2012 and $6.4 billion of capital and surplus after subtracting out liabilities on its insurance policies, equating to a gearing ratio of over twelve times. In market environments with low credit losses like we are currently experiencing, this leverage leads to a magnified net investment return that enhances operating profits.
In part due to this high leverage, insurance companies are highly regulated enterprises, and extraordinary dividends from the operating companies to the holding companies require approval by the domiciliary state regulator. In good operating environments, insurance companies are able to build excess capital at their operating subsidiaries that can be sent to the holding company and ultimately distributed to shareholders. Lincoln's business is highly geared towards yield curve sensitive products (fixed annuities, universal life, and stable value) and the equity markets. The stock traded at a relatively low multiple heading into 2013 due to the risks inherent in a "low for long" interest rate scenario that would compress margins given that most of its products were already at guaranteed minimum crediting rates and the company's sensitivity to falling equity markets. As interest rates have risen and the equity markets have soared, the company has been more profitable than expected, generating excess capital that has been returned to shareholders.
Lincoln National has also been beefing up its investment management team in a push to add investment yield in excess of crediting rates to its nearly $100 billion general account investment portfolio. If the company is able to increase investment returns without taking undue risk to its capital base, the company could increase the $400 million of annual free cash flow generation that the company has been deploying in share repurchases, further driving the value of the stock, which is still at a discount to book value even after this year's tremendous return.
Lowe's Cos Inc. (LOW)
Lowe's is a home improvement retailer that distributes building materials and supplies through stores in the United States. The housing recovery in the United States is boosting the fortunes of Lowe's, which last week boosted profit projections for the year. The stock is now trading just percentage points under where it closed at for the fiscal year ending in 2007. While EBITDA is still more than a billion dollars under the level experienced during the housing boom, the company is producing meaningfully higher levels of free cash flow as capital expenditures from store openings have slowed. This higher free cash flow generation is being returned to shareholders with the company repurchasing $1 billion of shares and paying $174 million of dividends in the most recent quarter. Rising interest rates will modestly crimp the number of new homeowners, but any pullback in the stock should be viewed as an opportunity to accumulate. Home affordability remains very high, and the company's cash generation and willingness and ability to return cash to shareholders will put "flooring" under the stock.
LSI Corp. (LSI)
LSI Corporation designs, develops, manufactures, and markets integrated circuits and storage systems. The company offers products and services for a variety of electronic systems applications that are marketed to original equipment manufacturers in the networking, telecom, computing, and storage industries.
Last month, LSI announced its first ever cash dividend, which CEO, Ahi Talwalkar, attributed to the company "benefiting from the massive growth of data and its demands on storage and networking in data centers and mobile networks" that has allowed the company to generate strong and stable free cash flow. In addition to the dividend initiation, the company has returned over $2 billion of cash to shareholders over the past six years through share repurchases, and had $350 million available for future share repurchases under the existing authorization as of last month.
With no debt, balance sheet cash equal to sixteen percent of market capitalization, and annual free cash flow generation of over seven percent of enterprise value, LSI will continue to be a stable distributor of capital to its shareholders.
Macy's Inc. (M)
Macy's operates department stores in the United States, and also operates direct mail catalog and electronic commerce subsidiaries. Macy' retail stores sells a wide range of merchandise, apparel and accessories for the family, cosmetics, home furnishings, and a host of other consumer goods.
Who said the department store business was dead? Since the company's November 2008 stock trough, the value of the company has octupled to over $17 billion. The company has regained investment grade credit ratings and is producing over $1.7 billion of free cash flow this year. However, the most recently quarterly earnings were disappointing with profits trailing analysts' estimates amidst an unexpected sales decline driven by still constrained consumer spending by the company's middle income target segment.
Macy's has been a "shining star" in its post-crisis turnaround, but this is a business driven by fickle consumer spending that in its best periods will see same store sales growth of low single digits and in its worst periods will see the secular headwinds of internet retailing and a value conscious consumer base again pressure the balance sheet. Even with the recent eleven percent drop in the share price since early July that has taken the stock from a year-to-date outperformer to underperformer, I believe that the company only warrants a market perform given its difficult industry.
Marathon Oil Corp. (MRO)
Marathon Oil Corporation is an independent international energy company engaged in exploration and production in the North America, Africa, and Europe.
After the 2011 spinoff of Marathon's downstream businesses into a separate entity, Marathon Petroleum Corporation (MPC), Marathon has focused on building an oil-focused base in U.S. unconventional basins, primarily the Eagle Ford and Bakken Shales. The company also has a diverse international business in the North Sea, Libya, Kurdistan, and offshore Africa.
The company trades at an EV/EBITDA discount to other pure-play E&Ps despite its oil-heavy focus. I am surprised that there has not been increased speculation about a further split of the onshore Americas business and the speculative international businesses, which feature a high degree of geopolitical risk in certain jurisdictions. The company is seeking the sale of Angolan assets valued at $1.5 billion, with the proceeds expected to be used for share repurchases.
The company maintains a strong balance sheet, which yielded a rating upgrade by Moody's to Baa1 at the end of July. Shortly after this announcement, the stock came under pressure after quarterly earnings that analysts viewed as weak. With the stock down eleven percent over the past two weeks, I believe that we will see a bounce back that will lead to outperformance over the intermediate term for patient capital.
Marriott International Inc. (MAR)
Marriott is a worldwide operator and franchiser of hotels, resorts, and related facilities at 3,500 properties globally under a range of brands from Residence Inn, Fairfield Inn, SpringHill Suites, and Courtyard by Marriott to Renaissance, JW Marriott, and upper end Ritz-Carlton and Bulgari Hotels. More than 95% of the company's units are franchised or managed, which drives significant management and franchise fees.
While this fee based business is more stable than operating a portfolio of company-operated lodging establishments, incentive fees tied to net profit can generate upside. The hotel business is inherently cyclical. Unlike other REITs, Marriott's ultimate tenants typically sign leases by the night. At an enterprise value/EBITDA of over 13 times and over 21 times trailing earnings, the stock looks fully and fairly valued despite the fact that the company expects to return $800 million to $1 billion to shareholders through repurchases and dividends in 2013 and has reduced the weighted average diluted share count by fifteen percent over the last three years.
As I featured in the first five versions of this article, and will further detail over four 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 percent thus far in 2013, so much of the value has been wrung out of these shares. As I said in the last 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.