Recent Dow Jones 30 Rejects: Great Buying Opportunity for Patient Investors

Includes: AA, BAC, HPQ
by: Brian Gilmartin, CFA

If history is any example of how bad the Dow Jones Selection Committee times these additions and removals from this ancient and now what is widely-thought-to-be-irrelevant index, look at the additions of Microsoft and Intel to the Dow Jones 30 to the Dow in October, 1999, just 6 months before the record (and still unsurpassed) blow-off peak in the Nasdaq in March, 2000.

What really bugged me about me about these recent additions and subtractions was not the additions, of which we are long Goldman Sachs (NYSE:GS), Visa (NYSE:V) and Nike (NYSE:NKE) in that order, (with our largest position of the three being GS), but what was booted from the index, given the respective valuations:

Alcoa (NYSE:AA):

Long considered a value-trap we remain long the alumina smelter even despite China making it difficult on the upstream business. China is both a producer and consumer of aluminum, and as their economy slowed, my guess is alumina production remained constant, while demand slipped. Even the considerable health of Alcoa's downstream businesses in the form of automobile OEM and aerospace demand couldn't offset the supply and considerable price weakness aluminum has suffered from the last two - three years.

This could be on the verge of changing with China, Japan and European economies improving.

One aspect to Alcoa's trading that has caught our eye is that despite the weak Q2 13 earnings report from July 9th, and subsequent weakness in earnings estimates, and now the public eviction from the Dow Jones 30 this week, the stock has weathered this storm and is still trading above its $7.78 - $7.80 level when it reported Q2 13 earnings. The July and August 13 highs were $8.25 and $8.29. A close on decent volume above those levels is a positive sign.

Current analyst consensus is looking for just $0.30 in EPS in 2013 and $0.50 in 2014, with downward pressure on both.

AA is still trading at 80% of tangible book value as well. Few people realize that Alcoa earned almost $3 per share and was trading at $48.77 in July '07. Those days are long gone, but Morningstar puts an intrinsic value of $19 on AA while our internal model values AA closer to $15 per share.

As the global economy improves and with the SP 500 remaining at a record high it remains difficult to find stocks and companies trading at significant discounts to intrinsic value. We think AA is one of those, but the catalyst and timing to realize that fair value remains elusive.

Technically the stock is looking better. Let's see if the October earnings report denotes any improvement.

Bank of America (NYSE:BAC):

In terms of valuation and sector selection, BAC is trading at a slight premium to tangible-book valuation of roughly $13.50 per share, with expected earnings growth of 264% and then 50% in 2013 and 2014.

The three year progression for EPS and revenue estimates for BAC is as follows:

BAC EPS and Revenue (actual and projected)

EPS y/y gro Rev's ($'s) y/y gro
2015 (est) $1.59 17% $95.3 4%
2014 (est) $1.36 49.5% $92.0 2%
2013 (est) $0.91 264% $90.5 5%
2012 $0.25 a lot $86.3 -7.5%
2011 $0.01 $93.4 bl
Click to enlarge

EPS = earnings per share

Rev's in billions of $

I do believe BAC has turned the corner on the mortgage mess, moving from being litigation and reserve focused to now beginning to focus on revenue growth and normal business banking activity.

In Q2 13, BAC beat on EPS by $0.07 printing $0.32 vs. the $0.25 consensus estimate with a lot of the upside coming from expense savings and reserve releases. The traditional banking businesses should continue to gain momentum as loan growth improves, while BAC still has the benefit of market sensitive businesses.

The real issue for BAC is whether they can drive revenue growth from non-mortgage businesses as the refi market dries up.

BAC's dividend is still pretty paltry.

Expect revenue growth to remain low-single-digits, while the bank continues to squeeze expenses and credit for earnings growth, but we do eventually expect BAC to transition back to a revenue growth sector.

Morningstar has an intrinsic value of $13 currently on BAC, while our internal model values BAC closer to $20. I do believe that BAC has at least 20% more upside given expense savings reserve releases even if the top-line businesses struggle.

Hewlett-Packard (NYSE:HPQ):

One of the iconic tech giants of the 20th century, started by two brilliant technologists, the 21st Century has been less kind to HPQ, as the company became too big and too monolithic to adroitly navigate the treacherous waters of the tech sector.

Today, Meg Whitman is trying to downsize HPQ as well as position for the former tech giant to sustain itself in the next 10 - 20 years of technology changes, as the PC business (50% of revenues and 45% of operating income) seems to become more irrelevant on a daily basis.

The key positive to HPQ in our opinion today is HPQ's cash-flow. Down from $28 to $22 per share, HPQ is now trading at 4(x) 4-quarter trailing cash-flow and 6(x) free-cash-flow.

On an enterprise valuation (NYSE:EV) basis, HPQ is trading at 0.41(x) EV to 4-qtr trailing sales and 4(x) EV to 4-qtr trailing cash-from operations.

Cash-flow and free-cash-flow have started to grow again for HPQ but Meg and the Board are not (yet) returning this cash to shareholders as just 25% - 30% of free-cash-flow is being used for dividends or share repos. Instead HPQ has cut their long-term debt from $26 billion to $17 billion as of the July quarter.

With a free-cash-flow yield for HPQ of 18%, HPQ is pretty cash flush, but is probably waiting to see if and when revenue growth returns to start allocating capital back to the shareholders.

The dividend yield is 2.60% and certainly could go higher.

The recent pullback in HPQ is a great buying opportunity in our opinion. Our internal model values HPQ at closer to $30 per share, while Morningstar values HPQ at $24 per share.

We think the stock will eventually trade back into the high $20's.

Expected 2013 and 2014 EPS are $3.55 and $3.64 with expected decline in EPS this year of 13% and 2% growth next year.

HPQ needs to return some form of revenue and EPS growth, but no question the stock is cheap here as Meg Whitman tries to stabilize the business.


From a timing perspective, the additions and subtractions to the Dow 30 are notable for their contrarian timing. We have been adding to all of the above names the last few days.

Here is our ranking in terms of capital appreciation for the 3 DJIA rejects:

1.) HPQ: potential 36% gain to $30 fair value;

2.) BAC: potential 40% gain to high teens. Could benefit from strong Q4 13 capital markets and returns;

3.) AA: potential 90% to 100% gain from $8 to $15 - $16 fair value but China complicates the matter. Might require a lot more time;

Thanks for reading.

Disclosure: I am long GS, V, NKE, BAC, AA, HPQ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.