Valero Energy Corp: The Hunt for Quality

When business conditions weaken, as they have at top U.S. bookseller Barnes & Noble, Inc. (BKS) and chip maker Advanced Micro Devices, Inc. (AMD), it raises questions about a company's underlying ability to withstand a prolonged setback. Firms that are not fundamentally sound can run into trouble, especially those with high debt levels. We searched the screens and found three "quality" candidates: Dialysis Corp of America (DCAI), Spartan Motors (SPAR) and Valero Energy Corp (VLO).

There's good reason to hunt for quality. Economists are expecting the pace of U.S. economic growth to ease this year. Even Alan Greenspan, the former chairman of the Federal Reserve, recently used the "R" word, saying a recession is possible down the road. One byproduct of easing economic activity is slowing revenue growth. Competition doesn't help either.

We started our search with the list of 463 companies that recently came across the Reuters Select stock screens. (Click here for an Excel sheet comparing these companies.) Focusing first on balance sheet strength, we filtered for companies with long-term debt to equity and total debt to equity ratios that are below the averages for their respective industries. This cut the list to 229 companies.

Because we don't want to worry about short-term liquidity issues, we focused on companies whose current ratio - current assets divided by current liabilities - is higher than the industry norm. This brought the list to 136 names.

Another factor that we need to consider is interest coverage. Interest coverage refers to the number of times a company's operating income can be used to meet its interest obligations. We filtered for companies that have interest coverage that is superior to the industry mean, bringing our list to 46 firms.

Next, we needed to consider some measure of profitability. Some industries have razor-thin margins and companies depend more heavily on turnover. The opposite holds true in other industries. Rather than focus on margins or turnover, we turned our attention to key measures of management effectiveness. Return on investment [ROI], for example, is measured as net income divided by shareholder equity, long-term debt and other long-term liabilities. We want companies with ROI above the industry average over the trailing 12 months [TTM] and last five years. Further, we want the ROI figures to be much higher, so we screened for companies where the ROI was at least 25 percent higher than the industry norm for both time periods. This left us with 18 names.

We would also like to see improvement in relative ROI over time. Our process may have identified companies with superior ROI results, but with conditions deteriorating, the company may also be losing its competitive advantage. To compensate for this, we filtered for companies where the ratio of the TTM ROI relative to the industry average is superior to the ratio of the company's own five-year ROI relative to the five-year industry figure. This trimmed the list to 11 companies.

Next, we turned our attention to analyst estimates and filtered for companies where the consensus earnings per share (EPS) estimate for the current fiscal year has climbed in recent weeks. The idea here is that analysts would not be upping their estimates if they expected business conditions to falter in the future. This brought us down to only three names.

Our process worked well to highlight a small list of seemingly solid companies. This does not mean, though, that they are trading at attractive valuations. Based on current prices and TTM earnings, only Valero Energy Corp. (VLO) has a price to earnings (P/E) ratio that is below the industry norm (6.6 relative to the industry norm of 14.4). Bargain hunters would do well to alter the process we used today and incorporate valuation filters early on.

Disclosure: At the time of publication, Erik Dellith did not directly own shares of any company mentioned in this article. He may be an owner, albeit indirectly, as an investor in a mutual fund or an Exchange Traded Fund.

Note: This is independent investment and analysis from the Reuters.com investment channel, and is not connected with Reuters News. The opinions and views expressed herein are those of the author and are not endorsed by Reuters.com.

Comments

[cherylb:]

Spartan Motors link didn't work.

2007 Mar 06 11:53 AM