By David Sterman
One of the biggest weaknesses of the Wall Street research model is that it tends to focus on stocks that are able to make the fastest upward move, failing to really look at which stocks could post strong returns over the long haul. As a result, a number of solid long-term investment opportunities simply fall through the cracks.
But it hasn't always been this way.
Back in the days of Benjamin Graham and David Dodd -- both known as the grandfathers of value investing -- an emphasis was placed on stocks as assets. These investors focused on what a company was worth in relation to its assets, the defensibility of its business model, and the level of cash flow that could be sustainably produced throughout the years.
Every once in a while, I come across what I call a "Graham & Dodd special." These opportunities typically involve large, well-established businesses that operate in an industry with deep barriers to entry. They often involve large amounts of capital spending, creating an impediment to new firms looking to crack the market. And they can count on a steady recurring base of customers that need to keep coming back to them.
My Graham & Dodd stock for 2012: Goodyear Tire & Rubber (NYSE:GT), which is currently deeply out of favor and remarkably cheap by almost any measure. Assuming we'll be driving vehicles that have tires in the next five or 10 years, this is a company with staying power. Yet you won't find Goodyear on any Wall Street lists of top stock ideas. Simply put, it's an unsexy business that isn't poised to outperform the market in the next few weeks or months.
The stock chart above paints a pretty clear picture. For a moment, forget the financial crisis of 2008 that severely punished all kinds of stocks. That anomalous event is highly unlikely to recur. Excluding that brutal period, this stock is near a four-year low, trading for less than half of what it did before the global economy began a multi-year slump.
Shares of Goodyear remain in a deep funk, even as the North American market gets stronger. Nowadays, it's Europe that weighs heavily. Yet as soon as the continent's economy hits bottom, we may see a fairly solid snap back in European vehicle sales. That market has been depressed for five years, and the average vehicle age creeps ever higher. We're seeing a snap back in the United States now, and will likely see one in Europe in a year or two.
Meanwhile, note how cheap this stock has become. At a recent $11, Goodyear trades for 4.5 times projected 2013 profits and sports a price-to-sales ratio of 0.12. Yet these numbers may not always give an accurate gauge of what a company should be worth. Instead, let's look at how this company is valued in relation to historical and projected EBITDA and free cash flow.
Goodyear carries a market value of $2.7 billion and an enterprise value of $5.8 billion. Cash flow generation can be erratic, because it's largely tied to raw materials (rubber) prices and unit volumes. In 2009, EBITDA fell to a decade-low of $580 million, but it rebounded to a decade-high of $1.67 billion in 2011. During the past eight years, EBITDA has averaged $1.2 billion. This means the company trades for less than five times normal EBITDA and less than four times trailing EBITDA. For a company with such a solid base of recurring revenue (sales bottomed out at a decade low $16.3 billion in 2009 and are already back above $22 billion), and a strong global brand, that's a very low EBITDA multiple.
Using free cash flow (FCF) as a measure, Goodyear doesn't look as appealing. The company has only reported positive free cash flow in one of the past three years, or a cumulative $236 million in the past three years. The explanation is simple. Goodyear routinely spent $600 million to $700 million on annual capital spending (2004 through 2009), but management has decided to step on the gas. Goodyear spiked CapEx by $300 million to $400 million above usual levels in each of the past two years so it could modernize plants and lower long-term manufacturing costs. This move should set the stage for much more robust free cash flow in coming years.
2012: A lost year?
Goodyear's stock stood at $15 in early January but is now down about $11. This suggests investors have thrown in the towel on 2012, perhaps noting that unit sales of tires are expected to be down this year. Yet it's important to see the total revenue figure and not just sales volumes.
Goodyear has pushed through a series of price hikes in all of its key markets, which will more than offset the sales decline in volume. As a result, sales are expected to rise around 3% this year to $23.5 billion and another 6% in 2013 to nearly $25 billion. That consensus forecast looks too conservative, because it appears to imply that 2013 tire sales will be even worse than 2012, blunting what will likely be high single-digit price increases, if recent history is any guide.
But even if 2012 is seen as a "lost year" because of weak global demand, it's worth noting the expected earnings of $1.85 per share will still be near record levels. And analysts say the heavy capital spending I noted earlier will lead to firming margins in 2013, which could propel earnings per share (EPS) to $2.50. Merrill Lynch says this figure could exceed $3 by 2014, which isn't bad for an $11 stock. Operating margins could hit a record 6.0% by 2014, thanks to those internal investments I mentioned earlier.
Still, investors are unloading this deep-value stock right now. "A large Q1 beat, confident 2013 affirmation, debt refinancing and improving pension metrics were met with a 5% stock sell-off that we, along with many investors, found puzzling," note analysts at Citigroup, who maintained their $21 price target.
Risks to Consider: Rubber prices are always a wildcard, so any sort of troubles on that front will impede margins for Goodyear.
There's really no reason to load up shares of Goodyear at this moment. Unless, of course, you want to own companies that have a tremendous long-term track record and sport very low valuations. What this stock lacks in timeliness it more than makes up for in safety, stability and a path to higher profits within a few years. And if shares reach that $21 price target set by Citigroup, you'd have nearly doubled your money if you bought at current prices.
Disclosure: David Sterman does not personally hold positions in any securities mentioned in this article. StreetAuthority LLC does not hold positions in any securities mentioned in this article.