MEMC Electronics and Gol Airlines: Deconstructing PE Expansion in Two Very Different Scenarios (WFR, GOL)

I've been thinking a bit about Price/Earnings ratio expansion lately. We all expect that when earnings go up, the stock price should go up as well -- by roughly the same amount -- since we're used to big stocks that have relatively stable PE ratios.

But there are two other things that happen with some frequency. The first is very unpleasant: ratio compression (also called multiple compression). This is what has bedeviled nearly all the large cap tech names except Google for the last five years. Earnings climbed dramatically over that time period for Microsoft, Yahoo, Cisco and the like, but the multiple that the market was willing to pay for those companies shrank just as significantly and the stocks therefore more or less treaded water over that period.

The second is what you really want to see -- not only increasing earnings, but an increasing PE ratio. The Big Picture Blog last month ran a little analysis of PE expansion's role in the market boom of the late 1990s; it's worth a look and it helps to understand the downside of multiple compression that many of those big companies have suffered.

I've seen this expansion with two companies in particular in my portfolio of late, and for two very different reasons: MEMC Electronic Materials (WAFR) and Gol Linhas Aereas Inteligentes (GOL).

MEMC Electronic Materials (WFR) has really been a turnaround story, truly cemented by their last earnings release and guidance. This supplier of silicon wafers to the semiconductor and solar power industries went from being a very undervalued stock just a year or so ago with a PE of 10, to a fast-growing powerhouse in its segment with a PE over 20.

During that time earnings have grown as well, so the shares have had a huge run of just about 200%. If you look at it mathematically, both the result (PE) and the denominator (earnings) have grown substantially, which means the numerator (price) had to go up quite dramatically. That's exactly what I like to see.

That tells me that the ideal scenario is to look for companies with the potential to grow earnings, but who are not trusted by Wall Street. WFR was very much unloved not only because they were seen as being in a highly cyclical industry in a downturn, but because they were coming out of a financial quagmire.

As the earnings increased and the semiconductor industry recovered significantly even as the solar power industry exploded into unexpected growth, the company also began to get its financial house in order and show good earnings, sober management, and reduction of debt. That allowed the Street to trust WFR again and allow them to trade at a higher multiple.

The other company I hold that calls itself to my attention vis-a-vis multiple expansion is Gol Linhas Aereas Inteligentes (GOL) the discount Brazilian airline. I've written a lot about GOL lately and don't want to overstate it, but I do like them a lot.

GOL has been growing rapidly ever since the company began operations, and this year their earnings continued to climb the ladder.

But earnings weren't the only thing moving GOL's stock up -- multiple expansion has moved them up just as much. In GOL's case, I think its projected future growth, discounting of Brazilian risk, and growing excitement about management that is allowing their multiple to expand. Just since December, when I first purchased shares, GOL has moved from a trailing PE of about 20 to one near 30 -- that on its face seems ridiculous both for an airline and for a Brazilian company.

But GOL grew traffic more than 50% last year and is expanding rapidly with very little debt, and it seems to me that people are more comfortable with the leftist leanings of South American leaders given their so-far hands-off treatment of the most successful companies in the region (for the most part).

GOL in fact benefits from governmental regulation, as air routes are tightly controlled and it would be very difficult for a new competitor to get approval to dramatically expand capacity (not to mention Brazil's governmental control of fuel prices, which helps dramatically to reduce GOL's costs when compared with global carriers).

The market's newfound enthusiasm for GOL, and their recognition that a dollar of GOL earnings is worth more than they had previously thought, is also related to management -- the company is family controlled and recently won an award for their top-notch investor relations and disclosure policies.

A careful eye on the press release wires will call your attention to all of their detailed monthly traffic updates and clear announcements of new routes and services, and their company presentations and conference calls are truly illuminating. They seem to take very seriously the need to communicate transparently and effectively with their investors, which is important for all companies but really critical for emerging market companies -- look at Shanda for the opposite amount of disclosure, and you can understand why I love GOL but SNDA makes me very nervous.

That, in its way, gets back to the same thing in my opinion: Trust.

The market now trusts WFR because they have recovered from some financial problems and have clearly set priorities and goals to serve their largest markets effectively, even as they've proven their success in their industry with increasing earnings. That trust means we're willing to pay twice as much for a dollar of WFR earnings as we were a year ago.

And the market is growing to trust GOL as more than just an emerging market airline with big growth potential -- they are proving their ability to manage new services and new routes at reduced cost, and they are going above and beyond the disclosure of most other companies in the world to show their hand to investors. As a result of that (and their continuing rapid growth that we can see in their monthly traffic statistics), the market is willing to pay more for GOL than for a typical South American company.

So where do we look for other companies like this, with both the ability to grow quickly and some kind of hook that will bring them into Wall Street's good graces and allow for significant multiple expansion? One at a time is the only way I know to find them, though I guess you could screen for low and growing PE ratios to start, but it certainly takes a lot of wide reading and some patience.

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