3 Stocks to Take Advantage of Corporations Releveraging

Includes: BDX, INTC, SCVL
by: Alan Brochstein, CFA

The stock market has turned into a huge spring break bash, and it's only February. Now, I am not surprised with the trends, only the pace. I continue to look for 1500 on the S&P 500 later this year, a call I initially made in early October but reiterated last week when discussing the cheapness of Mega-Caps as well as a month ago when I described the implications of a boom in dividends .

Still, I am blown away by some of the action I saw last week. An insider adds to his position and says he wants to buy Family Dollar (NYSE:FDO), and the stock soars initially by more than 25%. Timberland (NYSE:TBL) is selling lots of boots - that's worth a 30% gain after earnings. Weight Watchers International (NYSE:WTW) jumped 47% on good news last week. The list goes on, but I think you get my point.

While I expressed some caution in my weekly message to my subscribers at Invest By Model about a potential consolidation ahead, the PE expansion I have been discussing is likely to persist all year. It's not about the economy, it's about valuations. As long as the economy doesn't tank, the stage is set for stocks to continue their care-free ways. My advice: Get used to this.

If you are like me, this "Spring Break" mentality is frustrating. Perhaps you are not in the game, but would like to be. For me, the issue is that this rally is potentially diminishing the need for my services. After all, who needs to pay for advice when a monkey can throw darts? Fortunately, as difficult as it has been to keep up, both of my models are ahead of their benchmarks now.

One of the big drivers is that investors are beginning to see the implications of very strong balance sheets. A month ago, I touched on this them when I shared some examples of "high-quality cash-rich companies" that had boosted their stocks with repurchases (Copart (NASDAQ:CPRT) and C.R. Bard (NYSE:BCR) as well as three names that are in my models that I think are likely to do the same. I led off that discussion:

Low interest-rates, an improving economy and low to reasonable valuations are leading companies to restructure their balance sheets. Not just bad companies in need of restructuring, but also really good companies. In a perfectly efficient market, this wouldn't happen. The fact is that "perfectly efficient" exists only in the textbooks. In the real world, investors sometimes arrive en masse at the wrong conclusions.

I am revisiting this idea because it is a easily exploited opportunity for investors to take advantage of inefficiencies in the market. Just this week, another one of our holdings in the Top 20 model portfolio, Plexus (NASDAQ:PLXS) announced that it was going to use debt to repurchase $200mm in stock (market cap was about $1.2 billion before the announcement). The stock jumped over 12% on the news.

Folks, this shouldn't happen, but it does. Why? Because the stocks are cheap to begin with! It goes back to the reality that corporate balance sheets are BETTER THAN EVER. Surprising to some, but not really, most investors don't know how to incorporate this into their valuation frame-work. It can be easily adapted to the PE metric, especially these days (since cash earns squat). Here's a quick how-to:

  1. Take the expected earnings of a company (not per share, but total)
  2. Subtract out the amount that is expected to come from interest on cash (skip this step in this low-rate environment)
  3. Subtract the cash and short-term and long-term fixed-income from the market cap of the stock
  4. Divide this number by the amount you calculated in step 2

There are lots of companies with low PEs and even lower adjusted PEs. The real question to answer is this: How much debt can a company put on its balance sheet without being "too high"? That's the amount a company can borrow.

The next step is to add the cash on the books to the amount the company can borrow - this is how much stock they can buy.

The final step is to estimate the new earnings. This can be a bit complex, but here are the simple variables: share count and interest expense.

The share count will depend upon how quickly the company can get the stock and at what price. The interest expense will depend on many factors. Some companies will borrow short, and prudent investors should make adjustments (downward) to the value of the arbitrage, as the economic value ultimately realized will likely be lower (use a 5-10 year borrowing cost).

This all may be obvious to many readers, so I apologize if I have been simplifying to make my point. The conclusion that I reached this summer when JNJ issued 10-year bonds at 3% is that this powerful arbitrage is still very much alive despite higher interest rates and stocks that aren't as cheap. You can bet that more and more companies (their boards) will see the successes such as I have highlighted and say "I want some of that"...

Now, if this was 2007, I don't think I would be looking to front-run companies about to repurchase stock (I didn't, actually). This is a great time, though, for companies to releverage. We are just quarters out of a deep recession (and just barely) rather than 6 years into an expansion. There is room for margins to expand, and sluggish but steady sales growth is likely to allow the company to use free cash flow to pay down the debt they add.

OK, now for the fun part. Last time, I shared three stocks that I thought could play this game. In the past month, they are up an average of 11% (compared to the market being up less than 5%), and none of them have done what I am predicting yet! Today, I will share three more:

  • Becton Dickinson (NYSE:BDX)
  • Intel (NASDAQ:INTC)
  • Shoe Carnival (NASDAQ:SCVL)

BDX, which we just added back to the Conservative Growth/Balanced Model Portfolio very recently, doesn't have the huge cash wad but can still play the game. It should look to the recent move by BCR if it wants a clue as to why. BDX has a little debt, but just as much cash. By my calculation, they could easily add another $1 billion in debt and spend a portion of their cash to repurchase $2 billion in stock, reducing share-count by over 10% and boosting EPS by at least 7%. Maybe it's not the most exciting of my examples, but it coincides with a very reasonable valuation and a period of lackluster stock performance (14 PE, -16% vs. the S&P 500 over the past year).

INTC, which I have in both models, trades at less than 11X 2011 expected EPS (an estimate that has been rising over the past several months). This valuation excludes their cash and investments, which totaled $18 billion at year-end. The company had debt of $4.3 billion at year end, leaving net cash of almost $14 billion on equity of $49 billion (mostly tangible). I won't run through the math, but just crediting the company for its net cash reduces the PE to 9.5X. The "model" here is Texas Instruments (NYSE:TXN).

Finally, SCVL is an old friend to the Top 20 Model Portfolio that we just welcomed back. The company has massive insider ownership and is performing well in an improving industry. Yet, its valuation is just 12X projected earnings over the next year (again, a rising number over the past several months). Interestingly, the stock trades at just 1.4X tangible book value. As of October, the company had over $3 per share in cash, reducing the adjusted PE to less than 11X. What am I missing?

So, again, it's not too hard to find these examples of companies that could repurchase lots of stock without junking up the balance sheet. This is a trend that I expect to persist in 2011, likely intensifying as the year progresses.

Disclosure: As disclosed above, several of the stocks discussed are included in model portfolios offered by Invest By Model