A little over a year ago, I wrote an article delving into the details around Encore Wire Corp.'s (NASDAQ:WIRE), Last-In-First-Out (LIFO) accounting of inventory, and how it would likely lead to an opportunity to bet on a then Q3 2015 earnings report beat. Today the worm has turned for WIRE's accounting. With Q4 2016 in the books, we now know that Copper pricing, based on the futures market, was up 10.9% sequentially. In a search for brevity, I'm not going to rehash the explanation of how LIFO accounting works, or how it specifically applies in WIRE's case. Thus, I strongly encourage reviewing my previous article on the subject matter if you need a refresher.
Encore Wire Corp. is a manufacturer of building electrical wire and cable. They have been diversifying their business into Aluminum building wire products. As of their last 10-K in 2015, 80.7% of the dollar value of all raw materials used was made out of Copper. That's down from 2014's figure of nearly 83.5%, but it shows that the traditional Copper wire and cable business is still the dominant product in their portfolio.
Copper prices stayed in a fairly tight range for the vast majority of 2016, after having declined consistently since its peak back in 2011. Q4 however, brought about a significant change in trend, and sequentially, futures prices climbed by an average of 10.9% in the quarter. It's been a long time since WIRE faced such a headwind from LIFO accounting. In fact, the last time we saw double-digit sequential price increases were Q3 and Q4 of 2010, followed by Q1 of 2011. In other words, the big blow off peak in Copper pricing last cycle.
Just as a quick reminder, the reason why LIFO hurts WIRE's earnings during periods of significant increases is because the company is using the most recent highest cost of Copper purchased in inventory, while customers, (who generally all use and think of their own inventory on Average Cost or First-In-First-Out (FIFO) basis), will only pay up on an average basis.
After all, both buyers and sellers know in real time what Copper pricing is doing, and these are commodity prices that are driven by the underlying cost of the goods being sold. Here's what happened the last time WIRE saw such double-digit sequential increases in Copper prices:
Source: WIRE 10-Q & 10-K's sec.gov.
The EPS Impact line item in the above chart is calculated using WIRE's effective tax rate and diluted share count from the given quarter, and is my estimate of the bottom line effect based on the company provided figures. The LIFO adjustment figure is contained in the SEC reports, but also mentioned on the conference calls most of the time. It is not usually referenced in their press releases though. Hence, there is a bit of a vacuum between their report, and the full public knowledge of exactly how their LIFO accounting impacted their bottom line in any given report.
Note above though how consistent their gross margin on a FIFO basis was during that peak Copper pricing period, and the volatility and magnitude of the impact to their reported LIFO gross margin that the surge in Copper pricing had on their reports. So how did this affect their stock price back then?
Source: Fidelity Investments.
Here is a chart from September of 2010 to June of 2011 that contains the three earnings reports in question. The reports are denoted by the green triangles on the chart. Clearly, the first report had the largest negative impact, with a minimal effect in the second, and in the third report, the stock actually ripped on what was a sizeable beat to expectations despite the negative LIFO impact to earnings. Note from the previous chart that Q1 2011 had a significant pick up in volume for WIRE, that generated about 50 million more in sequential revenue.
The bottom line impact had EPS increasing to .46c from the previous quarters' .22c and .19c. Those were the absolute responses of the stock to the reports, but what about the relative performance to the market? 2010-2011 was a period of significant market price appreciation coming out of the financial crisis in the previous years. How did WIRE's stock compare with its small cap peers?
Generally, WIRE's relative performance struggled against the Russell 2000 while the company dealt with the headwinds of higher copper prices through mid-2011. However, that changed as soon as the trend in copper pricing reversed and went negative, and their relative performance peaked in early 2014.
In the last two quarters, WIRE reported .38c and .34c, excluding charges, for Q2 and Q3 of 2016. Both of those reports were significant misses relative to expectations. The Street is now expecting .35c for their Q4 report according to Yahoo Finance. If the past is prologue in WIRE's case, then it may be hard for the company to report much of a profit at all without a significant increase in volumes. So what should we expect from the stock if it misses again?
Source: Fidelity Investments.
The Q2 report saw the stock rallying strongly and touching $44 before the miss. It lost nearly (20%) a few days later. The Q3 report saw a very different response though. While the stock did decline, the magnitude was minimal. Valuation was likely the primary reason.
The Q3 miss last year occurred with the stock already trading near the low end of its historical Price to Book valuation range at 1.25x P/BV. This provided enough support as weakness was already factored into the stock price. That Q3 response stands in contrast with the Q2 miss in late July when the valuation was up around 1.6x P/BV. The 10-year chart of WIRE's P/BV shows that the 1.25x metric has been a fairly good low end of the range. Particularly over the last three years.
Looking back at the reports in 2010-2011 below, we can see something similar in regards to how valuation helped support WIRE's stock price despite the LIFO accounting impacting reported EPS. WIRE's recent stock rally since November has removed this valuation support zone, and left the stock vulnerable to a disappointment on its Q4 report.
This article is focused on WIRE's upcoming Q4 report, but in the past, and in the relative chart above, I've commented that a rising Copper price will cause WIRE's stock price to be a relative underperformer to the market due to its choice in using LIFO inventory accounting. Therefore, for the long-term investor, the primary concern should be about the recent surge in Copper pricing, and whether or not this is a long-term trend change from the tailwinds WIRE has received since 2011.
The blunt response here is that I don't have a strong opinion either way on the matter. I've seen lots of reasons for making both Bull and Bear cases on Copper prices from here.
The Bull argument hinges mostly on the usual suspects of Chinese infrastructure demand as this article from MetalMiner lays out from December. However, it also touches on the longer-term argument that global expectations for Copper mine supply growth has now stalled. This view argues that while Copper supplies are still currently high, the long-term nature of adding new supply will force future pricing higher as the lack of growth over the next four years will lead to shortages before a response from supply can occur.
Price is likely the primary culprit in causing the Bears on Copper pricing on the Street to switch to Bulls like Goldman Sachs did, but their fundamental calls are focusing on the expectation of the surplus switching to a deficit with the change in supply growth assumptions going forward.
On the Bearish side of the ledger for Copper prices, nothing seems more relevant than investors' positioning. In other words, it looks very much like everyone has moved from one side of the row boat to the other very fast. At the least, I would expect a sideways chop given this, and if there is any change in expectations around Copper supply this year growing at all, then a sharp pullback should ensue in short order.
Source: Twitter.Com: @freecotdata Tweet 1/3/2017.
I do like to fall back on technical analysis when gauging the directionality of commodities. My preference has been for Point & Figure analysis, and so far, the recent move did break through the Bear Trend line without producing any negatives quite yet. However, a bit more of a pullback in Copper futures to $2.44 would produce its first Sell signal since the surge up. The ultimate Bull trend support line though is back down at $2.20, so there's plenty of room for backing and filling before declaring a resumption of the previous Bear trend.
In regards to the specific call concerning WIRE's upcoming Q4 report, the primary risk that history teaches us comes from the Q1 report in 2011. Despite the continued surge in Copper pricing impacting WIRE's EPS for a third consecutive quarter, the company reported a sizable beat on the back of an unexpected surge in volumes. In 2011, however, the first quarter marked an inflection point in Commercial Construction spending.
That January marked the bottom of the cyclical decline from the financial crisis, and so far, the trend in spending hasn't looked back. With the current level of spending a lot closer to the previous 10-year peak than valley, it seems unlikely that WIRE will report an unexpected surge in Q4 volumes next month.
Is there a risk that WIRE eats through some of its LIFO layers in inventory, or has hedged their copper exposure in some way that prohibits the impact from manifesting itself in the Q4 report? While we can't be sure about the potential for LIFO layers offsetting some of the impact, the rate of inventory churn suggests the risk of the impact not being felt in the upcoming report is limited. Last quarter's reported figures place the company's Days-of-Sales-in-Inventory [DSI], figure at 41.4 days. i.e., they should churn through their total inventory over two times within a given quarter.
In regard to the risk of the company hedging their commodity exposure, on last quarter's conference call, a questioner posed that very issue to management. Here was the CEO, Daniel Jones's, response:
Okay. The last question, and I appreciate, this is great. do you or could you do any hedging on your raw material price?
The best hedge that we have that we talk about publicly is we turn our finished goods once a month. We buy on a month average and we tip our inventory once a month that's the best answer for that.
Mr. Jones is referring specifically to the Finished Goods portion of the inventory, but the sentiment is clear. Don't expect management to hedge out their commodity price exposure on a quarterly basis.
This is basically the inverse of the idea I posted just over a year ago. It's mostly an issue of accounting and the impacts upon the company's income statement. It is not so much a comment on the quality or long-term viability of the company itself. Although I would reiterate that I think management's decision to use LIFO over the industry norm of FIFO or Average Cost methods, is really not the best choice for providing the clearest representation of their quarterly and annual performance. They could still use LIFO for tax purposes when it comes to paying governments if they felt it improved their cash flows.
Nevertheless, history has shown that spikes in Copper pricing to the degree we had in Q4 of 2016, will create a charge to the LIFO adjustment that runs through the Cost of Goods Sold line item on their income statement, and then gets reflected on their balance sheet on the Adjustment to LIFO line item within their Inventory. The exact degree of the impact is difficult to determine, since we don't have all of the necessary information for all of the variables until they report, but again history has shown the degree is likely to be of a magnitude that will make it nearly impossible for them to beat current Street estimates.
If the stock was trading closer to a valuation that could support it around 1.25x P/BV, then it might be able to shrug off a significant miss to estimates. The recent rally, however, has likely taken that support zone away, and left the stock vulnerable to a materially negative report.
One theme I've tried to run throughout my occasional public articles, is that current investors need to be cognizant that daily trading is now dominated by machines. In my opinion, this has changed the behavior of the way stocks react to new information than previous decades. I believe that the people who create the trading programs, or to use the current vernacular, algorithms, do believe that their programs take into account what I would term context.
However, their context only runs so deep. The machines are going to trade off this report immediately. They are not going to consider the LIFO impact unless an analyst flags it at a later time, and removes the impact from their stated figures. For the record, this has not been the normal procedure with this company. In fact, we won't know the exact LIFO impact until WIRE either holds its conference call later in the day, or reports its 10-Q usually about six days after. It hasn't been provided in the press release in the past.
Herein lies the risk and or opportunity. Since I don't think there has been any massive surge in volume for WIRE in Q4, and the company historically hasn't used any hedging tool against moves in Copper, I'm fairly confident that the LIFO impact is going to create a sizable miss to the current expectation of a similar run rate for WIRE versus what the last few quarters produced. Usually, WIRE reports before the open, and then holds its conference call at 11:00am.
That's the earliest point information regarding the LIFO impact should begin to disseminate, and again it often only happens if one of the analysts on the call asks for the data. Add all of this together, and I'm speculating to the downside on WIRE now with a short position. If you want to use an option strategy here, then you'll have to use the March contract as WIRE tends to report Q4 in the early 20s of February. If you're a long-term holder who believes that the price of Copper isn't starting a new Bull trend, then perhaps you should consider some protection at least for this quarter. Good luck to all investing out there.
Disclosure: I am/we are short WIRE. 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.