Oh, Where Did These Seven Years Go? (Part I)

What's the haps on the craps?
Shake 'em up, shake 'em up, shake 'em up, shake 'em
Roll 'em in a circle of homies and watch me break 'em
with the seven, seven-eleven, seven-eleven

It Was a Good Day - Ice-Cube

Seven is usually considered a very lucky or unlucky number.  In craps, when you roll a seven you usually lose.  But in Japan, the Seven Gods of Fortune look over you.  And everyone knows that breaking a mirror causes seven years of bad luck. 

The last seven years have been unlucky for shareholders of some very high quality companies.  I've found seven excellent companies whose stocks haven't done anything since 2000.  I'm not talking about tech stocks that ran higher in 1999, crashed and haven't moved since.  I'm talking about strong companies whose stocks have been literally trading sideways for seven years.

So why would anyone want to invest in a stock that isn't going anywhere?  Wall Street analysts and stock pundits are always pumping stocks that are already moving higher.  You certainly can't win the CNBC $1,000,000 challenge or thestreet.com $100,000 trading contest by buying any of these seven stocks.  But long term investors should look for stocks that have the ability to sustain an advance for many years.  That means buying 1) quality companies, 2) with potential for good earnings growth, 3) with stocks trading at reasonable valuations, 4) that have built solid bases and 5) are held in "strong hands" who aren't going to sell at the next up-tick.  It might not be sexy or exciting, but investing in stocks like these leads to many nights of restful, tax-efficient sleep.

The power of long term bases can be seen in the stock of Nucor (NUE) which has sustained an almost 500% advance off of a huge nine year base.

Chart Courtesy Stockcharts.com

The following is a list of stocks that haven't done anything in seven years and are rated B+ or better by S&P.  I've listed some of the potential catalysts that could get the stocks moving.   If you're truly impatient, then you can wait for a breakout of the seven year bases before buying.  But I would do the opposite.  I would buy these great companies on a dip and wait patiently for a strong run higher. 

Walgreen (WAG)

If you look at any set of stock statistics, you'll see a "Long-Term Earnings Growth" number.  This number is usually a joke.  Most companies can't sustain the "Long-Term Earnings Growth," which is usually between 10% and 15%, for two years, let alone over the "long-term". 

But there are a couple of exceptions.  According to Baseline, Walgreen has a long term growth rate listed at 16%.  Its five year historical growth rate has been 15%.  Going back 10 years, WAG has grown at 15%.  And going back to 1985, when the company came public, the company's growth has been - you guessed it - 15%.

 

Chart Courtesy Baseline

The company is probably one of the best managed retailers in the world.  WAG's consistency is amazing.  Last quarter, the company grew revenues by 14.6% and earnings per share by 24.5%.  Earnings have risen faster than sales because of the increasing use of generic drugs, which carry higher margins than name brand drugs.   

For those of you who don't have a conveniently-located, open-24-hours Walgreen located in your town, WAG is the largest national retail pharmacy chain in terms of revenue and profitability.  While CVS has more stores, Walgreen's same store sales have grown faster than CVS', indicating that WAG is taking market share.  At present, the company operates 5,461 stores in 48 states and Puerto Rico.  The company has plans to operate more than 7,000 stores in 2010.

Despite the rapid expansion, the company still generates a large amount of free cash flow, which it uses to buy back stock.  WAG announced a new stock repurchase program of up to $1 billion, which the company plans to execute over the next four years.  In November 2006, Walgreens completed a $1 billion repurchase program that was announced in July 2004.  The balance sheet has no debt, although from time to time, inventory levels do rise a bit.

Yet despite these positives, the stock hasn't gone anywhere in the past seven years, which is equally amazing.  While CVS has ratcheted up the competition, I think WAG has proved it can continue growing in any kind of environment.  I don't see CVS as the main drag on the stock price. The problem was that Wall Street fell in love with the stock and WAG got way ahead of itself in 2001, trading at over 50x forward earnings. 

Chart Courtesy Stockcharts.com

The valuation is much more reasonable today.  While not cheap at 19x forward earnings, it seems a reasonable multiple for such a high quality company growing so consistently.  The P/E hasn't been this low since the mid 1990s. 

Chart Courtesy Baseline

WAG is at the top of my list to buy on dips for long term investors. 

Wal-mart (WMT)

The laundry list of problems affecting Wal-Mart are well known.  From worker's compensation, to non-organic organic food, to dirty stores, to problems in Germany, to high gas prices, it seems that Wal-Mart has been on a bad run for over five years now.  And the stock reflects that.

Chart Courtesy Stockcharts.com

So does the valuation.  WMT trades at the lowest price to earnings and price to sales ratio in 20 years.

Chart Courtesy Baseline

But if you step back for a moment and look at the company's fundamentals, they are pretty good.  In fact, for the world's largest retailer, they are outstanding.  The company has grown earnings at over 10% for the past seven years.  Since 2000, annual net income has gone from $5.5 billion to $12.2 billion.   To put that in perspective, Wal-mart's yearly NET INCOME GROWTH ($1 billion last year) is larger than most retailer's TOTAL REVENUES.   Even in the US, where the company has "struggled," revenues have grown faster than the overall retail industry and faster than those of its major competitors.

Chart Courtesy Baseline

That's why I think most long term investors should be adding to Wal-mart on every dip.  Sure the company is huge and can't sustain it's historical growth.  But 10% total growth and 30% international growth is unbelievable for a company Wal-mart's size.  If Wal-mart executes as well internationally as it has in the US, then the stock will move higher.

The main driver of growth for Wal-Mart will be the international division.  Wal-Mart’s International sales last quarter were $22.7 billion, up 29.6% y/y.  This sales increase included the impact of WMT’s acquisition in southern Brazil and the consolidation of Seiyu and Wal-Mart Central America. The strongest sales performances in the quarter came from Mexico, Brazil, China, and Argentina.  Operating income for international stores was an even better $1.513 billion, up 32% from last year.  More importantly, the company is showing improving operating leverage in its new markets. 

Wal-mart has been expanding through acquisition internationally to get a foothold in their target markets.  While I'm always cautious about growth through acquisition, I think WMT has shown this to be a good strategy for them.  The company recently announced an agreement under which it has purchased a 35% interest in Bounteous Company Ltd. which operates hypermarkets in China under the Trust-Mart banner.  As a leading hypermarket operator, BCL has 101 Trust-Mart retail stores in 34 cities in China.

Wal-mart's management has put forth a credible plan to revive growth in the US as well.  WMT is currently upgrading its existing stores to provide a new look to its customers with greater focus on high-margin categories, such as home, electronics, and apparel.  The company is also trying to control costs and improve its margins through better leverage of wages. WMT is also undertaking a complete revamp of its marketing and advertising strategy.

Despite the rapid expansion and big acquisitions, WMT still had cash enough to buy back $1.7B worth of shares in 4Q06.  In the past seven years, WMT's share count has actually decreased by about 8%.

It seems to me that the negatives have been well documented and discounted by the market.  This gives long-term investors an opportunity to buy one of the world's largest and best run companies at a discount to its historical valuation.   If the stock can break out of its seven year funk, I think it can make up for the lackluster performance in a hurry.   

Paychex (PAYX)

Many times buying a great company's stock doesn't work because all the good news is already reflected in the price.  That was the problem with Paychex (PAYX) in 2000.  The company had stunning growth in the relatively mundane industry of payroll processing. 

At the beginning of the century, PAYX earnings and revenue growth were strong and the company's returns on equity and operating margins were off the charts.  But the market knew all that and priced the stock accordingly.  When the company's earnings growth and returns declined slightly, the stock hit a wall.  While the company's fundamentals would have been the envy of most corporate executives, it wasn't enough for Wall Street.  The company's stock has done nothing for seven years. 

Chart Courtesy Stockcharts.com

Despite the stock's lackluster performance, the company's current fundamentals remain very impressive.  Total revenues in the company's fiscal second quarter were up 13.8% and earnings were up 16.2% in the last quarter.  Demand for both payroll and benefit services remains strong within the small business market, as evidenced by PAYX’s reported and forecast growth. 

The company recently added human resource services outsourcing (HRO) services which include retirement services administration, workers’ compensation administration, employee benefit solutions, and other administrative services for businesses.  Revenues and earnings in these new divisions grew at 23.7%, much faster than the company's core payroll service, which grew 9.4% last quarter.   

The market still provides ample opportunity for PAYX to grow its core payroll business, which makes up about 75% of the company’s total revenue.  Only 30% of small companies outsource their payroll administration. 

In addition, PAYX is just beginning to get traction in the larger human resources outsourcing market, where growth has been 20.0% for several years.  As smaller businesses are more aware of the ability to outsource more than just their payroll, and companies like PAYX create solutions that are tailored and priced for the small business market, the demand for other outsourcing services should remain as strong as it is, if not stronger.

With roughly $1.06 billion in cash and no debt, the company can raise its dividend, buy back stock, or make acquisitions.  In fact, PAYX increased its quarterly dividend by 31.0% during the quarter to $0.84, which creates a current dividend yield of 2.1%.

While the stock is still not cheap, trading at 24x estimated earnings, it is trading at the lowest valuation in over 15 years.   If the company's human resources division continues to grow above 20% and becomes a more significant part of PAYX's total business, the current valuation is not that far out of line.  In fact, at the bottom of the stock's seven year trading range (the low $30s), the valuation would be considered down right attractive.   All in all, PAYX is a high quality stock that's worth accumulating on dips despite the fact that it hasn't gone anywhere in a long time.

Chart Courtesy Baseline

We'll take a look at the other four company's on my "Where did these seven years go?" list later in the week. 

Comments

[Will Rahal]

NUE vs WMT is agood example when PPI(all commodities)
outperforms CPI.

Today’s report on CPI came at .4% . PPI(all commodities ) was .9%
In the last few years ,the PPI has been accelerating more rapidly than CPI.

The implication is for an overall stock market P/E contraction.

Ex-Fed Chairman Greenspan’s favorite way of measuring relative valuation
between Stocks and Bond is the Earnings-Yield to Bond-Yield ratio.
This ratio oscillates around one.

When should this ratio be above one?

The answer is: in an environment of PPI relative out-performance to CPI.
That is the environment we are in. This is due to the P/E contraction that
results when the PPI/CPI ratio goes up over time.

To see this behavior historically go to:

http://wrahal.blogspot.com/2007/05/earnings-yield-to-bond-yield-vs-cpi-to.html