Tom Slee writes:
So far the S&P 500 third-quarter results have been a dog's breakfast, although there are some ominous patterns emerging. As I write, 70% of companies reporting beat their consensus earnings forecasts. Once again, however, the crucial top line numbers are very disappointing. Almost 60% of the companies failed to meet the sales projections.
Even more alarming, 90% of fourth-quarter management guidance is lower than the analysts' current estimates, which have already been marked down. Regardless of the election results, corporate America is becoming discouraged.
The fact is that globalization, once heralded as a sure-fire way to prosperity, is a two-way street. The largest multinationals, with their tentacles all over the globe, are being hit by a worldwide downturn. Many European countries are in serious recession and now the Chinese economy is starting to soften. Meanwhile the U.S. recovery splutters. As a result, so far only 42% of S&P 500 companies have met or beaten their third-quarter revenue estimates compared to an average 59% over the last four years. It is the worst sales performance since early 2009 when we were mired in the financial collapse.
There is another cloud hanging over the third-quarter results. Senior level executives are increasingly concerned about U.S. business and consumer confidence. Keep in mind that these are the captains of industry, people who are supposed to take challenges in their stride and reassure investors. At the moment they are busy sounding the alarm.
On Oct. 18 the influential Financial Services Forum, a non-partisan organization comprising the CEOs of 20 of the largest and most diversified institutions in the United States, sent an open letter to the U.S. government. It said in part: "extremely elevated levels of business and consumer uncertainty...could become even more tentative if lawmakers delay addressing the present fiscal challenges". In effect, business leaders have very little faith in the fragile North American recovery. We can see their concern reflected in that somber fourth-quarter guidance.
I think that Canadian investors have to build this increasing uncertainty into their decisions. It affects us. A few weeks ago, Christine Legarde, managing director of the International Monetary Fund (IMF), paid us a flying visit and praised the way Canada had avoided most of the financial downturn. She then went on to point out that, despite our prudent policies, we are not home safe. The United States is still our major trading partner. Thus, we are heavily exposed.
Just so that there is no misunderstanding, I have not suddenly become bearish. I am, however, more cautious. There are close ties between business confidence, the economy, and financial markets and the 13% year-to-date increase in the S&P 500 Index has been in anticipation of corporate earnings growth. Now that seems to be a question mark. Managers are marking down their expectations and 95% of the major companies that recently issued fourth-quarter guidance lowered their estimates. On the larger scene, third-quarter U.S. GDP growth of 2% was due to defense expenditures, consumer spending, and an improved housing market. The all-important business investment component was a bust, falling 1.3%, the first time that it has dropped since 2009.
Here is the situation. This year`s stock market performance has been driven by expectations rather than fundamental earnings. It has been a leap of faith. Certainly profits have been respectable, often beating the forecasts, but in many cases they resulted from cost cutting and synergies. The important top line sales that really reflect expansion and meaningful growth have remained a concern. Unless we see a jump in revenues, which seems unlikely at the moment, earnings are going to slow. As a matter of fact, analysts are ratcheting down their fourth-quarter estimates but this has gone unnoticed because investors have been focused on the election.
It all suggests that the U.S. market in particular is ahead of itself. Any surge resulting from election result could make stocks even more expensive. By the same token, Canadian stocks are also vulnerable as our economy marks time. According to a National Bank report, overall S&P/TSX Composite third-quarter earnings will drop more than 8% year-over-year. Most of the predicted decline is attributed to the energy sector where profit could plunge 24.6% but the weakness is likely to be widespread. Given the poor global outlook for commodities, Canadian analysts are going to start marking down their still optimistic fourth quarter and 2013 forecasts.
A look at the railroads
How feeble is the U.S. recovery? Well, it's certainly anemic. Take a look at the railway sector. Many analysts and money managers, including Warren Buffett, carefully monitor railway traffic in order to get a handle on domestic economic activity. It's a way of keeping your finger on the pulse as it were and the third-quarter numbers were not very encouraging. Benchmark industry carloads were flat compared to 2011. On the plus side, there were no really unpleasant surprises but North American revenue per ton-mile declined 1.5% and coal shipments were down 11.5%. There was one bright spot: Intermodal (container) and merchandise traffic continued to improve thanks mainly to the auto industry and its related suppliers.
As to the railways themselves, four of the Class 1 carriers reported earnings in line with expectations. Of the other two, Norfolk Southern ran into some serious headwinds because of weak coal markets and reported lower year-over-year numbers. Canadian Pacific (TSX, NYSE: CP), though, came through in style and the stock responded.
Although it is not on our Recommended List at the moment, I am keeping a close eye on CP now that it's finally becoming a turnaround situation. While most of the attention has been focused on a high profile management shake-up, there has been a steady improvement in the company's performance. At long last we are seeing some better numbers.
Third-quarter earnings of $1.30 were up 18% year-over-year and well ahead of the $1.23 consensus forecast. Keep in mind, though, that many analysts had been marking down their estimates while CP's executives were distracted by the proxy fight. Total revenues of $1.5 billion increased a modest 8% but there was a significant reduction in costs. The operating ratio was cut from 75.8% to 74.1%.
The most encouraging thing about CP's numbers was the broad improvement in unit costs. Train speeds were up 11%, average terminal dwelling (lost time) was down 4%, and car miles per day jumped almost 22%. There was also an expansion of services. The company launched new and faster intermodal services between Vancouver and Toronto and Vancouver and Chicago. There is some real progress.
The problem is that the stock has taken off. Canadian Pacific still has a lot of problems. The operating ratio is still far too high, a long way from a targeted 65%. Revenue growth will have to improve despite a slowing economy and the weather, always a threat at CP, will have to be kind. Yet the shares, currently priced at C$90.10, US$89.86, are trading at 16.4 times next year's expected earnings of $5.50 per share. A lot of the anticipated improvement is already heavily discounted.
My feeling is that even with industry giant Hunter Harrison at the helm, CPR is bound to run into unexpected difficulties. Even if nothing goes wrong, the next round of cost cutting is going to be much harder, especially when it comes to paring back the work force. The feeling amongst analysts is that we will not see management's goal of a 65% operating ratio until 2016.
As a result, we are not adding Canadian Pacific Railway to our Recommended List at this time. However, there is a broad restructuring under way within the company and if the stock weakens it may become attractive. We will keep you informed.
TOM SLEE'S UPDATES
CN Rail (CNI)
Originally recommended on May 6/02 (#2218) at C$25.95 (split-adjusted). Closed Friday at C$86.38, US$86.28.
CN Railway reported another very strong quarter with earnings of $1.52 a share, up 10% year-over-year. Free cash flow of $492 million was impressive and brought the total cash before dividends this year to $1.35 billion. The market, however, was unimpressed. Investors were disappointed that management failed to meet its own ambitious target of 15% growth. Obviously it's a good idea to set modest goals, especially in these difficult times.
Revenues were up 9% and the company's operating ratio (the portion of sales needed to run the system) came in at an impressive 60.6%. Labour productivity was 6.3% higher and yard throughput was up 5%. CN is still by far the most efficient railway and its balance sheet remains strong. All of this would suggest impressive earnings growth in 2013. Management, however, is dampening expectations.
Pointing to a slowing economy and increased pension funding that could add 1.5% to the operating ratio CN has a cautionary outlook for the coming year. It looks as though we will see a profit of about $5.70 a share in 2012 and $6.25 or so in 2013. That means the stock at $86.38 is trading with a 15 trailing multiple. Given the gloomy prospects, CN is fully priced. I would not be a buyer for the moment.
Action now: CN Railway becomes a Hold but it would represent good value if the stock, which has a $93 target, drops into the low $80s. I will monitor the situation.
Norfolk Southern (NSC)
Originally recommended on Dec. 14/09 (#2944) at $52.22. Closed Friday at $58.00. (All figures in U.S. dollars.)
Norfolk Southern reported a poor third quarter. Earnings of $1.24 a share were down 21% from 2011 and in line with expectations only because the company had previously reduced its guidance. Revenues declined 7% and carloads fell 1.4% due to a precipitous drop in volumes late in the quarter when coal exports slumped. As a result, because of the substantial fixed costs, the operating ratio jumped 532 basis points to 72.9%.
Looking ahead, management remains cautiously optimistic about the coal market and expects shipments to stabilize in 2013. European demand, however, is likely to remain weak. On the other hand, intermodal traffic remains strong and NSC is double stacking containers in order to improve profit margins. The company is also expanding its crude oil business and is now shipping to six refineries. Assuming that the slow recovery continues, Norfolk is on track to earn about $5.25 a share this year and $5.65 in 2013, a modest 7.5% increase.
Normally, therefore, I would reduce our recommendation to a Hold until we have at least one good quarter under our belt. However, the stock has been punished and at $58 is trading with an 11 times earnings multiple. That is relatively cheap. I think that there is upside potential.
Action now: Norfolk Southern remains a Buy with a reduced target of $80. I will revisit the stock if it drops to $52.
Stella Jones (STLJF)
Originally recommended on April 2/12 (#21213) at C$42.20. Closed Friday at C$70.58, US$62.22 (Nov. 1).
Stella Jones, which I include as part of our railway industry coverage, reported a solid second quarter. Earnings of $1.30 a share were well above the $1.22 many analysts were looking for and 22% better than the $1.08 in 2011. Sales, spurred by robust demand for the company's core railway tie products, came in at $204 million, up 13% year-over-year. Distribution pole sales were also strong. Tighter cost controls improved the profit margins and operating cash flow rose 36% to $63 million. This is a company on the move.
As an example, Stella Jones has just announced the purchase of McFarland Cascade Holdings for $230 million. This is a great move and adds significantly to earnings going forward. Stella's shares (part of our Growth Portfolio) have rocketed up to over $70, a 67% gain since our recommendation at $42.20 in April. We could see earnings of $5.60 or better in 2013 and these forecasts are conservative. The major railways' tie inventories are low.
The shares are trading at a 12.5 multiple and good value. My suggestion is that they are still a Buy with a new target of $80 and a revisit level of $62.
However, some people who bought at the time of the original recommendation may want to take profits,
Action now: Stella-Jones remains a Buy with a new target of $80.
Tourmaline Oil (TRMLF)
Originally recommended on Feb. 14/11 (#21106) at C$24.42, US$24.85. Closed Friday at C$32.21, US$32.06.
On another front, Tourmaline Oil booked a record second quarter with production totaling 51,022 barrels of oil equivalent per day (boepd) while operating costs of $4.83 per boe were 16% lower year-over-year. Looking ahead, management expects to increase output and achieve an average production of about 65,000 boepd in 2013 while between 25 and 30 new horizontal wells are being brought on stream.
The company is planning an ambitious $525 million capital program next year. Moreover, analysts regard the company's recent $258 million all stock bid for Huron Energy Corp. as a positive move. Huron's infrastructure complements Tourmaline's plant and pipeline network.
My feeling is that Tourmaline remains an excellent, well-managed junior oil and gas play with top quality assets. The trouble is that with global energy demand weakening, all of the Canadian producers and explorers are likely to struggle for a while. Priced at $32.21 the shares have limited upside potential which makes the risk/return ratio unattractive.
Action now: Investors who are comfortable in the oil and gas exploration sector may wish to maintain their positions but Tourmaline becomes a Sell at $32.21, a 32% gain from our recommendation at $24.42 last year.
- end Tom Slee