Mr. Pzena is Founder and Co-Chief Investment Officer of Pzena Investment Management LLC, with more than $24 billion under management. Pzena started the firm in 1995. He earned a BS summa cum laude and an MBA from the Wharton School of the University of Pennsylvania in 1979 and 1980, respectively.
Pzena's philosophy is based on ranking companies from the cheapest to the most expensive on the basis of current share price to normal long-term earnings power. He purchases shares in good businesses that are selling at low prices. He understands that it is often unrealistic to expect such opportunities to be available absent some sort of problem which causes the price of the shares to drop. The question Pzena and his team try to answer is whether the issue that caused the drop in price is temporary or permanent. Pzena basically has expertise in determining normal earnings potential from a sector or specific Company. Based on that he calculates the intrinsic value and potential of the investment.
The problem with this kind of methodology is that you need strong, predictable companies in order to determine a “normal” earnings scenario. For example, in technology, how can you “normalize” when the Industry is constantly changing and new trends emerge every new year. So, the model of earnings normalization is sometimes tricky when you do not pick the right Company, as Pzena experienced in 2008, when he built models for normalized earnings in the financial sector and his investments went bust in less than a year causing his portfolio to drop more than 50%. Beware of “value traps”.
Let’s analyze in detail his top holdings.
(HPQ) HewlettPackard Co.
HPQ hasa market capitalization of $55.62 billion. The company employs 324,600 people, generates revenues of $126,033.00 million and has a net income of $8,761.00 million. There is no doubt this is a huge tech Company. The company's earnings before interest, taxes, depreciation and amortization (EBITDA) amounts to $12,963.00 million. Because of these figures, the EBITDA margin is 10.29 percent (operating margin 9.11 percent and the net profit margin finally 6.95 percent).
The total debt representing 17.91 percent of the company’s assets and the total debt in relation to the equity amounts to 55.14 percent. Due to the financial situation, the return on equity amounts to 21.64 percent, which is quite attractive.
HPQ multiples are ridiculously cheap: The P/E ratio is 6.58, Price/Sales 0.43 and Price/Book ratio 1.49. The 5-Year P/E ratio amounts to 6.7.
Management surprised recently announcing revenues to the upside at $32.1 billion in the quarter. As a result, HP was able to make back more than half of its 4% loss in regular Monday trading (a fairly bloody Monday, with the Dow down over 300 points before rallying back to -248 by the close) in the after-market.
That said, HP has guided even lower for next quarter. Consensus had been $1.11 including the lowered revisions, but HP's outlook now expects only 83-86 cents per share in its first quarter. Clearly, CEO Whitman has her work cut out for her. Adding to the company's potential woes — and more articulation is being sought in the ongoing conference call for Hewlett-Packard — are the recent floods in Thailand and an expected severe shortage in the company's hard disk drive market. Also, a potential price war in the printing space may be forthcoming.
Perhaps these issues are baked into the cake for HP's first quarter guidance. But for right now, Hewlett-Packard not falling on its face during its transitional phase is bringing out the bull sentiment for value portfolio managers. I would avoid this stock.
(SPLS) Staples Inc.
SPLS is the world's leading office products company, with $24 billion in sales and over 2,000 stores in 25 countries. The company's three segments allow it to serve individual consumers, Fortune 1,000 companies, and every customer category in between, worldwide. Staples' growing e-commerce business has garnered it the number-two spot in online retailers, behind Amazon.
While Staples' quarter wouldn't appear impressive (revenue up just 0.5% to $6.6 billion and margin expansion of 10 basis points to 8.1% excluding restructuring), the company continues to outperform its rivals. By segment, North American delivery sales were healthy (up 1.8%), thanks to strong growth in facilities and break-room supplies and promotional products. International revenue fell 1.9% or 7.0% on a local currency basis, because of weak economic conditions. European same-store sales were down 12.0%, and management noted weakness in the Australian market. Staples' sales outside North America represent just 22% of total revenue, leading to our opinion that Staples is well-poised to take advantage of international growth opportunities. Staples raised its share-repurchase target for the year to $600 million from $300 million-$500 million.
SPLS is in a cyclical industry and subject to the negative effects of high unemployment. This reality is compounded by the fact that a portion of Staples' customers are small businesses, even more sensitive to poor macroeconomic trends compared to larger companies. Pzena analyzed that in a normalized economic environment, Staples should improve its results as the business model is not broken.
Staples has increased revenue in each of the last 10 years. It has an average 10-year return of 3%. It has a projected EPS growth rate of 10.72% over the next 5 years. It has an ROE of 14% and a forward PE of 9.3. It has a dividend yield of 2.86% and a 5-year dividend growth rate of 16.75%.
SPLS appears undervalued based on its Price/Earnings (TTM) of 10.14 and a price-to-cash flow of 6.43. On a relative basis, SPLS has strong technicals and fundamentals.
(ABT) Abbott Laboratories
Abbott Laboratories is one of the largest drug manufacturers in the world. The company employs more than 90,000 workers worldwide. Abbott recently announced that it will split into two companies: One of the new companies will specialize in diversified medical products; the other will specialize in research-based pharmaceuticals. Abbott stock was trading at $53, with a 52-week range of $43.84 - $55.61. It has a market cap of $82.5 billion. Trailing twelve month P/E ratio is 18.27, and forward P/E ratio is 10.56. P/B, P/S, and P/CF ratios stand at 3.1, 2.2, and 8.7, respectively. The 3-year annualized revenue and EPS growth stand at 10.7% and 8.6%, respectively. Operating margin is 16.3%, and net profit margin is 13.8%. The company has some debt issues. Debt-to-equity ratio is 0.5. Abbott pays nifty dividends. The stock has been able to raise its dividends for 39 consecutive years. Current yield is 3.62%.
Abbott is a quality large cap stock. It has an interesting fact in its valuation. While its trailing P/E ratio is 18.27, it has a 5-year average P/E ratio of 23.2. Thus, Abbott is trading below its historical P/E ratio.
(XOM) Exxon Mobil Corp.
Exxon is the second most gas-focused among the major companies in the sector. It is next only to Royal Dutch Shell (RDS.A) with 48% of its current production from natural gas, compared with 42% of the global majors. Although globally natural gas prices are strong, they have lagged oil prices in the US. Thus, Exxon, which is overexposed to gas, is definitely not in a sweet spot. Although Exxon’s management is positive that US natural gas prices will catch up with the global prices eventually, I don’t see this happening in near to medium term. Since the start of 2010, U.S. natural gas production has climbed by an average of 0.4 Bcf/day per month. With macro uncertainty and talks of another recession, I don’t see any factor that can cause supply demand tightness in the US natural gas market.
But as we know, Rich Pzena is an expert in modeling “normalized” earnings, so he must have projected a scenario were nat gas catches up with oil and boost XOM earnings more than what the market expects.
(NOC, Financial) Northrop Grumman Corp.
Northrop Grumman offers a strong program portfolio positioned to take advantage of focus areas in the defense space, an improving balance sheet and an ongoing share repurchase program. NOC employs over 117,000 thousand employees worldwide. Currently, financial statements indicate a gross margin of 18%, operating margin of 9.26%, and new profit margin of 5.9%. Insiders own 0.51% of the company, and they increased their holdings by 35.36% in the last 6 months. The current P/E is 9.41, and forward P/E falls to 9.15. EPS increased by 39.11% this year, and analysts estimate an EPS growth of 6.65% in the next five years. However, given the past performance of 11.98%, I think an EPS growth of 9% is a better estimator.
Northrop Grumman paid regular dividends since 2001. The company even continued paying dividends in 2008, despite the big losses the earnings suffered. Dividends are also in an increasing trend since 2001. Payments started from $0.8 in 2001, and increased by more than 2-fold in 2010. Net income increased by more than 4-fold in the last 10 years. It reached the peak value of $2 billion in the last year. The company was badly affected by the 2008 crisis. Total Net Income in 2008 was -$1.3 billion. However, the recovery was strong. Revenue has a stable upward trend. Sales increased by 2.5-fold in the last decade, and reached $34.7 billion by 2010.
Northrop Grumman s strong balance sheet and cash flows provide substantial financial flexibility and a cushion through an incremental dividend, ongoing share repurchases and earnings accretive acquisitions. In the first nine months of 2011, the company repurchased 28.4 million shares for approximately $1.6 billion. At the end of the first nine months of 2011 Northrop still has approximately $2.4 billion remaining under its share repurchase authorization. At the end of the first nine months of 2011, the company had a low long-term debt-to capitalization of 23.8% (S&P 500 industry average was 42.9%). Total long-term debt was approximately $3.9 billion, of which $23 million is due in the near-term, along with cash holdings of $2.7 billion.
Pzena's philosophy is based on ranking companies from the cheapest to the most expensive on the basis of current share price to normal long-term earnings power. He purchases shares in good businesses that are selling at low prices. He understands that it is often unrealistic to expect such opportunities to be available absent some sort of problem which causes the price of the shares to drop. The question Pzena and his team try to answer is whether the issue that caused the drop in price is temporary or permanent. Pzena basically has expertise in determining normal earnings potential from a sector or specific Company. Based on that he calculates the intrinsic value and potential of the investment.
The problem with this kind of methodology is that you need strong, predictable companies in order to determine a “normal” earnings scenario. For example, in technology, how can you “normalize” when the Industry is constantly changing and new trends emerge every new year. So, the model of earnings normalization is sometimes tricky when you do not pick the right Company, as Pzena experienced in 2008, when he built models for normalized earnings in the financial sector and his investments went bust in less than a year causing his portfolio to drop more than 50%. Beware of “value traps”.
Let’s analyze in detail his top holdings.
(HPQ) HewlettPackard Co.
HPQ hasa market capitalization of $55.62 billion. The company employs 324,600 people, generates revenues of $126,033.00 million and has a net income of $8,761.00 million. There is no doubt this is a huge tech Company. The company's earnings before interest, taxes, depreciation and amortization (EBITDA) amounts to $12,963.00 million. Because of these figures, the EBITDA margin is 10.29 percent (operating margin 9.11 percent and the net profit margin finally 6.95 percent).
The total debt representing 17.91 percent of the company’s assets and the total debt in relation to the equity amounts to 55.14 percent. Due to the financial situation, the return on equity amounts to 21.64 percent, which is quite attractive.
HPQ multiples are ridiculously cheap: The P/E ratio is 6.58, Price/Sales 0.43 and Price/Book ratio 1.49. The 5-Year P/E ratio amounts to 6.7.
Management surprised recently announcing revenues to the upside at $32.1 billion in the quarter. As a result, HP was able to make back more than half of its 4% loss in regular Monday trading (a fairly bloody Monday, with the Dow down over 300 points before rallying back to -248 by the close) in the after-market.
That said, HP has guided even lower for next quarter. Consensus had been $1.11 including the lowered revisions, but HP's outlook now expects only 83-86 cents per share in its first quarter. Clearly, CEO Whitman has her work cut out for her. Adding to the company's potential woes — and more articulation is being sought in the ongoing conference call for Hewlett-Packard — are the recent floods in Thailand and an expected severe shortage in the company's hard disk drive market. Also, a potential price war in the printing space may be forthcoming.
Perhaps these issues are baked into the cake for HP's first quarter guidance. But for right now, Hewlett-Packard not falling on its face during its transitional phase is bringing out the bull sentiment for value portfolio managers. I would avoid this stock.
(SPLS) Staples Inc.
SPLS is the world's leading office products company, with $24 billion in sales and over 2,000 stores in 25 countries. The company's three segments allow it to serve individual consumers, Fortune 1,000 companies, and every customer category in between, worldwide. Staples' growing e-commerce business has garnered it the number-two spot in online retailers, behind Amazon.
While Staples' quarter wouldn't appear impressive (revenue up just 0.5% to $6.6 billion and margin expansion of 10 basis points to 8.1% excluding restructuring), the company continues to outperform its rivals. By segment, North American delivery sales were healthy (up 1.8%), thanks to strong growth in facilities and break-room supplies and promotional products. International revenue fell 1.9% or 7.0% on a local currency basis, because of weak economic conditions. European same-store sales were down 12.0%, and management noted weakness in the Australian market. Staples' sales outside North America represent just 22% of total revenue, leading to our opinion that Staples is well-poised to take advantage of international growth opportunities. Staples raised its share-repurchase target for the year to $600 million from $300 million-$500 million.
SPLS is in a cyclical industry and subject to the negative effects of high unemployment. This reality is compounded by the fact that a portion of Staples' customers are small businesses, even more sensitive to poor macroeconomic trends compared to larger companies. Pzena analyzed that in a normalized economic environment, Staples should improve its results as the business model is not broken.
Staples has increased revenue in each of the last 10 years. It has an average 10-year return of 3%. It has a projected EPS growth rate of 10.72% over the next 5 years. It has an ROE of 14% and a forward PE of 9.3. It has a dividend yield of 2.86% and a 5-year dividend growth rate of 16.75%.
SPLS appears undervalued based on its Price/Earnings (TTM) of 10.14 and a price-to-cash flow of 6.43. On a relative basis, SPLS has strong technicals and fundamentals.
(ABT) Abbott Laboratories
Abbott Laboratories is one of the largest drug manufacturers in the world. The company employs more than 90,000 workers worldwide. Abbott recently announced that it will split into two companies: One of the new companies will specialize in diversified medical products; the other will specialize in research-based pharmaceuticals. Abbott stock was trading at $53, with a 52-week range of $43.84 - $55.61. It has a market cap of $82.5 billion. Trailing twelve month P/E ratio is 18.27, and forward P/E ratio is 10.56. P/B, P/S, and P/CF ratios stand at 3.1, 2.2, and 8.7, respectively. The 3-year annualized revenue and EPS growth stand at 10.7% and 8.6%, respectively. Operating margin is 16.3%, and net profit margin is 13.8%. The company has some debt issues. Debt-to-equity ratio is 0.5. Abbott pays nifty dividends. The stock has been able to raise its dividends for 39 consecutive years. Current yield is 3.62%.
Abbott is a quality large cap stock. It has an interesting fact in its valuation. While its trailing P/E ratio is 18.27, it has a 5-year average P/E ratio of 23.2. Thus, Abbott is trading below its historical P/E ratio.
(XOM) Exxon Mobil Corp.
Exxon is the second most gas-focused among the major companies in the sector. It is next only to Royal Dutch Shell (RDS.A) with 48% of its current production from natural gas, compared with 42% of the global majors. Although globally natural gas prices are strong, they have lagged oil prices in the US. Thus, Exxon, which is overexposed to gas, is definitely not in a sweet spot. Although Exxon’s management is positive that US natural gas prices will catch up with the global prices eventually, I don’t see this happening in near to medium term. Since the start of 2010, U.S. natural gas production has climbed by an average of 0.4 Bcf/day per month. With macro uncertainty and talks of another recession, I don’t see any factor that can cause supply demand tightness in the US natural gas market.
But as we know, Rich Pzena is an expert in modeling “normalized” earnings, so he must have projected a scenario were nat gas catches up with oil and boost XOM earnings more than what the market expects.
(NOC, Financial) Northrop Grumman Corp.
Northrop Grumman offers a strong program portfolio positioned to take advantage of focus areas in the defense space, an improving balance sheet and an ongoing share repurchase program. NOC employs over 117,000 thousand employees worldwide. Currently, financial statements indicate a gross margin of 18%, operating margin of 9.26%, and new profit margin of 5.9%. Insiders own 0.51% of the company, and they increased their holdings by 35.36% in the last 6 months. The current P/E is 9.41, and forward P/E falls to 9.15. EPS increased by 39.11% this year, and analysts estimate an EPS growth of 6.65% in the next five years. However, given the past performance of 11.98%, I think an EPS growth of 9% is a better estimator.
Northrop Grumman paid regular dividends since 2001. The company even continued paying dividends in 2008, despite the big losses the earnings suffered. Dividends are also in an increasing trend since 2001. Payments started from $0.8 in 2001, and increased by more than 2-fold in 2010. Net income increased by more than 4-fold in the last 10 years. It reached the peak value of $2 billion in the last year. The company was badly affected by the 2008 crisis. Total Net Income in 2008 was -$1.3 billion. However, the recovery was strong. Revenue has a stable upward trend. Sales increased by 2.5-fold in the last decade, and reached $34.7 billion by 2010.
Northrop Grumman s strong balance sheet and cash flows provide substantial financial flexibility and a cushion through an incremental dividend, ongoing share repurchases and earnings accretive acquisitions. In the first nine months of 2011, the company repurchased 28.4 million shares for approximately $1.6 billion. At the end of the first nine months of 2011 Northrop still has approximately $2.4 billion remaining under its share repurchase authorization. At the end of the first nine months of 2011, the company had a low long-term debt-to capitalization of 23.8% (S&P 500 industry average was 42.9%). Total long-term debt was approximately $3.9 billion, of which $23 million is due in the near-term, along with cash holdings of $2.7 billion.
