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Whenever you see the markets slump badly, you need to look at the other side of the coin. You should ask yourself, “What investments can actually prosper from a darkening economic outlook?”
Well, we know that bonds rally sharply. For example, the iShares Barclays 20+ Year Treasury Bond ETF (NYSE: TLT) has risen more than 15% in just the past two months.
Whenever you hold a stock that is a victim of a key trend, you should look to balance your exposure by finding stocks that benefit from that same trend. Which got me thinking: What companies are the prime beneficiaries of lower commodity prices?
Auto makers like that steel prices are falling. Airlines are surely sighing with relief as crude oil prices move sharply lower.
Even the more obscure commodities are plunging. For example, I bet you didn’t know butadiene prices have fallen roughly 30% in just the past two months. Butadiene is a form of synthetic rubber that was discovered by a chemist in the 19th century, but came into vogue in World War II when it became difficult for global buyers to secure contracts with owners of rubber tree plantations.
Ever since, global tire makers have come to rely on butadiene in ever-increasing quantities. So there is a rare bit of cheer in corporate America, as our nation’s tire makers will soon be able to deliver the good news to investors that expenses are falling. The loudest cheer may be coming from Goodyear Tire & Rubber (NYSE: GT). Butadiene accounts for roughly one-quarter of Goodyear’s raw material expenses. Actual rubber is Goodyear’s biggest material cost, and the fact that rubber prices have also slumped 16% in the past two months also helps.
Too soon to pop the cork
This doesn’t mean Goodyear is on the cusp of a major profit surprise. Auto makers and after-market tire centers may have held off on orders in recent weeks for more tires, leading to a slight miss on the top line in the current quarter. More to the point, butadiene and rubber are contracted in advance, and it won’t be until the third quarter — which begins next month — that Goodyear will start to see real expense relief.
Yet when that relief comes, it should be significant. Consider this stat: Every 1% decline in raw material costs can boost Goodyear’s earnings per share (EPS) by 25 cents, according to the company. The fact that Goodyear was able to raise prices by 6% on April 1 tells you that gross margins could really surge later this year.
Of course, this is a volume-sensitive business. And total demand for tires has weakened even further since I profiled Goodyear in early May. Shares have dropped 15% since then, mirroring the drop of many other stocks in recent weeks, though this is the rare case of a stock that may actually see rising EPS forecasts for the second half of 2012 and beyond. Before valuing this stock, let’s take a look at some key numbers, which as I noted back in early May, must surely appeal to the Graham & Dodd value investing crowd.
Analysts at Merrill Lynch calculated the operating income forecast for 2012, 2013 and 2014 in the table above before butadiene and rubber prices began to fall. Now, in early June, Merrill’s analysts would likely trim their sales forecasts a bit, but they are likely to lower their expense assumptions by an even greater amount. Translation: those operating income forecasts have a clear bias to be raised.
The fact that this stock trades for less than four times (unrevised) 2014 cash flow projections highlights the value appeal. Even a straight ahead EPS analysis brings home the point. This is a stock trading below $10 that is likely to earn around $2 a share this year and in the range of $2.50 to $3 a share in 2013, as falling raw material costs cycle through the income statement. Trading for roughly three to four times 2013 EPS forecasts makes this one of the cheapest stocks in the S&P 500. The fact that EPS forecasts for Goodyear don’t hold the same risk as many other stocks is clearly unappreciated by the markets right now.
Then again, this is a company growing accustomed to being unappreciated. Goodyear has delivered earnings in three of the past four quarters that were at least 140% higher than the consensus. I am not anticipating a similar level of upside for the current quarter due to the delayed impact of the raw material pricing. But unless analysts start to raise their view for the third and fourth quarters, Goodyear is again set up to surge past forecasts in the third and fourth quarter.
The Downside Protection –> Auto sales have been solid in the United States thus far in 2012, though they remain very weak in Europe and have been cooling in Asia and Latin America. This global weakness is why shares have fallen from $35 in 2007 to $18 last summer to a recent $9.50. If U.S. auto sales start to tumble, then this stock could easily fall to $7 or $8, so a stop loss order in that range makes sense.
Don’t let Goodyear’s $3.1 billion in debt scare you off: it doesn’t face a major bond payment until 2019, as the company is one of many to take advantage of the sharp drop in corporate bond yields over the past few years. Meanwhile, debt-to-equity, which hit 182% in 2010, should fall to 133% this year and below 75% by 2014.
Upside Triggers –> There is one near-term trigger in place here: the falling raw material prices I noted above. The long-term opportunity comes from an eventual stabilization in European auto sales, which could see a powerful snapback considering the long-delayed replacement cycle for many cars on European roads. At that point, Goodyear’s operating income might settle into the $1.5 billion to $2 billion annual range, which is not far from the company’s entire $2.3 billion market value.
Action to Take –> I will be buy 600 shares of Goodyear (or roughly $5,400 worth) 48 hours after you read this. Shares can be bought under $12. To free up cash for this purchase, I will sell my remaining 300-share stake in the Direxion Daily Small Cap Bear 3X ETF (NYSE: TZA).
– David StermanSource: StreetAuthority
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