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Jubak's Journal
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2 more companies pass 'clean stocks' test
Applebee's and Expeditors International undergo thorough scrutiny from readers to join Paychex and Apache as companies to trust. They're not only honest, they make money, too.
By Jim Jubak
We all know of companies that fake the numbers, CEOs who lie, accountants who dont do the work theyre paid for and boards that help management steal. And we all know that these kinds of chicanery can keep a stock going up long enough for insiders to cash in on huge packages of options and stock grants, leaving public investors holding the bag. Its easy to tick off the names: Enron, Lucent Technologies (LU, news, msgs), HealthSouth (HLSH, news, msgs), Xerox (XRX, news, msgs), WorldCom. Do I need to go on?
Weve all sworn, more than once, never, never, never to put money into one of those again.
But can you name even a handful of companies that are clean? Where the CEO puts the interest of shareholders at least on an even plain with his own? Where the board rides a tight herd on investors' money? Where the company keeps its books and its business strategy simple -- and believes in explaining both to shareholders?
If they also showed the potential for solid returns, a lot of us would put stocks like those at the core of our portfolios.
This is why I launched a cooperative effort to build just such a list of clean stocks in my July 15 column, "Join forces to build a list of stocks to trust." I nominated Apache (APA, news, msgs), Northern Trust (NTRS, news, msgs) and Paychex (PAYX, news, msgs) as the initial members and invited readers to e-mail me with anything that they thought should keep those stocks off the list, or put them on it. Apache and Paychex survived to become the initial members of the Clean Stocks list on Aug. 1. In "Our first Clean Stocks: Apache and Paychex," I nominated three more candidates from reader suggestions: Applebees (APPB, news, msgs), Expeditors International (EXPD, news, msgs) and Paccar (PCAR, news, msgs).
Adding to the list
Its now time to make a decision on those three, nominate three more stocks from your suggestions, ask for new candidates and request nominations for the next Clean Stocks round on or about Oct. 15.
The results (drumroll, please): Applebees and Expeditors are in, but Paccar is out. The three nominees for the next round are Equifax (EFX, news, msgs), Stryker (SYK, news, msgs) and T. Rowe Price Group (TROW, news, msgs).
Before I get to the details of those picks and nominees, let me thank the hundreds of readers who participated in the first two rounds. I truly appreciate the time and thought evident in many of the e-mails I received on specific stocks and suggestions for improving the process.
Eight not-so-simple rules
To review, here are the eight rules that, with reader changes and additions, now form the test a Clean Stock has to pass.- Executive compensation: Excessive executive compensation, especially massive bonuses for mediocre performance, large personal loans and big grants of options are signs that the board of directors may be asleep. They also give executives an incentive to manage for short-term goals that line their pockets rather than working to increase long-term shareholder value.
- Accounting: Financial reporting should be as free as possible of one-time charges that make it difficult to get a handle on company performance. It should give a picture of company performance without the effect of trends outside the companys control such as currency exchange and interest rate changes. Lastly, it should give investors a way to judge the difference, if any, between growth produced by acquisitions and growth that comes from existing businesses.
- Conflicts of interest: Were looking for companies that work to control the potential for such conflicts and the potential damage they might cause. Danger signs include entrenched accountants that have done the books year-in and year-out and also do massive amounts of consulting work with the company; and a lack of strong outside directors on the companys accounting, compensation and corporate governance committees. To that, we add directors with outside business interests that do business with the company, and ownership structures that put the interests of a class of owners at variance with the interests of public shareholders.
- Growth strategies: Growth by acquisition can produce a constant barrage of one-time charges and write-offs that make it impossible to judge company performance. Companies structured as roll-ups where a single competitor acts to consolidate smaller businesses in a fragmented industry are notorious for producing overly optimistic pictures of revenue and earnings growth.
- Corporate structure: A company with a plethora of subsidiaries and off-balance-sheet entities presents a challenge to investors trying to figure out where the cash is coming from and where its going. Transfers of cash between related entities or less-than-arms-length business relationships among related entities present opportunities to hide or distort cash flows.
- Options accounting: Companies should engage in modest use of options and accounting that honestly tries to account for options as compensation. Readers anger on this issue is palpable. The role of options in creating the incentives for management to lie to shareholders at Enron, Lucent, Xerox and other companies has made a lasting impression on many investors.
- Pension accounting: Companies with defined-benefit pension plans that are clearly understating the size of their future pension liabilities should get the ax.
- Potential return to investors: The shares of the company in question should show the potential for outperforming the market over the long term.
Im not sure that any company will manage a perfect record on all eight of these issues, so Im not looking for the business world's saints. Clean Stocks companies will almost certainly have a blemish or two, but the bad marks should be limited, and, ideally, non-material to their investment quality.
Now to this month's candidates.
Caution is watchword at Applebee's
Applebees combines impressive performance with conservative corporate values to earn a place among our Clean Stocks. (In addition, Ill be adding shares to my Jubaks Picks portfolio with this column.) On the performance side, the company shows the highest return on invested capital among the casual dining segment, almost 24%, and has managed to improve that return since the restaurant industrys returns peaked in early 2002.
For the second quarter, the company reported a 4% increase in comparable-store sales, the 20th consecutive quarter of growth. The conservative values are apparent in the way that Applebees treated the $8.8 million note the company held from the Chevys chain. After reading the debtor companys 2002 financials, Applebees in the second quarter decided to write off the note as an impaired debt and reserved the full amount of principal and interest. That's about what Id expect from a company like Applebees with a minuscule 0.08 debt-to-equity ratio. Long-term debt stands at just $35 million.
No companys perfect, and I did manage to find a few dings in Applebees record. One board member, Eric Hansen, who sits on the audit committee, worked for Applebees accountant, Deloitte & Touche, for 17 years. On the other hand, the fees that Applebees pays its accountant are conservative. In 2001, audit fees were $220,000, and all other fees came to about $800,000. In 2002, non-audit fees spiked to more than $3 million, but that was for one-time consulting on installing new information systems. The work was completed in 2002. CEO Lloyd Hill did receive more in bonus pay than in regular compensation in 2002, but Hills salary, at $612,300, and bonus, at $726,330, arent excessive for these times. And the bonus was based on the company showing a 20% increase in earnings per share for 2002 from 2001, so the company and shareholders seem to have received good value from their incentives.
The stock could suffer a bump or two in the fourth quarter since the successful rollout of the companys new takeout service, due for completion this quarter, will make it difficult for Applebees to show the usual same-store sales growth. But the company continues to improve efficiency and add new menu ideas -- the most recent involving a partnership with Weight Watchers. The company is projected to drive earnings per share up 18% in 2003 and another 14% in 2004. The stock trades at 19 times projected 2003 earnings per share and 17 times projected 2004 earnings.
Big incentives for Expeditors employees
Expeditors is a company with a high-octane business model driven by a culture that ties every employees self-interest to that of the company and its shareholders. Everyone from top to bottom at Expeditors International works for a relatively low base salary and a bonus based on the companys pre-bonus operating income. So in 2002, CEO Peter Rose earned a salary of just $110,000 but received a bonus of $2.7 million. Executives as a group get 10% of the bonus pool. Individual Expeditors International offices retain 20% of their operating profits for distribution to their own local employees: Needless to say, that with base salaries low, increasing that local bonus pool is a big incentive for working hard and cutting costs. For example, in 2001, the company was able to cut accounts receivable to 46% of net revenue from 63% in 2000 by charging past-due receivables to each office.
Expeditors doesnt own any planes or trucks. Instead it buys bulk space on other carriers and resells it to customers. That low-asset business model is one reason that Expeditors shows a return on invested capital of 21%. The company has grown earnings per share by an average of 21% a year over the last five years, and, importantly for the Clean Stocks list, that growth has been accomplished without acquisitions.
Few checks on Paccar founding family
Its hard to toss out the stock of a company with Paccars impressive performance record, but this one doesnt make the cut. The company shows a record of 63 consecutive profitable years -- amazing for the trucking industry, where sales can easily drop 20% or more from year to year. The company has been able to build this record by relentlessly improving efficiency even in good markets, which lets the company gain market share in tough markets, and by adhering to conservative financial standards. At the June quarter's end, Paccar had about $1 billion in cash and cash equivalents. But Paccars corporate governance and executive compensation earn lower marks. CEO Mark Pigott is the great-grandson of company founder William Pigott. He took over in 1997 from his father. Mark Pigotts uncle, James Pigott, sits on the board. Many of the other members of the board seem overcommitted elsewhere, and I question their ability to provide a counterweight to the Pigott tradition. For example, director William Reed also serves on the boards of Microsoft (MSFT, news, msgs), Safeco (SAFC, news, msgs), Simpson Resource, The Seattle Times and Washington Mutual (WM, news, msgs). Maybe thats why CEO Pigott was paid so much in 2002: a salary of $1.1 million and a bonus of $1.1 million plus stock options worth $10.5 million, according to Paccars most recent proxy.
Now, e-mail me anything you know about the new nominees: Should they be on the Clean Stocks list? Meanwhile, send me your nominations for the next round.
Buy Applebees International (APPB, news, msgs)
Its well managed: At 24%, the companys return on invested capital is the best in the casual dining segment of the restaurant sector. Theres still plenty of growth ahead of it: Wall Street projects earnings per share will grow by 15% a year on average over the next five years. And the stock is value-priced. Shares are trading at just 19 times projected 2003 earnings per share and just 17 times projected 2004 earnings. (The stock also joined my Clean Stock list with my Sept. 19 column.) As of Sept. 19 Im setting a target price of $39 a share by June 2004.
New developments on past columns
3 food stocks face a leaner, meaner world
Smithfield Foods (SFD, news, msgs) has new competition in its bid to buy the pork processing unit of bankrupt Farmland Foods. On Sept. 12 privately held Cargill offered $385 million, topping Smithfield Foods bid by about $20 million. Cargills beef and pork operation, Excel, now holds about an 8% share of the U.S. pork market. Adding the pork unit of Farmland, once North Americas largest farm cooperative, would increase that share to 14%. Smithfield now controls about 20% of the pork market. That share would increase to 26% with a Farmland acquisition. The deal will go to an auction sometime before Oct. 13.
Editor's Note: A new Jubaks Journal is posted every Tuesday, Wednesday and Friday. The Wednesday edition stems from Jim's appearance on CNBCs Business Center most Wednesday nights at approximately 5:45 p.m. ET. Selected CNBC stories can be found in the TV Reports index.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Smithfield Foods and T. Rowe Price Group. He does not own short positions in any stock mentioned in this column.
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