Jubak's Journal
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5 stocks playing the spread
No, not the point spread. These companies are benefiting from the widening spread between their revenue and costs.
By Jim Jubak
Is inflation good or bad for corporate earnings?
Inflation can certainly take a bite out of profits if the cost of the raw materials that a company buys rises faster than the price that the company can charge for its finished products. Or inflation can give profits a boost if it gives a company the power to raise prices faster than its raw material costs are climbing.
In other words, at a time like this when inflation is getting pretty frisky in some economic sectors, its all about the spread between revenue and costs. And the best place for equity investors to put their money in this environment is in the shares of companies where the spread between revenue and costs is increasing.
Theres certainly more than one way to increase that spread. For example, the economy can hand a company a temporary advantage by driving down demand for its raw materials, cutting costs, while demand for its products increases. Thats exactly the situation for some steel companies such as Nucor (NUE, news, msgs) now.
Finding efficiencies
Or a company can increase the spread between revenue and costs by finding operating efficiencies that drive down its own costs at the same time as returning inflation gives it the opportunity to raise prices. This is the situation at electrical component maker Thomas & Betts (TNB, news, msgs).
Or a company can increase its spread by being smarter than its competitors. The smart company figures out how to keep costs steady despite inflation while its less savvy competitors see their costs jump. As those cash strapped competitors try to save themselves by raising prices, the smart company has the luxury of choosing either to go along (and see revenue increase) or to keep prices steady (and see market share climb). This is working in Southwest Airlines' (LUV, news, msgs) favor in the airline industry.
Heres how the spread is working in favor of these three companies.
A steel sweet spot
Nucor looks like its in the sweet spot of a complicated steel economy.
News that China was looking to slow its economy initially knocked the stuffing out of steel stocks as traders assumed that country would order less steel. That hasnt happened, and it now looks like Chinese restrictions aimed at making it harder to finance new steel mills and other industrial projects will take steel supply out of the market while leaving Chinese demand for steel imports about the same at 40 million metric tons.
Steel prices have climbed since April and are projected to climb again in June. Some steel companies arent getting much benefit from higher prices, however, since the costs of metallurgical coal and coke for making steel have climbed, too. But companies like Nucor that use scrap steel to make new steel and dont need to buy those raw materials are seeing spreads increase. Scrap prices have fallen about 20% from their March high thanks to supply increases.
Nucor's shares trade at nine times projected 2004 earnings per share.
The cost-cutting approach
Thomas & Betts is most of the way toward its goal of driving selling, general and administrative costs down to 20% of revenue. These expenses fell to 20.7% of revenue in the first quarter, down from 23.4% a year earlier. The decline puts the company within striking range of its goal of increasing gross profit margin to 30%; in the first quarter, it hit 28.2%.
The companys cost-cutting remains on track because, so far, it has been able to pass along the raw material cost increases to customers. It has used a steel surcharge for customers of its steel structures for power lines while boosting prices on its electrical connectors. The shares trade at 26 times trailing earnings and at 20 times projected 2004 earnings.
The friendly skies
Southwest shows that sometimes your competitors can be your best friends.
Airlines that didnt hedge their fuel costs by locking in lower prices months ago are getting killed by $40-a-barrel oil. At Continental Airlines (CAL, news, msgs), for example, every 1-cent increase in jet-fuel prices adds about $16 million to the companys annual pre-tax fuel bill. As of May 21, Continental was looking at a fuel bill about $700 million higher than the airline had budgeted.
Continental didnt hedge its 2004 fuel bill until near the end of the current spike in oil prices; most other of the U.S. majors didn't hedge at all. That has left Continental and the majority of U.S. airlines desperate to raise prices even though the these airlines know that even a $2 increase in ticket prices sends customers to the low-fare competition.
All this works to the advantage of Southwest, which is about 80% hedged for 2004. (JetBlue Airways (JBLU, news, msgs) is next-best hedged at 40%.) Any price increases by competitors send traffic Southwests way or lets the company raise its prices. If the majors dont boost revenue, theyll face capacity cuts and labor turmoil as they struggle to find ways to offset jet-fuel costs.
Southwest shares recently traded at 28 times trailing earnings, and the stock is trading near September 2001 lows.
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Portfolio Recovery Associates (PRAA, news, msgs) is the beneficiary of an increase in the supply of its raw materials, bad consumer debts. In the first quarter, the company bought defaulted debts with a face value of $613 million for $15 million. That was a cost of just 2.46%, down from the 3.05% Portfolio Recovery paid in the fourth quarter. Cash collected, meanwhile, increased by 35% over the first quarter of 2003.
The defaulted debt supply just keeps on growing, too. The company reported that the amount of debt available for purchase was up 50% from the 2003 first quarter. About 77% of the defaulted debt that the company bought in the first quarter was comprised of credit-card receivables. But for the first time, the company bought receivables from bankrupt debtors and defaulted utility debt. Given the level of consumer debt in the U.S. economy, I wouldnt expect Portfolio Recovery to run out of raw material any time soon, and Id expect to see the price it pays continue to fall.
The shares trade at 18 times trailing earnings and 16 times projected 2004 earnings.
Commercial Metals (CMC, news, msgs) is riding the same steel spread as Nucor. The company has pre-announced earnings of $1.50 to $1.70 a share for the May quarter, which would be its biggest quarterly earnings ever. Goldman Sachs projects that the company will earn $4.50 a share in fiscal 2004, which ends in August. The shares recently traded at six times those projected 2004 earnings per share.
Editor's Note: A new Jubaks Journal is posted every Tuesday and Friday.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak did not own shares in any of the equities mentioned in this column. He does not own short positions in any stock mentioned in this column.
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