Business services provider Cintas (CTAS) has experienced decent appreciation in their stock over the past month, essentially the up-trend started soon after they lowered guidance for the second half of their fiscal year.  As a provider of uniforms and other related business services products like fire safety equipment that help other businesses operate more smoothly, the recession and its effect on employment has been rough on Cintas.  However, since they revised guidance downward, management has said they are heartened by the slowing in job losses and can perceive a general improvement in the economy.  Apparently, the market agrees with this outlook as the stock has moved steadily higher by about 18% in just over a month.

The last quarterly results came in above the more conservative guidance, as EPS came in at $.32 and beat consensus analysts’ estimates of $.30.  Sales fell 5.2% to about $862 million, but topped Wall Street’s view of $854 million.  The market’s reaction has been a muted 1% rise, as these results would have fallen short of expectations before the downward guidance.  For the quarter ahead, management left the EPS outlook unchanged at $.30 to $.34.  Cintas is currently trading at just over 18x trailing twelve month earnings, but only 15x 1-year forward earnings per share.  Clearly, some improvement to the employment situation is baked into the forward looking estimates.

As you can see from our valuation history chart, we have rated CTAS as Undervalued for the last few years and we are reiterating that rating this week.  Given the current fundamentals, Cintas trades for about 10.1x price-to-cash earnings, while CTAS has normally traded for 11.8x to 17.1x cash earnings per share over the last ten years.  Better operating performance has enabled the company to maintain strong cash flow even while sales are down.  Furthermore, the historically normal range of price-to-sales is about 1.56x to 2.23x, but the metric for this fiscal year’s sales is well below that range at just 1.2x.  Based on the market’s historically normal valuation ranges, we think it is reasonable to believe the stock may be able to attain $32 per share before we would consider a downgrade to fairly valued.

We think that jobs will begin to return to the US economy in the next few months, but they will not soon recover to pre-recession levels.  That being said, Cintas may not be the most attractive stock in this environment, but we think it does have decent underlying value, and if the job recovery surprises to the upside CTAS would be a clear beneficiary of that trend. 

Steel Dynamics (STLD) has had a rough couple of weeks as the shares are trading 23% lower since January 8th.  On Wednesday. the nation’s fifth largest producer of carbon steel products reported net income of $26.7 million which equates to 12 cents per share and missed analysts’ estimates by five cents.  With that said, the company did grow production by 31% and topped analysts’ view of revenue which totaled $1.18 billion.  The company also lowered production costs 18%, but this was trumped by declines in steel prices.

For the year, revenue fell by 51% to $4 billion, and earnings per share showed a four cent loss.  However, analysts have projected a much stronger fiscal 2010 as they expect to see $1.37 per share in earnings, and the median price target is $22.75, a full 50% higher than the current price.  Steel Dynamics was able to greatly expand their tonnage produced in the last quarter while lowering production costs, but clearly these analysts’ projections are forecasting steel prices to rise as the global recovery continues.

Steel stocks have benefited greatly from hopes of recovery, particularly relating to resource hungry China.  However, there are growing concerns that both the Chinese and U.S. economies may not yet be out of the woods.  China’s GDP in the last quarter topped double digits which leads many to believe that their central bank will restrict the flow of cheap capital.  Furthermore, an executive for a Chinese steel producer recently said that domestic capacity is “reasonable” to meet demands.  In the United States, demand for steel used in building projects remains very weak, and continued trouble in the labor market dampens the perception of robust economic recovery.  For a stock like Steel Dynamics, which at one time had quadrupled from the lows, the renewed economic concerns are troubling investors.

As for the Ockham valuation, we continue to have an Overvalued stance coming into this week.  This stock had advanced well ahead of actual fundamental improvements, which is a key reason for the sell off today.  Generally, we look to find stocks that have seen their revenue and earnings grow but that improvement has yet to be reflected in the price.  With Steal Dynamics it is the inverse situation, so we believe there is still some downside risk as the price was being supported largely by sentiment.

In an interview with Bloomberg prior to the release of key unemployment data, Nobel Laureate Edmund Phelps discussed what he sees as the “new normal” for the U.S. economy.  His view is that the U.S. should prepare for times of greater than normal average unemployment, and the economy as a whole has less ability or urge to innovate, something he termed dynamism.

While the economy grew the most in two years in the third quarter and the decline in payrolls may bottom in the first quarter of 2010, that doesn’t change the fact that the economy has lost its “dynamism,” Phelps said.

The jobless rate in the medium-term may settle at between 6 percent and 7.5 percent, said Phelps, who was speaking before the payrolls data was published. That compares with a 4.9 percent average in the decade through 2007.

Economists’ Battle

“As output goes up, employment is going to continue to lag,” said Phelps. “Firms have gotten rid of a lot of their workforce cushion, so to speak, and they’re going to do without that for a quite a while.” — Bloomberg.com 11/6/2009

After Phelps’ interview we learned that the closely watched release of non-farm payroll data indicated that the real economy remains distraught.  About 190,000 jobs were lost in October bringing the unemployment rate four-tenths higher to 10.2%.  So much has been made of the unemployment rate crossing the 10% line, but that is largely a psychological barrier that reveals little new information.  The fact remains that this is the worst labor market that we have seen in at least 26 years and possibly longer before all is said and done.  Everyone knew that the labor market would lag the recovery in the economy, but for how long?

Over the last eight months, the market has brushed aside job losses and other bearish economic data in favor of the recovery thesis.  Job losses and the like are acceptable because there are other signals that growth will soon return.  Considering third quarter GDP yielded a return to growth thanks in no small part to government stimulus efforts, some market observers must wonder if jobs losses even matter then days.  The quintessential question that investors must ask in this circumstance, are we in the midst of a tremendous bear market rally or is this going to be a jobless recovery?

It seems from where we are now that there is little possibility for something other than these two scenarios.  The deepest recession since World War II has finally begun to show growth based on the most widely accepted measure of economic health, the Gross Domestic Product.  Yet, businesses are not willing to hire new workers, and a recent jump in productivity numbers suggests that existing workers are able to pick up the slack.  It has been about half a century since productivity has accelerated as quickly as it has in the past two quarters.  We hope that this will lead to companies hiring more in the next few months in order to expand and grow, and temp worker hiring has risen for three straight months.  That being said, most analysts and economists are not expecting net job growth until the beginning of next year at the earliest.

At Ockham, we tend to agree with Phelps’ assessment that this recovery is running out of gas.  There is simply too much strain on the economy from the growing numbers of unemployed to expect that consumer spending will boost us during the holiday season.  Similarly, foreclosure filings continue at a very rapid clip, straining banks and the housing market in general.  The stock market has enjoyed a fabulous run in the last few months, but it appears to be petering out.  We avoid making predictions about short term market movements, but one has to wonder over the next few months where will the upside in the market come from?  With the real economy still limping along in a recession mentality, where will the rally turn for a refueling?

The “father” of the securitized mortgage market, Lewis Ranieri, has drawn some attention for his views on the current real estate market.  Formerly of Salomon Brothers, Ranieri pioneered the practice of bundling government-backed mortgage bonds to create new debt securities, which was a highly profitable business.  As we all know now, the market for mortgage backed and other collateralized debt obligations collapsed in the face of declining asset values last year, leading to the greatest financial crisis in decades.  Of course, Ranieri now of Hyperion Partners, cannot be blamed for the perfect storm of circumstances that lead to the credit crunch, and we think his assessment of the real estate market is very credible.

In short, Ranieri says that expectations of an “instant gratification”, V-shaped recovery is unrealistic.  Far more likely he says, would be a slow two-plus year recovery.  Residential real estate has started to show signs of stabilization as the home sales data has improved and the S&P/Case-Shiller home price index has increased for the first time since the peak in 2006.  Ranieri says that most of the credit for that goes to the government’s extraordinary efforts; providing tax credits to new buyers, buying more than one trillion dollars worth of mortgage bonds to lower rates and increase affordability.  However, the recovery thus far has been seen in the lower priced homes and at current sales rates there is more than 4x more supply for properties worth more than $750,000. 

His fear is that rising mortgage rates and still prevalent foreclosures make the improvements seen thus far “still very fragile.”  The expiration of tax incentives, and the Fed’s program to buy mortgage bonds by the end of this year could drag on this market.  Even though the subprime crisis has largely been dealt with, Alt-A mortgages will continue to put pressure on the housing market going forward into next year.

Ranieri also thinks that commercial real estate will continue to be a thorn in the side of economic growth.  Persistently high unemployment rates could add to the strain in some already overbuilt areas, and banks with heavy exposure to CRE loans could be at risk.  Many experts believe that commercial real estate follows residential real estate in the real estate market cycle.  From Bloomberg.com,

‘Major Risk’

Commercial real estate is the “major risk” to the economy, Ranieri said, adding that he agrees “with a number of the Fed governors that it may very well be a very deep problem.”

Dennis Lockhart, president of the Federal Reserve Bank of Atlanta, said in Sept. 10 speech that “one risk I’m watching is the interplay of commercial real-estate and the financial sector.”

Since peaking in 2007, commercial-property values in the U.S. have plummeted 36 percent as banks restricted lending after mortgage losses and the collapse of the commercial-mortgage bond market, according to Moody’s Investors Service. The property market is unlikely to recover before 2012 and office rents in New York and San Francisco may drop 20 percent through next year, according to the quarterly PricewaterhouseCoopers Korpacz Real Estate Investor Survey released today.

At Ockham, we share Ranieri’s view that the recovery is going to be a slow one and the economy is still at risk for further trouble.  There are of course signs of stabilization all around us, but as we learned a year ago that could change very rapidly.  The stock market has priced in quite a bit of economic improvement and may be out ahead of itself right now.  Even with continued improvement and a return to economic growth, a small pull back would not be a surprise at this point.  However, any further major issues in the real estate sector could bring financial stocks down along with it.  According to Ranieri, we are still on shaky ground and caution is certainly warranted.

Toll Brothers (TOL) alluded to another painful quarter as the luxury homebuilder expects to take another bigger than expected write-down, this one in the neighborhood of $90 to $160 million.  The company issued its earnings outlook ahead of the official release two weeks from today, and Toll said that revenue has slipped 51% in the quarter.

“Luxury home builder Toll Brothers reports 2Q revenue of $398 million, that’s still 51% year-ago levels.” CNBC’s Squawk Box 5/20/2009

Closings were down 47% from a year ago, and the backlog of business fell 55%.  The bright spot in the release was the fact that the company has increased its stockpile of cash to about $2 billion, a stunning $12 per share.  This is a certainly a surprise as the company is projected to lose about $1.40 in fiscal 2009, and they are writing down the value of assets each quarter.  I have not heard of major asset sales, so the increased cash on hand must be reflective of the $400 million worth of notes they issued in April.  So, the cash hoard was not generated organically, and has added to Toll’s long term debt.

The stock has risen close to 3% in morning trading, which suggests the market is feeding off of Chairman and CEO Bob Toll’s remarks that suggest the worse is likely over in the housing market.

“With interest rates at an historic low, home price affordability at an historic high and consumer confidence starting to improve, we believe that more buyers are beginning to enter the housing market…Despite a weak economic and employment landscape, which was reflected in fiscal 2009’s second-quarter contracts, we have a few reasons for cautious optimism.  The most encouraging is our recent deposit activity.”–Bob Toll

Mr. Toll is correct to be cautious with his optimism, as just two days ago housing starts activity reported a record low for April.  In addition, April foreclosures were at a record pace as well.  There is still an oversupply of homes for sales it has just a shifted the supplier from home builders to banks holding foreclosed homes.  The worsening trend in foreclosures should give pause to anyone who thinks the housing market has certainly bottomed because foreclosures are bad for two reasons: they are destructive to demand as those foreclosed upon are very likely taken out of the buying pool and foreclosures increase supply at a time where there is already an imbalance.

At Ockham, we are confident to reaffirm our Overvalued rating on Toll Brothers because the price is still too high for the greatly eroded fundamentals.  Toll Brothers, whose stock one would think would be very effected by current market conditions, has been largely resilient thus far.  The stock is only down 27% from its 52-week highs, even as revenue and earnings are disappearing.  Furthermore, Toll is a luxury homebuilder which will be a tough place to be for some time, as home values have declined on existing homes making them even better competition.  So, even if the worst is over, which it may be, we think there are better stocks to take advantage of the recovery.