Recap from September’s Picks
Our Exec Comp Aligned With ROIC Model Portfolio (+1.8%) outperformed the S&P 500 (-0.4%) last month. The best performing stock in the portfolio was Southwest Airlines (LUV), which was up 8%. Overall, nine out of the 15 Exec Comp Aligned With ROIC Stocks outperformed the S&P in September.
The success of the Exec Comp Aligned With ROIC Model Portfolio highlights the value of our forensic accounting (featured in Barron’s). Return on invested capital (ROIC) is the primary driver of shareholder value creation. By analyzing footnotes in SEC filings, we are able to calculate an accurate and comparable ROIC for 3000+ companies under coverage.
This Model Portfolio only includes stocks that earn an Attractive or Very Attractive rating and align executive compensation with improving ROIC. We think this combination provides a uniquely well-screened list of long ideas.
New Stock Feature for October: Tenneco Inc. (TEN: $55/share)
Tenneco Inc. (TEN), automotive parts manufacturer, is one of the additions to our Exec Comp Aligned With ROIC Model Portfolio in October.
Since 2009, Tenneco has grown after-tax profit (NOPAT) by 25% compounded annually to $403 million in 2015 and $411 million over the last twelve months (TTM), per Figure 1. At the same time, Tenneco has improved its NOPAT margin from 2% in 2009 to 5% TTM and generated a cumulative $888 million in free cash flow over the past five years.
Figure 1: Tenneco’s NOPAT Growth Since 2009
Sources: New Constructs, LLC and company filings
Executive Compensation Aligned With ROIC Creates Shareholder Value
Tenneco has aligned executive compensation with the principles of Economic Value Added (EVA), aka economic earnings, since at least 1997, which is the earliest available electronic filing. While economic earnings have held steady in recent years, Tenneco has improved economic earnings from -$115 million in 2009 to $105 million TTM. ROIC has risen from 4% in 2009 to 11% TTM over the same time.
Figure 2: Tenneco’s ROIC & Economic Earnings Improvement Since 2009
Sources: New Constructs, LLC and company filings
Improving ROIC is directly correlated with creating shareholder value, and Tenneco’s focus on EVA ensures that executive’s interests are properly aligned with shareholders’ interests. 75% of Tenneco’s annual cash bonuses are tied to EVA improvement and Tenneco states it uses this approach because “EVA improvement performance is correlated with stockholder returns.” Per Figure 1, we see that linking executive compensation to economic earnings has resulted in improved economic earnings. Investors should see less risk and more upside in stocks where management incentives focus on economic earnings (aka EVA), the primary driver of which is ROIC.
TEN Is Significantly Undervalued
Despite the focus on EVA, the improving business fundamentals, and the stock price rising nearly 19% year-to-date, TEN remains significantly undervalued. At its current price of $55/share TEN has a price-to-economic-book value (PEBV) ratio of 1.0. This ratio means the market expects Tenneco’s NOPAT to never grow over the remainder of its corporate life. This expectation seems rather pessimistic for a firm that has grown NOPAT by 10% compounded annually since 1999.
If Tenneco can maintain TTM NOPAT margins (4.9%) and grow NOPAT by just 5% compounded annually for the next decade, the stock is worth $75/share today – a 36% upside. This scenario assumes Tenneco’s spending on working capital and fixed assets will be 1% of revenue, which is the average change in invested capital as a percent of revenue over the past decade.
Impacts of Footnotes Adjustments and Forensic Accounting
In order to derive the true recurring cash flows, an accurate invested capital, and a real shareholder value, we made the following adjustments to Tenneco’s 2015 10-K:
Income Statement: we made $348 million of adjustments with a net effect of removing $156 million in non-operating expenses (2% of revenue). We removed $252 million related to non-operating expenses and $96 million related to non-operating income. See all adjustments made to TEN’s income statement here.
Balance Sheet: we made $1.8 billion of adjustments to calculate invested capital with a net increase of $1.3 billion. The most notable adjustment was $665 million (31% of net assets) related to other comprehensive income. See all adjustments to TEN’s balance sheet here.
Valuation: we made $1.9 billion of adjustments with a net effect of decreasing shareholder value by $1.9 billion. A notable adjustment to shareholder value was the removal of $323 million due to pension-funded status. This lease adjustment represents 10% of Tenneco’s market value. Despite the net decrease in shareholder value, TEN remains undervalued.
This article originally published here on October 21, 2016.
Disclosure: David Trainer, Kyle Guske II, and Kyle Martone receive no compensation to write about any specific stock, style, or theme.
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