The Home Depot, The TJX Companies, And ICON PLC: Three Safe Stocks In A Stormy Market – Forbes

Posted: March 18, 2020 at 2:47 am

This is a picture of a storm as it is building up over an uncultivated agricultural field and some ... [+] wind turbines in the horizon. It was shot at a location in the eastern part of the Netherlands.

This week, were highlighting three stocks to buy that have been dragged down by the current market turmoil. These stocks are for great companies whose valuations are a little high. If those valuations decline, investors should scoop up these quality businesses. The Home Depot (HD), The TJX Companies (TJX), and ICON PLC (ICLR) are this weeksLong Ideas.

Market Fears Drive Overreactions

The global outbreak of the coronavirus has rattled the market. Investors and analysts alike are concerned about its impact on the global economy. The S&P 500 recently had itsworst weeksince October 2008 while entering correction territory at thefastest rate in history.

World leadersandexpertsbelieve the outbreak will get worse, which could lead to further downside in the market. However, its not all bad news for investors. Over the long-term, market corrections present great money-making opportunities, as Warren Buffett says be greedy when others are fearful.

Focus on ROIC It Drives Valuations

The winners both during and after a market crash,as I have shown, tend to be companies that earn a high return on invested capital (ROIC). Furthermore, there is astrong correlationbetween improving ROIC and increasing shareholder value. To that end, I began my search looking for companies with consistently high and/or rising ROICs.

In addition to high ROICs, the firms below have a history of risingcore earnings[1],economic earnings. and positivefree cash flow. Each of these companies are high-quality, value-creating businesses. However, as Figure 1 shows, their price-to-economic book value (PEBV) ratios show that the market still expects a significant amount of growth from them. PEBV compares the current valuation of a company to its zero-growth value. A PEBV of 1 would mean that the market expects the companys cash flows to stay flat into perpetuity.

Figure 1: Three Stocks Worth Buying If Prices Correct Further

Three Stocks To Buy After Prices Fall

MyStock Rating Methodologyconsiders a PEBV below 1.6 but above 1.1 to be attractive and a PEBV below 1.1 but above 0 to be very attractive. These companies are still less expensive than the S&P 500 (SPY) with a PEBV of 2.6 but more expensive than the stocks I typically recommend. As global fears send markets falling further, it could present an opportunity to get these quality businesses without paying a premium.

ICON, PLC (ICLR) Attractive Rating

ICON, PLC (ICLR) was recently upgraded to attractive (from neutral) after I parsed its 2019 20-F (filed on February 27, 2020). I first made ICON a Long Idea inMay 2017. The company remains a leading contract research organization (CRO) and a drop in price presents a great buying opportunity.

Over the past decade, ICLR has grown revenue by 12% compounded annually and core earnings by 16% compounded annually, per Figure 2. The firm has increased its net operating profit after-tax (NOPAT) margin year-over-year (YoY) in seven of the past 10 years and its 2019 NOPAT margin of 15% is up from 11% in 2009. ICLR has improved its ROIC from 16% in 2009 to a top-quintile 25% in 2019 and has generated $859 million (9% of market cap) in cumulative free cash flow over the past five years.

Figure 2: ICLRs Revenue & Core Earnings Since 2009

ICLR Revenue And Core Earnings

In 2019, ICLR had -$26 million in earnings distortion that caused GAAP earnings to be understated. Notable unusual expenses in ICLRs 20-F include:

These unusual expenses were partially offset by:

Only by removing these unusual expenses and gains can I evaluate the core earnings of ICLRs operations. In total, I identified $0.48/share (7% of GAAP EPS) in net unusual expenses in ICLRs 2019 GAAP results. After removing this earnings distortion, ICLRs 2019 core earnings of $7.27/share are higher than GAAP EPS of $6.79.

I define "hidden" expenses and gains in the same manner as Harvard Business School & MIT Sloan in this recent paperon the topic. More details on exactly what I mean by "hidden" versus reported results are here.

ICLRsEarnings Distortion Score(as featured on CNBC Squawk Box)is currently In-Line, which means I expect it to report in-line with consensus expectations. Earnings Distortion Scores provide investors with a short-term look at the likelihood a firm will beat/miss consensus expectations. Longer-term, I focus on my overallRisk/Reward Ratings, which take into account a firms historical profitability and the level of expectations baked into the current stock price. As noted above, ICON PLC earns an attractive Risk/Reward rating, which means it provides quality risk/reward going forward, even if its not more likely to beat consensus expectations in the coming quarter.

Economic Earnings Growing Faster Than Core Earnings

Core earnings account for unusual gains and expenses included in GAAP net income. To get the full picture of a companys operations and hold management accountable for capital allocation, I also analyze balance sheets to calculate an accurate ROIC andeconomic earnings, the truestdrivers of shareholder value.

Some notable adjustments to ICLRs balance sheet include:

After all adjustments, I find that ICLRs economic earnings grew 20% compounded annually over the past five years and 18% compounded annually over the past decade.

Shares Starting to Look Cheap

At its current price, ICLR has a price-to-economic book value (PEBV) ratio of 1.3.

The expectations baked into ICLRs valuation remain low relative to the firms historical growth and expected industry growth. Even if I assume ICLR simply maintains margins and grows NOPAT by 7% compounded annually (in-line with projected industry growth) for the next decade, the stock is worth $189/share today 45% above its current price.See the math behind this reverse DCF scenario.

Leading Profitability Amongst Competitors

As I pointed out in my original Long Idea, ICLRs lean cost structure and operational efficiency give it a competitive advantage over peers. Such an advantage is still present today. Per Figure 3, ICLRs ROIC and net operating profit before-tax (NOPBT) margin rank well above its publicly traded competitors (as listed in thefirms 20-F). I use NOPBT margin in the below comparison because being domiciled in Ireland provides a unique tax advantage for ICLR.

Figure 3: ICLRs Profitability Leads Competition

ICLR Profitability Vs. Peers

The TJX Companies (TJX) Attractive Rating

I first featured The TJX Companies (TJX) as a Long Idea inApril 2018. The company remains a best-in-class off-price retailer that is worth a close look after a market downturn.

Since 2009, TJX has grown revenue by 7% compounded annually and core earnings by 12% compounded annually, per Figure 4. TTM core earnings are up 5% over fiscal 2019.The firms profit growth can be attributed to its rising profitability, as its NOPAT margin has increased from 5.5% in 2009 to 8.2% TTM while its ROIC improved from 12% to 19% over the same time.

Figure 4: TJXs Revenue & Core Earnings Since 2009

TJX Revenue And Core Earnings

TJXs Earnings Distortion Score is currently In-Line, which means I expect it to report in-line with consensus expectations. As noted above, The TJX Companies earns an attractive Risk/Reward rating, which means it provides quality risk/reward going forward, even if its not more likely to beat consensus expectations in the coming quarter.

Economic Earnings Growing Even Faster

I analyze balance sheets to calculate an accurate ROIC and economic earnings and made the following adjustments to TJXs balance sheet:

After all adjustments, I find that TJXs economic earnings grew 13% compounded annually over the past decade.

Shares Are Almost a Bargain

At its current price, TJX has a price-to-economic book value (PEBV) ratio of 1.4.

At its current valuation, TJX investors benefit from a 1.8% dividend yield and 23 consecutive years of dividend growth. A market correction would make this high-quality company an even better stock.

The expectations baked into TJX remain low relative to the firms historical growth and consensus estimates. If I assume TJX can improve margins to 9% (from 8% TTM) and grow NOPAT by just 6% compounded annually for the next decade, the stock is worth $70/share today 70% above its current price.See the math behind this reverse DCF scenario.

TJX Bucks the Retail Apocalypse Narrative

In a retail environment where the weak are getting increasingly left behind, The TJX Companies has proven its staying power. Apart from the improving profitably noted above, TJX reported fiscal 2019 was its 24thconsecutive year in which comparable store sales grew year-over-year. The firms ability to grow comparable store sales for over two decades is a testament to TJXs value proposition to consumers and the ability to efficiently manage its operations.

As Rod Sides, vice chairman of Deloitte, and its U.S. retail and distribution sector leaderstated, off-price stores can help provide price relief during a more challenging economy. But, even in times of economic growth, these stores still do well. For a significant portion of the population, price and value are important from an income standpoint, and off-price is therefore very relevant and successful.

The TJX Companies has leveraged this success to achieve leading profitability in its industry. Of the 11 Discount Stores under coverage, TJX earns the highest ROIC and NOPAT margin.

Management Now Incentivized to Create Shareholder Value

TJX has achieved its past success despite not properly aligning executives interests with shareholders interests. Not anymore. Beginning in fiscal 2019, TJX introduced a newexecutive-compensation planthat seeks to balance growth, profitability, and returns.

Under this new plan, TJX added ROIC as a performance modifier to its long-term performance share program, which made up the largest portion of executives long-term incentives. ROIC was chosen to reinforce attention to capital investments and generating returns.

Going forward, if TJX fails to meet its ROIC performance goals, executives long-term performance share awards will be reduced by 20%. While I would recommend TJX use ROIC as more than just a modifier, I still applaud the compensation committees decision to hold executives accountable for prudent stewardship of capital. This improved compensation plan, along with TJXs strong fundamentals earned it a spot in FebruarysExec Comp Aligned with ROICModel Portfolio.

The Home Depot (HD) Attractive Rating

The Home Depot (HD) was recently upgraded to attractive (from Neutral). HD has long been on my radar, but its premium valuation has turned me to cheaper stocks. Further declines in this stock would make me an avid buyer.

Over the past decade, the company has grown revenue by 4% compounded annually and core earnings by 13% compounded annually, per Figure 5. The firm has increased its NOPAT margin every year since 2009 and its TTM NOPAT margin of 11% is up from 5% in 2009. HD improved its ROIC from 9% in 2009 to a top-quintile 32% TTM and generated $43.5 billion (17% of market cap) in cumulativefree cash flowover the past five years.

Figure 5: HDs Rising Core Earnings Over Past Decade

HD Revenue And Core Earnings

HDs Earnings Distortion Score is currently Miss, which means I expect it to miss upcoming consensus expectations. However, HD has proven resilient when missing expectations in the past, as investors focus on the long-term profit growth achieved by the firm. Looking over the long-term, The Home Depot earns an attractive Risk/Reward rating, which means it provides quality risk/reward going forward, even if its not more likely to beat consensus expectations in the coming quarter.

Economic Earnings Are Growing Too

I made the following adjustments to HDs balance sheet:

After all adjustments, I find that HDs economic earnings grew 20% compounded annually over the past decade and 16% compounded annually over the past two decades.

Shares Nearing a Buying Opportunity

At its current price, HD has a price-to-economic book value (PEBV) ratio of 1.5.

Even at its current valuation, HD investors still benefit from a 2.9% dividend yield and seven consecutive years of dividend growth. A market correction would make this high-quality company an even more attractive stock.

Best of all, the expectations baked into HDs stock price remain conservative. If I assume HD can improve margins to 12% (from 11%) and grow NOPAT by just 6% compounded annually for the next decade, the stock is worth $241/share today 46% above its current price.See the math behind this reverse DCF scenario.

Industry Leader with Leading Profitability

From Home DepotsInvestor Presentation, HD is the #1 home improvement retailer in the United States, Canada, and Mexico. Furthermore, the firm estimates it has captured just 15% of its total U.S. market opportunity of ~$650 billion.

My research indicates HD has leveraged its industry leading position to achieve greater profitability over its peers. Of the five Home Improvement Products & Services Retailers under coverage, HD has the highest ROIC and second highest NOPAT margin. HDs profitably looks particularly impressive against its closest peer, Lowes Companies. Per Figure 6, HDs NOPAT margin is nearly two times greater than LOWs while its ROIC is nearly three times greater.

Figure 6: HDs Profitability Advantage Over LOW

HD Profitability Vs. LOW

Executives Interests Aligned with Shareholders Interests

Its no coincidence that HD has significantly improved margins, profits, and ROIC over the past decade, its executives are paid to do so. In fiscal 2007, Home Depot added an ROIC performance goal to its long-term incentive plan. The firmsproxy statementnoted the decision to add ROIC was based on the Companys desire to focus management on the efficient use of capital. Since adding ROIC to its executive compensation plan, HD has improved ROIC from 15% in 2007 to 32% TTM.

In its latest proxy statement, HD disclosed that one half of executives performance based share awards are contingent upon achieving a target three-year average ROIC goal. The performance share award makes up anywhere from 29-33% of executives total compensation. HDs executive compensation plan lowers the risk of investing in the company as I know its executives are incentivized to create true shareholder value. This compensation plan, along with strong fundamentals earned HD a spot in FebruarysExec Comp Aligned with ROICModel Portfolio.

Macro Conditions Bode Well for HD

Going forward, macro-economic data suggests continued growth for Home Depot and the home improvement industry in general. According to data from the American Housing Survey andHome Depot, over 50% of homes in the U.S are over 40 years of age, and nearly 80% of homes are over 20 years old. Home Depotnotesthat home improvement spend per home increases with the age of the home.

Additionally, homeowners have greater capacity to improve their homes than any time in history. CoreLogic, an industry data provider,reportedthat homeowner equity reached all-time highs in the first half of 2019 while homeowner equity has more than doubled since the housing recovery began. Home equity allows homeowners greater financial freedom when undergoing a home improvement project and bodes well for the home improvement industry.

The Importance of Quantifying Expectations

At the end of the day, declines in these companies stock prices would change very little about the strength of their businesses. When searching for value, its important to understand theexpectations already baked into a stock price. My Company Valuation Modelsincorporate all the data from financial filings to truly assess whether a firm is under or overvalued and provide an accurate representation of the risk/reward in a stock.

Disclosure: David Trainer, Kyle Guske II, and Matt Shuler receive no compensation to write about any specific stock, sector, style, or theme.

[1]My firms Core earnings are a superior measure of profits, as demonstrated in InCore Earnings: New Data & Evidencea paper by professors at Harvard Business School (HBS) & MIT Sloan. The paper empirically shows that my data is superior to IBES Street Earnings, owned by Blackstone (BX) and Thomson Reuters (TRI), and Income Before Special Items from Compustat, owned by S&P Global (SPGI).

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The Home Depot, The TJX Companies, And ICON PLC: Three Safe Stocks In A Stormy Market - Forbes

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