RealMoney Silver - YRCW Is Cheap, but Look Elsewhere

YRCW Is Cheap, but Look Elsewhere
By Bill Trent
RealMoney.com Contributor
12/6/2007 2:01 PM EST

YRC Worldwide (YRCW) shares are pricing in a much lower EPS outlook than the consensus is calling for. For the very risk-tolerant, this could offer a buying opportunity, but there are safer names in the trucking sector.

Nobody believes the trucking company will earn the consensus estimate of $2.52 a share in 2008. If they did, the stock would be trading significantly higher than $17.50.

After all, the company earned $5.00 a share in 2006 and is expected to pull in $2.40 a share this year. If this year is really "the bottom" for earnings, investors should be willing to pay at least $30, which would be in line with the company's five-year average P/E of 12 times.

Investors clearly think YRC will earn less -- probably much less -- than $2.52. The questions then become:

How much less will it earn?
Does the current stock price reflect the worst-case scenario?
If nobody believes YRC will earn $2.52 a share in 2008, how did it become the consensus estimate?

I'll leave the last question to philosophers, but I think I can take a stab at the first two.

How Low Can It Go?

To get a feel for the potential earnings bottom, I looked at the history available from Zacks Research Wizard.

Source: Zacks Research Wizard

The per-share earnings can clearly be much lower than $2.52. In fact, the last economic slowdown included a year that wiped out the peak year, the subsequent down year and a good part of the next year's recovery. Furthermore, the late 1990s also indicate that several down years can wipe out a good deal of the positive earnings in up years. All of this goes to show why I prefer the non-asset-based transportation companies like Landstar (LSTR) and CH Robinson (CHRW) .

So one approach to valuation would be to take a page from Ben Graham's The Intelligent Investor -- page 313 in my edition -- and use a longer-term average of earnings per share. I chose five years, giving me the following chart:

Source: Zacks Research Wizard, William A. Trent

Right away, I see two useful takeaways from this chart. One is that the trough-peak pattern of 1999-2001 looks very similar to the one in 2004-2005. This gives me some confidence that this cyclical relationship may represent the next cycle as well. The other noteworthy observation is that the cumulative peak-peak growth rate from 2001-2006 is about 25%.

Applying 25% growth from the 2004 trough gives me a target for the average EPS in the next trough -- about 44 cents. This helps me answer the first question (as well as providing some indication of how severe the negative earnings year(s) will have to be in order to push the five-year average that low).

Is the Worst Case Priced In?

An old rule of thumb is to buy cyclical stocks when the P/E is high and sell when it is low. This is because the P/E is high when earnings are at their lowest and about to recover. Just looking at the estimates for YRC, though, shows you that the current P/E is low.

But we already established that the estimates aren't believed. If the five-year average EPS is about to drop to 44 cents, the stock is currently trading at about 40 times trough earnings. That sounds like the "high P/E" that would signal a buy.

And whaddya know? It looks from this chart that as YRC started to pull out of the last earnings trough, it was getting a multiple of about 40 times earnings. Furthermore, the stock is now trading below its levels five years ago even though the general EPS trend has been up.

This doesn't, of course, imply that the worst is priced in. Nobody can really know that for sure. But it sure looks as though we're getting close.

Cash Flow Talks

Of course, I always prefer to look at companies on a cash flow basis rather than an earnings basis. Free cash flow (cash from operations less capital expenditures) has been negative for the last three quarters. Over the trailing 12 months, it comes to $68 million -- a 3% yield on the $2.3 billion enterprise value.

For accepting the risk related to a stock like YRCW, I would ideally like to get a higher return than I would from other investments, such as a 3.3% five-year Treasury bond. Although the current free cash flow yield for YRC is less than the Treasury yield, if the risk is mostly reflected, then proximity to the risk-free rate isn't necessarily bad.

Once again turning to a full-cycle perspective, the five-year average free cash flow for YRC is $152 million, and the current yield based on that figure is 6.6% -- twice the Treasury yield.

Twice the Treasury yield would normally justify the investment, particularly for investors who are either more optimistic or more risk-tolerant than I am. But Landstar is yielding even more with less risk (in my opinion) over the full cycle, so YRCW isn't enough to make me switch.