KeyStone’s Stock Talk Show, Episode 218.
We have a great show for you this week. We will start by talking about my interview this past week on Money Talks with Mike Campbell and our upcoming Electrification Special Report. We will also briefly talk Meta’s launch of Twitter competitor, Threads as well as an interesting takeover bid from death services company Park Lawn Corp (PLC:TSX) and Carriage Services Inc.(CSV:NYSE) – both companies we have interviewed in the past. Aaron answers a viewer question on AZZ Inc. (AZZ:NYSE) an industrial company that provides metal galvanizing and coating solutions to a number of end markets including infrastructure and renewable energy. The company just reported strong Q1 results on Friday with 89% growth in revenue and 63% growth in adjusted EBITDA. He will let you know if it is an opportunity. Brett has put together an interesting segment on Earnings Quality and how it ties into the valuation of a company. This topic comes up because, on the Show, we commonly highlight certain adjusted earnings or metrics within public companies report we do not agree with – and a simple explanation is in order. Finally, fresh off a weekend wedding (as it his or a friends – we are yet unsure), Brennan rips into a fellow Canadian Podcaster after viewing an ad for an “Easy ETF Portfolio” using BMO’s ETFs.
Let’s get to the show – my co-hosts Aaron Dunn and the killer B’s, Brett, and Brennan.
This weekend I was the guest of honour on Money Talks with Mike Campbell – we can put the link to the full show in our email we send out to listeners of this show and Brett, you can put it at bottom of the show on YouTube.
Always enjoyable to guest on that show – Mike is a great interviewer – really let’s you get your point across well and the discussion is free flowing. This weekend I updated Hammond Power (HPS.A:TSX), which I had recommended on Money Talks in March 2023, October 2022, and over 20 years ago in 2002 – stock is up 75% in the last 4 months, 203% since October, and over 4,300% when it was recommended at $1.15 in 2002 to clients – so Mike wanted an update and we went through our current thoughts on the company. That discussion dovetailed into some thoughts on our current research into the “Electrification Report” we are putting together.
We are working on it now, compiling individual reports and interviewing management teams – to give you and idea of what we are including in the report is a broad cross section on any stock influenced by the electrification boom the push to electrify the world, from EV and battery stocks to rare earths and electrical equipment, electrical engineering, electrical maintenance, grid-related software, electrical production (utilities), electrical components or materials used in electrical components, and more, this report started with 400 related stocks and includes statistical analysis on 50+ stocks with a number of high conviction potential BUY recommendations as we search for the next Hammond Power (HPS.A:TSX) – up 615% in 18 months – unknown “electrification” stocks set to benefit from what could be a decade or more long boom as the world moves electric. We also let you know what to avoid. It is set to be released this month.
I also discussed three stocks and detailed our long-term investment case for each company.
Meta Releases “Threads”
“Threads”, looks similar to Twitter, and lets users post messages, reply to other users, and like or repost messages. The service also lets users of Meta-owned Instagram follow the same accounts on Threads, which could help people add followers.
Meta’s Threads app debuted a day earlier than expected, offering billions of users with an alternative to Twitter amid growing frustration with the Elon Musk-owned social media service.
Threads had been slated to be released at 10 a.m. Eastern Time on July 6, but the company on Wednesday pushed forward its countdown clock to 7 p.m. Eastern time on July 5.
In terms of downloads, it has been met with historic early success.
Threads actually broke ChatGPT records for downloads this year:
- Reaching 100 million downloads in just 4 days.
- For some context on just how rapid the userbase growth has been, Twitter took roughly 3 years to do what Threads did in 1 day.
- With 330 million monthly active users, Twitter’s lead is narrowing quickly.
Now, Threads has a long way to reach anything close to the engagement numbers that Twitter boasts, but Zuckerberg certainly launched it amid further frustration with Twitter at an opportune time. Whether it does what FaceBook did to MySpace, remains to be seen.
Start with an interesting bit of news on a company we monitor combined with a company we actually interviewed in person coming out of Covid at the Roth Conference.
The news involves a leaked potential deal between Park Lawn Corp (PLC:TSX) and Carriage Services Inc.(CSV:NYSE).
Both company’s provide funeral and cemetery services, and merchandise – Carriage in the United States and Park Lawn in Canada and the U.S.
Event: In late June, Parklawn confirmed a rumored preliminary non-binding offer to acquire Carriage Services, Inc. (CSV:NYSE). Carriage had recently announced a strategic review process.
Carriage’s shares rose from the $27 range to around $34 as the leak was confirmed. The source of the leak has not been confirmed to our knowledge.
Details: The non-binding bid as per the leaked bid letter was an all-cash $34.00 per share offer which was an approximate 25% premium at the time the letter was issued on June 13. The bid letter indicates Park Lawn has a Private Equity partner to help finance the offer (that would be Brookfield Asset Management). No details are available regarding the financing structure, but Park Lawn noted that no public equity financing would be required. The bid letter points out a good strategic fit between the two entities, notably a complementary footprint (low regional presence overlap in U.S.), and meaningful synergy opportunity (again, no details in that regard). Often these deals take months to come together, so one might suspect talks are very the early stage with less due diligence executed. However, as Carriage is a public company with publicly reported financials, deals can come together quicker than if it was a private entity.
Interestingly, both deathcare companies have been experiencing weaker results in recent quarters trying to find a new normal post COVID as it appears death rates were higher during the pandemic and they are facing tough comparable periods in the near-term.
Carriage Services, Inc. (CSV)
- Revenue decreased 2.5% to $95.5 million.
- EPS declined 43% to $0.57 per share form $1.00 in Q1 2022.
While Carriage’s stock has surged on the takeover speculation, it is still down 13% over the past year and 48% since its 2022 highs. The stock trades at about 15 times its expected 2023 EPS – given the lack of current growth, it is likely more than fairly valued near-term. There is the potential for some back and forth between the two companies and the ultimate price to be higher than the $34.00 bid. We do not see significant upside unless another Deathcare company really wants the asset and is prepared to reach for it at a higher price.
It could be an opportune bid by Park Lawn, but I am certain the company is not pleased with the leak.
So, today I’m going to talk about Earnings Quality and how it ties into the valuation of a company. This topic comes up because we commonly highlight when we don’t like certain adjusted earnings or metrics companies report.
First off, what is earnings quality?
If you look online you’ll find slightly different wording and definitions. Here I’ll define earnings quality as how reliable earnings are for the current quarter and future quarters as well as how persistent earnings are going forward. Simply, how well the financials represent the company.
The need for analyzing earnings quality is due to our accrual accounting system versus pure cash flows. Accrual accounting attempts to reconcile cash flows with the actual operations of the business, as cash flows are lumpy.
A basic example of accrual accounting is if you were to purchase $80 of inventory in Q1 but did not sell any, under a cash system you would be down $80, whereas under accrual accounting you do not account for that inventory until sold, as you match the costs with revenue when it occurs. So in the next quarter Q2 if you sold the inventory for $100 you would recognize $100 in revenue and $80 in costs resulting in $20 gross profit.
Really accrual accounting is just trying to smooth out revenues and costs to match the reality of the company’s operations, as cash flows tend to be lumpy and don’t always best represent a company’s operations within a time period. But, unfortunately, accruals require estimates and judgements as well which can be inaccurate or manipulated.
As well, management has incentives to make earnings look as good as they can. So, you have a system that is able to be manipulated and has the party who controls much of the process being incentivized to manipulate earnings. Two of the largest examples of extremely low earnings quality are Enron and Worldcom.
Part of Enron’s fraud was using mark-to-market accounting which is normally reserved for financial institutions to inflate earnings by having future estimated cash-flows represented as current earnings, vastly increasing earnings with little relying heavily on future estimates.
Whereas Worldcom capitalized expenses which effectively means they would be realized over time in the future, propping up current earnings.
Neither Enron nor Worldcom had cash flows nor would have cash flows to back up these accounting miss practices, in other words extremely low earnings quality.
But earnings manipulation is not solely reserved for completely fraudulent companies. The term earnings management is used when a manager manages the company’s accruals to fit its needs. As I mentioned before accrual accounting requires estimates, some items that have high management discretion include:
- Accounts receivable, for the portion of customers that won’t pay,
- Inventory, if it should be written down or kept at current value.
- PPE (property, plant, and equipment), where management needs to estimate the life of the asset which impacts the depreciation of the asset.
And more. All these actions are within GAAP principles but are highly dependent on managerial decisions, which allows for the manager to manage or massage earnings to fit what they need for the quarter or set up earnings for future quarters. Managing earnings could be self-interest such as hitting a bonus target, and profit from insider trading or for the company to be able to issue shares at a higher price.
That is not to say estimates can’t be changed in good faith, but it is not always clear if they are in good faith. For example, Alphabet, the parent company of Google just increased the estimated life of its servers from 4 to 6 years and other related equipment from 5 to 6 years, meaning depreciation expense is lowered by 988 million, resulting in a net income increase of $770 million or $0.06 per share for the last quarter, increasing EPS by roughly 5%, even though nothing actually changed for the companies operations. If the initial estimates were wrong earnings persistent would be lower and earnings going forward were understated. So, did the management of Alphabet do this to purely prop up earnings or was it a result of operational expectations?
Further, shifting out of GAAP earnings which are rule-based, non-GAAP metrics are becoming more and more common. Non-GAAP earnings allow for even more management discretion for what they include and disclude from what they report, common metrics include EBITDA, adjusted EBITDA, adjusted earnings, free cash flow, and many more. S&P500 companies who report at least one non-GAAP metric increased from 59% in 1996 to 94% in 2020, as well companies on average report more non-GAAP metrics previously, 2.5 per company now 7.5.
The pro of non-GAAP earnings is they can better represent the company’s operations such as removing the impact of one-off events like acquisition costs, but also decrease comparability and increase management discretion resulting in easier earnings management.
Let’s look at Nivida (NVDA) since it was in the spotlight the last quarter, with GAAP eps of 0.82 vs non-gaap of $1.09, the uplift primarily from stock compensation which contributes roughly $0.21 of the $0.27. Whereas other companies do not add back stock compensation in their non-GAAP metrics, reducing comparable earnings. Let’s say instead Nvidia issued shares and or sold options or warrants replicating their stock compensation in share amount and paid their employees cash instead, resulting in the same dilution but using this method would result in lower non-GAAP earnings despite having the same overall impact. The point is a purely non-standardized managerial decision is raising headline earnings, which many people end up using in valuations, making them more appealing investments.
Really the takeaway I want people to get from this segment is you need to understand what is going into earnings as it is not always the same and look at the company as a whole to really understand if its earnings and what it reports are actually reliable metric to predict its performance in the future.
BMO Easy ETF Portfolio
While I was on Facebook, I came across this ad from Jessica Moorhouse (who has a Canadian podcast) for an “Easy ETF Portfolio” using BMO’s ETFs. And knowing that big bank advisors and brokers tend to over-diversify their client’s portfolios through hundreds of stocks, I thought that I would dig in to see what kind of portfolio composition we would actually end up with if we did invest in an equally weighted average across these three ETF’s.
So let’s just quickly look at these 5 ETF’s, and then I will summarize the portfolio at the end. And just a note, I have gotten all of the info from these ETF’s directly from BMO’s website.
ZCN – BMO S&P/TSX Capped Composite Index ETF – which essentially aims to replicate the return of the TSX Index. And like the Canadian market, it is heavily weighted toward financials and energy stocks.
ZSP – BMO S&P 500 Index ETF – This tries to track the S&P 500, or in other words, the U.S. Market.
ZEA – BMO MSCI EAFE Index ETF – Which tracks the markets in Europe, Australasia (the region made up of Australia and New Zealand), and the Far East.
ZEM – BMO MSCI Emerging Markets Index ETF – which is pretty self explanatory.
ZAG – BMO Aggregate Bond Index ETF – which invests through Canadian Government and corporate bonds.
So in summary, if one was to invest in these 5 ETFs based on an equally weighted average. You would end up with a portfolio that holds over 2,300 stocks and just under 1,500 bonds. With an asset allocation of 80% in stocks and 20% in bonds.
First off, with our philosophy of trying to find the next Boyd, XPEL, Hammond Power, Water Furnace – absolute game changers for client’s portfolio’s – I think that this ETF portfolio is way overdiversified with over 2,300 stocks. And in the words of Bill Gross, “any good investment ideas that are in this portfolio, are essentially being diversified away into meaningless oblivion.” So even if one name provides a return of 500%, or 1,000%, it really isn’t going to move the needle of your overall portfolio….
On the fees being paid for holding these ETF’s, generally I do think that they are reasonable, and you can see here I made a few simple calculations using the weighted average Management Expense Ratio of 0.148% based on some hypothetical amounts that have been invested across these ETFs. So if you invested $100K, you would pay $148 per year, or if you invested $1M you would pay about $1,500 per year.
Now for the sector and geographic breakdown of the stocks across the portfolio, I think that Financials are a little overweight here at just under 20%. And realistically, I think that I would want my portfolio to have more than 25% exposure to the U.S. Market, as it is a leader in tech innovation. And I would likely want to limit my exposure to other locations in the world such as China, which makes up 7% of the portfolio, and although its quite small, also Russia, which makes up just under 1% of the portfolio.
All-in-all, for an investor that just wants to ride the markets of the world, I do not think that this portfolio of ETFs is bad. But for someone who actually wants to build a portfolio that isn’t overdiversified and can position you for life-changing stocks, I would advise that you avoid this portfolio of ETFs.