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Stock Screen: High Returns Earned on Total Capital - August 13, 2012
One quick way to cut through the large number of available investments is to review return on total capital. This statistic measures the percentage a company earns on its shareholders’ equity and long-term debt obligations. Value Line calculates this number, which appears in the Statistical Array on every research report, by dividing net profits plus half of the current year’s long-term interest due by the sum of shareholder equity and long-term debt. The general idea is to see how much a company earns on the money it has been given by outside investors. Companies with high scores are, presumably, better wards of capital.
That said, this measure is best used as a starting point and a comparison tool. Some industries will never show up on a screen of this nature, others will have many representatives. Thus, comparisons between companies in the same industry will provide more insight than comparisons between companies in different industries.
Since a quick review of this one measure can highlight companies that are making the best use of investor capital (on a combined basis from stock investors and bond investors), each weekly Index of The Value Line Investment Survey includes a screen listing the 50 companies that score high on this measure (subscribers can view recent and historical Index information here). A recent review of the screen turned up several companies worth a closer look, including Herbalife, LTD (HLF) and Coach, Inc. (COH).
Herbalife is one of the largest network marketing companies in the world, with net sales of approximately $3.5 billion in 2011. It sells weight management, nutritional supplement, energy, and sports & fitness products, as well as personal care items. Herbalife sells products in 79 countries through a network of approximately 2.7 million independent, contracted distributors. Weight management products accounted for 62.5% of 2011 sales, targeted nutrition (23%), energy (5%), sports & fitness and Outer Nutrition (4.3%), and other (5.2%). The weight management product portfolio includes meal replacement shakes, weight-loss enhancers, appetite suppressors, and a variety of healthy snacks. The company believes that the direct-selling channel is ideally suited to market products because sales of weight management, nutrition, and personal care items are strengthened by ongoing personal contact and education between retail consumers and their distributors.
Herbalife has done quite well of late, with 2011 earnings jumping 40% from the previous year and first quarter 2012 earnings per-share rising over 20% year over year. Indeed, aggressive efforts on the part of the company’s distributors, along with new products, are quite likely to lift the top and bottom lines, despite the slow economic recovery.
Much of Herbalife’s growth over the past few years can be attributed to its daily consumption business model. This includes distributor organized nutrition clubs, weight loss challenges, and fitness camps. These groups allow distributors and their consumers to have more frequent interaction than is usually achieved through direct sellers alone. These initiatives, along with rising obesity levels and an aging population have contributed to increasing customer demand that we think will continue in the near future. In addition to its attractive domestic prospects, Herbalife is also expanding internationally. Indeed, the company recently gained the right to conduct its direct-selling business to more provinces in China.
Despite all the upside, the stock price has been trending downward lately. This has largely been attributed to comments made by hedge fund manager David Einhorn. Mr. Einhorn questioned the company’s sales sources, distributor rewards, as well as its disclosure policy. In this case, we ask our investors to look at Herbalife’s fundamentals before following the market. The company has solid return on capital potential, and income investors ought to find its dividend yield quite attractive.
Coach, Inc. is a designer, producer, and marketer of high-quality modern American accessories. Its primary product offerings include handbags, women’s and men’s accessories, briefcases, luggage, leather outerwear, gloves, scarves, and personal planning products. The company also licenses watches, footwear, and home and office furniture.
Coach stock has not been doing well recently. Indeed, the price has declined by nearly 20% in the past three months. Though some investor concern is justified (more below), this company has largely been the victim of a declining appetite for relatively discretionary consumer products in this uncertain economic environment. That said, some wariness does concern the company itself, and various factors that can drag on earnings. Two major ones at this juncture are the elimination of in-store couponing and competition from rival retailer, Michael Kors (KORS).
Coach had previously eliminated coupons from its list of offerings, causing many customers to find cheaper alternatives (the competition with Kors was especially fierce at this juncture). However, management has since decided to reintroduce coupons in order to bring customers back. Indeed, since late June, the company has been reintroducing this option, though how much it might aid in retaining restless customers remains to be seen.
Unlike the first factor, the second, fierce competition from Michael Kors, is unlikely to abate in the near future. Kors operates in the same “affordable luxury” category that Coach dominates, and all indications suggest the battle for consumer dollars will remain intense.
That said, despite these negative factors, the company should thrive going forward. It’s repositioning its women's lines, emphasizing men’s furnishings, and moving further into China. All three strategies are quite likely to pay off during the 3 to 5 year period, and should provide a boost to the top and bottom lines despite the aforementioned obstacles. Indeed, we forecast a healthy stock price recovery over the 2015-2017 period.
At the time of this article's writing, the author did not have positions in any of the companies mentioned.