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Course 408
Cyclical Stocks

Introduction

Most companies dance to general economic rhythms, but while others tango or fox-trot, cyclicals slam dance. The profits of deeply cyclical companies surge in economic upswings and drop--sometimes disappear--during downswings. Moderate cyclicals show more resilience, but their earnings still ebb and flow with general economic tides. Morningstar uses a broad definition of what constitutes a cyclical: any company that belongs to the industrial-cyclical or consumer-durable sectors, with the exception of firms in our high-yield, distressed, or hard-asset groupings. These stocks include both deep and moderate cyclicals. Companies become cyclicals because they operate in relatively mature, saturated industries--industries that grow if the economy cooperates. United Technologies UTX is a perfect example. Demand for its aerospace equipment, air conditioners, and elevators fluctuates wildly in developed countries. In good years, the company can clean house. In bad years, it can lose money--a lot of money.

How Is the Company Doing Now?

Our first step is to identify where United Technologies is in its cycle. No one can predict exactly when a cyclical's earnings will peak or trough, but an examination of a company's financial statements can put us in the ballpark. At the end of 1999, United Technologies had been posting rapid earnings growth and high returns on capital--higher than the S&P 500 averages or the company's historical averages. (You can find this information in the Profitability section of the stock's Morningstar.com Report.) For a cyclical, lush profits suggest that peak earnings might not be too far off. United Technologies has historically never been able to sustain such stellar earnings. United Technologies' growth rates also suggest that the good times may be nearing an end. The firm has increased its sales for six straight years--about the average length of expansion for a cyclical--and its year-to-year growth rates have stayed fairly steady. The company's annual earnings growth, though, slowed from 24% in 1995 to about 18% in 1998 and 19% in 1999.

How Wildly Do Sales and Profits Fluctuate?

To see how deep a cyclical United Technologies is, the best place to look is the firm's record in the last recession. It is not a record for the queasy. Many cyclicals can limp through a slump without losing money, but United Technologies belly-flopped in the early 1990s, losing more than $1 billion in 1991 and losing $287 million in 1992. Contrast that dismal performance with 1999's. United Technologies' return on equity (ROE) of 21% ranked in the top quarter of both the aerospace industry and the broader market, whereas its ROEs during the two recessionary years were negative. That's fluctuation. United Technology's profits are even more volatile than those of the average company in this very cyclical industry. Why? A large chunk of United Technologies' sales depends on the capital-spending budgets of corporations and governments around the world. Because capital spending is especially sensitive to economic conditions, companies relying on it see extravolatile sales and earnings.

How Leveraged Is the Balance Sheet?

Another reason some cyclicals are more volatile than others is debt. Debt adds more fixed expenses (interest payments) into a company's cost structure, and those fixed expenses must be paid in both good and bad times. As a result, the more debt a company has, the more volatile its earnings can be. United Technologies is a highly leveraged company, though leverage improved in 1999. Shareholders' equity accounted for just 31% of total assets the September quarter, and its financial leverage of 3.3 is somewhat high for an aerospace company. The company's financial leverage inched up between 1996 and 1998 but then fell again in 1999, which is a positive sign.

Does the Company Consistently Generate Positive Cash Flow?

During a recession, it is more important for a company to post positive operating cash flows than to post positive earnings: Cash, not accounting profits, pays the bills. It's a good sign if a cyclical's cash flow from operations is positive even in tough years. From the 10-year financial history in its annual report, we learn that United Technologies has indeed posted positive operating cash flows in every year of the 1990s. The company is extremely cyclical, but it generates cash even in slumps.

How Steady Are the Company's Dividends over a Cycle?

Another gauge of the financial strength of a cyclical is how consistently it pays dividends. United Technologies has increased its dividend every year since 1994, but between 1990 and 1993, there were no increases. This is common for a cyclical; many reduce their dividends or cut them altogether when times get tough. Although you can't always rely on United Technologies to raise its dividends, you can be pretty sure the company will pay something, even in bad times such as in 1991 and 1992.

Is the Firm Diversified Geographically and by Product Line?

The reason cyclicals such as DuPont DD and Emerson Electric EMR can post rising earnings even in a recession is that they are diversified: Not all the cyclical businesses in their portfolios move in sync. United Technologies is diversified by product line, but all its businesses (aerospace equipment, heating and air-conditioning, and elevators) are both cyclical and dependent on the same economic factors. Of course, that's not so bad, even if it does spawn big swings in earnings. Cyclicals constantly face the temptation to diversify into new businesses to reduce risk, but their records at such diversification are often horrendous. They are generally best off sticking with what they know. A more appealing type of diversification is geographic, and United Technologies does better in that regard. About 40% of the company's revenues come from outside the United States. This diversification not only gives the company some cushion when the U.S. economy turns sour but it also means United Technologies has exposure to developing parts of the world, which are growing much more rapidly than the U.S.

Is the Long-Term Trend in Sales and Profits Upward?

The final step in the analysis of United Technologies' corporate performance is the most important. We need to look beneath the cyclical veneer of the company and determine whether United Technologies is a good long-term performer or if it is one of those ugly cyclicals that takes one step backward for every step forward. Despite its dramatic ups and downs, United Technologies has put together a pretty good long-term record. The company's sales and profits at one cyclical peak are consistently higher than their levels at the previous cyclical peak. In the late 1980s, for example, United Technologies' annual sales were about $20 billion, and its earnings peaked at $750 million. By 1995, its third year in the black after the last recession, the company regained those levels, and it continued to roar ahead in the following years. United Technologies earned twice as much in 1999 as it did during its previous cyclical peak.

How Has the Stock Performed?

Cyclicals can post tremendous stock returns--but they usually come in bursts. Because of United Technologies' surging earnings since 1992, the tremendous returns have predominated lately. United Technologies' shares more than tripled in value between 1994 and 1999, and they beat the S&P 500 index in three of five years during that time. Within the transportation-equipment industry, too, United Technologies' stock has excelled, ranking in the industry's top quintile for the trailing one-, three-, and five-year periods ended December 31, 1999.

How Expensive Is It?

The stock runup makes United Technologies a dicey investment. True, we have seen that United Technologies, for all its blotches, has been a pretty strong company over the long term. It is therefore natural that its stock should fetch higher valuations than the doormats of the cyclical category--companies such as the Big Three automakers, the big steel producers, and consumer-electronics makers. As with most cyclicals, though, it's only a matter of time before the bottom falls out from under United Technologies' profits. True, the company's P/E ratio of 19 at the end of 1999 was lower than that of the S&P 500, and even though it also had a P/E of 19 in 1995, it had actually fallen relative to the index. But a closer look at the stock's valuations shows that United Technologies is riskier than it might first appear.

How Expensive Is the Company Based on Normalized Earnings?

For a cyclical, earnings in any given year are not a reliable measure of a company's true earning power. To avoid overreliance on a single year's results, look at United Technologies' "normalized" earnings: the average of the company's earnings from the past five years. Normalized earnings give a smoother valuation picture, especially for companies with erratic earnings. United Technologies earned an average of $2.17 per share annually between 1995 and 1999. At its share price of $65 at the end of 1999, that works out to a normalized P/E ratio of 30. If the future turns out anything like the past, United Technologies' shares are pretty darn expensive for this type of stock.

How Does the Price/Sales Ratio Compare with Historical Levels?

Another good way to value a cyclical is to look at the price/sales ratio. Earnings bounce up and down, making P/E ratios erratic from year to year. Sales are much steadier than profits--even for a cyclical--thus making the price/sales ratio a pretty reliable guide to fluctuations in value over time. In terms of its price/sales ratio, United Technologies is more expensive than its historical average. At the end of 1999, it traded for 1.2 times sales, compared with 0.5 times in 1995. Although the company expanded its sales rapidly in the 1990s, its market value zipped up even faster, suggesting that now is not the best time to bet on United Technologies if you're looking for a bargain.

Conclusion: Get 'Em while They're Cold

With mild cyclicals--the ones that don't do too badly in a recession--you don't have to worry much about the timing of your purchase. General Electric GE may slow down in a recession, but it's not likely to lose money. With deep cyclicals such as United Technologies, however, buying when the company is earning peak profits may mean you'll have to wait a long time before your investment breaks even. We have seen how badly United Technologies gets hit in economic downturns, even if the company has many strengths (consistently positive cash flows and dividends, for example) that a lot of cyclicals don't have. With United Technologies' stock trading near its all-time highs, it is a hazardous time to take the plunge.

Quiz 408
There is only one correct answer to each question.

1 What kinds of industries tend to be cyclical?
a. Industries with only one or two major companies.
b. Young, volatile industries.
c. Mature, saturated industries.
2 How does debt affect the volatility of a cyclical company's earnings?
a. The lower the debt, the more volatile the earnings.
b. The higher the debt, the more volatile the earnings.
c. Debt has no effect on the earnings of cyclicals.
3 Which of the following is <em>not</em> a good reason for cyclicals to diversify?
a. It tends to make their earnings less volatile.
b. It tends to make them less dependent on the U.S. economy
c. It tends to decrease their financial leverage.
4 Negative earnings in a cyclical are easier to take if:
a. Its cash flows are positive.
b. It is growing very rapidly.
c. Its financial leverage is high.
5 Why is normalized P/E a good way to value cyclical stocks?
a. Earnings of cyclicals (and thus their P/Es) can fluctuate wildly, but averaging earnings over several years gives a smoother picture.
b. It takes growth into account.
c. It tells you how efficient the company is.
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