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Danger Zone 1/21/2013: Carpenter Technology (CRS)

Monday, January 21st, 2013

Check out this week’s Danger Zone interview with Chuck Jaffe of Money Life and MarketWatch.com.

Carpenter Technology (CRS) makes it into the Danger Zone this week due to misleading acquisition accounting.

We’ve discussed the High-Low Fallacy on this blog before. The fact that an acquisition is “earnings accretive” does not make it automatically good for investors. In fact, an acquisition can boost accounting earnings while destroying economic earnings and value, which is exactly what has happened in 2012 with Carpenter’s acquisition of Latrobe Specialty Metals, Inc.

The company has been lauding the acquisition as “already accretive” to earnings and therefore good for investors. It shows the Latrobe acquisition as adding $0.30 per share, or 12% of the $2.53 GAAP earnings.

However, in 2012, operating income from the acquisition was just $66.3 million (based on annualizing the $22.1mm in operating income reported for 4 months of the fiscal year), excluding charges for writing off bad inventory. That amounts to a 7.9% return on invested capital after tax. This is not enough to cover the weighted average cost of capital (WACC), which is 8.7%.

As a result, economic earnings decline by $40 million even as the company shows GAAP net income increasing by $50 million in 2012. That misleading trend has carried over to the valuation of the company, currently $52.18 per share.

That’s massively higher than CRS’s economic book value per share ($3.50), our measurement of the no-growth value of a stock. Note that our economic book value analysis accounts not only for the misleading accounting earnings but also for $644 million in pension underfunding on CRS’ books. The price to economic book value ratio of CRS is 14.9, which is quite high (a price to EBV ratio of 3.5 or greater is considered Very Dangerous).

For further perspective on the richness of CRS’ valuation: to justify the current share price, CRS would have to grow its net operating profit after tax (NOPAT) by 20% compounded annually for 15 years. That would be a quite impressive performance indeed for any company, but especially for one whose overstating profits with value-destroying acquisitions.

I think a more realistic, yet still optimistic, scenario for CRS would only justify a share price of about $25, not even half of its current valuation.

Investors should avoid ETFs and mutual funds that allocate significantly to CRS.  SPDR S&P Metals & Mining ETF (XME) and Capital Management Small-Cap Fund (CMSVX) in particular are two to avoid due to their Dangerous ratings and 3.17% and 3.45% allocation to CRS, respectively.

Disclosure: I receive no compensation to write about any specific stock, sector or theme.

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3 Comments

  1. varadha says:

    Terrific, yet simple analysis. I’ve always been a fan of ROIC as a measure of capital efficiency and believe that no size/growth outperformance can replace the quest for efficiency.

    Sort of like a big gas guzzling v8 that needs ever increasing gallons of fuel to keep its engine running

  2. David says:

    But Angie’s $90 per user acquisition cost is going to go away. That’s what their approach probably is. How would their outlook be if that $90 cost dropped down to a total cost of $3 per user?

  3. David:

    That would be great, but cost per user acquisition is not something that’s very easy for a company to fix. ANGI can slash their marketing budget to the bone, but then they would stop acquiring new members. They would probably lose members in fact, as their membership renewal rate is at ~75% and declining. If they cut marketing expense by ~95% as you seem to be suggesting, ANGI might be able to eke out 1 year of slight profits, but they would start shedding members and losing money very quickly. ANGI’s only hope is to keep its marketing budget high and hope it can reach the scale and brand awareness to be able to sustain its business while scaling back marketing costs enough to turn a profit. The fact that ANGI’s revenue growth is slowing down even as its marketing costs keep increasing makes it very unlikely it will achieve that goal.

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