Mean Reversion Candidates identified by an Improving Capital Structure, Significant Price Decline and….

Warren Buffett...sustained high ROE is a critical measure for management’s performance and investing. Companies reporting a sustained high ROE are destined for success.

ROE is not one number. It’s driven and influenced by a complex set of management’s integrated activities. What if you could identify companies turning the right levers creating a future high sustainable ROE? How can we uncover future high ROE ideas before the public assigns a higher valuation.

One approach towards building a discovery process for future favorable ROE, understand the components that drive ROE. Identify bottoms up improvements before a final enhanced ROE is public with a higher valuation. An example of success where the CEO’s focus was ROE improvement, Gerstner at IBM. IBM's market capitalization rose from $29 billion to $168 billion when CEO Gerstner focused on increasing ROE. IBM’s ROE improvements driven by improving capital structure, capital resources allocated to share buybacks reducing shares outstanding  and positively impacting ROE.

The DuPont equation or strategic profit formula takes a bottom up approach to analyzing ROE. DuPont Corporation used this approach in the 1920s. The equation is broken into 3 parts. This granularity provides transparency to understand and manage the drivers for positive or negative .  The DuPont equation/strategic profit formula enables the analyst to understand the source of superior or inferior actions driving ROE.

Return on equity = PROFITABILITY [profits/sales] x PRODUCTIVITY [sales/assets] x CAPITAL STRUCTURE [assets/equity] = DuPont equation=strategic profit formula.

DuPont Equation explained on Wikipedia. https://en.wikipedia.org/wiki/DuPont_analysis

Management can control or influence ROE by a complex set of integrated activities. For this post I won’t dig into the 3 components and its driving details. All 3 components (productivity, profitability, capital structure) must be proficient, an ineffective link weakens ROE.

This post emphasizes Capital Structure improvements to help find companies improving future ROE. Further, I added more value components to my filtering; share price returns, value oriented institutional ownership, and financial health as an example.

Below are sample ideas and a process description of discoveries for “Mean Reversion Candidates identified by an Improving Capital Structure, Significant Price Decline and….”

Iconix Brand Group  (ICON)

Iconix Brand Group is a brand management company (global licensing) that owns 35 brands. It is engaged in licensing, marketing and providing trend direction for a portfolio of consumer brands.

The company is distressed from temporary operational changes.Highly leveraged based on historical measures. But consistent positive FCF should suffice even during a slowing economy. ICON trades at a deep valuation based on historical and relative comparisons.  A ferocious cannibal of its own shares, $66,772,000 expended to buy back shares over the TTM. The original shares outstanding at end of 2011 reduced by 64%. 75,495,000 fully diluted shares outstanding at fiscal yearend 2011 down to the MRQ of 48,014,500 shares outstanding or 27.50M shares bought back.
The stock is down 63% over the past 52 weeks, 28% shares short as percentage of float.

Summary of key metrics over a 10, 5 and 1 year period

Revenue annual growth rates per share; 14.47%, 17.80% and 2.50% for 10 yrs, 5yrs and 12months respectively.
Free Cash Flow annual per share growth rates; 25.20%, 13.10%, 11.30% for 10 yrs, 5yrs and 12months respectively.
Book Value annual per share growth % rates; 28.60%, 9.10%, 15.00% for 10 yrs, 5yrs and 12months respectively.

ICON is a mean reversion candidate based on many factors commented above as an asset light historically high FCF and ROE company.

Price September 25 = $14.01
Market Cap: 677.10M , Enterprise Value:   2.04B
Trailing P/E:  5.56 , Price/Sales (ttm):   1.73
Price/Book (mrq):   0.70 ,Enterprise Value/Revenue (ttm):        5.21
Enterprise Value/EBITDA (ttm): 10.65
Profit Margin (ttm):   34.59% , Operating Margin (ttm): 47.46%
ROE = 16.46%
Qtrly Revenue Growth (yoy):  0.90% , CFFO (ttm):178.45M , FCF (ttm):   132.22M
52-Week Change:   -62.92% , % Held by Insiders:   5.44%
Short % of Float: 28.59%

Blount International Inc. (BLT)

Blount International designs, manufactures, and markets equipment, replacement and component parts, accessories for forestry, agriculture, concrete cutting, lawn, and garden.
Blount sells its products in more than 115 countries around the world.

Blount reported both debt and share buybacks, 20.50M stock buybacks expended for the TTM, long term debt was 667,629,000 for fiscal year ending 2011 down to MRQ 363,068,000. Z score improvements to MRQ of 1.50 from .76,98,.87 for 2011, 2012,2013 respectively. Shares outstanding MRQ were 48.68M down from 49.17M from 2012. Improving valuation, EV/Rev MRQ .74 down from 1.42 for 2011.

Historically cheap, 70% below 52 week high, % below historical high P/B 99.93%, % below historical P/S 80.98%.

Value investors Michael Price and John Rogers form Ariel continue to add to their positions.

Price on 09/29/15: $5.59

Market Cap: 269.73M , Enterprise Value: 663.95M
Price/Sales (ttm): 0.30 , Price/Book (mrq): 2.57
Enterprise Value/Revenue (ttm): 0.74 , Enterprise Value/EBITDA (ttm): 5.90
52-Week Change: -63.05%