Determining What’s Reasonable and What’s Not

 

Every SSG must make several judgments about the future, the most important of which is estimating the growth of earnings per share for the next 5 years. Estimating Sales growth is also important, especially when it is used to derive EPS growth as part of the BI/NAIC Preferred Procedure.

 

How do we determine what’s reasonable and what’s not?  The answer is easy to express (by comparisons) but much more complex to explain.  Consider this concrete example:

 

Is it reasonable to estimate 24.0% Sales growth for the next 5 years for Cognizant Technology Solutions (CTSH)?  Is 21.4% EPS growth reasonable?  How do we decide?

 

In the August 2008 issue of Better Investing magazine, guru Cy Lynch SSGed CTSH using S&P data.  Cy found that Cognizant had Sales growth of 48.4% per year during the last 10 years, “the highest rate in the IT services and consulting industry.”  His SSG also showed that CTSH averaged an even higher EPS growth rate, a whopping 49.6% annually, during the same 10 year period.

 

Moreover, over the last 5 years, CTSH’s annual growth rates actually increased to 55.3% Sales and 50.7% EPS.  So what do you think is a reasonable estimate for CTSH’s future growth in the next 5 years?

 

Here is Cy’s answer: “…applying arbitrary limits to projected growth in your stock studies under the guise of being conservative can lead to missed opportunities. I find estimated revenue growth of 24 percent to be reasonable.” [emphasis added]

 

DISCUSSION:

 

 – Cy asserts that a 24.0% estimate for Sales growth is reasonable, but marshals no evidence to support his claim.  He does say that Sales grew by an “exceptional 48.4 percent over the last 10 years,” which on its face would seem to support a substantially higher estimate.  However, Cy makes no effort to explain why he is estimating so much less than the company’s historical average or why he chose 24.0%.

 

– For CTSH, Morningstar is estimating 32.10% Sales growth for the next 5 years and Zacks is estimating 55.66%.  Cy’s 24.0% estimate is conservative by comparison even though it is greater than the 20.0% maximum advocated by some other BI gurus.

 

– When I looked on July 12th, the analysts were estimating long-term EPS at around 28-29% with FactSet CallStreet low at 27.00% and Zacks high at 29.86%.  S&P was 28.00%, FirstCall was 28.49%, Value Line was 28.50%, and Reuters via Morningstar was 29.00%.  There were six estimates at FactSet which ranged from 32.0% to 20.0% low while the seven estimates at Zacks ranged from 49.0% high to 20.0% low.

 

– Thus, 20.0% EPS is the very lowest estimate by any of these analysts and Cy’s 21.4% estimate seems conservative by comparison, especially compared to the 28-29.0% consensus analyst estimate.

 

– Cy derived his 21.4% estimated EPS from BI’s Preferred Procedure (PP)  which involves making four estimates for the next 5 years: Sales Growth, Pre-Tax Profit Margin, Tax Rate, and Shares Outstanding.  To get his 21.4% estimate, Cy estimated 24% Sales Growth, 19.2% PTPM, 25.0% Tax, and 300M Shares. 

 

– Certain tax breaks that CTSH receives from the Indian government are ending and Cy’s 25% Tax Rate estimate is close to Value Line’s 24% estimate in the next 3-5 years and identical to Morningstar’s estimated long-term tax rate of 25%.

 

– Cy wrote that his 300M Shares Outstanding was based on VL’s estimate, but VL was actually estimating 288M Shares Outstanding as per its 5-23-08 report. If Cy had used that number, his EPS estimate would have increased from 21.4 to 22.4%.

 

– Cy also used a Net Profit Margin of 14.3%, but did not explain how he converted that to get the Pre-Tax Profit Margin for his PP.  One way is to use this formula [NPM/ (1-Tax Rate)] which works out to 19.1% PTPM.  I also worked backwards from all his other factors to get 19.2% which is a slight decrease from 2007’s 19.4% and 5-year average of 20.2%.  PTPM has been trending down for the last 5 years.

 

CONCLUSION:

  

– I have two, related quarrels with CY’s analysis:

 

(1) his way low Sales and EPS estimates both of which were substantially lower compared to CTSH’s historical growth and to what the analysts were estimating.  Because of the way the NAIC/BI Preferred Procedure is structured, a Sales estimate that is way low results in an EPS estimate that is way, way too low; and

 

(2) I am not content with his unsupported assertion that a 24.0% Sales estimate is “reasonable”: simply claiming that something is appropriate does not make it so. 

 

– I no longer use the PP because it involves too many estimates and too much guesswork for me.  I prefer to survey the analysts, ascertain their long-term EPS consensus estimate, and thus learn what is high and what is low.  That way, I have some basis to know what EPS estimate is reasonably in the ball park and what is not.

 

– Make no mistake, I emphatically agree with Cy that arbitrary limits on our SSG estimates are serious mistakes, but I also insist on having some evidence to support each judgment and any claim of reasonableness.

 

– Armin 

 

Stryker (SYK): Looking Strong and Solid

 

Stryker Corp (SYK) is a major manufacturer of orthopedic implants (60% of 2007 sales) and medical-surgical equipment.  It has a remarkable record of EPS growth: over the past 30 years, the company’s EPS has increased by at least 20% in all but one year (1999, due to an acquisition) according to Value Line.  When I use S&P data, its EPS has averaged nearly 26% per year over the last 10 years.  However, growth has declined in the last 3 years to around 18% annually and Sales growth has also slowed to 11-12% during the same time. 

 

Despite the downtrend, the company’s Pre-Tax Profit Margin is trending up, a positive development, going from around 18% five years ago to 23% in 2007 (for a five-year average of about 21%).  According to Reuters.com, Stryker’s PTPM is almost twice as large as its industry average.  Moreover, SYK has virtually no debt, some $17.7M which is only .3% of Total Capital.

 

Morningstar especially likes the company’s “top-tier” position in the orthopedic implant market, particularly with regard to knees and trauma as well as spine products and SYK plans to launch two artificial spinal discs by 2010.  Its hip segment hasn’t done as well, primarily because of a product recall in early 2008.  The FDA sent a stern six-page warning letter in January ordering SYK to fix a host of long-standing manufacturing problems with its hip replacement parts.

 

The Investment Advisory Service chose Stryker as one of its featured stocks in July.  IAS is a pay service by investment professionals who use the SSG to analyze stocks.  Ann Cuneaz, Better Investing’s Education Program Manager, also recently SSGed Stryker.  Her analysis is available on the First Cut page of the BI website.

 

Here is a comparison of the SSG by IAS, Ann, myself and Take Stock.  Take Stock is a computerized program that is designed to produce a conservative result without input from the user.  I did two SSGs, one with S&P data and the other with Hemscott data, but both with the same judgments.

 

Stryker   Corp (SYK)	IAS	Ann Cuneaz		Armin-1	Armin-2	Take Stock
Date	6-16-08	6-26-08		6-27-08	6-27-08	6-27-08
Data	S&P	S&P		S&P	Hemscott	Hemscott
Price	$64.54	$62.00		$62.26	Same	$62.54
Sales Growth	13.00%	12.00%		12.00%	Same	10.90%
EPS Growth	17.00%	12.00%		15.00%	Same	08.71%
Forecast High PE	30.0	28.0		27.7 (2006 low)	26.7 (2006 low)	30.0
Forecast High Price	$157.80 (8.8% > VL)	$124.30		$140.40	$135.10	$109.26
Value Line Estimated High Price = $110-145 on 2-25-08 and 5-30-08
Forecast Low PE	20.0	18.0		19.7 (2006 low)	20.3 (2006 low)	20.6
Forecast Low Price	$48.00 (Low PE x Low EPS)	$45.40 (Low PE x Low EPS)		$49.60 (Low PE x Low EPS)	$51.50 (Low PE x Low EPS	$50.68
Upside/Down	5.6	3.8		6.2	6.6	3.9 (imputed)
Total Return	19.9%	15.4%		17.9%	17.0%	12.6%
A SSG Buy at	$75.45	N/A		$70.53	$67.84	$55.59
Rel Value & Projected RV	89.9% & 78.1%	84.8% & 75.7%		85.2% & 74.1%	85.8% & 74.3%	N/A
Quality	S&P = B +	N/A		S&P = A+	No Rating	TS = 6.3, acceptable
PTPM – 5 yr ave	19.1% Trend up		20.7% Trend up	20.7% Trend up	19.1% Trend up	21.0% Trend N/A
ROE – 5 yr ave End Equity	20.4% Trend down		20.3% Trend down	20.3% Trend down	20.1% Trend down	N/A
ROE -5 yr ave Start Equity	26.1% Trend down		N/A	26.1% Trend down	25.8% Trend down	25.8% Trend N/A
Debt : Equity 5 yr ave	-0- Trend even		N/A	1.3% Trend down	1.3% Trend down	N/A

 

– Morningstar recently raised its Sales Growth estimate for SYK from 12 to 13% for the next 5 years.  Zacks is also estimating 13.45% Sales Growth for the next 5 years.  IAS, Ann and I were all near these estimates.

 

– When I did my SSG, six sets of analysts were closely estimating long-term EPS at around 18-18.50% with Value Line low at 17.50% and First Call high at 20.00%.  S&P was 18.50%, Reuters via Morningstar was 18.70%, Zacks was 18.88%, and First Call was 19.00%.  First Call’s seven estimates ranged from a low of 13.00% to a high of 20.00%; at Zacks, the eight estimates ranged from a low of 15.00% to a high of 20.00%.

 

– I use comparisons to assess what I think is reasonable and I do not rely on my gut feelings (or how well I sleep at night). The analyst estimates ranged from 13.0% to 20.0% and anything within that range I define as acceptable.  For SYK, more than 20.0% seems too high and less than 13.0% seems too low.

 

– My 15.00% EPS estimate is 5.00% lower than the highest estimate (First Call) and 2.50% lower than the lowest (Value Line).  More importantly to me, now that Reuters.com has stopped reporting the Standard Deviation of its analyst estimates, is that my Forecast High Price is squarely within Value Line’s High Price estimate.  This combination tells me that my judgments are reasonably conservative, not too high and not too low.

 

– Take Stock’s EPS estimate seems unreasonably low at 8.71%, nearly 9.0% below the lowest estimate which was VL at 17.50%.  It’s no surprise, then, that Take Stock is the only analysis that did not result in a SSG Buy with a 12.6% Total Return (15% minimum required). 

 

– Take Stock gave Stryker a Quality Rating of 6.3: a minimum of 3.4 is required to pass muster, 6.7 is desired and 10.0 is the maximum.  In contrast, S&P gave Stryker an A+ for Quality, its highest of 8 ratings.

 

– IAS explicitly said it was using conservative judgments: 30 for its Forecast High PE instead of 34, the average High PE for the past 5 years, and 20 for its Forecast Low PE instead of the 24.3 average Low PE.  IAS also said its 17.0% estimated EPS was conservative compared to the 20.0% that the analysts were estimating, but I found 20.0% by only the very highest analyst at First Call.  Still, IAS’s estimate of 17.0% is less than the 18.0-18.5% consensus I discovered.

 

– However, IAS’s so-called conservative judgments produced a Forecast High Price that was almost 9% higher than the high end of Value Line’s Estimated High Price.  That’s high, but not outrageously or unreasonably high, but neither is it conservative.

 

– Ann said her 12.0% EPS estimate was “validated” by her Preferred Procedure (PP), but when I used her judgments in my PP, I got 13.9% which was closer to my 15.0% estimate than to her 12.0%.  If Ann had used 13.9%, her SSG would have resulted in 5.7 Upside/Downside Ratio (instead of her 3.8 U/D) and a 16.8% Total Return (instead of 15.4%).  I don’t understand the point of using the PP only to ignore it and then arbitrarily lower the EPS estimate by an unsupported amount.

 

–  The PP involves making four estimates for the next 5 years: Sales Growth, Pre-Tax Profit Margin, Tax Rate and Shares Outstanding.  I don’t use the PP because it involves too many estimates and too much guesswork for me.  For example, the default PP with my 12% Sales growth estimate results in 9.5% EPS growth; with VL’s estimated Shares Outstanding and estimated Tax Rate, it increases to 13.1%; and when I also use the last three year average for PTPM (instead of the default’s last 5 year average), I get 14.3%.  So, which is more fitting: 9.5%, 13.1%, or 14.3%?

 

– My “preferred procedure” <joke> is to survey all the analyst EPS estimates and decide what is reasonably conservative: not too high and not too low.

 

– Three different methods were used to decide the Forecast High and Low PEs.  IAS limited its forecast to a pre-determined maximum (30.0 High PE and 20.0 Low) which no stock, no matter what, could exceed; Ann chose SYK’s lowest PEs in the last 10 years (28.0 High and 18.0 Low); and I picked the lowest PEs in the last 5 years (27.7 High and 19.7 Low).

 

– SYK’s direct competitors (not industry peers) are Medtronics (MDT), Zimmer Holdings (ZMH), and DePuy, a subsidiary of JNJ.  The Online SSG at the BI website now allows users to pick up to three peer companies, but provides no advice on which companies are peers nor does it define the peer group.

 

Armin