The Economy May Spell Trouble for These Dow Stocks

So far, in this series of commentaries on the Dow Jones Industrial Average (NYSE: ^DJI  ) component stocks that are in each S&P 500 sector, we have looked at the Telecommunications, Financial, and Consumer Discretionary Sector stocks. We now turn our attention to Kraft Foods (Nasdaq: KFT  ) , Coca-Cola (NYSE: KO  ) , Proctor & Gamble (NYSE: PG  ) , and Walmart (NYSE: WMT  ) . These Dow stocks are in the S&P 500 Consumer Staples Sector. 

Company Year To Date G/L Dividend Yield Total Return YTD Price/Earnings Ratio

Earnings Quality Score

Kraft

12.25%

2.77%

15.02%

20.81

C

Coca-Cola

6.30%

2.74%

9.04%

19.72

C

Proctor & Gamble

0.85%

3.34%

4.19%

18.42

D

Walmart

21.85%

2.16%

24.01%

15.51

F

Source: S&P Capital IQ

Note the earnings quality scores. In the past, my research has incorporated a Motley Fool Earnings Quality Score, which taps into a database that ranks individual stocks. The database designates an A through F weekly ranking, based on price, cash flow, revenue, and relative strength, among other things. Stocks with poor earnings quality tend to underperform, so we look for trends that might predict future outcomes.

Kraft
Kraft managed to advance its operating margin year over year by 2%, to 16%, and its net profit margin by 1%, to 8%, despite reporting nearly $600 million less in revenue. This resulted from judicious cost management. The operating cash flow margin grew to 10%, the highest it's been in two years. The EBITDA margin held steady at 17%, which means that more earnings translated into cash flow.

Metrics affecting cash flow increased, which is a negative for earnings quality. Receivables, as a percentage of revenue, were up slightly from last year, to 50%, and collections have slowed. Kraft held $1 billion more inventory on average during the year, and turns slowed to 67 days. Also, the finished goods to raw materials ratio grew.  This means more finished product in warehouses awaiting shipment.  Long-term debt has been creeping upwards lately, also.

Analysts expect Kraft to report slightly higher revenue and earnings this year, but Kraft's margins don't validate the PE ratio. However, Kraft's brand has become synonymous with quality for generations of homemakers. For now, consumers will pay higher prices for this perceived quality, but this may not continue, unless the economy improves. Kraft is a hold.  

Coca-Cola
Coca-Cola, in the past, has used cash and debt to boost earnings by reducing its shares outstanding, or "float," and this trend continues. Revenue growth has slowed considerably year over year, and Coke has reappeared as a mature, slow grower. Coke's use of debt to manipulate earnings is not the best use of cash, and does not always translate into a higher stock price. But it's always refreshing to review the company that coined the phrase "the pause that refreshes."

Coke split its stock two for one on August 13, at $39.20, and is down -4.9% since then. Costs have risen 7% over the past two years, and the margins have declined accordingly. Revenue grew by 3% year over year, and quarterly earnings grew only 1%. By pushing its payables out to 166 days, Coke is artificially boosting cash flow. 

As I noted, Coke increased debt by more than $5 billion in recent quarters, and repurchased several million shares. Earnings would have been lower without these repurchases. Coke's performance of late does not warrant the price, so beware in the short term.

Proctor & Gamble
P&G reported lower revenue and earnings last quarter year over year, but its costs and margins, as a percentage of revenue, held steady. Actually, the cost of goods sold value dropped 2% year over year, but the inventory value -- the largest component of COGS -- dropped 8.92%. The ratio of finished goods to raw materials in inventory increased to 247%, up from 209% last year. This suggests rising costs combined with production cuts to match lower demand. This might also explain lower revenue numbers. The disparity between the stock's performance and its PE is the largest, so I would not be a buyer here.

Walmart
Walmart's 24% return this year belies its earnings quality ranking and its growth trends. Despite Walmart's record as this year's fourth best Dow performer, the trend data are flashing warning signs.  Revenue and earnings growth is in the mid to high single digits, not double digits, as the PE ratio would suggest. Like many retailers, operating and profit margins are low. Walmart's payables, as a percentage of revenue, are a lot higher than its receivables, and they take longer to pay creditors than to collect money due. The company is fairly leveraged, and -- yes -- the float is smaller than two years ago. Some investors are betting that the stock splits soon. And, let's face it, when times are tough, consumers seek out the lowest prices. Regardless, I'm betting the stock price will abate.

Foolish Bottom Line
This group's year-to-date total average return is 13.06%, and they're all confronting rising input costs and lower consumer demand. They are all overvalued relative to their growth trends. Foolish readers should base investment decisions on earnings quality.

The Dow is loaded with companies with solid dividend payouts and highly sustainable business models built for the long haul. The three stocks in our recent report all have an X factor that makes them stand out from their illustrious Dow peers. Download a free copy of this in-depth report now.

Fool Contributor John Del Vecchio is Co-Advisor to Motley Fool Alpha,and co-manager of the Active Bear ETF. You may follow him on Twitter @johnfdelvecchio. He does not own any shares in the companies mentioned in this article.The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


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