Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...
Whirlpool (NYSE:WHR) is on a tear.
Over the past 52 weeks, Whirlpool shares have climbed 26% (against just a 3% gain for the S&P 500), and the stock's more recent performance has been even better -- up 44% since the start of 2019! Of course, the best news may be that today, investment banker J.P. Morgan predicted that Whirlpool's run is far from done, and shares will climb even higher over the next year -- as high as $172.
Then again, that's only good news if J.P. Morgan is right about Whirlpool.
A good year for steel consumers
Make no mistake: The trends have been Whirlpool's friend so far in 2019, a year that has seen the Federal Reserve lower interest rates -- a big plus for a company carrying $7.7 billion in debt -- and the federal government remove trade protection from steel producers, allowing an influx of cheaper steel from Canada and Mexico to flow into the country, sinking steel prices.
As a result, J.P. Morgan points out in a note covered on StreetInsider.com, Whirlpool has shown "consistent margin performance in North America." On the revenue front as well, "U.S. industry shipments [appear] stable YOY through the end of 2019 and [should] show modest growth in 2020," and the manufacturer's European operations (accounting for about 22% of revenue, according to data from S&P Global Market Intelligence) have "significant upside potential."
On top of all that, despite the stock's run-up, the analyst views Whirlpool shares as "inexpensive," "[t]rading at roughly 10x and 8.5x our 2019E and 2020E EPS, respectively, which represent discounts of roughly 10-15% to its 5-year averages."
Good news already priced in
And yet, despite all this good news, I still have a few nits to pick with J.P. Morgan's upgrade. Let's start with the most obvious: the "inexpensive" stock price.
On the one hand, yes, Whirlpool's trailing price-to-earnings ratio does look attractive on the surface. What's of greater concern to me, though, is the quality of those earnings.
According to S&P Global data, you see, although Whirlpool reported $918 million in GAAP profits over the past year, its free cash flow for the period was only $399 million. In other words, for every $1 in "accounting profits" the company reports, it's generating only about $0.43 per share in real cash profit, suggesting the business isn't really as profitable as it appears.
Consistent with those numbers, most analysts who follow Whirlpool expect earnings to decline next year -- down about 2% -- before resuming their rise. Over the next five years combined, analyst estimates predict the company will grow its GAAP earnings only about 5% per year. Granted, combined with the 3.2% dividend yield, 11 times earnings may not a horrible price to pay for that kind of growth, but it's certainly not "inexpensive."
I also have to take issue with J.P. Morgan's positive comments on Whirlpool's profit margin. On the one hand, yes, operating profits in the North American business segment have performed well over the past five years, rising about 25% from 2013 levels, or about 5% per year -- more than twice as fast as revenue. But that doesn't change the fact that outside of America, things are looking pretty grim.
Combined, Whirlpool's international revenue roughly equals sales in North America, and has grown at a similar rate -- up about 13% over the past five years. International profits, however, are another story. While operating profits at Whirlpool's tiny Asian division have more than doubled over the past half-decade, Latin American profits are down by two-thirds, and Europe, the Middle East and Africa (EMEA) losses have swelled from $4 million five years ago to $106 million last year.
Were it possible to buy stock only in Whirlpool's American operations, therefore, J.P. Morgan's recommendation might make more sense. But seeing as an investment in Whirlpool necessitates taking on both the marginally profitable Latin American business and the deeply unprofitable EMEA segment as well, I have to say that I don't like the look of either of those.
The upshot for investors
At 10.4 times earnings, with a 5% growth rate and a 3.2% dividend yield, Whirlpool stock looks cheap on the surface, but that seeming cheapness is an illusion. Its recent rebound in profitability is largely limited to just one market (North America) and at least partly dependent upon low steel prices (down 33% from a year ago, but unlikely to remain low forever).
Furthermore, weak free cash flow suggests that even in this benign economic environment, the company isn't able to take full advantage of or generate the cash necessary to pay down its $7.7 billion debt load. With an enterprise value nearly 43 times the amount of cash it generates in a year, I cannot recommend Whirlpool stock today.