Intentional Investing : Tough Love on Housing Recovery (Part 1)

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I am actually quite enthusiastic about the current economic trend in "housing". There is an obvious discrepancy between housing inventory and housing demand. "Households" are even beginning to form again. I believe this "recovery" is real, but just not as robust as many would have us think. 

Demographic shifts are definitely at work and I want to consider these before making any investment decisions. The "new normal" would suggest that rental units will be in higher demand going forward (not only in apartment complexes, but in what were previously considered single family homes). The "new normal" would also suggest that more households may be deciding to stay in place for a longer period of time (deciding to MAKE upgrades to their existing homes, rather than BUY those upgrades in the form of a new home every couple of years). Then there is the aging demographic (myself included) which is downsizing to smaller "digs", retiring to a senior living community, or moving into a child's repurposed/refinished basement. I also believe that checking-in (or being checked-in) to an assisted living facility / health care center should be considered a part of "housing". 

In considering the "housing recovery theme" I have decided to focus on companies lower down the food chain. Rather than homebuilders, I am more interested in those companies who manufacture or provide the goods and services needed in ALL these areas and to ALL end-users. I'm talking paint, climate control, tools and equipment, roofing, flooring, ceilings, insulation, title insurance, windows, doors, appliances, lighting, faucets, data services, cement ... you know, the real sexy stuff.

Here are 10 industrial companies that manufacture major home appliances, HVAC equipment, water heaters and purifiers, and back-up generators. Most have enjoyed a healthy appreciation in market price over the past 15 months. Can any stand-up to some tough love?

<table> <thead> <tr> <td>Company</td> <td>% Total Return *</td> <th>What Was I Thinking?</th></tr> </thead> <tbody> <tr> <td><strong><span class="ticker" data-id="202684">(NASDAQ: <a href="">AAON</a>)</span></strong></td> <td><strong>69</strong></td> <td><strong>HVAC for apartment buildings & senior living facilities</strong></td> </tr> <tr> <td><strong><span class="ticker" data-id="202828">(NYSE: <a href="">AOS</a>)</span> </strong></td> <td><strong>68</strong></td> <td><strong>Water heaters and purifiers with strong expansion into China and India</strong></td> </tr> <tr> <td><strong><span class="ticker" data-id="203389">(NYSE: <a href="">EMR</a>)</span> </strong></td> <td><strong>19</strong></td> <td><strong>Everything from ceiling fans to heat pumps to garbage disposals</strong></td> </tr> <tr> <td><strong><span class="ticker" data-id="250178">(NYSE: <a href="">FBHS</a>)</span></strong></td> <td><strong>79</strong></td> <td><strong>Everything from Moen faucets to windows & doors to cabinets</strong></td> </tr> <tr> <td><strong><span class="ticker" data-id="223768">(NYSE: <a href="">GNRC</a>)</span></strong></td> <td><strong>71</strong></td> <td><strong>Back-up power generators</strong></td> </tr> <tr> <td><strong><span class="ticker" data-id="204046">(NYSE: <a href="">IR</a>)</span></strong></td> <td><strong>47</strong></td> <td><strong>Climate control, security systems, home automation</strong></td> </tr> <tr> <td><strong><span class="ticker" data-id="204311">(NYSE: <a href="">LII</a>)</span></strong></td> <td><strong>79</strong></td> <td><strong>Residential air conditioners & climate control</strong></td> </tr> <tr> <td><strong><span class="ticker" data-id="208674">(NYSE: <a href="">LXU</a>)</span></strong></td> <td><strong><span>(26)</span></strong></td> <td><strong>Geothermal climate control (single, multi-family, institutional)</strong></td> </tr> <tr> <td><strong><span class="ticker" data-id="271689">(NASDAQ: <a href="">NTK</a>)</span></strong></td> <td><strong>69</strong></td> <td><strong>Everything from climate control to range hoods to attic ventilation fans</strong></td> </tr> <tr> <td><strong><span class="ticker" data-id="206061">(NYSE: <a href="">WHR</a>)</span> </strong></td> <td><strong>65</strong></td> <td><strong>Home appliances (bought up almost everyone, but GE)</strong></td> </tr> </tbody> </table>

15 month Total Return thru 4/5/2013

I have 3 "deal beakers" among the 15 or so initial criteria I use to evaluate companies. I figure it's best to get the pain out of the way early. I don't expect many companies to pass this first test.

<table> <thead> <tr><th><strong>Company</strong></th><th><strong>ROIC >10% </strong></th><th><strong>Debt / Avg Free Cash Flow < 4 years *</strong></th><th><strong>Goodwill / Book Value < 50% </strong></th></tr> </thead> <tbody> <tr> <td><strong>AAON </strong></td> <td><strong>20%</strong></td> <td><strong>0.00</strong></td> <td><strong>0%</strong></td> </tr> <tr> <td><strong>AO SMITH</strong></td> <td><strong>14%</strong></td> <td><strong>4.77</strong></td> <td><strong>36%</strong></td> </tr> <tr> <td><strong>EMERSON</strong></td> <td><strong>15%</strong></td> <td><strong>2.05</strong></td> <td><strong>77%</strong></td> </tr> <tr> <td><strong>FORTUNE</strong></td> <td><strong>5%</strong></td> <td><strong>2.35</strong></td> <td><strong>58%</strong></td> </tr> <tr> <td><strong>GENERAC</strong></td> <td><strong>10%</strong></td> <td><strong>5.63</strong></td> <td><strong>119%</strong></td> </tr> <tr> <td><strong>INGERSOLL-RAND</strong></td> <td><strong>12%</strong></td> <td><strong>3.94</strong></td> <td><strong>85%</strong></td> </tr> <tr> <td><strong>LENNOX</strong></td> <td><strong>18%</strong></td> <td><strong>3.32</strong></td> <td><strong>45%</strong></td> </tr> <tr> <td><strong>LSB INDUSTRIES</strong></td> <td><strong>18%</strong></td> <td><strong>3.90</strong></td> <td><strong>0%</strong></td> </tr> <tr> <td><strong>NORTEK </strong></td> <td><strong>4%</strong></td> <td><strong>14.26</strong></td> <td><strong>327%</strong></td> </tr> <tr> <td><strong>WHIRLPOOL</strong></td> <td><strong>10%</strong></td> <td><strong>10.67</strong></td> <td><strong>40%</strong></td> </tr> <tr> <td><strong> </strong></td> <td><strong> </strong></td> <td><strong> </strong></td> <td><strong> </strong></td> </tr> </tbody> </table>

*Free cash flow is averaged over 3 years to smooth-out the bumps.

I don't think I have set the bar too high on any one of these criteria. A return on Invested capital (ROIC) above 10% is certainly not unreasonable. Being agnostic about debt versus equity does not mean I don't take notice when a company takes on more debt than it can cover with free cash flow in 4 years. And if goodwill -- even without considering other intangibles -- represents 50% or more of total book value (aka stockholder equity), I'll pass. For me, that's a big red flag that suggests that someone has been paying too much for acquisitions.

So, while these 3 drop-dead criteria are not too hurtful when considered separately, they narrow the field quite considerably when combined.

I'm shocked, I tell you. Shocked. Shocked by those names that did not make it over the first 3 hurdles. My first temptation is to back-track and lower the bar on a selective basis. This is definitely where I find I need nerves of steel. 

On to round two.

<table> <thead> <tr><th>Company</th><th>Asset Utilization* >100% ?</th><th>Retained Earnings / Total Assets</th><th>Quick ** Ratio >1 ?</th></tr> </thead> <tbody> <tr> <td><strong>AAON </strong></td> <td><strong>157%</strong></td> <td><strong>71.34%</strong></td> <td><strong>1.26</strong></td> </tr> <tr> <td><strong>LENNOX </strong></td> <td><strong>174%</strong></td> <td><strong>44.00%</strong></td> <td><strong>0.66</strong></td> </tr> <tr> <td><strong>LSB INDUSTRIES</strong></td> <td><strong>132%</strong></td> <td><strong>36.80%</strong></td> <td><strong>1.54</strong></td> </tr> </tbody> </table>

 *Annual Revenues / Total Assets 

All 3 of the remaining contenders are generating more than $1 in revenues for every $1 in assets. Buffett would be impressed. AAON, in particular, shows a strong history of profits (and organic growth) judging by its very high percentage of retained earnings to total assets. And while AAON and LSB Industries seem to be managing their working capital requirements quite well, Lennox appears to be struggling. That's almost enough to take Lennox off the list.

Third step : Where have all the earnings gone? (Do I need my guitar?)

<table> <thead> <tr><th>Company</th><th>3-Yr Avg EPS Growth</th><th>3-Yr Avg BVPS* Growth</th><th>3-Yr Avg Dividend Growth</th><th>3-Yr Avg Payout Yield**</th></tr> </thead> <tbody> <tr> <td><strong>AAON</strong></td> <td><strong>1.34</strong></td> <td><strong>7.23</strong></td> <td><strong>0</strong></td> <td><strong>2.51%</strong></td> </tr> <tr> <td><strong>LENNOX</strong></td> <td><strong>34.13</strong></td> <td><strong>-2.71</strong></td> <td><strong>10.72</strong></td> <td><strong>4.79%</strong></td> </tr> <tr> <td><strong>LSB INDUSTRIES</strong></td> <td><strong>37.11</strong></td> <td><strong>31.14</strong></td> <td><strong>0</strong></td> <td><strong>0.04%</strong></td> </tr> </tbody> </table>

*Book value per share. **Net dividends and share repurchases / market cap.

 You gotta love it when you see a company like AAON building its asset base even when earnings are under pressure. And, it also looks like LSB Industries is putting almost everything it can muster into building for the future. Lennox seems to have taken the path of making payments to shareholders, which is certainly a-okay with me. However, the difference in growth rates between earnings and book value seem out of wack to me. I wonder.

Does a good business necessarily make a good investment? What I'm looking for right now is reasonable growth at a reasonable price. The Earnings Yield must be a least twice the bond rate of ~ 3% to compensate for my extra risk. It turns out that ~6.2% is the current earnings yield for the S&P 500. So, 6.2% is my minimum threshold.

<table> <thead> <tr><th>Company</th><th>Operating Earnings Yield*</th><th>Current Earnings Yield** >6.2% ?</th><th>Est Earnings Yield** This Year >6.2% ?</th><th>Forward Dividend Yield***</th><th>Sustainable Growth Rate</th></tr> </thead> <tbody> <tr> <td> </td> <td> </td> <td> </td> <td> </td> <td> </td> <td> </td> </tr> <tr> <td><strong>AAON</strong></td> <td><strong>8.73%</strong></td> <td><strong>4.09%</strong></td> <td><strong>5.49%</strong></td> <td><strong>0.88%</strong></td> <td><strong>16.51%</strong></td> </tr> <tr> <td><strong>LENNOX </strong></td> <td><strong>7.99%</strong></td> <td><strong>4.27%</strong></td> <td><strong>6.06%</strong></td> <td><strong>1.30%</strong></td> <td><strong>13.27%</strong></td> </tr> <tr> <td><strong>LSB INDUSTRIES</strong></td> <td><strong>16.62%</strong></td> <td><strong>7.79%</strong></td> <td><strong>10.40%</strong></td> <td><strong>0.00%</strong></td> <td><strong>18.17%</strong></td> </tr> </tbody> </table>

*EBITDA / EV  **Earnings / Price  ***Based on this year's dividend announcements.

The sustainable growth rate is important to me because it suggests what the company is capable of with no change in capital structure. Of course, there also has to be a market for the company's products !! Fundamental analysis is not gonna help me on that one.

Here's my take.

AAON appears to be a superior, exceptionally well-run small cap that is currently overpriced following its run-up after last quarter's positive earnings report. This stock deserves a position on my serious watch list.

Reviewing all the results, My gut tells me to take a pass on Lennox. I let it initially slip by the working capital (quick ratio) requirement. It was also pretty close to my 50% cut off on the goodwill  / book value front with 45%. And it's only a hunch, but I'm not clear about how all the earnings are benefiting shareholders. 

Of all the stocks on my initial list, who would have thought a company in the agricultural chemicals industry subgroup would earn a passing grade in my housing recovery theme?  Not me, that's for sure. In addition to its geothermal and heat pump equipment manufacturing business, LSB Industries is also a leading producer of chemicals and agricultural inputs. It has been (rightfully) punished in the market for severe (and numerous) disruptions in its production plants this past year. I consider these to be temporary problems that may actually provide a good buy-in opportunity. I don't think LSB Industries has hit market bottom yet, so that may give me time to do some more qualitative analysis. For now, this stub has earned its rightful place on my serious watchlist and a very possible future position in my real life portfolio.

For background on how and why I've embarked on this "Intentional Investing" journey,  click here for my CAPS Blog and my first 15 rules. 

Penny Czarra has no position in any stocks mentioned. The Motley Fool recommends Emerson Electric Co.. The Motley Fool owns shares of Generac Holdings. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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