2 Companies That Are Improving Shareholder Equity and Another That Isn't

Rupert is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

It is companies that are working hard to improve shareholder equity and returns on shareholder equity that are usually the best investments for the future, as growing equity usually means a growing company.

To weed out some of the best looking company's in the S&P 500, I started by looking for firms that had an earnings-before-interest-and-tax margin of around 20%, indicating a good flow of cash in to the company's coffers. Secondly, using historic figures, I whittled down the results to companies that had achieved a five year average return-on-shareholder-equity of greater than 15% to draw out the companies that have consistently delivered a good return on shareholder capital.

Lastly, I searched through analyst predictions and reports to whittle down the remaining candidates, looking for companies that were predicted to improve their gearing ratio by at least 50% over the next three years. For example, a company's net debt to shareholder equity ratio should fall by 50% over the next three years, indicating improving free cash flows, fiscal prudence, and balance sheet strength.

Note: for the purpose of this piece, gearing is total debt divided by shareholder equity.

The results

Firstly, contract driller Helmerich & Payne (NYSE: HP), which has achieved a 13.5% return-on-shareholder equity (ROE), on average per year for the last five years. Part of this strong consistent return is the company's wide EBIT margin, which for 2012 stood at 28.2%.

<table> <thead> <tr><th> Company</th><th> <p>EBIT margin, 2012</p> </th><th> <p>ROE 5-yr average </p> </th></tr> </thead> <tbody> <tr> <td> <p>Helmerich & Payne</p> </td> <td> <p>28.20%</p> </td> <td> <p>13.50%</p> </td> </tr> </tbody> </table>

Helmerich's EBIT margin is forecast to widen as the company pays down debt and gearing is expected to move into negative territory (net cash balance) this year. Indeed, I can see that in the company's first-quarter results, gearing had already started to fall, from a level of 3% at the end of last year to 1.5% at the end of the first quarter. The company's ROE also ticked up slightly based on Q1 annualized data to 14.5% from the 13.5% five-year average.

<img alt="" src="http://g.fool.com/editorial/images/54515/1_large.png" />

A chart showing Helmerich's predicted gearing over the next few years. I have added a logarithmic moving average with a four period prediction to highlight the improving cash position of the company during the next few years.

Next up

Next up is Occidental Petroleum (NYSE: OXY), which is fast becoming the next major oil conglomerate and is rapidly closing the valuation gap on the world's third-largest company by revenue, Gazprom. (Gazprom's currently trading at a record low valuation of two times forward earnings with a market cap of approx. $85 billion. Occidental is worth $77 billion, trading at 16 times forward earnings.)

<table> <thead> <tr><th>Company </th><th> <p>EBIT margin, 2012</p> </th><th> <p>ROE 5-yr average </p> </th></tr> </thead> <tbody> <tr> <td> <p>Occidental Petroleum</p> </td> <td> <p>37.80%</p> </td> <td> <p>15.90%</p> </td> </tr> </tbody> </table>

Occidental has an EBIT margin of 37.8% and has achieved an average ROE of 15.9% during the past five years. The company does pay about 40% tax however, which impacts its net profit margin, sending it down to around 21%.

<img alt="" src="http://g.fool.com/editorial/images/54515/2_large.png" />

Having said that, Occidental is still forecast to rapidly pay down its debt over the next few years. Once again, I have added a logarithmic moving average with a four period forecast to show how the debt will fall in the future.

And finally

Finally, a company that is not reducing its level of gearing, Philip Morris International (NYSE: PM). The majority of Philip Morris' debt is used for the buyback of its own stock, which I have discussed the benefits of in detail here. Having said that, the levels of debt that Philip Morris is building up are starting to become worrying and are distorting figures such as gearing and ROE.

<table> <thead> <tr><th> <p>Year</p> </th><th> <p>2009</p> </th><th> <p>2010</p> </th><th> <p>2011</p> </th><th> <p>2012</p> </th><th> <p>% Change</p> </th></tr> </thead> <tbody> <tr> <td> <p>Net Income</p> </td> <td> <p>$6,342</p> </td> <td> <p>$7,259</p> </td> <td> <p>$8,591</p> </td> <td> <p>$8,800</p> </td> <td> <p>38%</p> </td> </tr> <tr> <td> <p>Total Assets</p> </td> <td> <p>$34,552</p> </td> <td> <p>$35,050</p> </td> <td> <p>$35,488</p> </td> <td> <p>$37,670</p> </td> <td> <p>9%</p> </td> </tr> <tr> <td> <p>Total Liabilities</p> </td> <td> <p>$28,836</p> </td> <td> <p>$31,544</p> </td> <td> <p>$35,259</p> </td> <td> <p>$41,146</p> </td> <td> <p>42%</p> </td> </tr> <tr> <td> <p>Total Debt</p> </td> <td> <p>$13,672</p> </td> <td> <p>$13,370</p> </td> <td> <p>$14,828</p> </td> <td> <p>$17,639</p> </td> <td> <p>29%</p> </td> </tr> <tr> <td> <p>Shareholder Equity</p> </td> <td> <p>$5,716</p> </td> <td> <p>$3,506</p> </td> <td> <p>$229</p> </td> <td> <p>-$3,476</p> </td> <td> <p>-161%</p> </td> </tr> <tr> <td> <p>ROE</p> </td> <td> <p>111%</p> </td> <td> <p>207%</p> </td> <td> <p>3752%</p> </td> <td> <p>N/A</p> </td> <td> <p>3281%</p> </td> </tr> <tr> <td> <p>Gearing</p> </td> <td> <p>239%</p> </td> <td> <p>381%</p> </td> <td> <p>6475%</p> </td> <td> <p>N/A</p> </td> <td> <p>2607%</p> </td> </tr> </tbody> </table>

Figures in millions of $US except for ratios.

Philip Morris' debt binge has all but destroyed shareholder equity, as a result, ROE and gearing figures are not possible to calculate and have become extremely distorted in recent years, (a gearing level of 6475% during 2011 looks ridiculous). While the benefits of borrowing to buy back stock continue to be debated, one thing is for sure -- Philip Morris' debt binge is starting to sway investor opinion as the company's key ratios become unreliable. 

Conclusion

Overall, both Helmerich and Occidental are working hard to achieve a good return on equity for investors, which is paying off and the companies are building solid balance sheets with which to fund expansion or increase financial stability in times of stress. 

On the other hand, Philip Morris' borrowing is starting to get out of hand and the company's key ratios are distorted and although the debt maybe easy to finance right now, with low interest rates, when the time comes to refinance, interest rates could have risen, making it more difficult for the company to service its debt.

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Fool contributor Rupert Hargreaves has no position in any stocks mentioned. The Motley Fool owns shares of Philip Morris International. 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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