Streetwise

Lauren Rudd

Sunday, February 23, 2014

Ignorance More Frequently Begets Confidence than does Knowledge

A deafening diatribe of commentary regarding current economic policy leads to the conclusion that seldom have so many said so much about a subject about which they know so little. As Charles Darwin wrote, “Ignorance more frequently begets confidence than does knowledge.”

Failure to envision the future objectively is not limited to governments or the media.  A few days before the 1929 market crash, Irving Fisher, a well-known monetary economist, confidently predicted that, "Stock prices have reached what looks like a permanently high plateau." For months after the market crashed, Fisher continued to assure investors that a recovery was just around the corner.

Fisher was blindsided by personal bias. Letting emotions or bias color your investment strategy will be expensive. You must remain unemotional as you search for investment candidates. Consider for example Owens & Minor (OMI).

OMI is a leading national distributor of medical and surgical supplies, while at the same time offering global third-party logistics services to pharmaceutical, life-science, and medical-device manufacturers through OM HealthCare Logistics and its European business unit, Movianto.

With distribution centers throughout the United States, OMI serves hospitals, integrated healthcare systems, alternate site locations, group purchasing organizations, healthcare manufacturers, and the federal government. OMI also provides technology and consulting programs that improve inventory management and streamline logistics across the entire medical supply chain.

When I first wrote about the company a year ago, my earnings estimate for 2013 was $1.92 per share, with a 12-month target price on the shares of $36.00. As it turned out, the actual results were a bit lighter than my estimates with earnings coming in at $1.90, while the shares recently closed at $35.30.

OMI’s 131-year operating history has brought forth an exceptional corporate culture and expertise, as well as scale and scope advantages that are virtually unrivaled. Moreover, given the under-penetrated and competitively fragmented marketplace in which it competes, OMI’s relative revenue stability and future growth rate is most likely assured.

A strong history of impressive working capital management, including low bad debt exposure, an industry-leading day-sales-outstanding number and healthy inventory turns, lead to approximately a 30-day cash conversion cycle with minimal balance sheet risk.

The cash conversion cycle indicates the speed with which cash outflows are converted back into cash inflows? In other words, how fast is cash converted into goods or services and then back into cash?

Why does the CCC matter? The less time it takes a firm to convert outgoing cash into incoming cash, means that less cash is tied up in inventory and accounts receivable, resulting in more cash being available underwrite growth along with increased distributions to shareholders.

To calculate a cash conversion cycle, add days inventory outstanding (DIO) to days sales outstanding (DSO), then subtract days payable outstanding. The lower the number, the more efficient is the operation.

Looking ahead, the company’s financial guidance for 2014 has projected revenue growth at up to 2 percent and net income per share of $1.95 to $2.05, excluding exit, realignment and transaction-related costs, with a gross margin of 11.8 to 12.3 percent.

The intrinsic value of the shares using a discounted earnings model, with an earnings growth rate of 9.5 percent and a discount rate of 12 percent is $35.45 per share. The more conservative free cash flow to the firm methodology yields an intrinsic value of $61.34 per share.

My earnings estimate for 2014 is $2.02 per share, with a 12-month target price on the shares of $38.80 for a capital gain of about 10 percent. In addition, there is an indicated dividend of $1.00 or 2.80 percent. Of note, the company has been increasing its dividend for 16 years.