The Good And Bad: Eni SpA And Eaton Corporation

The Good And Bad: Eni SpA And Eaton Corporation

August Performance Recap

The Most Attractive Stocks (-4.6%) outperformed the S&P 500 (-4.8%) from August 3, 2022 through August 31, 2022 by 0.2%. The best performing large cap stock gained 7% and the best performing small cap stock was up 26%. Overall, 22 out of the 40 Most Attractive stocks outperformed the S&P 500.

The Most Dangerous Stocks (-2.6%) underperformed the S&P 500 (-4.8%) as a short portfolio from August 3, 2022 through August 31, 2022 by 2.2%. The best performing large cap short stock fell by 24%, and the best performing small cap short stock fell by 22%. Overall, 19 out of the 36 Most Dangerous stocks outperformed the S&P 500 as shorts.

The Most Attractive/Most Dangerous Model Portfolios underperformed as an equal-weighted long/short portfolio by 2.0%.

Ten new stocks made the Most Attractive list this month, and 22 new stocks also fell onto the Most Dangerous list. The Most Attractive stocks have high and rising returns on invested capital (ROIC) and low price to economic book value ratios. Most Dangerous stocks have misleading earnings and long growth appreciation periods implied by their market valuations.

Most Attractive Stocks Feature for September: Eni SpA

Eni is the featured stock from September’s Most Attractive Stocks Model Portfolio.

Eni has grown net operating profit after-tax (NOPAT) by 60% compounded annually over the past five years. Eni’s NOPAT margin has increased from 1.5% in 2016 to 13% over the trailing-twelve-months (TTM), while invested capital turns rose from 0.6 to 1.2 over the same time. Rising NOPAT margins and invested capital turns drive the company’s return on invested capital (ROIC) from 1% in 2016 to 15% over the TTM.

Figure 1: NOPAT Since 2016

Eni Is Undervalued

At its current price of $23/share, E has a price-to-economic book value (PEBV) ratio of 0.1. This ratio means the market expects Eni’s NOPAT to permanently decline by 90%. This expectation seems overly pessimistic for a company that grew NOPAT by 60% compounded annually over the past five years.

Even if Eni’s NOPAT margin falls to its 10-year average of 5% (vs. 13% TTM) and NOPAT falls 8% compounded annually for the next decade, the stock would be worth $35+/share today – a 52% upside. See the math behind this reverse DCF scenario. Should Eni grow profits more in line with historical levels, the stock has even more upside.

Critical Details Found in Financial Filings by My Firm’s Robo-Analyst Technology

Below are specifics on the adjustments I made based on Robo-Analyst findings in Eni’s 10-Qs and 10-Ks:

Income Statement: I made $12.1 billion in adjustments, with a net effect of removing $3.1 billion in non-operating expenses (4% of revenue).

Balance Sheet: I made $47.5 billion in adjustments to calculate invested capital with a net decrease of $3.1 billion. One of the most notable adjustments was $16.5 million in asset write-downs. This adjustment represented 15% of reported net assets.

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Valuation: I made $44.8 billion of adjustments with a net effect of decreasing shareholder value by $20.0 billion. Apart from total debt, the most notable adjustment to shareholder value was $6.7 billion in excess cash. This adjustment represents 16% of Eni’s market cap.

Most Dangerous Stocks Feature: Eaton Corporation PLC

Eaton Corporation PLC (ETN) is the featured stock from September’s Most Dangerous Stocks Model Portfolio.

Since its acquisition of Cooper Industries, Eaton’s economic earnings, the true cash flows of the business, have fallen from $922 million in 2012 to -$22 million over the TTM. Eaton’s NOPAT margin has fallen from 10.9% to 10.5%, while invested capital turns fell from 0.9 to 0.6 over the same time. Falling NOPAT margins and invested capital turns drive Eaton’s ROIC from 10% in 2016 to 6% TTM.

Figure 2: Economic Earnings Since 2012

Eaton Provides Poor Risk/Reward

Despite its poor fundamentals, Eaton’s stock is priced for significant profit growth, and I believe the stock is overvalued.

To justify its current price of $143/share, Eaton must improve its NOPAT margin to 13% (all-time high compared to 11% TTM) and grow NOPAT by 10% compounded annually for the next ten years. See the math behind this reverse DCF scenario. Given that Eaton’s NOPAT fell 3% compounded annually over the past five years, I think these expectations are overly optimistic.

Even if Eaton can maintain its TTM NOPAT margin of 11% and grow NOPAT by 5% compounded annually for the next decade, the stock would be worth no more than $80/share today – a 44% downside to the current stock price. See the math behind this reverse DCF scenario.

Each of these scenarios also assumes Eaton can grow revenue, NOPAT, and FCF without increasing working capital or fixed assets. This assumption is unlikely but allows me to create truly best-case scenarios that demonstrate how high expectations embedded in the current valuation are.

Critical Details Found in Financial Filings by My Firm’s Robo-Analyst Technology

Below are specifics on the adjustments I made based on Robo-Analyst findings in Eaton’s 10-Qs and 10-Ks:

Income Statement: I made $1 billion in adjustments, with a net effect of removing $204 million in non-operating income (1% of revenue).

Balance Sheet: I made $8.6 billion in adjustments to calculate invested capital with a net increase of $4.6 billion. One of the most notable adjustments was $3.6 billion in other comprehensive income. This adjustment represented 14% of reported net assets.

Valuation: I made $11.2 billion in adjustments, with a net decrease to shareholder value of $11.2 billion. Apart from total debt, the most notable adjustment to shareholder value was $963 million in underfunded pensions. This adjustment represents 2% of Eaton’s market cap.

Disclosure: David Trainer, Kyle Guske II, Matt Shuler, and Brian Pellegrini receive no compensation to write about any specific stock, style, or theme.

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