Popular Inc. And Realty Income

June Performance Recap

The Most Attractive Stocks (-14.2%) underperformed the S&P 500 (-8.3%) from June 2, 2022 through July 5, 2022 by 5.9%. The best performing large cap stock gained 1% and the best performing small cap stock was up 8%. Overall, 12 out of the 40 Most Attractive stocks outperformed the S&P 500.

The Most Dangerous Stocks (-9.5%) outperformed the S&P 500 (-8.3%) as a short portfolio from June 2, 2022 through July 5, 2022 by 1.2%. The best performing large cap short stock fell by 22%, and the best performing small cap short stock fell by 25%. Overall, 22 out of the 37 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 4.7%.

Eleven new stocks made the Most Attractive list this month, and five 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 July: Popular Inc.
BPOP

Popular Inc. (BPOP) is the featured stock from July’s Most Attractive Stocks Model Portfolio.

Popular has grown revenue by 7% compounded annually and net operating profit after-tax (NOPAT) by 17% compounded annually over the past five years. Popular’s NOPAT margin has increased from 18% in 2016 to 28% TTM, while invested capital turns rose from 0.3 to 0.4 over the same time. Rising NOPAT margins and invested capital turns drove the company’s return on invested capital (ROIC) from 5% in 2016 to 11% TTM.

Figure 1: Revenue & NOPAT Since 2016

Popular Is Undervalued

At its current price of $76/share, BPOP has a price-to-economic book value (PEBV) ratio of 0.6. This ratio means the market expects Popular’s NOPAT to permanently decline by 40%. This expectation seems overly pessimistic for a company that grew NOPAT by 17% compounded annually over the past five years and 14% compounded annually over the past ten years.

Even if Popular’s NOPAT margin falls to 23% (equal to five-year average, compared to 28% TTM) and the company’s NOPAT declines by <1% compounded annually for the next decade, the stock is worth $109/share today – a 58% upside. See the math behind this reverse DCF scenario. Should Popular 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 Popular’s 10-Qs and 10-K:

Income Statement: I made $357 million in adjustments, with a net effect of removing $159 million in non-operating income (6% of revenue).

Balance Sheet: I made $2.5 billion in adjustments to calculate invested capital with a net increase of $714 million. One of the most notable adjustments was $695 million related to total reserves. This adjustment represented 11% of reported net assets.

Valuation: I made $347 million of adjustments, all of which decreased shareholder value. One of the most notable adjustments to shareholder value was $151 million in underfunded pensions. This adjustment represents 3% of Popular’s market cap.

Most Dangerous Stocks Feature: Realty Income Corp
O

Realty Income Corp (O) is the featured stock from July’s Most Dangerous Stocks Model Portfolio.

Realty Income’s economic earnings, the true cash flows of the business, have fallen from $47 million in 2011 to negative $743 million over the TTM. The company’s NOPAT margin has fallen from 63% to 35%, while invested capital turns fell from 0.11 to 0.08 over the same time. Falling NOPAT margins and invested capital turns drove Realty Income’s ROIC from 7% in 2011 to 3% TTM.

Figure 2: Economic Earnings Since 2011

Realty Income Provides Poor Risk/Reward

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

To justify its current price of $69/share, Realty Income must improve its NOPAT margin to 49% (three-year, pre-pandemic average from 2016 – 2019, compared to 36% TTM) and grow revenue by 14% compounded annually for the next decade. See the math behind this reverse DCF scenario. In this scenario, Realty Income grows NOPAT by 17% compounded annually over the next ten years. Given that Realty Income’s NOPAT grew by just 8% compounded annually since 2016, I think these expectations look overly optimistic.

Even if Realty Income can achieve a NOPAT margin of 49% and grow revenue by 10% compounded annually for the next decade, the stock is worth just $39/share today – a 43% downside to the current stock price. See the math behind this reverse DCF scenario. Should Realty Income’s revenue grow at a slower rate or NOPAT margins remain below pre-pandemic levels, the stock has even more downside.

Each of these scenarios also assumes Realty Income can grow revenue, NOPAT, and FCF without increasing working capital or fixed assets. This assumption is unlikely but allows us 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 Realty Income’s 10-Qs and 10-K:

Income Statement: I made $547 million in adjustments, with a net effect of removing $415 million in non-operating expense (20% of revenue).

Balance Sheet: I made $13.6 billion in adjustments to calculate invested capital with a net decrease of $3.2 billion. One of the most notable adjustments was $3.2 billion in midyear acquisitions. This adjustment represented 8% of reported net assets.

Valuation: I made $17.6 billion in adjustments, with a net decrease to shareholder value of $17.4 billion. Apart from total debt, the most notable adjustment to shareholder value was $103 million in excess cash. This adjustment represents <1% of Realty Income’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.