Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...
Shareholders had high hopes for the union between Knight Transportation and Swift Transportation when the two trucking firms announced their merger in April 2017 -- and at first, those hopes seemed valid. Over the 11 months following their merger announcement, shares of the renamed Knight-Swift Transportation (NYSE: KNX) surged nearly 50% in value as the company's revenue surged more than 300% and profits grew sevenfold.
The last eight months, however, haven't been so happy. From mid-March 2018 through this morning, Knight-Swift shares gave up all their gains since before the merger announcement, and a little bit more besides.
And yet, one analyst isn't losing faith in the merger. This morning, investment banker Goldman Sachs announced it's taking advantage of Knight-Swift's stock slide, and rating it a buy with a $48 price target. If Goldman Sachs is right about this, Knight-Swift shareholders who've suffered so much this year now stand to reap as much as a 43% profit as the stock recovers the majority of its losses.
But is Goldman Sachs right? Let's find out.
Knight-Swift shares have fallen. Should you hitch a ride, or let this stock keep on truckin' without you? Image source: Getty Images.
Upgrading Knight-Swift stock
Goldman Sachs laid out three main reasons why it's optimistic about Knight-Swift's chances, in a note covered by StreetInsider.com (subscription required).
According to the analyst, Knight-Swift's declining share price has "de-risked" the stock and made it a more "defensive" pick for investors worried that stocks in general may suffer from a "down-cycle" in the economy. Contributing to this de-risking, says Goldman, is the fact that Knight-Swift's recent guidance has reset investor expectations, such that analyst estimates for the company are now more forgiving and easier to hit. Finally, Goldman expresses hope that a combined Knight-Swift "can offer margin improvement through the end of the current decade" -- which would also assist the company in meeting Wall Street's expectations.
Let's examine these three assertions in turn, beginning with...
De-risking the stock
At a stock price now below $34, with per-share earnings of nearly $4, Knight-Swift appears at first glance to offer investors an incredible bargain -- a P/E ratio of just 8.9. With Wall Street now projecting better-than-16% long-term annualized earnings growth, there seems to be very little risk indeed to owning this stock.
Take a closer look, however, and things aren't quite as attractive as they seem. For example, a review of Knight-Swift's income statement reveals that nearly one-third of the company's $715 million in trailing net income came via a one-time boost from tax reform. Worse, the company's cash flow statement shows that just $84.4 million of Knight-Swift's reported earnings were backed by real free cash flow -- less than $0.12 per $1 of claimed net income.
Simply put, Goldman Sachs may see Knight-Swift stock as too cheap to be risky, but this stock isn't nearly as cheap as it seems.
Goldman also argues that the market is moderating its expectations for Knight-Swift, and to an extent that's true. In Q2 of this year, company management gave new guidance, telling investors it expected to earn "$0.56 to $0.60" in adjusted EPS in the year's third quarter, and "$0.68 to $0.72" in the fourth quarter. Three months later, management raised guidance for Q4 (to $0.71 to $0.75 per share), and added new guidance of $0.50 to $0.54 for Q1 of 2019. Currently, analyst estimates cited on Yahoo! Finance basically track this outlook.
As far as these estimates getting "more conservative," however, and thus implicitly easier to beat, well, that's debatable. In fact, Yahoo! Finance data shows that over the past 90 days, analyst expectations for both Q4 and full-year 2018 earnings have risen, not fallen -- and 2019 expectations have moderated by only $0.01 per share.
Might margin improvement hold the potential to grow Knight-Swift's earnings faster than guidance suggests? Perhaps.
Historically, Swift Transportation earned weaker profit margin than did Knight Transportation, and that has depressed profit margin for the combined operation (now at 9.5%, versus Knight's operating margin high of 13.7%, achieved pre-merger in 2015). Margin has improved sequentially over the last two quarters, however, according to data from S&P Global Market Intelligence, and so long as that trend holds true, it's possible that Goldman Sachs will be proven right to have recommended the stock at current prices.
The upshot for investors
Still, if one assumes (as seems likely) that margin growth is already part and parcel of Wall Street's overall assessment that Knight-Swift will grow its earnings at 16%-plus annually over the next five years, then this brings us back to our initial question: Is 16%-ish growth sufficient to justify Knight-Swift's valuation?
If you trust the company's GAAP numbers, and believe that 8.9 times earnings correctly reflects the cheapness of Knight-Swift shares today, I suspect the answer to that question is "yes." (And Goldman Sachs certainly seems convinced.) On the other hand, if you're worried about Knight's swiftly rising capital spending, and its prediction last quarter that "cash expenditures [will] be significantly higher" going forward, it may be best to pull over and allow this particular opportunity to pass you by.
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