Market Overview

Danger Zone 1/21/2014: Carpenter Technology (CRS)



Check out this week’s Danger Zone interview with Chuck Jaffe of

Carpenter Technology (CRS) makes it into the Danger Zone this week due to misleading acquisition accounting.

We’ve discussed the High-Low Fallacy on this blog before. The fact that an acquisition is “earnings accretive” does not make it automatically good for investors. In fact, an acquisition can boost accounting earnings while destroying economic earnings and value, which is exactly what has happened in 2012 with Carpenter’s acquisition of Latrobe Specialty Metals, Inc.

The company has been lauding the acquisition as “already accretive” to earnings and therefore good for investors. It shows the Latrobe acquisition as adding $0.30 per share, or 12% of the $2.53 GAAP earnings.

However, in 2012, operating income from the acquisition was just $24.9 million, excluding charges for writing off bad inventory. That amounts to a 4.6% return on invested capital – BEFORE tax. After taxes, theROIC of the acquisition is just 2.9%. This is not nearly enough to cover the weighted average cost of capital (WACC), which is 8.7%.

As a result, economic earnings decline by $40 million even as the company shows GAAP net income increasing by $50 million in 2012. That misleading trend has carried over to the valuation of the company, currently $52.18 per share.

That’s massively higher than CRS’s economic book value per share ($3.50), our measurement of the no-growth value of a stock. Note that our economic book value analysis accounts not only forthe misleading accounting earnings but also for $644 million in pension underfunding on CRS’ books. The price to economic book value ratio of CRS is 14.9, which is quite high (a price to EBV ratio of 3.5 or greater is considered Very Dangerous).

For further perspective on the richness of CRS’ valuation: to justify the current share price, CRS would have to grow its net operating profit after tax (NOPAT) by 20% compounded annually for 15 years. That would be a quite impressive performance indeed for any company, but especially for one whose overstating profits with value-destroying acquisitions.

I think a more realistic, yet still optimistic, scenario for CRS would only justify a share price of about $25, not even half of its current valuation.

Investors should avoid ETFs and mutual funds that allocate significantly to CRS.  SPDR S&P Metals & Mining ETF (XME) and Capital Management Small-Cap Fund (CMSVX) in particular are two to avoid due to their Dangerous ratings and 3.17% and 3.45% allocation to CRS, respectively.

Disclosure: I receive no compensation to write about any specific stock, sector or theme.


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