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Jubak's Journal
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| | Jubak's Journal
5 stocks to love -- that everybody hates
Ingredients for a turnaround exist at each of these widely disparaged companies. Get em while theyre cheap, because next year, they might not be.
By Jim Jubak
Its time to go out on a limb and buy stocks that everyone still hates. Yep, its time to add some turnaround candidates to your portfolio.
Here are five stocks that the market despises now but may well adore in 2004:
- Electronic Data Systems (EDS, news, msgs)
- Federated Investors (FII, news, msgs)
- Level 3 Communications (LVLT, news, msgs)
- Sara Lee (SLE, news, msgs)
- Schlumberger (SLB, news, msgs)
Investing in a downtrodden stock takes a strong stomach and a lot of self-confidence. After all, youre betting youve found something that no one else has seen. The key is weighing the potential return of success against the risk of a continued flop. See if any of these five meets your own tests.
Why turnarounds now? Three reasons:
The stock market feels a bit tired right now. Certainly the momentum of the Nasdaq stocks that have led the rally since March is slowing. The Nasdaq Composite Index ($COMPX) has tested support (meaning dropped down) at the important 50-day moving average with increasing frequency. According to Briefing.com, major recent tests of Nasdaq support came in August (89 days after the previous test), September (37 days after the previous test) and October (18 days after the previous test).
When this rally resumes, we're probably going to see investors sell expensive stocks. Theyll dump those with high price-to-earnings ratios and rotate into ones with the strongest earnings. Anticipation of just such a rotation is one reason the market run-up has paused in recent days. No one wants to be left holding the bag if the market moves away from the leaders of the last eight months.
Turnaround stocks have the potential to go up even if the stock market as a whole stagnates. Turnaround candidates often aren't dependent on the economy. The low prices -- awarded to turnaround stocks before the turnaround becomes widely visible -- make these stocks less risky in case the market pulls back more sharply than I now expect.
When searching for potential turnarounds, it's important to distinguish between genuine turnaround candidates, which tend to be downtrodden and despised, and the following three types of stocks:
- Slumping market leaders. Example: Western Digital (WDC, news, msgs), down 8% in the last month but up 40% in the last quarter, based on a surge in demand for its core disk drive products.
- Potential turnaround stocks. This breed's salvation is very far down the road, with any potential turnaround not possible for years, at least. These stocks tend to be burdened by major problems, ranging from deeply depressed end markets to truly terrible management. These stocks are the domain of deep value investors. Example: Capstone Turbine (CPST, news, msgs), which has nearly as much cash ($120 million) as market capitalization ($152 million) but operates in an electric utility market that's awash in capacity.
- Former stars locked in irreversible spirals. Example: Eastman Kodak (EK, news, msgs), which cant do anything to reverse the decline in the traditional film and photography market.
And now for my five turnaround candidates. Even as youre considering their turnaround potential, remember also to consider their possibilities for failure.
Electronic Data Systems
You dont clean up a mess like this overnight, but new management headed by CEO Michael Jordan has made a decent start. Management has reduced (but unfortunately not eliminated) the use of percentage-of-completion accounting that got the company in trouble when it booked revenue that hadnt actually come in the door. It has raised about $2 billion in new debt, so EDS has an ample cushion to pay off the $1 billion in debt thats due in 2003. And it has cut way back on the goal of winning splashy new contracts that dont actually produce any profit.
But the company still is working through a backlog of contracts -- about 20% of current business -- with clauses that let customers renegotiate the prices of their deals. Some older contracts with financially stretched clients could still blow up; others will simply cost the company money. EDS is still struggling to generate decent cash flow: Management now projects that free cash flow in 2003 will be just $100 million instead of the $400 million to $600 million projected earlier. The stock now trades at a price-to-earnings ratio of 29.7 times projected 2003 earnings per share and 18.5 times projected 2004 earnings per share. StockScouter rates the shares a measly 2. While the stock has doubled since bottoming in October 2002 and is up nearly 20% so far this year, it is still down 69% from its peak in November 2001.
Federated Investors
Why would anybody want to buy a mutual fund company in the middle of a mutual fund scandal, especially when that mutual fund company has admitted participating in so-called "market timing" arrangements that ripped off investors? Well, you might still find the company attractive if it were a cash cow that specialized in untainted money market funds. Equity funds make up only about 10% of assets under management at Federated; the rest of the companys products, comprising money market and bond funds, arent likely to be involved in the scandal.
You'd be even more interested if management moved quickly to buy assets from the fund companies that have been more damaged by events. Thats the big question for Federated: Will its ongoing internal investigation be thorough enough to convince individual and institutional investors that the company knows the scope of the problem and has dealt with it? Federated Investors shares are now up 13% on the year. They currently trade at 15.9 times projected 2003 earnings per share and 14 times projected 2004 earnings per share. Our StockScouter gives the shares an impressive 8 rating.
Level 3 Communications
The resurrection of this star of the telecommunications bubble began in 2002, when value investors Warren Buffett and William Miller of Legg Mason got involved. They gave the company a $500 million vote of confidence by buying its convertible debt. (Buffett and Miller converted that debt to equity this year. Buffett recently sold 18.3 million of his position leaving him with 1.6 million shares. At the end of June, Legg Mason owned 10.7%.)
Since then, Level 3 has used that deal as a springboard to restructuring its balance sheet. The company has raised about $1 billion and used it to pay down its bank credit line, removing restrictive debt covenants and pushing debt due in 2007 and 2008 off into 2011. The financial stability has won Level 3 business this year from Verizon (VZ, news, msgs), SBC Communications (SBC, news, msgs), Cox Communications (COX, news, msgs), and Time Warner (TWX, news, msgs).
But thats the good news. The company still has $4 billion in debt, even after its restructuring. Growth remains a challenge: Third-quarter 2003 sales fell below those of the third quarter of 2002. Lehman Bros. estimates that 2004 recurring communications revenue will grow by just 9%. To add revenue, the company has acquired two software businesses as well as the Internet-services company Genuity. But the key for Level 3 remains how long it takes for the brutally competitive telecommunications business to start showing decent revenue growth. This stock is for the patient investor who is willing to take on speculative risk. Analysts estimate that the company will lose $1.46 a share in 2003 and $1.24 a share in 2004. The stock is up 8.7% so far this year but still down 96% from its peak in March 2000. Our StockScouter rates the stock at 5.
Sara Lee
What a gold mine of underperforming brands. Everybody knows Sara Lees baked goods (No. 2 in the deli and baked goods market). But the company also owns Hanes, Playtex and Wonderbra (giving Sara Lee the No. 1 U.S. market share in intimates and underwear) and Kiwi (the top brand in shoe care).
But sales have climbed only 3% a year over the last four years, and income hasnt done any better. In 2002, the company began shedding marginal brands, increasing marketing and cutting manufacturing costs. Those changes have been slow to take effect, and noncore brands still account for 50% of sales, according to Morgan Stanley. Earnings are projected to grow just 4% in the current fiscal year. But there are promising signs: Operating profit in the meat segment increased by 8% in the September quarter, and management has set a goal of 8% to 10% annual earnings growth.
Earnings growth or not, the company remains a huge cash cow, generating $1.8 billion in cash flow in fiscal 2003. Sara Lee used some of that cash to increase its dividend 21%; more cash went into a stock buyback that repurchased 13 million shares in the September quarter. The current yield is now 3.7%. The stock trades at a P/E of 13 on fiscal 2004 earnings and a P/E of 13 times fiscal 2005 earnings. (The companys fiscal year ends in June.) Shares are down 8% for 2003 but up 6% in the last month and 23% since the end of April. Our StockScouter gives Sara Lee a rating of 9 out of 10.
Schlumberger
It certainly has taken management long enough to admit its mistake: Schlumberger is dumping Sema, an information software company that the oil services giant bought in 2001. The acquisition had taken managements eye off the ball in the companys core business and never produced enough revenue to offset the cyclical nature of Schlumbergers oil-sector business. The combination of a distracting acquisition and a cyclical downturn in oil exploration and drilling has punished the company. Revenues fell to $13.5 billion in 2002, just slightly below the $13.7 billion in 2001. The loss for the year ballooned to $4.01 a share.
But trends in oil exploration and drilling in the next decade play into the strengths of the refocused company with more and more oil companies looking to use advanced imaging and oil-well management technologies -- Schlumbergers strength. That should help the company grow its operating margin to 15% over the next five years from just 10% at the end of 2002. The stock, up 12.1% this year, now trades at 32 times projected 2003 earnings per share and 24 times projected 2004 earnings per share. Our StockScouter rates Schlumberger an 8.
Youll have to apply your own risk/reward standards to these to see if any make sense for your portfolio. Im still in a wait-and-see mode with some of these shares, though all of them intrigue me.
Heres what I would want to see for a portfolio thats relatively conservative as Jubaks Picks is right now:
- Id like to see EDS make more progress toward generating cash flow.
- I want to see better revenue growth out of Level 3 (and Id like to let the dust settle from the news of Buffetts sale of most of his position).
- I need to see Schlumberger complete its restructuring with the sale of its metering and smart-card businesses.
- I have to see the internal-investigation report from Federated.
On the other hand, for this portfolio, Sara Lee seems just right. So Im adding the shares to Jubaks Picks with a target price of $25.50 by October 2004.
Changes to Jubak's Picks
Sell Applebees International
Its a question of valuation. On Nov. 12, Applebees International (APPB, news, msgs) hit my June 2004 target price of $39 a share just a tad early. That puts the stock at about 20 times projected 2004 earnings of $1.94 a share, well above the stocks historical average price to earnings ratio of 16.5. Add that to the steady trickle of insider selling and, I just cant see my way to upping my target price from current levels despite the very strong results that the company delivered in the third quarter, when sales climbed 22% and earnings per share rose 21%. I have a gain of 17% in Applebees International since I added the shares to Jubaks Picks at $33.40 on Sept. 19.
Buy Sara Lee
If somebody could just turn this ship around, Sara Lee (SLE, news, msgs) would be a brand-name powerhouse with its lineup of Hanes, Kiwi, Sara Lee, Earthgrains, Ballpark and other food and apparel brands. As it is, the company produces a river of cash, $1.8 billion in cash flow in 2002, but very little in the way of earnings or sales growth. Management is committed to turning this situation around and has set a goal of 8% to 10% annual earnings growth. While investors wait to see if the company can deliver, Sara Lee pays a dividend of 3.7%. As of Nov. 14, Im adding Sara Lee to Jubaks Picks with a target price of $25.50 by October 2004.
New developments on past columns
3 food stocks face a leaner, meaner world
Its been off to the races since Smithfield Foods (SFD, news, msgs) told Wall Street to expect earnings from continuing operations of 29 cents a share instead of the analyst consensus of 26 cents for the quarter that ended Oct. 26. The stock climbed 10% in the two days after the Nov. 10 press release on almost double the average daily volume of 519,000 shares traded. The company attributed the better than expected results to improved hog production and higher beef margins. Smithfield Farms reports earnings on Nov. 20.
Editor's Note: A new Jubaks Journal is posted every Tuesday and Friday.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Smithfield Foods. He does not own short positions in any stock mentioned in this column.
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