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3 blue chips at bargain prices
Morningstar says these companies trade below their fair values, offering investors a chance to get in at relatively cheap prices.
By Michael Brush
It's no secret in financial circles that Morningstar, long the Rosetta stone for mutual fund analysis, has been staffing up a division that covers stocks. Now that the Chicago-based research group has had a chance to find its footing in equity research, it seems like a good time get its best picks.
To do so, we checked in with Patrick Dorsey, Morningstar's equity research director. He went straight for a handful of blue-chip companies, all of which trade well below Morningstar's estimate of their fair value. This means if you buy them now, you're getting a bargain. The way Morningstar calculates fair value comes right out of a business school textbook. It estimates a company's future earnings and then puts a value on what it's worth now.
Here's a look at Morningstar's view on three major blue chips, as well as input from analysts at other firms and my take on Morningstar's calls.
The real thing?
- Coca-Cola (KO, news, msgs). Thanks to a litany of problems -- from the impact of U.S. foreign policy overseas to the SARS outbreak in Asia and competition from archrival PepsiCo (PEP, news, msgs) -- business at Coca-Cola has gone decidedly flat. (Read Jon Markman's take on Coke here.)
Things got so bad last summer that Coca-Cola's board pulled former exec Neville Isdell out of retirement to right the company. But this autumn the stock continued its descent as the company lowered earnings expectations. Coke shares recently sunk to $40, 25% below their 52-week high of $53.50.
3 reasons to believe
Morningstar analyst Matthew Reilly believes Coca-Cola shares will settle in here but end up being a good buy for long-term investors who step in now. Reilly has a fair-value price of $54 on the shares. The Morningstar analyst cites at least three reasons why Coca-Cola will reward patient investors. - A renewed focus on emerging markets. Economists have documented a direct link between gross domestic product growth and soft drink consumption. So Coke's renewed focus on expanding in emerging markets, which have hotter economic growth than the United States or Europe, could put some fizz back in its shares. Isdell's clearly the right man for this job. Before retiring, he worked for Coca-Cola in Zambia, South Africa, the Philippines, Austria, Central Europe, India, the Middle-East and the Soviet Union. Coke has extensive international distribution, an advantage that Pepsi lacks.
- Better marketing. Isdell plans to increase the yearly marketing budget by $350 million to $400 million, roughly 20% over the company's current annual marketing budget of $1.9 billion. He also wants to return to a more focused brand message. "This has been sorely lacking in Coke's advertising," says Reilly. "We see tremendous upside in the stock if the company can find a marketing angle that resonates with consumers." One opportunity: Coke needs to invent new products so it can catch up on the consumer shift to non-carbonated and "healthy" beverages like Pepsi's Gatorade, Aquafina, Propel Fitness Water and Tropicana.
- More managers. Former Chief Executive Douglas Daft cut more than 5,000 bosses. Isdell will focus on building the bench again and boosting morale. Emulating Pepsi, Isdell wants managers who focus on innovation and cater to consumer tastes, rather than trying to control them, says Reilly.
The turnaround at this soft drink icon will take time, perhaps as long as two years. But Reilly points out that Coca-Cola's financials remain strong enough to support a 2.5% dividend yield. The company is also buying back shares.
Legg Mason analyst Mark Swartzberg agrees the stock will bounce around in a trading range of $38 to $42 in the near term, but eventually move up to $52 in 12 months.
Bottom line: It would be a mistake to count out a company that has four of the world's top five soft drinks, especially since it plans a comeback by boosting sales in emerging markets under a chief executive who spent his career doing just that.
Better than it seems
- Johnson & Johnson (JNJ, news, msgs). Glance at the chart for Johnson & Johnson, and you'll wonder how anyone could think it's trading below fair value. Unlike troubled pharmaceutical stocks like Merck (MRK, news, msgs), Johnson & Johnson at the recent price of $60.40 per share flirts with its 52-week high.
But looks can be deceiving.
While J&J's stock has climbed this year, revenue and earnings have leapt, too. This has left the stock trading at 18 times next year's Thomson Financial consensus estimate of $3.34 per share. That may not seem cheap, but it's near the low end of the stock's historic range of 15 to 30 times earnings.
There are plenty of reasons why J&J trades near the bottom of its valuation range. Investors are fretting about the entire sector because of everything from drug patent expirations to Merck's recent recall of blockbuster painkiller Vioxx.
Johnson & Johnson also faces problems of its own. Its cash cow Duragesic, a painkiller, is going off patent soon, giving generic drug makers the chance to make cheaper copies. Another big seller, Procrit, taken for chemotherapy-induced anemia, is losing share to Amgen's (AMGN, news, msgs) Aranesp. And J&J's drug-coated stent, Cypher, faces competition from Boston Scientific's (BSX, news, msgs) Taxus stent.
Trusty household brands
Will J&J conquer these obstacles? Most likely yes, since the company has such a long history of getting things right, says Morningstar analyst Tom D'Amore. He suggests buying anywhere below $72.
For one thing, the company has several high-growth drugs that are relatively new to the market, like Risperdal for schizophrenia, Remicade for rheumatoid arthritis and Crohn's disease, and Topamax for epilepsy. Next, D'Amore expects a "panoply" of new products from J&J's medical devices division. The company is targeting 50 new patents or line extensions over the next five years, he says.
Meanwhile, its consumer products division throws off tons of cash by steadily cranking out trusty household brand names like Band-Aids, Johnson's Baby Shampoo and Tylenol. This cash machine helps fund research in pharmaceuticals and medical devices. It also helps support the company's stock buyback and solid financial position. J&J has $9.6 billion in net cash, part of which may go for more acquisitions. That's yet another avenue for growth.
Investing in Johnson & Johnson may be about as close as you can get to buying a health-care mutual fund in a single stock, says Dorsey. The company has diversity in pharmaceuticals, medical devices and consumer health products. Taken as a stand-alone company, J&J's biotech divisions would be the world's second-largest biotech company.
"Johnson & Johnson is probably the lowest risk, single stock way to play the attractive valuations you are seeing in health care right," says Dorsey.
Stephen O'Neil, an analyst with Hilliard Lyons Equity Research, agrees double-digit revenue growth should help make Johnson & Johnson an $80 stock in two years. The stock carries a 1.8% dividend yield.
Bottom line: Given the company's track record of delivering 19 years of double-digit earnings growth and 42 years of dividend hikes, it's hard to imagine it won't figure out a way to pull through the current turbulence.
Staying at home
- Lloyds TSB Group PLC (LYG, news, msgs). The London-based bank, which isn't the world-renowned insurance syndicate, has undergone some radical surgery since Chief Executive Eric Daniels took over in 2003.
The new CEO got rid of the company's foreign operations, leaving it to focus on U.K.-based retail banking, mortgage, annuity and corporate finance work. Investors have doubts about this strategy. They've driven the company's American depositary receipts down to $32.30 from $36 earlier this year.
The good news is that Lloyds is a household name with powerful brands. It's one of the U.K.'s leading home mortgage lenders, thanks to its Cheltenham & Gloucester division.
But that's also what worries investors. Lloyds gets the lion's share of its revenue from home mortgages and consumer loans, both areas likely to cool off as interest rates climb. This is one reason First Global analyst Abhishek Shukla advises clients to be cautious about Lloyds.
But Morningstar analyst Mike Ford-Taggart thinks Lloyds' plan to cross-sell services to clients and beef up a long-neglected corporate banking business will pay off. He has a fair value estimate of $48 on the stock. Meanwhile, the stock has a fat dividend yield of 7%, giving investors something while they wait for the turnaround.
Bottom line: This is one of the riskier Morningstar calls given the direction of interest rates and the intensely competitive nature of the U.K. retail banking sector. On the other hand, with a dividend like that, it's probably worth the risk.
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