Roundtable: 1 Underdog Stock I'm Watching

Here's what water heaters, IHOP, and a Russian search engine all have in common.

Brian Stoffel
Brian Stoffel, Timothy Green, and Tyler Crowe
Jun 15, 2017 at 4:24PM
Technology and Telecom

It's never a good idea to get emotionally attached to an investment, and that's especially true of stocks. But sometimes, we can't help but root for the underdog. If the stock becomes a big winner, it could mean enormous upside potential. With this in mind, our analysts talk about three underdog stocks theyre watching closely: Dine Equity (NYSE:DIN), A.O. Smith (NYSE:AOS), and Yandex (NASDAQ:YNDX).

A small boxer taking on a much larger opponent.

Image source: Getty Images.

Revamping tired restaurant chains

Tim Green (DineEquity): I won't sugarcoat it: DineEquity, owner of the Applebee's and IHOP brands, isn't doing well. The company franchises restaurants under the two banners, and both are suffering. During the latest quarter, same-restaurant sales slumped 1.7% for IHOP and 7.9% for Applebee's.

DineEquity is working to stabilize Applebee's. Executives have been shuffled, a new advertising agency has been selected, and changes have been made to the menu. At IHOP, the company is hoping that restaurant remodels and a push into delivery will drive sales higher.

The restaurant business is tough, but DineEquity's franchise model remains extremely profitable. The bottom line dropped significantly during the latest quarter due to lower franchise fees and spending on Applebee's stabilization efforts, but the company still managed a pre-tax margin of 15.5%. The company expects most of these extra costs not to recur next year, which should boost the bottom line.

DineEquity also pays a generous dividend, which currently yields 8.3%. The dividend may get cut if the situation doesn't improve this year, but for now, investors collect quite the payday each quarter. DineEquity certainly has a lot of work to do, but with the stock trading for just 8.5 times last year's earnings, it's one I'm keeping an eye on.

Great returns for an underappreciated stock

Tyler Crowe (A.O. Smith): There are hundreds of stocks that don't get an ounce of press coverage. Perhaps it's because they're in boring industries, or perhaps they're no-nonsense businesses that don't bother with flashy acquisitions, or other attention-seeking actions.

In the case of A.O. Smith, it's a boring business -- manufacturing and selling water heaters and water-purification equipment -- and has a management team that keeps its head down. This means that A.O. Smith doesn't get much attention in the market, but investors should pay attention because this company is a high-return gem. 

AOS Total Return Price Chart

AOS Total Return Price data by YCharts.

The knee-jerk reaction for most investors is that selling water heaters and similar equipment sounds like a business intrinsically tied to the housing and construction market. While new housing starts is a contributor to the business, it isn't as much as you might think. More than 80% of U.S. water-heater installations are replacements, which makes for a steady cash-generating business where A.O. Smith can leverage its dominant market share for pricing power

Chart of U.S. residential water heater sales over time, which shows a vast majority of sales come from replacements.

Image source: A.O. Smith investor presentation.

While the North American market provides a steady business that throws off cash, A.O. Smith also has an immense growth driver with its sales in China and India. Sales growth in China has grown 22% annually over the past 10 years, and there are few signs of it slowing down as middle-class Chinese consumers elect for higher-quality foreign manufactured products.

From 2002 to 2016, the company has grown its water-heater market share in China from 6% to 25%, and growth rates for its household water and air-purification systems are growing at an even faster rate. A.O. Smith is still getting its feet wet in the Indian market, but it anticipates a similar growth trajectory over the next several years. 

Few people on Wall Street are paying attention to this stock because, frankly, too many people think that a boring business like water heaters isn't a place to find the next great growth stock. They are missing out because this is a company growing adjusted net income at a 25% annual rate, and its price-to-earnings ratio isn't completely unreasonable at 29 times. Is there anyone who can't root for this kind of underdog stock?

Growing up in the shadow of Google

Brian Stoffel (Yandex): It isn't easy being a search engine not named "Google." Just ask shareholders of Yandex, the dominant search engine in Russia, who watched the stock fall 75% between early 2014 and mid-2015. Though shares have recovered somewhat since then, the company still operates in the shadow of Google.

As it is, there's a lot to like about Yandex. It's a founder-led company where insiders own 11% of shares and 47% of the voting power. The company also has been broadening its reach impressively: Revenue is growing at an impressive clip from e-commerce (24%), classified ads (54%), taxi hailing (75%), and a host of other "experiments" (76%).

The company also recently won an important antitrust suit against Alphabet. Previously, Android smartphones used Google as the automatic search app. Now, however, that won't be the case, and investors hope this helps stabilize Yandex's search-market share, which hovers just above 56%.

Though I already own shares of the stock, it constitutes less than 1% of my real-life holdings. For the time being, I'm waiting to see if this underdog can retake market share and benefit from its homegrown initiatives to become a full-fledged success story.