Call me a contrarian, but if you're going to beat the market, I believe that you've got to look in places everyone else is ignoring. With that in mind, I turned to stocks with mere one-star ratings in our CAPS community, hoping to find some diamonds in the rough. I was particularly seeking companies in the early stages of a turnaround, making them all the more likely to slip through Wall Street's cracks.
I turned up two one-star stocks that have recently begun to rally amid potential turnarounds. On closer inspection, I think one's worth considering -- but the other definitely isn't.
Like a slew of other apparel retailers, Talbots has had a rough year. It's lost roughly half its value over the last 12 months, despite a recent rally -- but that rally has me interested. Not coincidentally, it began when the company announced that it would be profitable this year, despite slow same-store sales.
Talbots generated strong free cash flow of about $140 million in the 2008 fiscal year (ended in February). It used most of that to pay down roughly $125 million in debt, leaving the company with just $389 million in total debt. I don't think some of its cash flows (such as inventory reductions) are sustainable, but I believe that $50 million-$60 million in normalized free cash flow is a reasonable assumption. Relative to Talbots' $665 million market cap, that's quite a healthy yield.
Another positive sign for Talbots is the recent doubling of its credit line by Sumitomo Mitsui Bank. When credit was being handed out like jelly beans a year ago, this wouldn't have been a big deal. In the midst of a credit crunch, it marks an impressive vote of confidence.
Two Fridays ago, the company also announced a new Chief Marketing Officer. Her task, "to revitalize and elevate our core Talbots brand," will definitely be challenging. That said, given the company's recent performance, the hurdles she must clear are set fairly low.
Best known for its tax-preparation services, H&R Block "diworisfied" into mortgage lending a few years ago. However, the company has finally put that episode behind it, selling what remains of the business to equity fund WL Ross & Co. for $1.1 billion.
Unfortunately, that $1.1 billion won't go very far. In the last year, H&R Block burned through that much cash with its operating activities alone. Free cash flow? Fuhgettaboudit.
True, analysts have raised their earnings estimates for H&R Block, and the mortgage-unit sale isn't expected to materially impact those estimates. If the company can indeed earn $1.53 per share in the 12 months ending April 2009, it certainly seems cheap on a P/E basis.
However, that $1.53 in earnings per share would merely return H&R Block to its 2006 levels of roughly $400 million in free cash flow. So even if Block manages to pull off the recovery, the cash flow it generates will only represent slightly more than a 5% yield on its current market cap.
Playing the odds
Let's see ... with Talbots, I get nearly a 10% free cash flow yield before the turnaround, while with Block, I have to hope the turnaround succeeds just to enter the neighborhood of a 5% free cash flow yield.
It isn't hard to figure out the best way to play these turnaround stories.
For more Foolishness:
Want more in-depth stock market analysis? Try any of our market-beating newsletters free for 30 days.
Fool contributor William Trent co-authored Understanding and Evaluating Prospectuses, Offering Documents, and Proxy Statements, and he blogs at Stock Market Beat. He owns no positions in any of the companies mentioned. The Fool has a disclosure policy.