Not even the enacting of $85 billion in budget cuts has been enough to keep more than 50% of companies in the Motley Fool CAPS Screener from creeping within 10% of a new 52-week high. For skeptics like me, that's an opportunity to see whether companies have earned their current valuations.
Keep in mind that some companies deserve their current valuations. Southern regional bank Regions Financial (NYSE:RF) is a great example. In its most recent quarter, Regions reported a $265 million profit, reversing a huge $548 million year-ago loss, and noted that its net interest margin expanded two basis points to 3.1% as it shed and paid off undesirable commercial real estate assets. As the economy continues to improve, Regions loan quality should improve as well, sending this company markedly higher.
Still, other companies might deserve a kick in the pants. Here's a look at three companies that could be worth selling.
This is speculating, not investing
The past week has been like 1999 all over again for mortgage insurers like Radian Group (NYSE:RDN) and MGIC Investment (NYSE:MTG). Both companies were upgraded on Tuesday by Barclays analyst Mark DeVries, who sees sector earnings returning to normal by 2015 as bad legacy loans are slowly wiped off the books. He also set price targets of $14 on Radian and $8 on MGIC, which was practically a double from the $4.18 it closed at prior to the upgrade. Today, I'm going to rake MGIC over the coals once again!
DeVries' call has definitely brought out the message-board day traders, but little substance exists behind his analysis on MGIC, in my opinion. To begin with, I'll point to the company's abysmal and worsening operating performance, which includes 10 straight quarterly losses and a risk-to-capital ratio of 44.7:1 that's only expected to worsen and is approaching double of what U.S. regulators would consider safe on the top-end of their estimates. Even with its situation improving, 13.9% of all loans are still delinquent -- certainly not a manageable figure.
There's also the fact that MGIC's plan to get back into compliance involves crushing shareholders who've ridden this rally higher by issuing 135 million shares and $350 million in convertible debt. Furthermore, underwriters have the option to purchase an additional $50 million in convertible debt. Prior to this offering, MGIC had only 202 million shares outstanding. Following this offering, and hypothetically including the potential conversion of all debt to shares, MGIC's outstanding shares count could more than double to 408 million shares. This type of dilution should quickly crush MGIC's share price!
There's a fine line to be walked in the software-as-a-service sector between sky-high valuations and incredible growth rates. Unfortunately, I don't feel that E2open (UNKNOWN:EOPN.DL) makes the cut.
E2open, which provides on-demand supply chain management software for enterprises, delivered solid growth in its third-quarter results released in early January. Revenue rose 31% to $19.5 million and the company increased its booking forecast for 2013 to 30%-35%. However, there are plenty of negatives counteracting this rapid growth.
To begin with, E2open is still burning through cash and losing money. Its 2013 projections call for a free cash outflow of $3.1 million to $4.2 million and a loss of $0.06-$0.08 per share. With sales growth expected to slow to just 22% according to the Street's estimates in 2014, is it worth paying 433 times forward earnings? I'd certainly say, "No!" What's more, it isn't as if E2open is sitting on a gigantic pile of cash, either. Yes, it boasts $32.4 million in net cash, but, that doesn't make up for the fact that it's valued at seven time sales and 26 times book value. It'll be years before E2open's costs are brought under control, which makes further upside seem very unlikely.
Someone dim these lights
Every once in a while an idea comes along that makes a lot of sense, but the underlying valuation of that company does not. This would be a perfect description for LED bulb company Cree (NASDAQ:CREE) which just boosted its quarterly sales forecast to a range of $335 million to $350 million from $325 million to $345 million, and announced that it was introducing a new energy-saving LED for just $9.97.
On the surface, this looks like it could be a big seller for Cree, with consumers switching from standard incandescent light bulbs to very affordable energy-saving bulbs from Cree. However, the magnitude of extra sales I'd expect Cree to get is pretty nominal relative to the $900 million in market value Cree has tacked on since it announced this news on Tuesday. Based on Cree's and analyst estimates, Cree is expected to grow sales by 17% in each of the next two years, but is valued at a smidge over 30 times forward earnings. With a PEG ratio near 2, it's difficult to assume Cree will head higher.
Given Cree's shaky earnings history that has seen it miss the Street's estimates in five of the past nine quarters, I'd suggest taking this recent rally as the perfect time to exit stage left.
This week's theme is all about realistic expectations. It's not too far-fetched to assume that the mortgage insurance industry is improving, that supply chain management demand is growing, or that LED demand is rising. What is difficult to imagine are the valuations on all three companies persisting with all three having a sketchy earnings history at best.
Fool contributor Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.
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