Even though cost-cutting has been the primary reason for most EPS beats early on this earnings season, the broad-market S&P 500 continues to take out new all-time closing highs on a nearly everyday basis. 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. Take Texas Instruments, for example, which reported better-than-expected second-quarter results earlier this week as it's beginning to reap the benefits of moving away from semiconductors used in wireless devices and instead focusing on those used for power management and in automobiles. With far less competition in these areas, Texas Instruments is expected to generate more robust margins.
Still, other companies might deserve a kick in the pants. Here's a look at three companies that could be worth selling.
Lights out, China
China may have its fair share of struggles -- which has caused its strong economy to back off its 30-year average growth rate of 10% -- but when push comes to shove, plenty of investors are still paying close attention to multinational companies making investments in China. However, if there were one sector with a gigantic "beware" stamp attached to it, it would be Chinese solar panel producers like Hanwha SolarOne (NASDAQ:HQCL).
Hanwha and much of the Chinese solar sector have seen enormous rallies in recent weeks on the heels of news from China that it plans to add 35 GW of solar energy by 2015. Even with prices nowhere near optimal, this move is seen as a way for the Chinese government to support a very debt-riddled sector. But two key factors are working against Hanwha.
To begin with, Europe is set to enforce a whopping 67% tariff on Chinese solar panels beginning early in August. This movie will wipe out almost any pricing advantage Chinese companies had in Europe. The other factor here is the health and pricing power that U.S. solar producers like First Solar (NASDAQ:FSLR) suddenly have. Comparatively speaking, First Solar has strong free cash generation and $439 million in net cash. Hanwha has had a free cash outflow in all but one year since inception and boasts $622 million in net debt with a shrinking cash pile. With First Solar's higher-efficiency panels and lessening costs, it can give any Chinese manufacturer a run for its money in the States and even overseas.
With the prospect of profitability a long way off, I'd say even something as simple as survivability could be in question with Hanwha, and, as such, would recommend hitting the exits here.
Don't fight history
Sometimes we just have to remember as investors that there isn't room enough for every company to succeed. Thus enters dELiA*s (NASDAQOTH:DLIAQ), an online and mail catalog retailer that markets apparel to teenage girls and young women.
Some common thoughts might enter your mind here, such as, "That sounds like a core niche where it should be able to expand its market share," or, "Focusing on Web sales, it should have no trouble reaching young consumers." What I need you to do now is take those thoughts and completely throw them out the window, because that isn't the case with dELiA*s at all. In fact, in dELiA*s most recent quarter, it delivered a depressing 14.6% decrease in cumulative revenue and a same-store sales decline for its prominent retail segment of 7.1%. Furthermore, gross margins declined by 740 basis points in its retail segment as it turned to steep markdowns to help move excess inventory.
This might sound like a problem that could have a fix, but if you look at dELiA*s historically, it's had plenty of time to right the ship and has failed. It's only turned an annual profit in two of the past 10 years, and has been free cash flow positive only once since 2004 -- and that was a year in which it struggled to deliver $0.01 per share in free cash flow! To add even more complexity to its apparent issues, it recently hired a new CEO, Tracy Gardner, who was herself just hired in April as the company's chief creative officer.
This has all the makings of a sinking ship without any identifiable catalyst or differentiating factor from its peers. If you ask me, I'd say, avoid, avoid, avoid!
Paper profits and real-world disappointments
We really can't deny the fact anymore that cybersecurity has become a practical necessity for today's businesses and governments. Hackers are becoming more sophisticated, but so are software developers, who are coming up with countless new ways to stay ahead of would-be hackers. While the entire sector is likely to see an influx of business, not every company makes sense as a smart investment.
One company in particular I'd suggest putting back on the sales rack is Proofpoint (NASDAQ:PFPT), a threat and regulatory security-as-a-service provider. The profit potential is certainly there. Proofpoint's SaaS model is built around getting the client hooked on its products and making it inconvenient and cost-inefficient for them to switch to a competitor. In other words, it's setting up its own razor-and-blades model that should fuel recurring revenue for years to come.
Unfortunately, investors seem to think we're already in the year 2016 or beyond, because they're pricing Proofpoint up in nosebleed status despite the fact that it's unlikely to be profitable on an annual basis until fiscal 2015. In its most recent quarter it saw sales rise by 25% (that aforementioned but expected robust sales growth), but delivered net operating cash flow of just $1.2 million. Extrapolated, that's a market value to free cash flow value of around 170! I don't know about you, but this sounds like the epitome of trying to squeeze blood out of a turnip. My suggestion would be to wait for a significant pullback or allow Proofpoint's cash flow to catch up with its valuation over the next year or two.
This week's theme is all about "what you've done for me lately." In each case, all three companies present compelling reasons for a rebound on paper, but none of the three has delivered a profitable year anytime recently (or ever, in some cases!). Until we see decisive steps in the right direction, I'd suggest keeping your distance.
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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