There's more to value investing than just screening for stocks with low P/E ratios. Often, companies are valued at low multiples for a good reason, and it's important to weed out these value traps from legitimate opportunities. When a company's business is declining the price you pay needs to be reasonable based on the future, not on the present. Let's take a look at three companies that appear to offer value, but in reality should likely be avoided.
The mail business
As email and other forms of electronic communication have proliferated since the age of the Internet began, physical mail volumes has been on a sustained decline. First class mail volume handled by the United States Postal Service annually peaked in 2011 at a little more than 100 billion items, falling to about 69 billion items by 2012. This reduction in volume has caused the United States Postal Service to face big deficits, and as a result companies that supply postal equipment, like Pitney Bowes (NYSE:PBI), have faced issues as well.
Pitney Bowes derives much of its revenue from the sale and rental of mail-processing equipment, and although the company has branched out into software, the core business is on the decline. Revenue peaked in 2008 at approximately $6.3 billion, falling to just $4.9 billion by 2012. One big reason for owning Pitney in the past was its dividend, but this was cut in half earlier this year. The stock still yields about 4.4% based on this new dividend, but a dividend cut should be anathema to a dividend investor.
In 2012, Pitney earned $2.21 per share, putting the stock at just 7.8 times earnings. If Pitney were a growing or even a stagnant company this price would be a steal, but there's no reason to believe that the company will be able to halt falling revenue and profits for the foreseeable future. Another issue is the company's $3.6 billion in debt, on which Pitney paid nearly $200 million in interest last year.
There seems to be no end in sight to the decline in mail volume, and with Pitney still heavily dependent on physical mail there is no telling when the company might stabilize. Long term, Pitney is a terrible idea, and while the high dividend may look attractive it's not worth the risk.
There's an app for that
Shares of Weight Watchers International (NYSE:WTW) have fallen by more than 50% from a high of about $80 per share in early 2012, creating what appears to be a bargain. The stock trades at just 8.8 times last year's earnings, with the company achieving an impressive net income margin of 14%. But these numbers don't tell the whole story.
Back in 2012, Weight Watchers took out about $1.4 billion in debt in order to buy back about a quarter of its outstanding shares at a price of $82 each. At that price the stock certainly wasn't cheap, and with the stock price falling under $40 per share the move looks increasingly like a terrible idea.
Today, Weight Watchers has nearly $2.4 billion in debt compared to a market capitalization of just $2.1 billion, putting its enterprise value at $4.5 billion. This puts the EV/NOPAT ratio at about 13.5 using 2012 figures; not nearly as cheap as the simple P/E ratio suggests.
The other issue is the future. Weight Watchers is essentially a program that counts calories via a points system, and the unique aspect of the business is the company's network of weekly meetings. However, meeting attendance has been falling, threatening the very thing that makes the company stand out.
One reason for this decline is likely the enormous number of free weight loss and calorie counting apps available for smartphones. These apps essentially do what the Weight Watchers' program does for free, and I suspect that Weight Watchers will have trouble maintaining its extremely high margins going forward.
Analysts are expecting earnings to decline, with the average estimate at $3.65 per share this year and $3.22 per share next year. These estimates are down from $4.23 per share in 2012.
The death of the DVD
Automated-retail company Outerwall (NASDAQ:OUTR), formerly Coinstar, derives most of its revenue from Redbox movie-rental kiosks. Although the company is not in decline yet, growth is slowing, and the shift to digital promises to eventually make the Redbox business obsolete.
Outerwall trades at about 12.2 times last year's earnings and 9.7 the average analyst estimate for this year's earnings. If the company were capable of matching its growth over the last decade, the stock would be a great deal. But increasingly, consumption of content is shifting from disc-based to digital, with the popularity of Netflix a glaring example. Outerwall, through a partnership with Verizon, has its own streaming platform, but with intense competition from Netflix and Amazon.com it will be difficult to turn a significant profit from this venture.
Outerwall is testing some new concepts, such as coffee vending machines, but none of these have the potential to become as big as Redbox. Exactly when the decline starts is anyone's guess, but physical disc rental is a dying business. And with it goes Outerwall's most important component.
The bottom line
Just because a company looks cheap doesn't mean that it is. Many times a low P/E ratio indicates a dismal future instead of value, and these three companies all face big problems going forward. Buying a declining business is a risky move, and the price needs to be extremely cheap for it to make sense. None of these companies are cheap enough, and they should probably be avoided.
Timothy Green has no position in any stocks mentioned. The Motley Fool owns shares of Weight Watchers International. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.