Yesterday was a day of records, with the broad-based S&P 500 again surging to a new all-time record closing high and more than half of all stocks in The Motley Fool CAPS database finishing 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. Take grocer Safeway (NYSE:SWY) for example, which leapt to new highs this week after it was reported that Jana Partners had taken a 6.2% stake in the company. Although Safeway adopted a poison pill plan meant to thwart any attempted takeover, it still points to the likelihood of Safeway's management and Jana possibly coming to agreement whereby the company will jettison some of its lower-margin and less profitable assets. With supermarket margins being a game of inches, any potential for a boost in its bottom line is bound to excite Safeway shareholders.
Still, other companies might deserve a kick in the pants. Here's a look at three companies that could be worth selling.
Cement this selection out of your portfolio
What better way to start kicking companies to the curb than with a business directly influenced by yesterday's Federal Open Market Committee decision not to taper: global cement and heavy construction materials company CRH (NYSE:CRH).
Now if you recall, not every company mentioned in this weekly series is necessarily a poor one, or even one that I'd suggest avoiding for the long-term necessarily. In the case of CRH, it's simply a matter of a share price that's come too far, too fast given the weak state of current and upcoming conditions in the global cement market.
In the U.S., CRH received a pop yesterday because the lack of tapering should mean a continued boom in the home construction sector. By continuing to stimulate the U.S. economy on a monthly basis, the Fed is hoping to keep interest rates low so as to encourage consumers and businesses to borrow, expand, and buy everything from personal items to homes and commercial properties.
But there are also current and imminent concerns on the horizon. Currently, Europe is a mess. Austerity measures throughout the region aren't going to be remedied overnight, meaning infrastructure projects there are predominantly on hold. In the U.S., the consumer and commercial industries are simply biding their time until the Fed actually does begin to taper QE3, which will more than likely send rates higher and stymie the advance in housing.
If CRH were trading with a forward P/E around 10-15, I could maybe support its current valuation. But with its forward P/E of 20 (a higher point than all but two years over the past decade) and a price-to-cash flow of 15 (the highest point over the past decade), CRH would need everything to continue to go its way in order to simply maintain its current valuation. I just don't see that happening.
Running on empty
It has been tough sledding if you're a short seller, or even simply a seller, of application software over the past couple of years. The push toward improved corporate efficiency and cloud-based software that can be accessed from multiple content mediums has pushed the valuation of much of the sector into nosebleed territory. While some companies are turning huge profits and enormous cash flow in its wake, others are merely skimming along despite a frothy valuation. Today, I'm suggesting kicking one to the curb that falls into that latter descriptor: Exa (NASDAQ:EXA).
Exa is actually a niche software provider in that it provides simulation software that automotive manufacturers use to test the specifications of their vehicles and to make their production and functionality more efficient. In theory, this sounds like some very intriguing software -- and it is. However, you have to understand that Exa only became a publicly traded company 15 months ago, and it's debuted into the best automotive sales market the U.S. consumer has seen in seven years. So, playing devil's advocate here, where's the upside in Exa's share price from here on out?
My concern would be what happens when interest rates begin to normalize from these stimulus-induced lows? Aren't car deals with low interest rates going to dry up as well, and hasn't that been the main push behind the recent forecast for 16 million units sold in 2013? That concern should have kept Exa shares grounded, but in actuality, they're now valued at more than 100 times forward earnings and nearly 600 times free cash flow. In other words, if Exa is only marginally profitable in the best automotive market we've seen in seven years, where's the catalyst? I don't believe there is one, and that's why I think it's time to put Exa back on the shelf for the time being.
Closing Pandora's box
OK, so this is a double-down because Pandora Media (NYSE:P) has been on my "sell now and don't look back" list before, but how this company continues to push to new highs following its recent secondary offering announcement and its history of ongoing losses is absolutely beyond my comprehension.
Earlier this week, Pandora announced that it would be offering 18.2 million shares for sale -- 13 million of which are being offered by the company at $25, and the remaining 5.2 million by Pandora's largest shareholder, Crosslink. Although the move, if successful, would raise $325 million for Pandora, it would also dilute existing shareholders by expanding the outstanding shares base by 7.4%. Furthermore, as my Foolish colleague Michael Olson points out, the deal allows Pandora's largest shareholder to jump ship. If Crosslink felt confident in Pandora when it's apparently just a few quarters away from becoming profitable, why bail now?
There are other disturbing factors that should give investors reason for caution. For one, as Michael also points out, Pandora's customer acquisition costs are rising, which is going to make it progressively harder to become profitable. Another aspect that has always concerned me about Pandora's business model is that 82% of its revenue in the second quarter came from advertising. Companies that rely heavily on advertising run the risk of serious problems in stagnant and recessionary economies. Also, when, if ever, will Pandora be profitable?
If you're looking for the digital media play in this space, it's Sirius XM (NASDAQ:SIRI) and not Pandora. Even after Sirius' huge run over the past four years, it recently boosted its EBITDA guidance for the full year to $1.14 billion and passed the 25 million subscriber mark. In addition, customer acquisition costs rose by just 4.5% through the first six months compared to a 12% increase in revenue. In other words, Sirius XM has pricing power and profitability. Pandora really has neither. This is a perfect case of "buy this, and sell that" if I've ever seen one!
This week's theme is all about a looming reality check. With the exception of Pandora, CRH and Exa still look to have a solid, very long-term outlook. However, an imminent paring back of QE3 will come within the next few months, and that alone has the potential to stymie loan and buying activity, which would negatively affect CRH and Exa. In the case of Pandora, it seems apparent to me that at some point, reality will kick in and traders are going to realize that they own a piece of a $4.5 billion company that's never turned an annual profit, whose largest shareholders is cashing in its chips, and that's just issued a dilutive share offering.
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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