Mr. Market appears to have called Congress' debt-ceiling bluff and was off to the races yesterday, approaching another all-time 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. Yesterday's share price explosion from Advance Auto Parts (NYSE:AAP) following its announced $2.04 billion all-cash purchase of privately held General Parts International could be just the beginning for this auto parts supplier. The acquisition will move Advance Auto Parts into new product categories, reduce costs via synergies, and create the largest aftermarket auto parts e-commerce platform in the country. In other words, with an accelerated growth rate now expected, Advance Auto Parts could be a steal at just 16 times forward earnings.
Still, other companies might deserve a kick in the pants. Here's a look at three that could be worth selling.
No four-leaf clovers here
It's been a surprising and impressively strong year for European banks such as the Bank of Ireland (NYSE: IRE).
Bank of Ireland is up about 150% over the trailing-12-month period, yet it still trades at just 95% of book value. It has done a good job of controlling costs by reducing staff, and it has raised its Tier 1 Basel II ratio to 14.2% as of the second quarter, which is considerably higher than the 10.5% minimum requirement set by regulators. It has also benefited from investments by billionaire Wilbur Ross and Canada's Prem Watsa. However, I don't believe things are nearly as rosy as they appear for Bank of Ireland, and I think its luck could be about to run out.
First, Irish GDP growth has been erratic at best: The country has delivered growth in just eight of the past 22 quarters. It's difficult to see how Ireland will be able to dramatically expand its economy when much of Europe remains deeply entrenched in spending cuts.
Second, where are the profits? Although Bank of Ireland is getting a lot closer to profitability than it was, say, two years ago, it still needs to pay back the remainder of its 24 billion euros in loans from the European Central Bank. Thus far, Bank of Ireland is 70% of the way there.
Another concern that has to be on everyone's mind is that Bank of Ireland is still dealing with poor-quality loans in its credit portfolio. Although credit quality has improved, another moderate and/or prolonged recession could easily have Bank of Ireland needing assistance again.
I'm certainly not throwing in the towel on this turnaround, but I no longer see any value in Bank of Ireland at these levels.
A not-so-bright future
Just when you thought the Chinese solar industry was dead, it came roaring back with a vengeance. Many Chinese solar-providers have struggled under mounds of debt and rampant oversupply, which have punished solar-panel pricing. Furthermore, many of these companies have seen unfavorable overseas pricing because of recently instituted antidumping tariffs.
The one saving grace, though, has been the Chinese government, which plans to deploy 35 gigawatts of new solar usage through 2015. In other words, it's single-handedly supporting the Chinese solar industry and polysilicon suppliers like Daqo New Energy (NYSE:DQ).
Daqo shares have more than tripled over the past month as day traders latched onto long-term contracts the company signed on Sept. 19. While these contracts are good news from a volume perspective, they also leave Daqo very much exposed to weak spot market pricing for its polysilicon. It also puts Daqo in trouble should one of its three largest customers pack its bags and leave once its contract expires, as the polysilicon supplier receives a whopping 70% of its revenue from those three customers.
Like Bank of Ireland, another primary worry is that profits are still a long way off. Even if Daqo's revenue explodes higher because of these newly forged deals, polysilicon prices aren't moving much higher. This means its margins won't be conducive to turning a profit. Daqo actually lost $7.61 per share through the first six months of the year. That's a concern for a company that only had $6 million in cash and $260 million in net debt as of last quarter.
Until Daqo's margins improve dramatically, I don't see a scenario in which this stock is anywhere near a good value.
Time to hit the escape key?
Sticking with small-cap companies, let's turn our attention to CTS (NYSE:CTS), a manufacturer of electronic components and sensors.
Normally, electric component makers trade at relatively low multiples because they deal in a business that's becoming increasingly more commoditized. Although they may see sales rise or volume increase, margins for technology components are generally not very high. In the case of CTS, the company has missed earnings-per-share expectations once over the past year, and full-year EPS expectations were again lowered after its most recent earnings report.
The reason for the recent surge in shares relates to the sale of its electronics manufacturing solution segment, or EMS, to Benchmark Electronics for $75 million. The deal definitely is a positive in that it generated $75 million from a segment that I saw as a slowly sinking ship. Unfortunately, that leaves CTS with its components and sensors business, which hasn't exactly been lighting things up, either.
CTS is dependent on government and aerospace spending to drive growth, and I have trouble seeing how it'll generate any consistent increase in its top and bottom lines with Congress looking to aggressively reduce the federal budget deficit. What this means is that CTS could be exceptionally expensive at even 18 times forward earnings, as its revenue base is shrinking.
Until I see consistent top-line expansion, I think it best to keep your distance from CTS.
This week's theme is all about hope versus reality. In all three cases investors have viable hope for a turnaround, with Ireland's GDP growth in the second quarter back in the black, Daqo racking up long-term orders, and CTS ridding itself of its shrinking EMS business. However, for Bank of Ireland and Daqo there's nothing to signal that either will be profitable anytime soon, and for CTS it's difficult to see a scenario in which aerospace spending improves its remaining operations.