A few days back, in an article called "Buffett's Stealth Values," I used a simple screen to try and identify low-key, consistent growers that might be trading at a discount to the present value of their long-term potential. I did this because, unlike other idea-generating resources that we use at Motley Fool Inside Value, such as the 52-week low list, I figured this screen would be a little less likely to come back with overly complex, distressed companies. To review, the screen looked for companies that displayed:
- Growth in earnings per share between 10% and 25% over the past five years. I wanted to get rid of companies whose high growth would be more likely to attract crazy money. But I'm also looking for companies with a track record of steady growth.
- Trading at a price-to-earnings (P/E) ratio between 8 and 20. Companies trading at this ratio, at the growth rates above, fit into a broad definition of "reasonable."
- Trading at a 10% discount to its average P/E ratio over the past half decade. No reason to pay full price if the market is willing to hand us a deal, right?
- Market capitalization of less than $10 billion. I'm more interested in slightly smaller companies. Behemoths can grow, too, but it's tougher for them to find room to run.
Of course, the problem with screening is that it relies on lagging indicators, like past earnings, so it's only a source of ideas, and maybe not good ones. Whether you've got stealth values or steel deathtraps depends on what's coming down the pike for the companies that ended up in the sieve. I picked the following companies out of the few dozen that survived the screen because they had the advantages of well-known consumer brands -- something I think is a key asset when hard times come a-calling, as they always eventually do.
|
Current |
5-yr Avg. |
Market Cap | |
|---|---|---|---|
|
Brunswick |
11 |
16 |
$3.6 |
|
H&R Block |
13 |
14 |
$7.8 |
|
Lexmark Intl. |
11 |
25 |
$5.1 |
|
Ruby Tuesday |
14 |
16 |
$1.3 |
|
Stanley Works |
15 |
20 |
$3.8 |
|
Tiffany |
18 |
24 |
$5.6 |
|
Wolverine World Wide |
19 |
21 |
$1.3 |
|
Yankee Candle |
14 |
19 |
$1.1 |
Today, we'll take a look at the biggest "No, thank you's" on that list -- companies that are, in fact, pretty complex, distressed enterprises.
Bet against Buffett?
Feeling lucky, punk? That's what Warren Buffett might ask you about H&R Block -- that is, if Warren Buffett were inclined to paraphrase Dirty Harry -- and let's hope that he is. And it's what investors may need to ask themselves, as well. Do you want to buy what Buffett didn't want?
You may think you know H&R Block, but the tax-time franchise has been getting its growth lately from a couple of decidedly different segments. One is business services, which is still a small and unprofitable portion. The other is mortgage loans, and therein resides the risk, from many investors' perspective.
While the mortgage biz was only 28% of revenues for the year ended in April, 2005, it comprised 48.7% of net profit before taxes. To put it another way, the pre-tax net margin for the segment ran near 40%, versus the 28% at the larger tax-services segment. And we're talking here about non-prime lending. For investors, that means a fair degree of risk from financial complexities, intense competition, and a fair degree of profit risk if the mortgage market cools. And there are plenty of smart people out there who think that this is not a question of if, but when.
While this company has a strong brand name, its traditional business faces challenges from software, as well as the risk that our tax code just might get simpler. Given those potential upheavals and the amount of current growth that relies on an overheated housing market, I'd need to see H&R Block get a lot cheaper before it would make it onto my true value list.
Wax on, wax off
Yankee Candle Company is a firm people have written me about for months, but I have to admit -- I was skeptical even without digging into the numbers. High-end fragrances for our sniffers? Sounds OK, I guess. But my problem has always been this: Just how many candles can you sell? And what, exactly, is the moat here?
Turns out, I didn't need to rely on knee-jerk doubts to come up with a reason to be concerned about Yankee Candle. The firm's recent financial performance gives us all the worry we need. When I heard about this company's recent earnings announcement and restructuring plans during the morning news on NPR (not well known for its in-depth coverage of individual businesses), I knew things were bad.
Third-quarter revenue rose just 7%, while comparable sales were an anemic 1%. EPS grew to $0.35 from $0.33, but that increase was owed entirely to share buybacks. Net income actually dropped. More disturbingly, the quarter simply continues a trend that's been set for much of the year. And the larger-than-sales-growth increase in accounts receivable suggests to me that we'll be seeing more troubles in moving products.
Management deserves accolades for tackling the problem head-on, announcing plans to close up to 20 underperforming stores and lift prices. But given the problems competitors are having, a strong divergence from the generally decent sales other retailers are showing, my guess is that the candle biz just isn't all that great. This looks like the healthiest of an unhealthy bunch, and cash-flow generation is decent. But without growth, that cash flow isn't worth the going price. Unless the market offers Yankee Candle at a much better discount, I wouldn't buy into the dripping wax biz.
Blurry pictures
Lexmark International was one of the Street's screamers recently, dropping a third of its market cap in just a couple days and dribbling down to less than half of what it was worth a year ago, putting the stock near a five-year low.
The problems were detailed by my colleague and a fellow fan of cheap stocks, Stephen Simpson. Suffice to say that a warning for earnings at half the rate expected, accompanied by revenue shortfalls, was not treated too kindly by the jittery, late-summer market.
But as Stephen also pointed out, Lexmark's balance sheet is strong, and it's got a history of producing good cash flow. So the real question here is not whether it can weather a short storm, but whether this is, in fact, a short storm or a long-term problem.
I think it's the latter. Read an earnings release from any of the players in the field, and you'll see that the printer market is intensely competitive, with other big outfits like Hewlett-Packard slugging it out alongside Asian manufacturers like Canon and Epson. At the same time, the market for computers and peripherals seems to have fractured into a couple of segments -- must-have brands like Apple, and everything else, where agnostic consumers demand low prices.
Lexmark, a brand that doesn't resonate with consumers as well as even HP, is probably stuck in the "everything else" category. Therefore, competing in this arena is going to take a constant culture of cost-cutting, and I don't think the recent work-force reduction is going to do enough to fix the situation for good. For that reason, I wouldn't be surprised at all to see recent margins near 10% eroding back toward the 7% and 8% marks that were the norm a few years back.
I wouldn't count out Lexmark forever, but again, like Stephen, I don't expect to see anyone rush to get back into Lexmark. There are still too many things that can go wrong here to warrant betting on this horse. I'd rather pay more for the shares later and pay up for a little clarity than jump in before all the problems have been shaken out.
The Foolish bottom line
Screens are useful tools, but they're only the beginning. Next week, we'll take a look at the survivors from the list. Until then, if you're looking for thoroughly vetted value plays, or just want to join a community of investors who are interested in digging up strong companies that the street ignores, a free trial of our premium service, Motley Fool Inside Value, is only a click away.
For related Foolishness:
- How to Buy Low and Sell High
- Is HP a Turnaround Play?
- Check out H&R Block's Figure
- Lexmark's Spotty Guidance
Though he likes the spicy meatballs, too, Seth Jayson is a cheapskate at heart, which is why he's a member of the extended Inside Value family. At the time of publication, he had no positions in any company mentioned. View his stock holdings and Fool profilehere. Fool rules arehere.
