A Year for New Bargains

January has to be the best month of the year. (In the interest of disclosure, I was born in January.) January includes the 31 days when we have the best chance of keeping our new year's resolutions. It offers the finest skiing in North America. And it provides some of the best post-holiday shopping bargains. This year, though, I am keeping my car in the garage and my credit card in my wallet, and I'm going after some bargain stocks.

I ran a screen based on my bargain hunting article that The Motley Fool published in September 2004. Here are the screen's criteria:

1. The current price is less than half the two-year high;

2. The P/E ratio is less than three-quarters of the industry average;

3. And enterprise value/free cash flow/growth is less than 0.75.

After throwing out financial companies and real estate investment trusts (REITs), I was left with six prospects for this year:

* Market cap in millions

** EV/FCF/G ratio equals enterprise value to free cash flow to expected growth.

Next, I did a little Foolish research on these guys. Three of the companies had compelling attributes, and three seemed like dogs. I'll start with the dogs. We'll discuss the good bets in my next article (so stay tuned).

Career Education
Career Education provides in-classroom and online post-secondary education. Along with the rest of the sector, Career Education has received a lot of negative attention recently. The Department of Education is concerned about some of the company's operations and has restricted the company's ability to obtain federal funds related to student financial assistance. A regional accrediting body put the company on probation, and the Securities and Exchange Commission is investigating whether it fudged enrollment figures to attract investors. If all of that weren't enough, some of the company's aggressive sales tactics were profiled on a 60 Minutes segment -- not the type of publicity that makes investors happy. The resulting decline in the stock's price led to Career Education being removed from the Nasdaq 100 index, which caused the company to lose another 4.4% of market cap.

Still, this is certainly not a company to give up on easily. From 1999 through 2004, Career Education's net margins grew nearly 16% per year on 51% annualized revenue growth. These numbers make a stock trading at less than 15 times earnings look pretty attractive. However, there are a few reasons to be cautious.

Career Education is facing stiff competition from some very big fish, including Apollo Group (NASDAQ:APOL), CorinthianColleges, and ITTEducation Services. As companies battle for warm bodies, profit margins and revenue growth may erode. Compounding this pressure is the upturn in the economy. When job prospects improve, fewer people go back to school, which means the post-secondary student market shrinks. If the economy continues to recover (a big if in my book), these companies may face decreased enrollment. For my money, there is too much uncertainty here, not to mention regulators' angst, to justify the risk.

Infocrossing
Infocrossing provides outsourced IT management services. If you needed to get your new offices outfitted with copiers, phone systems, and computers, you could call these guys. They could also help you manage your payroll, customer relations, and some accounting issues.

In March, Infocrossing guided quarterly earnings numbers lower. It did it again in July, and to top it off, completely withdrew its guidance for the year. The company said it was having difficulty closing new contracts, and that was making it hard to estimate revenue numbers. Investors punished it, dropping the stock from $20 to $6.35.

There are a few reasons why I would be hesitant to invest in Infocrossing. The company has been very active in acquiring new businesses. Incorporating acquisitions is often problematic and always expensive. In addition, acquisitions must be paid for -- either with equity, cash on hand, or debt.

For a small company, equity is the most appealing currency because it essentially comes at no cost. And although existing shareholders pay through share dilution, they are presumably getting something of value (the acquired company) in return. Infocrossing, however, has relied much more heavily on cash and debt to finance its acquisitions. Cash is a precious commodity -- using up cash can jeopardize a company's ability to maintain ongoing operations -- especially when revenue is uncertain. And debt is expensive. Infocrossing has racked up a debt-to-equity ratio of 96%. That is a little high for my tastes. With uncertain revenue and the challenge of incorporating new businesses -- on whose success Infocrossing seems to have bet heavily -- I would sit this one out.

Multimedia Games
Multimedia Games makes equipment for Indian, charitable, and video lottery gaming operations. From 2000 to 2004, the company was a 30-bagger. Since then, things haven't looked so rosy. And neither does the future.

Recently, Multimedia Games has made a habit of disappointing investors with reduced guidance numbers. Over the last year, gaming equipment and system revenue declined 76% and operating income declined 41%, while administrative costs increased 6%. The company is having a hard time selling its product, and that is bad news.

I went to its website to look a little deeper and came across this gem (on the front page of the investment relations section):

"Multimedia Games presently has activities under way in 12 states . that present meaningful opportunities for expansion in fiscal 2002."

So, if costs are increasing, revenue is decreasing, and the website hasn't been updated since 2001, what the heck are they doing over there? I see no reason to gamble on this one.

Foolish bottom line
Obviously, not every cheap stock is a good deal. These three companies highlight some potential pitfalls:

1. Be skeptical of companies under investigation or on probation (especially if there are multiple issues);

2. Be wary of (smaller) companies that are trying to grow through many acquisitions that may be indigestible;

3. Avoid companies facing stiff competition or shrinking markets, or both. Declining margins are likely to follow.

In my next article, I will look at SFBC, InfoSpace, and SigmaTel. I will explain why I believe all represent potential bargains. As always, be a Fool and do your own due diligence before you consider an investment in any stock.

For related Fool content:

• Bargain Hunting
• Has Career Education Learned Its Lesson?

Philip Durell likes shopping for bargains, too. His Motley Fool Inside Value newsletter looks at companies whose stocks are undervalued. Click here to learn more, and if you subscribe for one year, you'll get a free copy of Stocks 2006 , our analysts' top picks, free.

Fool contributor Jim Schoettler's new year's resolution is to invest solely in 10-baggers. He does not own shares in any of the stocks mentioned in this article. The Motley Fool is investors writing for investors.