| Two
Undervalued Income Stocks |
Published: July 20, 2004
Editor's Note: In each monthly issue of her High-Yield
Investing newsletter, experienced analyst Carla Pasternak devotes an
article to an in-depth analysis of two high-quality income-producing
investment ideas. In her most recent issue she placed the spotlight on
two undervalued stocks in out-of-favor industries, and below you'll find
an excerpt from that article...
CITIGROUP (C)
It’s a knee-jerk reaction. When rates rise, bank stocks fall. The fear
is that bank earnings may be squeezed by the need to offer higher rates
on customer deposits than banks will earn on fixed, long-term loans.
Since February, the benchmark bank index has dropped
more than -4%, compared with just a -1% fall in the overall market. Bank
stocks have declined despite the fact that most firms delivered robust
first-quarter results--a sign that investors weren’t looking beyond
their wall of worry.
The truth is that not all banks will be hard hit by
higher interest rates. In fact, some might even benefit from them. Firms
such as Citigroup, the world’s largest financial services provider,
don’t depend on interest income for a major portion of their revenue.
Instead, sales come from a variety of sources, including fees from
investment banking, asset management and insurance. A few weeks ago, for
instance, Citigroup bought the mortgage servicing business of Principal
Financial Group (PFG).
The timing of that purchase was a stroke of genius.
Last year’s record low mortgage rates led to a rash of new loan
activity. As rates continue to rise in the months ahead, new financing
levels will fall off. However, existing loans will still need to be
serviced. The profits Citigroup will generate by servicing long-term
loans--especially ones at floating rates--will give the bank a hedge
against higher interest rates.
But mortgage servicing is only a small portion of
Citigroup’s $18 billion earnings picture. The company is one of the
most diversified financial services firms in the world. In fact,
Citigroup is a global leader in a full spectrum of financial services,
including credit card processing, consumer finance, retail banking,
corporate lending, investment banking, brokerage and asset management
services--just to name a few. Interest rate changes will have little
impact on the firm's host of fee-based businesses. And with services in
over a 100 countries throughout the world, Citigroup’s geographical
diversification offers yet another moat against the Fed’s attack on
the U.S. economy.
The bank has proven itself to be one of the most
consistently profitable performers throughout both good times and bad,
whether interest rates are moving up or down. Citigroup has churned out
average earnings growth of +20% a year for decades. Its return on
equity, a key measure of the bank’s ability to generate income from
its asset base, has been in an above-average 20+%-range for years. In
the most recent quarter, company revenues rose nearly +10% to $15.8
billion thanks to higher loan interest and fees received. Earnings rose
+28% to $1.01 a share, helped by expanding margins.
Citigroup has also enriched shareholders with a
dividend that has grown at the same clip as earnings. The stock pays a
$1.60 dividend (a roughly +3.5% yield) and has increased its payout by
an average of +32% in each of the last five years. Citigroup's currently
steep dividend yield is more than twice the firm’s own historical
average. Meanwhile, its PE of 13 times last year’s earnings and its
PEG (PE to growth rate) of less than one times future earnings are both
at relatively low levels when compared to the stock’s historical
norms. Together, these measures suggest this is an opportune time to
capture the stock at undervalued levels and lock in its above-average
yield.
PULTE HOMES (PHM)
Leading homebuilders such as Pulte Homes (PHM) have recently posted
robust quarterly results, but their stocks are trading about 10% below
their March highs. What gives?
The answer is obvious: when interest rates rise,
building stocks will suffer--or so says conventional wisdom. In reality,
however, higher rates may affect the cost of buying a new home, but the
impact on major builders such as Pulte might not be as dramatic as many
people think.
Pulte is among the largest residential homebuilders in
the country and one of the few that serves all major population groups.
With a strong presence in the first-time, move-up, and aging baby-boomer
markets, Pulte should benefit from a variety of long-term demographic
trends expected to boost demand for new homes in the years ahead.
The company’s performance speaks volumes. Last year,
Pulte earned $624 million ($4.90 a share) on $9 billion in revenues.
Profits have been growing at a roughly +30% annual clip for years. In
addition, a close look at how the firm fared throughout the last two
rate-rising periods is especially enlightening. In the
high-interest-rate cycles of 1994 and 1999, Pulte’s sales grew +18%
and +30%, respectively. Meanwhile, operating profits ballooned +14% in
1994 and +69% in 1999. Past results don’t guarantee future success,
but they sure are a testament to the company’s resilience in tough
times.
Record earnings, expanding markets, a substantial
order backlog and an improved earnings outlook all point to a bright
future for Pulte. In the first quarter the firm posted record earnings
of $1.02 a share, which represented an increase of +46% from a year ago.
What's more, the company's +30% increase in new orders during the
quarter proves that Pulte’s move into diversified housing markets is
paying off.
Equally important going forward, a record $5.4 billion
backlog of 18,000 new home orders should keep the builder busy for the
next six months. Encouraged by its growth outlook, management recently
raised its earnings guidance for 2004 from $6.00-$6.25 to $7.00-$7.25 a
share. That kind of earnings visibility should certainly help the firm
build a loyal shareholder base.
|
Register
for Carla Pasternak's High-Yield Investing newsletter
today and you'll receive as many as SIX in-depth research reports absolutely FREE!
|
|
Of course, no stock is without downside risk,
especially a building stock in a rising interest rate environment. Some
potential chinks in the firm's armor include debt servicing costs on its
seven-year supply of raw land, as well as escalating costs on optioned
land to be paid in full a few years down the road. These commitments
could squeeze the firm's profit margins going forward, especially if
housing demand slows. However, Pulte's excellent operating efficiencies
should offset much of the potential decline.
Pulte pays a small dividend of 20 cents a share, which
gives the stock a yield of around +0.4%. However, the real payoff here
will be the firm's long-term stock performance. With a forward P/E of
around 7 based on 2004 projected earnings of $7.05, the stock is now
trading at the low end of its historical valuation range and well below
both its peers and the market. Pulte may take a short-term hit if
interest rates rise aggressively, but in the long run the company is
built to last.
ACTION TO TAKE
Both Citigroup and Pulte are bulletproof blue chips with long
histories of successful performance. Their diversified operations
provide a wide moat of safety in a rising interest rate environment, and
both have delivered market-beating returns amidst even the most
difficult of times. In addition, both stocks have pulled back in recent
months, providing long-term investors with a window of opportunity to
build new positions at attractive valuations.
|
Please Note: The above article was merely a
small excerpt from an issue of our premium income newsletter -- High-Yield
Investing. In each issue Carla Pasternak presents
a wealth of information and timely investment ideas to help you earn a
steady income stream from your investments. To receive a
complimentary three-week trial or to learn more about our High-Yield
Investing service, please visit the following link: http://www.StreetAuthority.com/subscribe.asp#hy |
|
