| Four
Undervalued Income Stocks with +52% Average Earnings Growth |
Published: October 7, 2004
Dividend stocks are rising to
new heights. The Dow Jones Dividend Index (^DJJ, 676.90) closed at a
fresh all-time high on October 1st, and the same is true of the Dow
Jones Real Estate Investment (REIT) Index (^DJR, 205.15). That may seem
like good news. However, when stocks are priced for perfection, they can
be vulnerable to the slightest disappointment. For example, consider the
recent plunge off their 52-week highs of Unilever (UL, $33.21),
Coca-Cola (KO, $40.31) and Colgate-Palmolive (CL, $45.12).
Finding undervalued income stocks in this market is not easy, but there
is one corner of the market that holds promise -- firms that have
recently engineered a successful corporate turnaround.
Finding the Sweet Spot
Buying a company on the road to recovery after a major earnings
shortfall can be risky business. Those who manage to invest during the
early stage of a turnaround often reap the greatest profits, but also
the greatest losses. Investors who bought K-Mart (KMRT, $88.06) at $22
in January and rode it to a high of $90 nine months later were
exceptionally well rewarded for the risk they took. On the other hand,
investors in Nortel (NT, $3.48) weren't so lucky. Its turnaround has
turned out to be an all-too-familiar story of broken promises and failed
execution. Shares of the beleaguered network equipment maker went on a
wild ride as they bounced off their lows to a high of $8.50 in February,
only to lose -65% of their value three months later.
How can you reap the most reward with the least risk from a turnaround
stock? The key is finding the “sweet spot” in a stock's turnaround
cycle. Like the story of Goldilocks and the three bears, if you invest
too early in the turnaround cycle, then you're likely to take on too
much risk. Too late, and your potential rewards are likely to be low.
However, like a delicious bowl of porridge, firms that are right in the
middle of a successful turnaround often prove to be "just
right."
Four Stocks That Have Turned the Corner
The four stocks we'll introduce you to in today's article are all in the
midst of what should prove to be successful turnarounds. All four firms
have not only turned the corner, but they've also delivered double -- or
in some cases even triple -- digit earnings growth in the most recent
quarter. On average, these four firms are expected to post a stunning
+52% jump in earnings this year, and this momentum should continue into
2005 and beyond.
Despite their superior growth rate, all of these stocks are still
trading at bargain levels. One common measure of value, the
price-to-earnings (P/E) ratio, compares a company's share price to its
earnings. Based on this measure, all four turnaround picks are trading
at a discount relative to their industry peers. The same is true whether
we use as a measure this year's earnings, next year's earnings, or even
their expected five-year earnings growth rate. With their best years
ahead of them, these four stocks appear primed to move higher.
One more point is worth checking when looking under the hood of a
mid-stage turnaround stock. Besides a recent history of profitability,
good growth going forward, and an attractive valuation, a solid stock
should have a healthy-looking balance sheet. Companies with a manageable
debt load -- say, a debt-to-equity ratio of less than 1 -- are less
likely to fail if business conditions deteriorate. All four of the
stocks we'll profile today are improving their financial condition and
three of them boast a debt-to-equity ratio of less than 1.
Without further ado, here's a closer look at each of these four solid
turnaround plays...
LINCOLN ELECTRIC (LECO,
$33.13)
Little-known Lincoln is the world's largest maker of welding and cutting
products, ranging from hand-held tools to robotic arms for heavy
manufacturing. The firm sells its equipment in 160 countries worldwide
and employs 7,000 people. In July, Lincoln bought three welding
companies in China, making it the only full-service welding equipment
maker in that nation.
Lincoln
Electric (LECO)
Business: Makes and sells welding and cutting equipment.
Growth Driver: A worldwide rise in industrial production is
fueling strong demand in international and domestic markets.
Target Price: $37
Rating: Top Pick |
Market Capitalization: $1.3
billion
2003 Revenue: $1.0 billion
2003 EPS: $1.32
2004 EPS: $2.10 (est.)
2005 EPS: $2.54 (est.)
Annual Dividend Payment: $0.68
Dividend Yield: 2.2%
Five-Year Proj. EPS Growth: +18%
P/E on 2005 EPS estimate: 12
52-Week Range: $21.55 - $34.96 |
The welding industry is highly
cyclical, and Lincoln was the victim of a global recession in industrial
markets during the past two years. However, cost-cutting measures
introduced in 2002-- including the voluntary retirement of 3% of its
U.S. workforce -- have made the company lean and mean. Profit margins
are strengthening and the firm is in good shape to weather a future
economic slowdown.
Meanwhile, demand has been strong for industrial machinery this year and
Lincoln Electric is now firing on all cylinders. After two years of
profit shortfalls, the firm's earnings are expected to rise an estimated
+59% in 2004 to $2.10 a share. When compared to 2001's record high
earnings, this year's earnings will be +7% higher. Next year, Lincoln's
earnings are expected to jump another +21% to $2.54 a share. Looking
even further ahead, the firm's earnings momentum is expected to continue
at an +18% annual pace over the next five years.
Dividend: Lincoln pays a 68-cent dividend per share, which
equates to an above-average yield of 2.2% at current prices. The
century-old company has paid regular dividends since 1915, and
management has boosted the firm's dividend payments +9% a year over the
last five years.
Valuation: The firm's shares have rallied +28% this year,
yet LECO still sells for just 12X next year's earnings. Based on a
projected long-term growth rate of +18%, LECO sports a PEG ratio of less
than 1. (The PEG ratio compares a firm's stock price to the underlying
company's future growth prospects. A PEG of less than 1 shows compelling
value.) By comparison, closest competitor Illinois Tool Works (ITW,
$94.70) trades at substantially higher multiple of 18 times forward
earnings and sports a lofty PEG of 1.7.
Industry Outlook: Lincoln's fortunes will tend to rise and
fall with the industrial machinery market. Low interest rates and a
relatively strong economy bode well for this stock over the coming
months. If the economy were to slow, then the company's trimmed-down
operations and improved efficiencies should cushion the impact. In any
case, the cyclical nature of the firm's business is priced into the
shares, which are still trading at below-average multiples.
The chart below shows how LECO
has outperformed the S&P 500 (GSPC) since March...
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