The investing world is often broken down into two broad camps: growth and value. The growth group looks for companies with earnings that are advancing at a material clip. The value camp, meanwhile, looks for stocks that are trading on the cheap. The desire to find undervalued stocks is both emotionally and intellectually appealing—after all, who doesn’t like to take advantage of a sale? Moreover, value investing follows one of the oldest, and most obvious, sayings on Wall Street, “buy low, sell high.”
The problem is that everyone is trying to buy low and sell high, even the growth investors. So it’s important to properly define “cheap” and have a systematic way of identifying candidates that meet that criterion. Equally paramount is remembering that some merchandise winds up on the sale heap because it is damaged in some way. A fact that is as true for stocks as it is for consumer goods.
To help investors cull through the list of potential investments, Value Line provides weekly screens. One of the more useful screens for value investors is the Bargain Basement Stocks screen. The screen is fairly simple, highlighting companies with price-to-earnings multiples and price to “net” working capital ratios near the bottom of the Value Line universe. The idea is to identify companies that are trading cheaply relative to earnings and to the money that would be “left over” if the company were to be liquidated. Note that most stocks never trade below their liquidation value, but even trading at two or three times that value is noteworthy.
This screen is available every week in the Index section of The Value Line Investment Survey. Subscribers can access the most recent Index here to see all 35 names on the list. Two companies of interest that we have highlighted for their recovery potential are Western Digital Corporation (WDC) and Ingram Micro (IM).
Western Digital Corporation
Western Digital designs, develops, manufactures and sells hard disk drives (HDDs), that are primarily used in desktop PCs, notebooks, corporate and cloud computing data centers, DVR set-top boxes, game consoles, and stand-alone consumer storage devices. It also produces enterprise solid-state drives (SSDs) used in embedded applications for the network communications, industrial, medical, military, and aerospace markets. Its commercial SSDs are used in mobile devices, such as tablets and smartphones. WDC's external storage devices provide extra capacity for users to backup data and store digital photos, videos and music.
The company’s second-quarter (fiscal year ends June 30th) results were hammered by the flooding in Thailand. Revenues fell nearly 20%, and the bottom line tumbled over 35% due to the lost manufacturing capacity. Management said it should take another six months or so to fully restore production. As a result, we suspect that earnings power will remain limited for the coming six to 12 months. Meanwhile, rival, Seagate Technology (STX), which was not nearly as impacted by the floods, has been able to command higher prices due to shortages and lock in some beneficial long-term contracts. After Western Digital recovers, the market share of both companies should become more even, with a little under half the overall market each, versus an approximate 20% advantage for Seagate in the 4Q of calendar 2011.
Overall, we think the stock is still a viable turnaround candidate. Indeed, it’s trading at a steep discount to the recovery we envision out to 2015-2017. End-market demand remains healthy and production capacity restoration is reportedly progressing ahead of schedule. According to market research firm IDC, HDD growth will likely increase at a compounded annual growth rate of 8.6% per year from 2011 to 2016 as mobility, cloud computing, social business, and big data analytics stimulate demand for digital content, and thus, new storage devices.
Meanwhile, WDC announced its long awaited purchase of Viviti Technologies (formerly Hitachi Global Storage) on March 8th for $3.9 billion and 25 million shares of stock. The two subsidiaries will compete in the marketplace with separate brands and product lines. The merger will significantly expand the combined entities’ customer base in enterprise HDD and SSD, cloud, mobility, small business storage, and hybrid HDD/SSD solutions for Ultrabooks (very thin laptops that look similar to, but cost less than Apple’s (AAPL) MacBook Air).
Although the merger has helped turn investor sentiment around, we believe that the stock may well have more room to run with the former Hitachi business in the mix. Indeed, greater exposure to higher-margined enterprise products, better execution, economies of scale, and some cost synergies should immediately start benefiting the bottom line (excluding restructuring costs) and raise the full year 2012 earnings per share tally by $2.50 to $3.00 per share.
Ingram Micro, Inc. is a Fortune 100 company and the largest global information technology wholesale distributor by net sales. It boasts a wide customer base and impressive geographic diversification, serving more than 170,000 reseller customers in more than 100 countries. Customers include value added resellers, retailers, systems integrators, direct marketers, independent dealers, cloud providers and PC assemblers. Ingram sells hundreds of thousands of technology products worldwide including, but not limited to, printers and scanners; LCD displays; mass storage; cell phones; digital cameras; DVD players; game consoles; rack, tower and blade servers; tablets; business, operating system, security, storage, virtualization, and entertainment software; middleware; switches, hubs, and routers; wireless LANs and WANs, network interface cards, modems, phone systems and video/audio conferencing devices.
At first blush, it seems as though the company may have turned the corner in the December period. Indeed, it reported its first and only quarterly gain of 2011 in the fourth quarter with the top line showing unexpected improvement. However, further inspection reveals that much of the sales gain failed to make it to the bottom-line and that the share-net improvement was largely a product of share repurchases. Value Line analyst Justin Hellman believes that a product mix shift toward lower-margined smartphones and tablet PCs is contributing to weaker profitability.
Management provided cautious guidance and Hellman seems to agree. He looks for global IT spending to remain under wraps, especially in Europe as it contends with a difficult macroeconomic backdrop. Australia has also been a weak spot due to price wars and lower rebate achievement. As a result, margins are likely to continue being constricted in the near term. Still, management believes operating cash flows in the land down under will turn positive by the end of the calendar year.
Those willing to exercise some patience may be rewarded. The stock is trading at roughly 9 times 2012 earnings expectations, below Hellman’s mid-decade assumption and current tangible book value. He feels that earnings growth will be back on track by 2015, and that profits will easily top the $3-a-share mark once the global economic picture improves and new specialty businesses gain their footing. A healthy balance sheet and ongoing share repurchases ought to help ease shareholder concerns in the interim.
At the time of this article's writing, the author did not have positions in any of the companies mentioned.