Three Beaten-Down Stocks Poised to Rebound
These stocks offer 20%-plus expected returns.
Following is a roundup of stocks that recently jumped to 5 stars. By way of background, we award a stock 5 stars when it trades at a suitably large discount--i.e., a margin of safety--to our fair value estimate. Thus, when a stock hits 5-star territory, we consider it an especially compelling value.
Moat: Narrow | Risk: Above Average | Price/Fair Value Ratio*: 0.63 | Three-Year Expected Annual Return*: 30.4%
What It Does: Cogent (COGT) is a leading provider of automated fingerprint identification systems and other biometric systems. The company's proprietary hardware and software provide fast and accurate matching of biometric information. Company sales of biometric products constitute 78% of total sales, while maintenance and service contracts constitute the remaining 22%.
What Gives It an Edge: Morningstar analyst Rick Hanna credits high switching costs as the primary basis for Cogent's narrow moat. The firm's unique biometric matching technology closely couples hardware and software, which makes it expensive to replace the overall system. Also, the company's technology is the basis for the US-VISIT program, which is currently the largest biometric identification database operating in the world. US-VISIT is an immigration and border management system that the U.S. Department of Homeland Security uses to track incoming visitors against a known database of terrorists or criminals. As evidence of the high switching costs, the company has been awarded a contract to upgrade its system to be able to compare 10 fingerprints instead of two, which was used previously. The company is also being awarded border security, criminal investigation and other commercial applications throughout the world.
What the Risks Are: The biggest risk facing Cogent's business is penetrating new customers and markets. The company's customer base is highly concentrated, with close to half of 2006 revenues being derived from the U.S. government and Venezuela. Additionally, securing government contracts can be challenging. They often require up-front investment of time and cost before being awarded, and they are also subject to significant budgetary scrutiny. Political motivations can also affect contract awards. Hanna believes Cogent may have difficulty securing contracts in Japan and the European Union due to the governments' preferences for local suppliers.
What the Market Is Missing: Hanna thinks Cogent is trading at a discount because the market has been unwilling to wait through the long lead times required for the firm to secure big awards. While the company has been dependent upon two key contracts for the majority of its revenues in the past, Hanna believes Cogent has made strides recently to diversify its customer base. Hanna points out that in the company's latest quarter, Cogent announced the highest backlog in its history. In addition, the backlog does not include some major contract awards that Hanna believes are imminent within the next six to 12 months. According to Hanna, the biggest contract outstanding is for the U.S. FBI Next Generation Identification. Although Cogent is not a lock on this contract by any means, its proven ability to execute large complex databases, and its growing list of international customers, give it a wide variety of growth opportunities.
Moat: Narrow | Risk: Average | Price/Fair Value Ratio*: 0.72 | Three-Year Expected Annual Return*: 23.7%
What It Does: Embarq (EQ), the fourth-largest phone company in the U.S., was spun out of Sprint Nextel (S) in May 2006. The firm provides local phone service to about 6.5 million lines across 18 states, including several larger markets such as Las Vegas and Orlando. In addition to phone service, Embarq serves 1.2 million high-speed Internet access customers, 190,000 television customers via a resale agreement with EchoStar, and 108,000 wireless customers via an agreement with Sprint.
What Gives It an Edge: Morningstar analyst Michael Hodel assigns Embarq a narrow economic moat. Embarq provides local phone and data services to a balanced mix of rural and urban markets. The firm has struggled to grow recently as cable companies steal phone customers and many households choose to use wireless service exclusively. However, Embarq continues to generate strong cash flow and the firm, unlike many smaller phone companies, hasn't committed an excessive amount of this resource to dividend payments. As a result, Hodel argues that Embarq will have the ability to invest adequately in its networks to maintain its competitive position, which is critical as data services replace traditional phone service in importance.
What the Risks Are: The biggest risks Embarq faces are increasing competition and changing technology. Cable companies are still in the process of rolling out phone services to the firm's customers, and wireless service is increasingly serving as a substitute for fixed-line calling. Technologies such as WiMax could make wireless an attractive alternative to Embarq's Internet access services. The firm may be forced to either spend heavily on network upgrades or cut prices sharply, either of which could hurt returns on capital. Though it isn't as exposed as pure rural phone companies, future regulatory changes could take a bite out of high-margin subsidy or access revenue.
What the Market Is Missing: In Hodel's view, telecom and cable stocks have sold off sharply across the board in recent months on fears that the two groups will compete fiercely for customers. However, increasing competition within the industry is not new news, and Hodel already assumes little, if any, growth and shrinking margins for firms such as Embarq. Still, Hodel contends that investors should favor firms in the industry with the financial strength to withstand this pressure and take advantage of weaker competitors. Hodel believes Embarq fits this bill. In addition, Hodel expects the cable and phone companies to compete rationally over time.
Calamos Asset Management, Inc.
Moat: Wide | Risk: Average | Price/Fair Value Ratio*: 0.71 | Three-Year Expected Annual Return*: 25.7%
What It Does: Calamos (CLMS) is a medium-sized asset manager with around $45 billion in assets under management. Founded in 1977, the firm was originally known for its prowess investing in convertibles, but it has since shifted its concentration to growth strategies. Its funds are divided into open (61%), closed (14%), and separate accounts (25%), almost entirely sourced and invested in the U.S. Around 44% of the company's revenue comes from the flagship Calamos Growth Fund (CVGRX). The firm has been public since 2004.
What Gives It an Edge: According to Morningstar analyst Andrew Richards, a solid investment lineup, operational efficiency, and a diversifying base of assets under management provide Calamos Asset Management with a wide economic moat. Two funds, Calamos Growth and Calamos Growth & Income (CVTRX) make up around half the firm's assets under management. Richards believes both funds have delivered astounding long-term results, which raises Calamos' fee base and should attract additional assets. In addition, Richards points out that the company's lean operating model (margins over 40%, over $1 million in revenue per employee) should allow for ample cash flow generation even in down periods.
What the Risks Are: The Growth Fund generated 44% of the firm's revenue in 2006. If the fund's performance suffers, so will Calamos' bottom line. Furthermore, although the company's other products are diverse in style, they are highly concentrated in the U.S. market. Talent departures could cause a loss of skills, harming investment returns. The company's voting structure is stacked against outside investors, so there is always the risk of management making decisions that favor insiders at the expense of all shareholders.
What the Market Is Missing: Richards thinks Calamos' shares are currently suffering from a downswing in performance in its key funds. Both Calamos Growth and Calamos Growth & Income are deep in the red in 2008, weighed down by large positions in recent market whipping boys such as Apple (AAPL), Google (GOOG), and Microsoft (MSFT). In addition, Richards believes negative attention surrounding closed-end fund preferred securities auction failures may also be depressing the stock price. Although the auction failures do raise borrowing costs for the closed-end funds, Richards counters that their effect on Calamos' bottom line should be insignificant. Also, Richards admits that the flagship fund underperformance will hurt the firm's revenue in the near term, but given the funds' outstanding long-term records, Richards expects the company's growth in assets under management and revenue to remain strong. To Richards, this justifies a much higher valuation than is reflected in the current market price.
* Price/fair value ratios and expected returns calculated using fair value estimates, closing prices, and cost of equity estimates as of Friday, Feb. 29, 2008.
Jeff Viksjo does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.