Two Beaten-Down Stocks Poised to Rebound
These stocks offer 20%-plus expected returns.
Following is a sampling 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.
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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.
* 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.