Buy Low, Sell High, with These Cyclical Stocks
These 5-star 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.
Asbury Automotive Group, Inc.
Moat: Narrow | FV Uncertainty: High | Price/Fair Value Ratio*: 0.64 | Three-Year Expected Annual Return*: 27.8%
What It Does: Asbury Automotive (ABG) is a nationwide collection of automobile dealerships that went public in March 2002. The company operates 90 stores (including 122 new-car franchises and related used-vehicle sales) with associated parts and service departments. It also offers third-party finance and insurance products. Operating in 11 states, the company divides itself into four regions: Florida, West (Texas and California), Mid-Atlantic, and South.
What Gives It an Edge: According to Morningstar analyst David Whiston, Asbury earns a narrow economic moat due to its size, which enables it to make the investments needed to maintain its lucrative parts and servicing division. With cars becoming increasingly complex in design, more training and computer equipment is needed to service these vehicles and only a large dealership like Asbury can afford the required investment each year. Whiston points out that while parts and services were only 12% of Asbury's revenue last year, they contributed 41% of total gross profit. Also, the big automakers require dealers to make large capital expenditures to maintain their rights to sell a particular brand. Given Asbury's deep pockets, Whiston believes the firm is more able to make these investments than smaller dealerships, giving it a leg up in the industry.
What the Risks Are: A significant portion of Asbury's growth comes from roll-up acquisitions. This strategy has the potential for the company taking on too much debt to fund deals, overpaying, or buying dealerships that prove to be unprofitable. Restrictions in franchise agreements with auto manufacturers and debt covenants could limit Asbury's ability to execute its growth plan. Auto sales are cyclical, and the U.S. auto market is in a downward trend in sales, as evidenced by 2007 light vehicle sales continuing their decline from a 2000 peak of 17.3 million units. Worse still, 2008 sales are expected to be below 16 million units for the first time since 1998. A recession would mean consumers put off large purchases, such as vehicles, which would negatively impact Asbury's profits. We think that the company's luxury product mix somewhat mitigates this risk.
What the Market Is Missing: In Whiston's view, Asbury shares are cheap because the market has focused solely on the severe crash in U.S. auto sales, while forgetting that dealerships, like Asbury, are profitable businesses in any economic climate. Asbury takes advantage of its lucrative parts business to remain profitable and will be even more profitable upon the inevitable cyclical recovery in sales of used and new cars. While this recovery appears to be more than a quarter or two away, Whiston believes the patient investor can profit by buying Asbury now cheaply and hanging around until the eventual cyclical recovery buoys the stock price. If that's not enough, Asbury pays investors a hefty 5.5% dividend yield while they wait.
Moat: None | FV Uncertainty: Medium | Price/Fair Value Ratio*: 0.72 | Three-Year Expected Annual Return*: 23.5%
What It Does: Staples (SPLS) is the world's largest supplier of office products and related services to consumers and businesses. The company operates about 1,900 office-supply superstores and also sells products through catalogs, Web sites, and a direct salesforce. Staples operates in 21 countries.
What Gives It an Edge: Given that it competes in a commodity business, Morningstar analyst John Gabriel does not think Staples possesses a structural competitive advantage that warrants an economic moat. That said, Gabriel still believes Staples is the clear industry leader with the lowest cost structure and most efficient capital base relative to its office superstore rivals, Office Depot (ODP) and OfficeMax (OMX). For instance, despite operating nearly identical businesses, over the past five years Staples' operating margin has averaged 7.6% versus 3.5% and 1.7% for Office Depot and OfficeMax, respectively. Staples also trounces its rivals in terms of return on equity; over the past five years Staples' average return on equity was 18.5% compared with 12.8% at Office Depot and 3.8% at OfficeMax.
What the Risks Are: The primary risk facing Staples is the aggressive turnaround efforts at its two main competitors, Office Depot and OfficeMax. If those companies are able to execute successful turnarounds sooner than expected, there is potential for increased pricing pressure amid a heightened battle for market share. This would make it more challenging for Staples to be the third entrant in new markets where rivals currently have a stronghold. Price competition is an ongoing concern and could pressure Staples' operating profits.
What the Market Is Missing: Gabriel believes Staples' stock has a taken a hit after it became clear that the uncertain macroeconomic climate in the U.S. would cause consumers and small-business customers to cut back spending. While Gabriel acknowledges that this weak climate should persist into 2009, Gabriel thinks the market is focusing too much on this near-term outlook and ignoring Staples' long-term growth opportunities. In the U.S., Staples has adapted to the ever-changing demands in the marketplace by implementing its EasyTech service (similar to Best Buy's (BBY) Geek Squad) and enhancing the service offerings at its copy and print centers. Though likely a tough year in the U.S., Gabriel is confident that actions like these will allow Staples to capture market share from weaker rivals. Also, in recent years, Staples has actively expanded its footprint in international markets, including building operations in China and India, two of the world's fastest-growing markets for office supplies. While still a small part of total revenues, Gabriel contends that Staples' international presence puts the firm in a better position to weather the current U.S. downturn.
More New 5 Star Stocks
Central North Airport Group (OMAB)
KT Corporation (KTC)
National CineMedia, Inc. (NCMI)
* Price/fair value ratios and expected returns calculated using fair value estimates, closing prices, and cost of equity estimates as of Friday, May 9, 2008.
Jeff Viksjo does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.