13 targets for earnings-season torpedoes
<I sure agree with their KG pick. That's a safe and sane stock poised for impressive growth. This is more an article in the "food for thought" category than anything else.>
As a crucial reporting period begins, analysts look at key ratios for signs of a sinking ship. Here are the companies in the crosshairs -- and those in the clear.
By Michael Brush
With earnings reporting season around the corner, it’s high time to make sure your market radar is tuned to pick up any incoming torpedoes. Those are the earnings misses -- or signs that mishaps may be shaping up next quarter -- that can quickly sink the stocks in your armada and leave them collecting sand on the ocean floor. Refinance your car.
Save big bucks.
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One good way to stay afloat is to use a system like the one recently revived by Prudential Securities. Researchers at the securities house scan corporate books to pick up five signs of trouble, which the brokerage aptly calls “torpedo ratios.”
Basically, these ratios of financial measures attempt to turn up signs that companies are using legal -- but disturbing -- accounting methods to stretch the numbers to meet estimates. When that’s happening, a company’s stock often blows up as soon as its financial officers are no longer able to push the envelope when calculating earnings. So the stock sinks, as if struck by a torpedo. Or else it goes down sooner, as investment pros using similar radar systems pick up bad vibes and sell.
Here are the five torpedo ratios Prudential looks for:
Rising accounts receivable to sales, compared with a year ago. This may mean customers are so weak they can’t pay. Or the company must extend better terms to keep them.
Rising inventory to sales, compared with a year before. This shows that business is weak, and an earnings-busting write down may be on the way.
Declines in free cash flow relative to stock price. That’s the hard cash left after you strip out accounting adjustments like depreciation and amortization. At the end of the day, cash matters a lot more than the earnings number the accountants come up with.
Rising debt-to-equity levels. This can be a sign a company may be running into financial trouble.
Declining profits compared with interest due on bonds. Also a sign a company may be running into financial trouble.
“If we see inventories or receivables backing up, negative cash flow or signs of financial trouble, we often get out of those positions,” agrees Sean Reidy, a co-portfolio manager at the Olstein Financial Alert Fund (OFALX). “We don’t like to take those risks.”
Keep in mind that torpedo ratios don’t always mean a stock is going to blow up. “What we are trying to do with the list is raise red flags for investors,” says Prudential’s Steven DeSanctis.
But they do have a decent record of predicting the future. As a group, stocks that rank among the worst 20% for torpedo ratios -- with some other factors blended in to measure growth prospects -- end up doing worse than the market. And the top-ranked stocks outperform, says DeSanctis.
In short, Prudential’s radar can be used to find torpedo-free stocks, as well as those which might be going down. We’ll start on the safe side.
All clear here
Health-care stocks. If you think the economy is going to come back fast in 2002, then defensive health-care stocks aren’t the best place to be, says Tim Ghriskey, of Ghriskey Capital Management in Greenwich, Conn. Money will be flowing into more cyclical stocks -- the ones that get a bigger kick from economic growth. But if you believe the recovery may be tepid, then there are plenty of defensive health-care companies which still offer decent growth rates, says Michael Yellen, who manages the AIM Global Health Care Fund (GGHCX).
To find some of the best ones that should also be immune from torpedoes, I culled out the companies on Prudential’s safe list to find those with the best upward earnings-estimate revisions according to IBES International. Strong upward earnings revisions are a good sign that decent growth will carry on. Then Yellen picked the ones most likely to continue performing well because they’re favored with strong markets and decent barriers to entry.
The final cut included Tenet Healthcare (THC, news, msgs), a hospital benefiting from better pricing and the aging of the population, King Pharmaceuticals (KG, news, msgs) and Lincare Holdings (LNCR, news, msgs), which is consolidating the home respiratory and infusion therapy sector. There were also two turnaround plays. One is DaVita (DVA, news, msgs), a provider of kidney dialysis. The other: PSS World Medical (PSSI, news, msgs), which offers same-day delivery of medical supplies to physicians and hospitals.
Retailers and consumer-oriented stocks. Successful retailers have recently risen to lofty levels in anticipation of an economic recovery. This leaves shareholders vulnerable to even bigger losses if torpedoes strike. But here’s a group of torpedo-free retailers with great upward earnings revisions. Athletic footwear vendor Finish Line (FINL, news, msgs) and a discount chain called Fred’s (FRED, news, msgs) rank high on both counts. So do Movie Gallery (MOVI, news, msgs), a video rental chain, and Ruby Tuesday (RI, news, msgs), a casual dining chain. Other consumer-oriented stocks clearing both hurdles include game software company Activision (ATVI, news, msgs), Copart (CPRT, news, msgs), which auctions off used or damaged vehicles, and Corinthian Colleges (COCO, news, msgs), a private post-secondary school.
Business services. Despite the sharp cutback in spending by businesses, several firms which sell mainly to other companies still have strong revisions and clean financials. Top-ranked companies here include: Storage Technology (STK, news, msgs), which offers data storage; Reynolds & Reynolds (REY, news, msgs), which provides information management systems to car retailers; Metro One Telecomm (MTON, news, msgs), which contracts with wireless providers to offer information services; and Cendant (CD, news, msgs), which offers travel and real estate services to businesses and consumers.
Torpedoes ahead?
Not surprisingly, the list of stocks that show signs they might get taken out by torpedoes is rich with cyclical companies hit hard by the downturn -- in areas such as technology, basic materials and business services.
To narrow down Prudential’s torpedo list, I cut out any stocks that already are doing a lot worse than the market. After all, what good is it to point out that Eastman Kodak (EK, news, msgs) has signs of trouble in its financials? From the looks of the chart, the market has already figured this out. Instead, I focused on those that have done better than the S&P 500 ($INX) in the past three to six months, even though they have a very high ranking on Prudential’s hit list and poor earnings revisions, to boot.
Technology. In this camp, for example, Artesyn Technologies (ATSN, news, msgs), has nearly doubled to $9.30 from $5 since early October, even though inventories are rising, cash flow is down and the debt measures are weakening. The company makes power management tools used in weak sectors like telecom, networking and computing equipment. Another networking equipment company, Redback Networks (RBAK, news, msgs), also has high inventories, and signs of weakness in debt and interest coverage levels. But the stock has more than doubled to $3.50 from $1.50 since early October.
Business software company Aspen Technology (AZPN, news, msgs) shows signs of trouble (declining cash flow). So do wireless radio tower operator Crown Castle (CCI, news, msgs) (inventories and interest coverage) and Compaq Computer (CPQ, news, msgs), which has weakness in debt and interest coverage levels.
Retailers. Two retailers continue to perform suspiciously well even though there are signs that torpedoes are on the way. One is Quiksilver (ZQK, news, msgs), which markets clothes to alternative sports fans like snowboarders. Debt levels are sending off the strongest negative signals. Things are weakening on the inventories, receivables and cash flow fronts, as well. Natural food store Wild Oats Markets (OATS, news, msgs) has potential problems with debt and interest coverage levels. This comes at a time when it has to cut prices and increase marketing costs to fend off category-killer Whole Foods Market (WFMI, news, msgs). Nevertheless, the stock has moved to $10.30 from $7 since early November. Wild Oats is in the midst of a turnaround led by former Ben & Jerry’s chief executive Perry Odak.
Business services and basic industry. Two business services providers have performed well recently, despite coming up weak on most of the torpedo measures. They are Bowne (BNE, news, msgs), which does financial sector printing, and TeleTech Holdings (TTEC, news, msgs), which manages call centers and other types of interaction with customers.
It’s the same story for several companies in basic industries -- such as farm equipment producer Deere (DE, news, msgs); newsprint and pulp producer Bowater (BOW, news, msgs); and Visteon (VC, news, msgs), which makes car parts and counts troubled Ford (F, news, msgs) as a major customer.
To many investors, the recent strength in some of the cyclical stocks in areas like tech, retail and basic industries makes sense despite the negative torpedo ratios -- assuming an economic rebound really is around the corner. “But if the economy rolls over, a lot of these companies are going to be in trouble,” says Ghriskey. The ones most likely to end up on the ocean floor: those with the worst torpedo ratios.
At the time of publication, Michael Brush owned shares in none of the companies mentioned in this column. |
