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Published: August 19, 2010
When traveling in the United Kingdom, I often heard the
phrase "cheap and cheerful." It was a compliment for something
that may be a bit dowdy, but still appealing.
As I looked over the stocks in the S&P 500 that sported
extremely low P/E ratios, I also found some of these names to be
both cheap and cheerful. There are some good reasons why these
stocks are so unloved right now, and some offer compelling value
and limited downside.
The table below highlights all the stocks in the S&P 500 that
trade for less than seven times trailing profits. Let's look at
three of them, and then decide which one looks like the best
bargain in the S&P 500.
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Western Digital (NYSE: WDC)
This hard-disk drive maker is the poster child for the notion of
supply and demand. Only a handful of companies in the world make
these devices that go into every PC and server, and those firms
are constantly trying to make sure that industry supply is right
in line with demand. If they make too many drives, or if
computer sales slow, then prices for their products can plunge.
Right now, the market is a bit oversupplied, which explains why
shares of Western Digital are trading right near their 52-week
low. In the most recent quarter, revenue dropped -10%
sequentially, and the company trailed the $1.35
EPS consensus by about a dime. Yet that's the point. Even in
a fairly tepid quarter, Western Digital still made more than
$1.00 a share. Per share profits were closer to $2.00 in each of
the previous two quarters, but Western Digital has shown that it
can still earn plenty of money in tougher times.
That's not enough to catch investor attention, though. They
prefer to see
earnings grow at a consistent rate, and have a hard time
coming up with a target price for volatile earnings streams,
which is why shares are stuck with such a low P/E ratio. To
garner a higher P/E, Western Digital will need to get back into
growth mode. Management concedes that the current quarter will
be even weaker than the June quarter, but they also see a turn
coming and expect results to start rebounding by the December
quarter, as industry-wide production plans call for a pullback
in output while demand should be flat. And that should help
pricing.
Analysts at Avian Securities concur. They check the pulse of the
disk drive in a weekly survey and have found that "pricing for
high capacity desktop drives in North America stopped falling in
the first week of August. In particular spot pricing for 1
Terabyte and 2 Terabyte drives appears to have lifted $1 - $2
since the late July time frame." The analysts think that is a
result of a steady drawdown in inventories of unsold drives that
has been underway since mid-May. If they're right and prices
keep firming as disk drive inventories fall, then shares of
Western Digital could quickly move back into favor with
investors.
SUPERVALU (NYSE: SVU)
Shares of Supervalu, operator of the Albertson's, Save-A-Lot and
Shaw's grocery chains, have been falling for much of the past
five years -- and with good reason. Earnings growth has been
anemic and is expected to turn negative in fiscal (February)
2011 on a -6% drop in sales. Part of that sales weakness is the
result of a decision to close or sell underperforming stores,
but management has yet to prove how to boost profits at the
stores that will remain open.
I recently wrote about the brutal environment for all major
grocery chains thanks to mighty Walmart (NYSE: WMT).
[Read:
Grocers Won't See Green for Long]
I predicted that shares of Kroger (NYSE: KR) and
Safeway (NYSE: SWY) were especially vulnerable, but added
that "for investors, the impact is unlikely to be felt on shares
of Supervalu, which already trade at very low
price-to-earnings ratio (P/E) multiple."
Yet that's hardly an endorsement. This is a clear case of why
certain stocks deserve very low P/E ratios. Nevertheless, it's
not clear why Kroger and Safeway deserve to trade for more than
10 times projected profits, while Supervalu trades for about six
times projected earnings. As a silver lining, Supervalu has
relatively fresh management that has implemented a turnaround
plan. Those plans include more rational pricing strategies,
which will take time to resonate with consumers. But if they
start to have an impact, then investors may start to pursue this
very, very cheap stock.
Gannett (NYSE: GCI)
Unlike some newspaper publishers that have sought bankruptcy
protection and had to shut down some key titles, Gannett has
emerged as a long-term survivor thanks to a wide range of cost
cuts, a sharp pay-down in debt, and the robust
cash flow derived
from the company's 23 television stations.
Yet weakness at beleaguered rivals such as Tribune, Hearst and
McClatchy (NYSE: MNI) creates a clear opportunity for Gannett.
The company can aggressively target new subscriptions for its
flagship USA Today newspaper from former devotees of the
weakening local papers owned by those firms. Yes, newspaper
circulation is shrinking, but Gannett has a chance to pick up a
larger slice of that smaller pie.
Barrington Research upgraded shares of Gannett in late July
based on "increasing evidence that current levels of earnings
and cash flow generation can be sustained and improved upon, and
valuation metrics that seem much too conservative." They think
shares have more than +50% upside, noting that "even if we
assign only a 5x Enterprise Value/EBITDA multiple which
corresponds to a P/E multiple of less than 9x, we can justify a
target price valuation of $21 based on 2010 estimates." The
current P/E is less than six.
Even as the economy has been quite bleak, Gannett remains a cash
cow.
Free cash flow surged +40% in 2009 to $680 million, thanks
to the aforementioned cost cuts. That total could exceed $800
million this year.
All of that cash is helping to clean up the
balance sheet. Total
debt stood at $5.4 billion in 2005, but should be closer to $2.5
billion by the end of this year. Once debt moves below $2
billion, management has hinted that it may reinstate a formerly
robust
dividend, which had reached $1.60 a share in 2008 before
being sharply cut. Even if the dividend is only brought back to
$1.00 a share, then investors would be looking at a 7.7%
yield
at current prices.
Action to Take --> Of the stocks profiled here, Gannett looks
like the biggest bargain thanks to its prodigious cash flow and
consistent results offered by its stream of media assets.
Western Digital is compellingly cheap but likely won't rally
until it can start to post stronger quarterly results. Guidance
for the company's fiscal second quarter (December), which should
be issued in late October, could be robust enough to bring new
life to shares. As for Supervalu, it's hard to see what can get
this stock going, unless and until new management can stem the
bleeding.
-- David Sterman
Staff Writer
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