My Next Real-Money Portfolio Stock Could Easily Gain 50% or More
When you voluntarily cease doing business with your biggest customer, you best have a good explanation. If not, then investors will think you’re nuts — and dump your stock. But car battery maker Exide Technologies (Nasdaq: XIDE) had a good excuse. The company’s biggest customer, Wal-Mart (NYSE: WMT) made life unbearable, asking for price cut after price cut, making it almost impossible to earn a profit.
Management hoped investors would appreciate that sales would fall but margins would sharply improve. Investors initially balked when the Wal-Mart decision was announced in February 2010, pushing the stock down more than 20% to $6 in just one day. Eventually, investors got wise to the logic of the Wal-Mart divorce, and a year later, shares had doubled to $12.
Exide operates in two niches. Auto and truck batteries account for roughly two-thirds of Exide’s $2 billion in total sales , while the rest of sales are from everything from energy monitors to energy storage units used in the industrial market. Companies in the telecommunications, utilities and mining sectors use Exide’s equipment .
Exide looked set to deliver very strong cash flow in calendar 2011, but instead delivered a series of disastrous quarters. The prime culprit: rising lead prices, which lead to negative gross margins. (Lead is the most expensive item in car batteries, accounting for about 50% of the cost of production.)
Lithium isn’t a cure-all
In the last half decade, a range of companies have been working with lithium-based batteries that are capable of a rapid release of energy and are fairly lightweight. Despite heavy investments, these batteries are still far more expensive than traditional lead-acid batteries — Exide’s bread and butter. It increasingly appears that the transportation world will need both kinds of batteries as hybrid and electric vehicles see greater demand . Even the most ardent boosters of these green vehicles realize that these cars won’t dominate the sales mix for a number of years, if at all.
Exide, for its part, continues to refine the traditional lead-based batteries, securing a dozen patents in fiscal (March) 2011 in the areas of design, materials and construction processes. The ultimate goal is to keep advancing the number of cycles that a traditional battery can handle without increasing cost.
That’s not to say that Exide is missing out on the rapidly-changing auto sector. An increasing number of traditional (non-hybrid or electric) cars are using stop/start technology and regenerative braking to boost fuel economy, and Exide has developed batteries that are optimized for those applications.
Still, despite a strong presence in U.S. and European battery markets, Exide has continually been dogged by very competitive pricing from peers, which has led to wafer-thin profits. The company saw operating profits drop from $120 million in fiscal (March) 2009 to $109 million in fiscal 2010 to just $80 million in fiscal 2011. That’s too close a margin for error for a company that must pay out $60 million in interest expense every year. The fact that Exide carries nearly $800 million in short and long-term debt has spooked investors, explaining why this stock has traded ever lower.
Recent quarterly results surely didn’t help matters. Exide has missed forecasts for three straight quarters in a row, and analysts have had to repeatedly cut estimates. As noted earlier, much of that is related to the cost of lead. Exide recycles used batteries and thus secures its own supply. But the cost to extract the lead from batteries rose nearly 30% in fiscal 2011 as rising energy prices and a (then) rising euro crimped any profits the company have prevented Exide from turning a profit for three straight quarters. (Exide did not formally break down the total cost to extract lead from batteries in its latest conference call, as the company’s lead uses are a mix of costs from market-based rates and from recycling.)
On the company’s most recent conference call, management walked through a series of steps to cut costs in hopes of boosting cash flow. Still, the damage was done, and shares fell to just $2.50 in late November, well below the $12 levels seen a year ago.
For stocks like this, it’s often best to wait for a tangible improvement in business conditions. Indeed, that has been my plan for Exide. I wanted to introduce this stock into my portfolio AFTER I had a chance to digest the next quarterly earnings report, which is slated for Feb. 12.
But the market is not cooperating with that plan. Shares of Exide are starting to percolate, recently moving across the $3.50 mark, which is likely a sign that a combination of cost cuts and price increases will enable Exide to get back on track in coming quarters. If I wait for confirmation of such a trend, then this stock could already be above $4 by the time that happens.
The Downside Protection –> Unlike most of my picks, this stock does not have downside support, simply because it’s debt burden is so large. If I’m wrong, and management is not able to fix the broken income statement, then Exide’s debts may start to really bite, pushing this stock to fresh lows. That makes this a pick I’m willing to hold in an otherwise low-risk portfolio, but it may not be suitable for you.
Upside Triggers –> This stock is completely washed out in terms of potential cash flow strength. The company’s equity is being valued at around $270 million, yet operating cash flow is capable of hitting the $100 million to $150 million mark when revenue and costs are more typically aligned. Assuming this business is worth just four times the base case of cash flow (using market value and not enterprise value), then shares would likely rise 50% into the $5 to $6 range. If this business is worth five times the higher end of that cash flow target, then this stock could double or even triple.
Even if that happened, shares would remain well below the 52-week high. The risk in this stock is clear. Yet the potential reward is undeniable.
Action to Take –> 48 hours after you read this, I will be buying 1,500 shares (or roughly $5,200 worth) of Exide Technologies. That position could grow in size management notes clear progress on the upcoming conference call and shares don’t get too far ahead of themselves.
[Note: As always, you're invited to trade right along with me. To ensure you're notified as soon as I buy or sell a stock in my portfolio, I invite you to sign up to receive these articles in your inbox for free by clicking here.]
– David StermanSource: StreetAuthority
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