When it comes to price-to-earnings (P/E) ratios, the notion of "buy low and sell-high" doesn't always apply. Some stocks with the lowest P/Es are cheap for good reason. Perhaps they are in the midst of a long-term decline that will see sales and profits shrink. Or perhaps they are simply out-of-favor at the moment, and will be snapped up by investors (and garner a higher P/E) once operations are on the upswing.
We ran a screen of all the stocks in the S&P 500 and came up with a short list of the companies that have a P/E ratio below 10. Each has entered the dog house for their own company-specific reasons. What will it take to get then our of the dog house?
Eastman Kodak (EK)
This venerable photography equipment firm has seen its obituary written before, though many are betting its days may still be numbered. Shares trade for just nine times trailing profits, simply because investors believe future profits will shrink or even turn to losses. This is a real case of the Bears vs. Bulls.
Bearish investors predict that the core film developing business, which has shrunken considerably but still throws off cash flow, will eventually dry up. (Though some believe the legacy business may have found a floor, supporting demand for printing press plates, color negative paper and other old-school photography hardware). The company has bought time by re-financing its debt burden but will eventually need to start paying off its more than $2 billion in debt.
Bullish investors can cite a host of positives. For example, few would have guessed a few years ago that Eastman Kodak would re-emerge as a rising vendor of digital cameras. The company has boostedmarket share in this area for three straight years, though it still lags the market share rates of the biggest players. In addition, Kodak chose to take the high road in the ink-jet printer market, charging higher prices for a line of printers that pack more features than basic ink-jet printers. Right now, cash flow generated from these two newer businesses roughly offset the decline in the legacy film business.
The wildcard in the mix -- and a possible game changer -- is the company's strong base of patents. Earlier this year, Samsung cut Eastman Kodak a check for $550 million after it was found that patents were violated. The United States International Trade Commission is still expected to weigh in on some patent contentions, so any future royalty payments from firms like Apple (NASDAQ:AAPL) andResearch in Motion (RIMM) are unlikely to materialize until 2011 -- if at all. But royalty income is notoriously erratic, so most investors ignore it when calculating earnings estimates or P/E ratios. Most investors think Kodak will lose a small amount in 2011 -- unless it can secure more patent agreements.
Notably, Kodak is valued at a very low rate relative to its sales base. Sure annual sales have shrunk from $10 billion in 2007 to the current $7.0-$7.5 billion range, but the company's enterprise value (market value minus cash plus debt) is just $2.3 billion, implying an EV/sales ratio of just 0.3. That's absurdly low for a tech company, even more absurd that a P/E ratio of nine.
Action to Take --> Eastman Kodak is going to either get real traction on its new sexier business lines or will find itself being chased by suitors for the value of its still-strong revenue base. A larger tech firm can surely find a way to squeeze more profits out of the $7 billion revenue base. In this instance, the low P/E ratio is alerting investors to a real bargain.
We recently looked at the deep troubles of major grocery chains, though we also concluded that SUPERVALU is likely most immune from further share price weakness, especially since it has the lowest P/E ratio in the S&P 500. While shares are super-cheap, management is applying cash flow to share buybacks and if that process continues, per share profits could start rising at a +10% to +12 % clip.
Some stocks deserve a low P/E if their sales and profits are likely to keep falling. That appears to be the case for GameStop. For starters, video game makers are tired of seeing their customers spend money on used games at places like GameStop, as they derive zero revenue from those re-sales. So they have begun to release periodic online updates of hot games, in hopes of securing more revenue from each title and discouraging consumers from trading them in for other titles. The trend is already underway in China, and is just getting started here in the United States.
In addition, a 10,000 pound gorilla just walked into the neighborhood. Best Buy (NYSE:BBY) has announced plans to enter the market for used video games. You can bet they'll aggressively price used gaming titles to quickly steal customers away from GameStop. GameStop has few options but to play the price war game.
Analysts see the company boosting sales another +5% this year, but forecasts of further growth in 2011 appear increasingly unlikely even though analysts still assume GameStop can keep growing. They appear to be ignoring those above-cited factors. That's why shares trade for less than 10 times trailing profits and around seven times consensus fiscal (January) 2012 profits. Few believe the consensus figure will be reached, otherwise shares would be well higher.
Action to Take --> Wait for some positive news that pushes shares back into the $20s. The company may announce a solid quarter or benefit from a fresh market rally. This would then set up a great trade -- on the short side.
Dean Foods (NYSE:DF)
In a similar vein, Dean Foods' low P/E multiple shouldn't entice investors. As we wrote last month, pricing pressures are forcing profit margins down to historical lows for this supplier of dairy products to supermarket chains. We added that the company's high debt levels means massive interest costs, which saps many of the profits the company would hope to keep.
Action to Take --> In early May, we predicted that shares had further to fall. They've actually risen +10% since then, but still look headed for further weakness.
A low P/E ratio does not ensure that a stock will rise, but when paired with a very low price-to-book value ratio, it tells you that shares are being overly discounted. Assurant, which provides insurance policies in niche areas like disability, funeral care expense and after-warranty protection for aging cars, trades for just eight times trailing profits and around 80% of book value.
Assurant has taken its shares of lumps. The company was heavily exposed to the housing crisis as it offered debt and credit protection to consumers, only to end up making big payouts. But that trend has abated and results are on the upswing. Profits have rebounded, bringing in more cash for the balance sheet and pushing tangible book value ever-higher to a recent $43 a share.
Action to Take --> Assuming shares simply rise up to book value, then investors are looking at a +20% gain. Looking at it another way, if shares trade up to a forward P/E of 10, then shares would reach about $48 -- more than +30% above current levels.
-- David Sterman