2 Low PE Stocks You Will Love

Madhukar is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Investors have always shown their love towards low PE stocks. These beaten-up stocks have their price lower relative to net worth and maintain a lower PE in comparison to other industry peers. Investor ideology behind investing in a low PE stock is that it offers them the best bargain for an asset that is likely to gain in the future. Though this strategy paid off in 2012 for investors who laid their bet on the S&P 500's lowest PE stocks of 2011, there is no guarantee that this strategy will pay-off going forward. My idea of picking up the low PE stocks is to go a bit further and test them on the grounds of their long term performance. I have analyzed three stocks, Magna International Incorporated (NYSE: MGA)Discover Financial Services (NYSE: DFS) and Northrop Grumman Corporation (NYSE: NOC) that have lower PE's in comparison to industry peers and applied the “long term feasibility test” on each of them. I feel that Magna and Discover are undervalued and have potential to grow while Northrop is fairly valued at the current price level. (Read my other coverage on low PE stocks here.)

Let’s analyze these stocks in detail.

<table> <tbody> <tr> <td> <p><strong>Name of Company</strong></p> </td> <td> <p><strong>Price Earnings Ratio (P/E)</strong></p> </td> </tr> <tr> <td> <p>Magna International Incorporated</p> </td> <td> <p>8.89x</p> </td> </tr> <tr> <td> <p>Discover Financial Services</p> </td> <td> <p>8.78x</p> </td> </tr> <tr> <td> <p>Northrop Grumman Corporation</p> </td> <td> <p>8.79x</p> </td> </tr> </tbody> </table>

 Magna International Incorporated

Recently Magna announced its guidance for the year 2013. The company expects to achieve total sales of ~$31.3 billion in FY13. Although half of its revenue is projected to be generated from the North American region, it has increased its focus towards the other parts of the world as well. Almost 40% of the growth in the Production sales segment for the next two years is to be contributed from ROW.  In FY13, it shall generate ~$2.2 billion from the Rest of the World (ROW) region. To achieve this desired growth it has plans to open 14 new facilities in the next two years. In addition, the Chinese market for light vehicles is also growing that will help the company to generate ~$2 billion by 2014 which is double its current revenue from the country.

Coming over to the revenue generated from the European region, the sluggish economy has dragged the region's profitability. As a counter measure, Magna has deployed restructuring initiatives transferring part of its production capacity to the lower cost Eastern Europe. For the same purpose, in December 2012, it acquired ixetic Verwaltungs GmbH, a Germany-based manufacturer of automotive vacuum, engine and transmission pumps for ~$399.3 million. In 2013 this acquisition is expected to generate ~$400 million in the form of revenue and will help in increasing the production sales of the region. Along with some recent tailwinds in the region also came from operational improvements in specific under-performing facilities and by achieving price increases on selected contracts.

Discover Financial Services

The stock of Discover Financial Services showed some weakness post the announcement of the Master Trust Credit Card Data. The “net charge-off rate” increased by 29 bps month-over-month (m/m) to ~2.31% in December, 2012. Even after a mixed bag of credit card data, I feel that the future endeavors of the company will help it attract more card holders. The company currently has 50 million cardholders. The company's biggest marketing investment of 2013 is the new “IT” card. The card provides the combination of some solid features such as cash back, foreign transactions, pay-by-phone, and over-limit facilities without any fees charged. It will serve as Discover’s flagship card for customer acquisitions. The card had been successfully tested in four markets in the summer of 2012. While current plans call for a sizable investment behind the card, if the performance and returns are not according to expectations, management will be able to quickly reduce the spending. I expect a mid-single digit growth rate in total credit card loans, which will be ~$48.99 billion by the end of 1Q13.

Along with that, recently Discover entered into a financial plan for the Comprehensive Capital Analysis and Review (CCAR) and it will be more aggressive in returning capital to shareholders in 2013. Regulators have set an upper limit of the total return of capital at 100% of net income and only 30% of which can be dividends. I anticipate Discover’s dividend payout ratio to be ~14% in 2013.

Northrop Grumman Corporation

With the $487 billion cut already made in the defense budget over the next decade, the Department of Defense has proposed another ~$500 billion budget cut. This definitely raises some issues for the defense contractors but I don’t think these budget cuts will affect defense giants like Northrop Grumman, Raytheon etc., in the short run. The reason for this is that their existing Defense contracts have long gestation periods and the realization of funds will also take time. If the budget cuts do pound they will hit the company in either 2014 or 2015. In addition, Northrop has been awarded with a contract worth ~$95 million to upgrade Navy's NGC2P data link processor and is a final contender to develop the next-generation radar system for Navy surface ships which could easily be a ~$16 billion program.

Northrop's cash reserve is vast enough to sustain the company from such tough times in the short run. Its earnings are more than 5 times its debt and it maintains a forward P/E of 9x. Even if in 2013 profits fall by ~40%, at its current price the company shall be trading at a P/E of about 15x, which still will be less than the industry average of 16x.

What's in it for investors?

Magna's strong North American region, increasing focus on emerging economies and restructuring program will help the stock to grow in the future. Discover’s future endeavors and payout plan will fortify the stock. Hence, both of them seem to be a Buy. Finally, because of the cloudy defense budget cuts I will suggest not to make any new positions on Northrop for now 

madhudube has no position in any stocks mentioned. The Motley Fool owns shares of Northrop Grumman. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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