3 Cheap Stocks That Aren't Value Traps
David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
You know the drill: Sometimes companies trade at low multiples because they are undervalued. Other times, it's because they have poor fundamentals. In my view, however, all too often the market generalizes poor fundamentals with a bleak future. In reality, some of the strongest brands out there have gone through challenging periods only to recover and generate substantial returns. Below, I review three cheap stocks that are undervalued despite corporate challenges.
Xerox (NYSE: XRX): Both Takeover Targets
In my view, Xerox is one of the most attractive takeover targets on the Street. While it trades at just 7.8x past earnings, the fundamentals are surprisingly good. For example, the PEG ratio stands at 0.81x with 9.6% annual EPS growth forecasted over the next five years. With a 5-year average PE multiple of 16.2x, the company has plenty of room to recover.
Meanwhile, it generates considerable free cash flow that can quickly pay off the takeover suitors. $1.5 billion was generated in the TTM ending 2Q12, which is at a 16.5% yield to the market capitalization. It is also noteworthy that the company has seen the fastest top-line growth in its peer group over the last five years.
Equipped with $814 million in cash, management remains committed to returning free cash flow to shareholder through share repurchases. Acquisitions in office technology and distribution have also helped the company to generate revenue synergies and thereby create value. Some have also speculated about a restructuring through a possible sale of the financing business. In my view, a PE firm would be best prepared to unlock the most value given the focus on asset stripping and mitigating risks.
Pitney Bowes trades at a respective 7.2x and 7.4x past and forward earnings with an incredible dividend yield of 10.5%. This compares to 4x forward earnings for HP, which is 50.8% below its 52-week high and looking increasingly like a "value trap." Why don't I say Pitney Bowes is a "value trap?"
Well, for one, analysts are rating Pitney Bowes a "hold" despite expecting earnings to hold roughly steady over the next five years. Second, I believe earnings will go up - not hold "roughly steady." All of the last four quarters have beaten analyst expectations, with an average beat of 8.9%. By contrast, while HP has been ahead of forecasts, it is still declining by double-digits.
As the world's largest mail processor equipment provider, Pitney Bowes is well exposed to greater overall economic activity. Since I am more bullish on international macro trends than typical media commentators, this obviously presents a compelling reason to buy. With a history of raising dividends over the last three decades, management has also shown confidence over the fundamentals and meaningfully reduced uncertainty for shareholders. HP, obviously, is floundering under substitute competition from smartphones and tablets.
In my view, however, HP is still undervalued. Windows 8 should catalyze the PC market, and I ultimately view tablets as a very short-term phenomenon. However, several competitors will exit the field in the interim and thus enable HP to expand margins. Fortunately, management has already taken the appropriate steps to cut costs through improving inventory management and laying off around 30,000 workers. In the long run, this will help the company generate the war chest cash it needs to pursue undervalued businesses, take them over, and unlock synergistic value.
TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. 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.If you have questions about this post or the Fool’s blog network, click here for information.