3 Stocks Trading Under Book Value, Possibly Takeover Targets

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When a company trades below book value, it means that the existing assets are not believed to generate enough free cash flow return above weighted average cost of capital. In general, it means the liquidation value exceeds the company's current market cap. For this reason, you would either think that the company would be bought out, have exceptionally poor growth prospects, or, most likely, have some combination of the two. Below, I provide my take on three companies that trade under book value.

Devon Energy (NYSE: DVN): Avoid

Devon is one of the major natural gas companies with particularly strong exposure to oil. In fact, four-fifths of business comes from oil & liquids. It is valued just under book value and carries consider cash at $18.52 per share, or 35.4% of market cap. And unlike some of its peers, such as Chesapeake, it is not highly leveraged, as evidenced by the long-term debt-to-equity ratio of 0.4x. Return on invested capital is also strong at 12.7%. Despite the relatively low downside, I recommend avoiding the stock for several reasons…

Companies are valued based on their future streams of free cash flow, and Devon has seen weakening return on capital from limited production. It has missed expectations and risen capital expectations three times this year at a time when margins are being eroded. 2 of its Utica wells have been disappointed, and yet management is seeking to drill 5 more in 2012. It wouldn't be the only natural gas producer having trouble with this area. Chesapeake's CEO McClendon calls it a "foundational play", and yet oil prospects, the Wall Street Journal reports, are dimming. According to the CEO of EOG Resources, the main areas to be developed are Bakken and Eagle Ford--Utica is nothing more than "a lot of PR". 

Production misses and a weak growth trajectory has caused Devon to slash its 2013 production by 4%. As a result, analysts have become more bearish on the company. Shares have fallen 15.6% for the year to date.

Weatherford (NYSE: WFT): A "Hold"

This oilfields service company trades 20% under book value and is forecasted for a considerable recovery by some analysts. Duetsche Bank has a "buy" rating with a $24 price target, and FBR Capital is also optimistic at $17. This, however, should not overstate the degree of bullishness. 13 of 27 reporting analysts rate the stock a "hold". I share this mixed sentiment for several reasons…

First, return on invested capital is very poor at 3.4%, which is ~690 bps below the industry average. Further, EBIT margins of 10.8% are 650 bps below average levels and reflect a poor cost structure. Free cash flow has also been in the negative territory for more than half a decade on a TTM-basis. Schlumberger and Halliburton has been more or less in the positive territory for a while now, and Baker Hughes is starting to recover after entering the negative territory around 1Q10. It wouldn't be so bad if there was an end in sight, like there is for Baker Hughes, but free cash flow is still at -$540 million--a loss that is 6.1% of the market cap in size.

With that said, there is reason to be optimistic on the stock. I am very bullish on the oilfield service market from greater demand for deepwater drilling and specialized equipment. Dahlman Rose has even cited Weatherford as an acquisition candidate due to its global presence. Halliburton would like the company for its leading exposure to Russia and complementary offerings; GE might be interested to add coherency to its diverse product lines. Again, it's, in my view, neither a "buy" nor "sell".

Xerox (NYSE: XRX): Risky But Undervalued

Xerox is actually another company that has been cited as a possible takeover target at a 30% discount to book value. While the company is known for scanning and photocopying, it has since moved into IT and business process outsourcing support ("BPO"). HP and Dell have both done acquisitions in this field and could benefit from tacking on Xerox's operations that they can then promote to larger customer bases.

In a less speculative sense, the company is in decline an very risky to hold.  In light of a weak economy, management has become less optimistic about growth and has thus increased the payout by 35% and the sure repurchase program by $1 billion. The latter is particularly accretive given the low P/B ratio and need for hedging. Lexmark was able to surge after beating expectations form a combination of what Xerox is doing today: cutting costs and aggressively buying back shares. In the third quarter, Xerox missed expectations by $110 million with revenue of $5.4 billion and saw earnings fall 12% from FX headwinds and Europe's slow economy. However, business in outsourcing and services held up with a 1% growth.

All things considered, I recommend buying the stock. Free cash flow is considerable at $1.7 billion (a 19% yield) over the TTM ending 3Q12, and it has been in this territory over the last decade. Billionaire investor David Einhorn, who is known for taking short positions, disclosed a long position with 17 million shares around one year ago. Revenue growth has also been much faster than HP and Dell's BPO / IT outpouring segments. Accordingly, I strongly recommend taking on the risk.


TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of Devon Energy. 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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