Expensive, Slow, & Bad: 3 Stocks That Have Turnaround Potential
David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Typically, when a company trades at a high PE multiple, there are several explanations: (1) growth potential is significant, (2) the market has overvalued the business, or (3) there is an isolated softness in the local business environment. In my screen of companies with lower than 5% five-year EPS growth and both trailing and forward PE multiples greater than 15x, three companies really stood out to me: Avon, Carnival, and PepsiCo. While all three of the companies have been very poorly managed, they are all still at incredible junctures where they can turn around operations and create tremendous value for shareholders, new and old. From buyout potential to pricing and international marketing changes, the possibility is there. Below, I review these three companies in greater detail.
Avon Products (NYSE: AVP): Buyout and Activist Target
Avon Product is a poorly performing direct seller of beauty products, such as fragrances, skin care, and cosmetics. While the company has done well in emerging markets such as Brazil, it has failed to cut costs in a way that generates meaningful long-term value. In the last five years, EPS grew by 2.4%, but shares still trade at 15.6x forward earnings. A few months ago, Coty offered to buy out the company for $10.7 billion, and the stock price has since fallen 37.4% from the time of the high. It is quite clear that investors would do much better locking in a 70% return and then re-investing the proceeds elsewhere, because, as it stands, Avon is a poorly-managed business. I encourage buying shares with the expectation that a tender offer or solicited bid will emerge.
Rumors are now indeed circulating that Coty will try again to buy out the business, and the market has reacted accordingly, sending shares up 4.9% higher. If the board rejects an even moderately close offer again, it deserves--if it hasn't already--being entirely replaced. For this reason, I believe a shareholder activist could disclose a position and lobby for ever higher prices for the bidder. Again, a 70% return from a bleak position today is a healthy amount to lock in.
In the third quarter, even Avon had to admit performance was disappointing and, given cash flow concerns, had to cut the dividend distribution by 73%. And yet management is still committed to its cost cutting and non-innovation strategy--the same strategy that got it where it is today. Just this Wednesday, the company announced a planned cut of 1,500 jobs globally and an exit from South Korea and Vietnam. While this may generate $400 million per year by 2015, it is a tacit admission that the company's brand is failing abroad. Let's hope that the board doesn't fail this time around in buyout talks.
Carnival (NYSE: CCL): Righting the Ship
This operator of cruise lines has seen EPS fall by a rate of 2.6% over the past five years and, despite this poor performance and a Costa Concordia sinking later, the company manages to trade at 20.8x earnings and near the 52-week high. Stifel Nicolaus is still calling the stock a "buy" with a $48 price target, a valuation that is 26.7% higher than the current price. Analysts forecast 11.9% annual EPS growth over the next five years. Assuming expectations are met, 2016 EPS will come out to $3.46. At a multiple of 15x, this translates to a future stock value of $51.90. This provides a 10% average annual return when you factor in dividend yields. Even still, when you discount backwards by 10%, you arrive at a $32.23 present value, which indicates the stock is around 15% overvalued. In my view, this return is not large enough to warrant taking on the risk that shares could fall 15%.
There are several factors to consider before choosing to invest in Carnival. First, the company is planning to build two new cruise ships in 2015 and 2016 that fit 2,600 and 4,000 passengers, respectively. Second, operating performance has started to improve. It boosted its full-year earnings guidance off of a higher pricing that has not seen a commensurate decline in bookings. In fact, during the third quarter, management beat expectations by 9 cents on EPS of $1.53. This followed an 8% rise in bookings volumes in the second quarter.
PepsiCo (NYSE: PEP): It's All About the International Strategy
Like Avon, PepsiCo has been poorly managed and received significant shareholder pressure. Over the past five years, EPS has declined by a rate of 3.8% but the PE multiple is still incredibly high at 18.7x. To put this into perspective, Coca-Cola, which commands a much greater brand image and geographical exposure, trades at an only slightly higher 19.6x despite growing EPS by a rate of 14.1%. Moreover, Coca-Cola is starting to penetrate PepsiCo's leading Middle East market with the large purchase of Saudi Arabia's Aujun Industries. It is a challenging market in light of a 13% decline in domestic soda sales over the past seven years.
No matter, investors are still confident about the future of PepsiCo. Shares have risen 17.2% from the 52-week low through a series of catalysts. In recent days, the company announced that it would be creating new "liquid snacks." If that sounds weird to you, it's because it is. That's right, the company may be turning its Fritos chips brand into a liquid brand, and management points to a popular oatmeal drink in Brazil as evidence the plan may work. I'm not entirely sure what they have in mind, but I actually think it sounds like an innovative concept that could catalyze interest, if not in the products themselves then certainly the brands that they are derived from.
The soda industry's future lies abroad, and PepsiCo is a mixed bag in this factor. Pressure in India, for example, is coming from regional brands that are drinking away market share. Data shows that PepsiCo's market share may have fallen by 800 bps to 40% in just the last two years. The introduction of Pepsi Special in Japan, despite a widespread scientific consensus that the product's positive health claims are dubious at best, offers opportunities. The opening of an R&D center in Shanghai further allows for a better marketing strategy to target this emerging economy. This mixed bag of poor performance and opportunities makes PepsiCo a "hold."