3 Stock Valuation Bubbles Which Are Ready to Burst

Includes: CSGP, ECL, RAVN, ROL
by: Joe Kunkle

Stocks that are lesser known offer many of the best investment opportunities as people fail to accurately price the security, and lack of Analyst coverage on the Street does not pin any valuation price target.

However, simple valuation metrics compared to industry and market averages allow any investor to find disconnects to take advantage of as a longer term investment.

Today I came across 3 stocks exhibiting exorbitant and unjustified valuations that are ripe to short as either a catalyst such as an earnings report or new Street coverage alerts investors to ask the question: Why is this stock trading at such a high price?

I will briefly explain the companies’ lines of business, the valuation concerns, and a practical explanation of why the companies are sinking ships with decelerating growth and face major headwinds.

Rollins Inc. (NYSE:ROL): Rollins provides pest and termite control services, and is known for its Orkin product that produces 66% of revenues. 39% of sales are residential and 41% are commercial. Gross margins have basically been flat around 47.5% for the past 5 years. Shares are trading 20.5X forward earnings, a PEG of 2.37, 7.4X book value, and 30.7X Free Cash Flow. One also has to questions near term liquidity with a quick ratio of 0.4, so the company could be forced to raise money through issuing shares. Shares have traded in a tight range the past few months and look willing to breakdown after not participating in much of the markets rally.

Rollins is only covered by one firm on the Street, Davenport, which last upgraded it to a Buy in July of 2008, which raises the question of whether the firm has totally forgotten about Rollins. As a practical matter the demand for pest control could suffer due to multiple factors, including businesses cutting back on spending as well as cash strapped consumers and the unseasonable cold weather which is keeping most pests at bay. With growth decelerating and near term liquidity issues, Rollins does not serve to be trading at the valuation of a Technology stock. Closest competitor EcoLabs (NYSE:ECL) trades at a rich valuation as well, but is slightly better valued than Rollins. Insiders own more than 56% of shares in Rollins, which is the one worrisome part, due to the possibility the firm is taken private.

Raven Industries (NASDAQ:RAVN): Raven Industries is listed in the Technology sector as a printed circuit board manufacturer, but when looking to the industries it supplies, it questions why it is defined this way. The company provides products for agricultural sprayers, plastic sheeting for construction and industrial applications, air seeding, and also uniforms for the government. The CEO was an active seller of shares throughout late May, selling nearly 75,000 shares. Shares of Raven Industries trade 16X forward earnings, 3.7X book value, and 32.9X Free Cash Flow. Sales have been decelerating the last few quarters. Raven is covered by 2 firms on the Street, Piper Jaffray and Canaccord Adams. As Aerospace enters a cyclical downturn it will materially impact earnings at Raven, and its businesses in general are very susceptible to the economic slowdown, although it has not been priced in at this point.

CoStar Group (NASDAQ:CSGP): CoStar provides marketing and information services to the real estate industry, including real estate listings and tenant information databases. Shares trade 28.9X trailing earnings, 36X forward earnings, 3.5X sales, and 19.4X Free Cash Flow. Sales slowed by 1.7% q/q in its last report, and it will report earnings on July 22. CoStar is followed by some tier 1 firms, with coverage at 6 firms overall. Real Estate is not exactly hot right now, even as everyone has called a bottom in housing the lack of new home sales is disturbing, and people are being denied mortgages everywhere. Competitive threats from the hundreds of listing agencies make me wonder what competitive edge CoStar can offer to justify this valuation. Compared to competitor LoopNet (NASDAQ:LOOP), CoStar is overvalued despite it being a faster growing and better company.

After doing some searching I do not have a full grasp on the company’s business, and Buffett says to never buy something you can’t understand, but that does not mean you cannot short it, because this price is unwarranted. One concerning factor is the 21.5% short float, so if shares begin to trend higher and breakout, a short squeeze could be in the making. However, the bearish action I saw in the options market today suggests CSGP is heading to below $33 by October.

Disclosure: No Holdings