By Larry Gellar
Last week, we wrote about the best eight stocks in the Dow. Here are the eight worst according to valuation metrics. Companies like IBM (IBM) and Caterpillar (CAT) have been bid to prices too high for our taste, while companies like Disney (DIS) and Verizon (VZ) have concerns with acquisition strategies at the company or elsewhere. Further still, companies like Cisco (CSCO) suffer from foresight-lacking management. As always, use the list below as a starting point for your own due diligence.
Walt Disney Co (DIS) – Disney has been more or less flat since the beginning of 2011, although the stock has been buoyed recently by the resolution of the NFL lockout. But look for the new NBA lockout to be a bloodbath until a resolution is reached. In other words, basketball games will be missed, and Disney will be affected negatively (chiefly through the games it would’ve broadcast on ABC and ESPN). Disney also appears a bit overvalued on measures such as P/E and PEG. Its P/E of 17.1 and PEG of 1.04 are both higher than Time Warner (TWX). While News Corp. (NWSA) has obviously struggled as of late due to its infamous phone hacking scandal, it should remain tough competition for Disney in the future. These three companies will report earnings within a week of each other, so that will probably be an important factor for Disney's stock price in the short-term. Some analysts are predicting weak earnings for Disney. Others question the logic behind its recent buyout of UTV Software in India. Although India is certainly a market worth targeting with its population of 1.2 billion, Disney may have paid too much for the company.
International Business Machines Co (IBM) – IBM has been on a tear since September of 2010, but investors across the country are wondering how much longer this can keep up. Common sense dictates that at some point people will move their money over to Hewlett-Packard (HPQ). Note that IBM’s P/E and PEG are 14.77 and 1.15 respectively, while HPQ is only 8.64 and 0.78 for these same numbers. Additionally, for the period ending June 30, 2011, IBM had a sizable net cash outflow of $1.048 billion. (Next quarter will probably see a net cash inflow though due to Google’s (GOOG) recent purchase of patents from IBM). IBM will also be hurt by sentiment in Washington to cut spending; spending cuts could hurt IBM’s business one way or another. Although there are plenty of people who think IBM still has some upside, it seems unlikely that investors will continue to ignore cheaper alternatives like HPQ and Dell (DELL) much longer. IBM may be a suitable choice for investors who prefer dividends, but an even better technology stock with dividends is Microsoft (MSFT). We recently identified IBM as one company that is hiring again.
Kraft Foods Inc (KFT) – Kraft has been on the rise since the beginning of spring, and the P/E ratio certainly shows it. Kraft is currently trading at 19.94 times earnings, which is somewhat larger than competitors like Danone (OTCQX:DANOY) and ConAgra Foods (CAG). Those two stocks are trading at 16.31 and 13.67 times earnings, respectively. Although Kraft represents a safe choice in an otherwise uncertain economy, it is clear that other companies may have more upside at this point in time. Kraft reports earnings next week, and although this earnings season has been surprisingly strong, investors are probably catching on. In other words, although the first stocks to have surprisingly good earnings saw big gains, investors are probably already expecting Kraft to beat what was the previous consensus for its earnings. Even if Kraft does beat expectations, it seems unlikely that the stock will gain much because the stock has already been on such a climb to begin with. For other reasons why Kraft may not be a solid choice right now consider reading this. Kraft historically has made poor choices between buying back stock and distributing dividends. Additionally, the Cadbury acquisition has had some negative consequences, most notably causing investment mogul Warren Buffett to sell some of his shares.
Verizon Communications Inc (VZ) – Similar to many of the other stocks discussed in this article, there is a serious argument to be made that Verizon is overvalued. Like IBM mentioned above, the stock started its climb all the way back in September of 2010 and now has an inflated P/E ratio. VZ is trading at 15.83 times earnings, a far cry from more reasonably priced AT&T (T), whose P/E ratio is only 8.52. Although some investors will find Verizon’s 5.50% dividend yield extremely attractive, there are a few concerns to be had with this company. One notable event is a potential strike on the part of its workers, who are refusing to back down to a company that is asking for some serious concessions. Being that the unemployment rate is over 9% though, it remains to be seen how much bargaining power the union actually has. As explained in this article, Verizon may also have some cash flow problems. One important point is a low free cash flow margin compared to AT&T and Vodafone. In fact, Vodafone owns 45% of Verizon Wireless, so some of that cash flow isn’t really Verizon’s to begin with. Additionally, some of the company’s cash flows are temporary in nature and may not accurately represent future strength.
Pfizer Inc (PFE) – Pfizer has been on the rise the past eight months, and as one would expect the price to earnings growth ratio is a little out of whack. For the 5-year version of this metric, Pfizer comes in at 2.46, higher than important competitors including Bayer (OTCPK:BAYZF), Merck (MRK), and Novartis (NVS). Earnings will be announced on Tuesday, August 2nd, and some analysts believe the company will disappoint. Long-term shareholders also question new CEO Ian Read’s leadership after a history of extremely liked chief executives including Jeff Kindler and Henry McKinnell. Additionally, some investors note that the company has historically needed to use acquisitions to supplement a below-average R&D department, although this may be changing. In fact, drugs such as Axitinib, Crizotinib, and Tofacitinib appear to be well on their way to hitting markets. At the same time though, Pfizer has had two straight quarters of negative cash flow, which makes it hard to justify over a company like Merck that has had four straight quarters of positive cash flow. Merck has also announced recently that the company will cut 13% of its workforce by 2015, which is the type of move that should keep it running efficiently for a long time to come. Pfizer may need to make a similar decision to stay competitive, but until then we like Merck over Pfizer.
EI DuPont de Nemours & Co. (DD) – DuPont has been up and down in 2011 as uncertainty about the economy looms. In fact, with a beta of 1.52, DuPont is more sensitive to market changes than many other stocks in the Dow 30. A wiser choice may be BASF SE (OTCQX:BASFY). Although perhaps less known on this side of the Atlantic, this German enterprise is actually the largest chemical company in the world. Despite this, it is trading at quite a discount at the moment, with a P/E of 9.74 and PEG of 0.50. Note that this is significantly lower than DuPont’s P/E of 14.38 and PEG of 1.34 as well as those same metrics for Dow Chemical (DOW). Of course, one reason for this is due to eurozone debt worries. But still one has to question whether this stock should be trading higher, especially with a quarterly revenue growth of 25.3%. BASF aside though, other problems with DuPont deserve mentioning. Two of the past four quarters for which data is currently available have seen negative cash flows. (Note that the Danisco acquisition happened in the quarter for which data is not available yet). Although DuPont reported strong earnings, it is simply too hard to justify paying 1.44 times sales for this stock.
Caterpilar Inc (CAT) – Caterpillar is up year-to-date, and even the most casual observer should find that shocking. The earnings reported on July 22nd were disappointing in comparison with Wall Street estimates, but it did not have as much of an impact as it should have. This stock has always been at the mercy of the economy overall, and its beta of 1.93 certainly proves that. With U.S. unemployment currently over 9%, it is hard to imagine that this stock has much upside. Investors should keep in mind that a new employment report will be released this week, but it seems unlikely that the situation has much improved, especially considering the damage that has been done recently by the debt uncertainty. Additionally, Caterpillar is currently trading at 16.34 times earnings, which is higher than other important players in the farm and construction machinery business. Consider other stocks like CNH Global (CNH), Komtasu (OTCQB:KMTUY), and Volvo (OTCPK:VOLVY). While Komatsu and Volvo have of course been hurt by Japan’s catastrophe, these stocks certainly have potential due to the rebuilding that must take place in that country. The industry as a whole may not be a great place for investment though, due to a possible lessening of growth in China.
Cisco Systems Inc (CSCO) – The last time Cisco traded this low was the beginning of 2009. As discussed above in the IBM section, HPQ seems to be the technology stock to buy at the moment. Note that Cisco’s P/E and PEG are 12.47 and 0.99 respectively, compared to 8.64 and 0.78 respectively for HPQ. Recent developments have also hurt Cisco’s ability to dominate their usual markets. Specifically, it is widely known that Juniper Networks (JNPR) is releasing better routers and switches at a cheaper price. In fact, one client that seems to be big fan of Juniper is the Department of Defense. Brocade Communication Systems (BRCD) is an even smaller competitor of Cisco that could be a serious threat in the years to come. Additionally, while some investors are excited about Cisco’s cloud computing business, there are so many competitors in that market that it remains to be seen how successful Cisco can be. Cisco CEO John Chambers is one person who has taken a lot of heat for Cisco’s recent failures, and it’s unclear how much longer he’ll be able to keep his job. Investors have duly noted Cisco’s indecisiveness regarding plans to break into the consumer market. Consider reading this article to learn more about the pros and cons of Cisco’s future. We identified CSCO's CEO as one who should be fired this year.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.