The impasse between Germany/ECB and debt-heavy profligate nations pushed volatility up 4% in recent days. Aversion to risk is increasing. Investors are demanding more safety for riskier stocks, resulting in a drop in stock price, and lower valuation.
Stocks that are locked in an established share price decline are inherently less risky, with one exception. If negative macro trends challenge a broken business model, risks accelerate and shareholders lose.
Stocks with a broken business model often have one or more of the following characteristics:
1. Reliance on too few customers or products for profits.
2. Main product line not innovative enough to match offering of competitors.
3. Main products are being commoditized due to excess supply or inadequate demand.
4. Heavy dependency on debt to service positive cash flow and operations.
5. Company least competitive in an unhealthy industry/sector.
Value investors are likely to have any one of the stocks discussed below on their watch list: Nokia Corporation (NYSE:NOK), Research in Motion (RIMM), OmniVision Technologies (NASDAQ:OVTI), Bank of America Corp (NYSE:BAC), Cree, Inc. (NASDAQ:CREE), and ATP Oil and Gas Corporation (ATPG).
Do these companies have one of the above-listed characteristics of a having broken business model?
1) Nokia Corporation (NOK)
Nokia rallied to around $7.25 in late-October after reporting earnings above investor expectations. Shares have since dropped to $5.29 and are down 52.16% from its 52-week high. The company pays a dividend of 10.80%, a rate that is unsustainable. Dividends have not yet been cut because the company decides on the dividend payment rate once a year.
With the Microsoft-Nokia phone partnership, Nokia is broken in two ways. It has (1) a reliance on too few customers or products for profits and (2) a main product line not innovative enough to match offering of competitors.
In the 3rd quarter, Gartner reported that Microsoft’s (NASDAQ:MSFT) Windows Phone 7 market share dropped from 2,203.9M units to 1,701.9M units. Without Nokia yet making a major launch (other than the Lumia) Microsoft’s Windows Phone market share dropped from 2.7% to 1.5%.
2) Research in Motion (RIMM)
Research in Motion’s (RIMM) troubles are already well-documented. RIM closed recently at $16.00 and has a P/E of just 2.93. Short-sellers and option put buyers are now sitting on big profits this year.
The major events that took place since the company was last reviewed include a multiple-day service outage, a Playbook tablet fire sale ($199 for the 16GB model), and a riot in Indonesia when the Blackberry Bold was promoted for half-price for the first 1000 customers.
RIM’s business model appears to be broken, with item (2), main product line not innovative enough to match offering of competitors applicable to the company. For the current quarter, the company’s research and development costs are expected to rise, and margins are expected to fall. Investors will have a better understanding on the health of RIM’s business when the company reports in December.
In the meantime, RIM is a transition story. Its major transition from the just-released BBOS7 system to BBX will cost the company market share. The company will need to provide tools and a road map to developers, if it wants to ensure app development continues in the future.
3) OmniVision Technologies (OVTI)
OmniVision designs image sensors for smart phones. Shares rode high between $30-35 when investors expected OmniVision to supply image sensors for Apple’s (NASDAQ:AAPL) iPhone 4S camera. Instead, Apple was found to be using Sony (NYSE:SNE) sensors. After an earnings warning, OmniVision shares tumbled further from $18 down to $10.41.
The company has a market capitalization of $620.54M and a P/E of just 4.18. Investors assigned too high a valuation by relying too much on Apple for profit (item #1). With ample cash ($8.49/sh, $13.66 book value per share), the company is not completely broken.
OmniVision will be reporting on November 29 after the market closes.
4) Bank of America (BAC)
In addition to risks in the Countrywide Financial portfolio, regulators want Bank of America to stress test a worsening macroeconomic scenario in Europe. Bank of America shares are near a 52-week low, closing at $5.17. Shares are down 66.14%. After failing to pass fees to customers, the company is arguably (6) a company least competitive in an unhealthy industry/sector.
5) Cree Inc. (CREE)
To some degree, Cree will benefit as China and the U.S. implement a mandatory transition from incandescent light bulbs to LED. The greatest risk to investors is excess supply of LED. Cree’s main products are being commoditized due to inadequate demand.
Cree did report earnings that were better than expected, but investors renewed their risk-aversion to Cree. The company closed at $23.85 and has a still-high P/E of 25.92.
6) ATP Oil and Gas (ATPG)
Despite some insider buying activity that helped push shares up, ATP closed at $6.67. ATP is one of the most heavily-shorted stocks no the Nasdaq exchange. A short-interest of 19,263,955 shares were open as of October 14, 2011. ATP’s business model is broken because the company has (4) a heavy dependency on debt to service positive cash flow and operations.
ATP has a very high debt and is at risk of defaulting. Some wells are not producing as much oil as initial thought, putting a strain on expected cash flow.
Disclosure: I am long MSFT.