Any skilled value investor will tell you, the best bargains are generally found in stocks enveloped by fear and pessimism. Such stocks invariably have low expectations embedded in their prices, setting up the optimal risk/reward situation: Low risk coincident with high prospective reward.
It’s the case with each one of the stock picks for my Top 10 List for 2012, including the final two picks, detailed below. That the last two picks are tainted by negativity and controversy should come as no surprise. They’re leveraged to the real estate industry, after all.
In columns posted earlier this month, I recommended eight other bargains for my Top 10 list: General Electric (NYSE:GE), Terex (NYSE:TEX), Manitowoc (NYSE:MTW), Whirlpool (NYSE:WHR), Hartford Financial (NYSE:HIG), MFC Industrial (MIL), Citigroup (NYSE:C) and Bank of America (NYSE:BAC).
Buy: USG (NYSE:USG)
If any cycle should not scare investors, it’s the real estate cycle. Not because of a lack of pain – the latest decline was the most painful since the Great Depression – but because it’s an elongated cycle with almost no oscillation. When real estate is bad, it’s consistently bad, and for several years running. And when it’s good, it’s consistently good, with up-cycles that can last for a decade or more.
While I can’t tell you with precision when the real estate cycle will turn, it’s a safe bet that it will. The housing depression has lasted for five years already (the downturn actually began in early 2006) and excess supply is getting sopped up.
Even if an improvement is another year or two or three away, this is a good time to buy stocks leveraged to real estate. If you wait for clear evidence of a turn, it’ll be too late. The stock price of USG and Mueller Water (recommended later in this column) will have already moved higher.
A 110-year-old company, USG is the market leader in gypsum wallboard. With housing starts trending at less than one-half of normal levels (600,000 per year versus 1.5 million norm), USG has been unable to generate a profit. When demand improves - even if the uptick is modest - powerful earnings leverage will be unleashed. That’s because costs have been taken out of the system in a big way. For example, USG shuttered 3.8 billion feet of gypsum capacity, and the rest of the industry took out another 6.3 billion feet. After the last three housing recessions, USG generated incremental operating profit margins (on gypsum wallboard) of 35% (post ’82-’85), 56% (post ’92-’95) and 33% (post ’01-’04).
For valuation purposes, I peg shares outstanding at 135 million, factoring in dilution from a convertible that’s currently out of the money. The strike price is $11.40 for the convert, higher than the current quote of $10. When demand improves, revenue should normalize at about $4.5 billion (the current run-rate is $3 billion), with earnings of $2.20 per share. Even if it takes two or three years to get there, it’ll be worth the wait. Such an earnings stream warrants a stock price in the low $20s, more than double today’s quote.
Buy: MUELLER WATER (NYSE:MWA)
My tenth and final pick for the Top 10 list is Mueller Water Products (MWA). The company manufactures and sells products into the water infrastructure market – a portfolio that includes fire hydrants, valves, pipes, pipe fittings, and metering systems, among other things. More than 70% of sales come from products where MWA has a #1 or #2 market share position.
Like USG, Mueller has been hit hard by the depression in residential housing and new construction. To put it in context, in 2006, 40% of the company’s sales were tied to residential construction. Today, its 5%. That’s not to say the company is standing idly by, waiting for housing to improve. It’s gotten stronger and more efficient in areas within its control. For example, it has closed six plants, reduced headcount by 24%, lowered capital expenditure by almost 60% (2009-2011 period compared with 2006-2008 period), and successfully restructured the balance sheet to eliminate all significant near-term maturities.
A near-term catalyst that could drive Mueller Water stock higher involves the U.S. Pipe division (28% of sales). It has hired an investment bank to look at selling this business, a desirable goal since it masks profits from the company’s other two businesses, Mueller (46% of sales), and Anvil (26%). Over the last two years, U.S. Pipe lost $111.7M from operations (this includes $16.4M in restructuring expenses). Over the same two-year period Mueller and Anvil, respectively, generated $135M and $54M in operating profit.
Let’s put this in perspective: The entire company is valued by the market at only $374M, yet two of its three divisions generated $189M in operating profit ($135M + $54M) over the last two years, and at the trough of the real estate cycle. If the company can successfully exit the U.S. Pipe business, what would be left are two businesses (Mueller and Anvil) that generate nearly $1B in sales with a 10% operating margin. Even in today’s depressed valuation environment, that merits a healthy bump in the stock, from $2.40 to $4 or so.