Value Traps: Watch Your Step

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 |  Includes: BBRY, DSX, KWK, NRG, RSH
by: Inefficient Market

Everyone loves a bargain, but how can you spot the difference between a diamond in the rough and a dog with fleas? We've all heard the adage "buy low, sell high", but it's easier said than done. Many times, the stocks that are beaten down unfairly can create some of the best opportunities if you have patience. Other times, there's a reason your stock continues to slide despite cheap valuations. The latter describes the classic "value trap" whereby a stock appears to be cheap because of low multiples of earnings, book value, or even cash flow. Investors looking for a bargain buy into these companies only to never see the stock price improve. Competition, poor management, declining overall sector growth, and inconsistent earnings can all set the bait for the perfect value trap. As with any investment, strong due diligence is required not just into financial metrics, but also in the operational aspects of the business. Underperformance of the broader markets and sharp downward revisions to analyst estimates can usually signal rough waters ahead. Let's take a look at a few companies that look cheap at first glance, but are they really?

Diana Shipping Inc. (DSX)

It's no surprise that the shipping industry has been hit hard over the last few years with a glut of new ships and less demand for dry bulk cargo. While the Baltic Dry Index has recovered in the last few months, it is still down over 33% year to date, and there is still too much supply in the shipping industry. Diana is a company that looks cheap with a trailing P/E of 6.71 and a book value of $15.41. Normally, that would be tremendously undervalued for a company trading at just under $8 a share. Let's look at the EPS estimate trends.

EPS Estimates

Earnings est.

June 2012

September 2012

Current Year 2012

Next Year 2013

Average est.

$0.19

$0.18

$0.72

$0.26

Year ago EPS

$0.34

$0.33

$1.33

$0.72

Growth est.

(44.10%)

(45.50%)

(45.90%)

(63.90%)

Click to enlarge

A stock that once looked cheap at under a 7 P/E is now trading at about 30 times earnings for 2013. The average EPS estimate for 2013 has crashed from $0.47 three months ago to just $0.26 currently. This is even more troubling since the industry growth trend estimates are for 15.70% in fiscal 2012 and 77.30% in fiscal 2013. DSX is slated to grow (45.9%) and (63.9%) in 2012 and 2013, respectively. Are these estimates set in stone? No, things can certainly change and DSX is well positioned with a nice cash balance and manageable debt. However, the shipping industry still has a long way to go to get back to its glory days of 2006/2007. According to Moody's, dry-bulk shipping rates will stay pressured for the next 12 to 15 months because there are as many as 30 percent too many vessels.

Quicksilver Resources (KWK)

This is an independent oil and gas company trading at about $4.50 a share with a trailing P/E of 8.54 and a book value of $7.46. Obviously, natural gas has not been having a good go of it lately, but the EPS estimates for KWK might spell further trouble ahead.

EPS Estimates

Earnings est.

March 2012

June 2012

Current Year 2012

Next Year 2013

Average est.

($0.04)

($.04)

($0.10)

($0.18)

Year ago EPS

$0.02

$0.07

$0.12

($0.10)

Growth est.

(300%)

(157%)

(183%)

(80%)

Click to enlarge

It's hard to say what the stock is worth because all the earnings estimates are negative. Tangible book value is $7.46, but that could start to dwindle as cash flow turns negative or impairments to PP&E are needed. Another problem is the huge debt load at nearly $2B. It is hard to imagine being able to service that much debt with only $13M in cash and negative earnings for likely the next 2 years. The current ratio is 0.90 which means their current assets are not sufficient to cover their current liabilities. Levered Free Cash flow for the trailing 12 months is ($462M). It is likely that a secondary offering or some type of financing will be needed to weather the downturn.

NRG Energy Inc (NRG)

This is an energy company engaged in the wholesale power generation and retail electricity markets. It is currently trading at about $15.50 a share with a trailing P/E of 15 and a book value of over $32 a share. Generally, utilities don't trade at super high multiples since their operations are fairly stable and growth is typically low. NRG is commanding a fairly high multiple on both a trailing and forward basis.

EPS Estimates

Earnings est.

June 2012

September 2012

Current Year 2012

Next Year 2013

Average est.

$0.10

$0.55

$0.77

$0.10

Year ago EPS

$2.53

$0.43

$1.42

$0.77

Growth est.

(96%)

27.90%

(45.80%)

(87%)

Click to enlarge

The stock is now trading at a forward P/E of 154. Not exactly a bargain. Book value is over $32 a share, but only about $18 of that is tangible. The company's debt/equity ratio is 129, implying that it is significantly levered. Levered free cash flow for the trailing 12 months was ($1.60B). I would be cautious of buying this company based strictly on book value. If earnings estimates are revised down further to where the company starts losing money, they could get into trouble with their debt load.

Research in Motion (RIMM)

Everyone loves to pick on RIMM, and probably for good reason. Their management team has been left in the dust by competitors. Trading at just over $12 a share, it might seem cheap with a trailing P/E of 5.41 and a book value of just under $20, but the financial metrics don't tell the whole story. Especially with tech companies,Wall Street pays for growth. If you're not sizably growing, your multiples get slashed.

EPS Estimates

Earnings est.

May 2012

August 2012

Current Year 2013

Next Year 2014

Average est.

$0.44

$0.35

$1.92

$1.75

Year ago EPS

$1.33

$0.80

$4.20

$1.92

Growth est.

(66.90%)

(56.20%)

(54.30%)

(8.90%)

Click to enlarge

RIMM is still making money, so it's not like they're going out of business anytime soon. The question is what's the catalyst that's going to move the stock higher? Some have made the case that it's a compelling acquisition target because of its network. That very well could be true. I personally don't feel it's a sound investment strategy to be betting on buyouts, simply because most companies don't get bought out (brilliant analysis, I know). The fact is, even at a 7 forward P/E RIMM looks cheap, but does anyone actually expect those earnings to improve in 2015 or 2016? The EPS trend is clearly down and it has been for sometime. Maybe it's possible they pull an Apple circa 2003 when everyone had written them off, but I wouldn't bet on it. I'm guessing the BlackBerry 25 (or whatever number they're on now) probably isn't going to turn the company around. RIMM will likely continue to limp into the future, a shadow of its former self, and its stock price stuck in financial purgatory.

RadioShack (RSH)

In Greek mythology, Sirens would lure sailors to their islands with enchanting music only to see their ships crash on the rocky coast. RadioShack looks quite inviting with a 10% yield, $7 book value and modest P/E, but one should exercise caution when navigating this rough water. RadioShack's earnings estimates have fallen off a cliff over the past few months.

Earnings est.

June 2012

September 2012

Current Year 2012

Next Year 2013

Average est.

$0.05

$0.09

$0.32

$0.41

Year ago EPS

$0.23

$0.15

$0.58

$0.32

Growth est.

(78.30%)

(40%)

(64.40%)

28.10%

Click to enlarge

Quite honestly, I'm impressed RadioShack has been able to stay in business for as long as they have. You wouldn't think people buy enough AA batteries and strobe lights to keep them in business, but apparently they do. While RadioShack is expected to generate positive EPS growth in 2013, the analyst EPS estimates for 2013 have been slashed from $0.84 a share to just $0.41 in three months. For fiscal year 2012, estimates have been cut from $0.79 to just $0.32 in three months. That still amounts for a forward P/E of just over 12, which isn't terribly expensive, but there is not a lot of room for error. RadioShack faces stiff competition and foot traffic in their store has been down recently. If they can right the ship, it could be a very nice turn around play. If not, we may see them go the way of Circuit City.

Conclusion

It's quite possible that some of these companies are able to improve their businesses and prove the analysts (and me) wrong. Some of the best opportunities in investing come when everyone is telling you to sell. That said, when diving into the bargain bin you need to know exactly what you're buying, not just on financial analysis, but also the competitive advantages of the company. Companies that are losing market share due to inferior products or poor management many times never recover until large scale changes are made.

*Financial Figures from Capital IQ

*Chart Source: Dailyfinance.com

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.