Thursday, July 6, 2006

The S&P 500's Hottest-- and Coldest-- Stocks

News Analysis
July 6, 2006

Business Week Online

The S&P 500's Hottest—and Coldest—Stocks

Metals outfit Allegheny Technologies led the pack while KB Homes brought up the rear. Both could improve in the months ahead

Red-hot metals and cooling housing. For the first half of 2006, the best- and worst-performing stocks in the Standard & Poor's 500 index reflected those two themes. Coming off a surge in commodity prices, metals producer Allegheny Technologies (ATI ) sprinted to the head of the index with a 92% half-year gain. On the flip side, homebuilder KB Homes (KBH ) brought up the rear with a 37% loss amid a softening housing market (see, 7/5/06, "Second-Half Outlook: Housing").

What's next for the leader and the laggard? The two stocks have taken different paths in 2006, but each could have room to grow in the year's second half, analysts say. Recent market volatility may signal an opportunity to buy Allegheny on the cheap, according to some analysts. Meanwhile, homebuilders may not be out of the woods yet, but KB's high profit margins and favorable valuation could put in prime position when the housing market recovers.

One caveat—both stocks have exposure to cyclical industries, so investors should bear those risks in mind. Here's the down and dirty on each:

Allegheny Technologies
Pittsburgh-based Allegheny makes stainless steel, titanium alloys, and other specialty metals. The jump in its share price came amid strong demand for metals, as the company unveiled expansion plans and posted healthy profits. "The outlook remains strong for our major markets," which include defense, chemicals and energy, noted Patrick Hassey, the company's chairman, president, and CEO, in a June 6 slide show presentation.

On May 11, Allegheny hit a 52-week high of $87.50 as metals producers soared. Prices have since cooled, to $68.71 on July 6, but not enough to displace the stock as the S&P 500's first-half leader. "We've had good operational execution, and we continue to invest for growth," says Dan Greenfield, a company spokesperson.

Continued client demand has enabled the metal producer to keep raising prices. On Apr. 22, Allegheny reported 68% higher first-quarter profit. Its key growth markets—aerospace and defense, the chemical process industry, oil and gas, electrical energy, and medicine—accounted for 62% of a company-record $1 billion in sales, Hassey said in a prepared statement. Allegheny typically posts second-quarter earnings in late July.

Growth initiatives have also propelled Allegheny's stock, and could provide further upside. On June 26, the company announced its latest expansion, a $325 million titanium sponge plant in Utah. With no demand slowdown in sight, this and other recent additions should increase Allegheny's capacity without leading to overbuilding, analysts say.

SOMEWHAT SHIELDED.  "We continue to favor [Allegheny] as 'quality on sale,'" Citigroup analyst John Hill wrote in a June 26 report. Hill has a buy recommendation on the stock. (Citigroup has an investment-banking relationship with and a significant financial interest in both Allegheny and KB. Citigroup also makes a market in the companies' securities.)

As a specialty metals producer, the company is shielded to an extent from the recent speculative frenzy in exchange-traded base metals, Hill says. Meanwhile, the markets Allegheny serves, such as the defense sector, are typically considered less susceptible to broad economic downturns.

The stock also has exposure to the red-hot ethanol market. Corrosion-resistant materials such as stainless steel are essential to ethanol production, and Allegheny received orders related to constructing about 20 ethanol facilities in the first quarter, Bear Stearns analyst Anthony Rizzuto pointed out in a June 22 report.

Rizzuto has an outperform recommendation on the stock and a year-end price target of $80, which he deems "conservative." (Bear Stearns has a non-investment-banking relationship with Allegheny and is affiliated with the specialist that makes a market in the company's common stock.)

KB Homes
Headquartered in Los Angeles, KB is the fifth-largest company in its industry, focusing on homes for first-time and move-up buyers. KB wasn't the only homebuilding stock hammered in a tough six months for the housing sector. Smaller rivals like Hovnanian (HOV ) and Ryland (RYL ) posted modestly bigger percentage losses, though they aren't S&P 500 members. But KB still has its fans. "KB Homes is one of the best-managed home builders, if not the best," says S&P equity analyst William Mack.

The first half of 2006 was a trying time for KB stockholders, as data releases indicated a gradual slowdown in the housing market (see, 6/21/06, "Housing's Steady Foundation"). On June 13, shares in the homebuilder scraped a 52-week low of $41.95, before recovering to $46.05 on Jul. 6. The drop came after Morgan Stanley analyst Robert Stevenson downgraded his industry view from attractive to cautious.

Declining home demand and rising cancellation rates hampered KB's first-half performance, said Bruce Karatz, the company's chairman and CEO, in a June 16 conference call. "While it is difficult to predict, we do believe that the cancellation rates will begin to subside," he added. A company spokesperson said executives were unavailable to comment further prior to deadline.

BACKLOG BOOST.  Despite housing-market softness, KB's second-quarter earnings report June 15 still beat Wall Street expectations, though the company also trimmed its full-year guidance. An increase in average order prices should keep margins strong, and the stock is trading well below its average price-to-earnings multiple, according to UBS analyst Margaret Whelan, who rates the stock a buy. (UBS has an investment banking relationship with KB and makes a market in the company's securities.)

A higher-than-expected backlog in the second quarter should help boost revenues in the second half of the year, observes Citigroup analyst Stephen Kim, who also has a buy rating on the stock. "As a result of their ability to better navigate supply constraints, the public builders are rapidly growing their share of a highly fragmented market, fueling double-digit long-term revenue growth potential," Kim wrote in a June 19 report. The homebuilder also recently knitted a potentially lucrative branding alliance with Martha Stewart Omnimedia (MSO ).

Nevertheless, it's anybody's guess when the housing market will hit bottom. Credit Suisse analyst Ivy Zelman made this point in a June 19 report lowering the 12-month price target for KB from $55 to $49, also citing the company's high exposure in California and Nevada. Credit Suisse has an underperform recommendation on the stock. (Credit Suisse has an investment banking relationship with KB and makes a market in the company's securities.)

Metals and housing may not remain the big stories in the second half. Still, Allegheny's fundamentals suggest the metals producer could continue its rise. And if KB can weather a cooling market and rising interest rates—a big if, admittedly—the homebuilder might just position itself for a rebound.

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