Wednesday, August 2, 2006

Back-to-School Stocks: BW's Honor Roll

News Analysis
August 2, 2006

Business Week Online

Back-to-School Stocks: BW's Honor Roll

As summer ends, school looms, and kids—and parents—get ready to restock, Apple and Gap are among the companies poised to benefit

School's out for summer, as Alice Cooper once sang, but the golf-loving metalmeister got the "out forever" part wrong. In fact, the U.S. Education Dept. projects pre-kindergarten through 12th-grade enrollment to increase to 16.5 million in 2006, up 17% from a decade ago. With the student body expanding, a few stocks stand ready to enjoy seasonal back-to-school trends.

First, though, some of these companies must pass the test of declining consumer spending. Shoppers have tightened their wallets amid soaring gasoline prices and a cooling housing market (see, 7/31/06, (see, 07/31/06, "The Economy's Pop-Tart Problem"). If current trends worsen, it could be difficult for retailers and others to get to the head of this year's back-to-school class.

CALENDAR QUIRKS.  The quirks of the calendar could further complicate year-to-year sales comparisons this year, some analysts say. Last year the two biggest weeks for back-to-school spending both fell in August, but in 2006 they'll be spread across different months, according to Dan Genter, president and chief executive officer of Los Angeles-based investment firm RNC Genter. "August is probably going to look a little bit weaker compared to last year, all things being equal," Genter says. "But then it's going to make September look a little bit better."

Nonetheless, certain well-positioned outfits stand ready to overcome the negative trends. This week's Five for the Money looks at five smart stocks that might benefit from the annual autumn return of reading, writing, and arithmetic.

1. Apple Computer
Apple (AAPL), which traditionally has had a solid presence in the education market, is looking to tighten its grip. Earlier this year, the computer maker unveiled a new low-end PC that sells for $899 to schools, students, and teachers. In Europe, it's even seeking to build education technology around the iPod (see BusinessWeek, 3/23/06, "Apple Loves France, Sometimes").

While Apple isn't the biggest-selling PC maker in the education segment, its presence there has been a boon for its PC business. In 2005, the Cupertino (Calif.) computer giant grabbed a 15% share, by units, of the $6.1 billion U.S. education market, far behind Dell (DELL ) but ahead of Hewlett-Packard (HPQ ). While the overall school market grew by 9.6%, Apple saw its units-sold increase by 14.9%, helped by Apple's ongoing focus on the K-12 market, according to IDC analyst David Daoud. Those may not be iPod numbers, but the education space is crucial to Apple's efforts to build brand loyalty "straight from the get-go," Daoud says.

But Apple isn't earning better marks only in education. Following 13 straight quarters of upside earnings surprises, the company stands to turn in more gains thanks to iPod growth, the shift to Intel (INTC ) processors, and potential new product launches, observes Bear Stearns analyst Andrew Neff.

"Unlike a year ago when Apple's growth was dependent on one 'hit' product, we see Apple with multiple growth drivers," Neff wrote in a July 19 report. He has an outperform recommendation on the stock. (Bear Stearns has a non-investment-banking relationship with Apple and makes a market in the company's securities.)

Apple shares are still down from their 52-week high of $86.40, touched Jan. 12. In afternoon trading Aug. 2, Apple shares bounced to $68.02.

2. Staples
Would a new school year really be complete without new pencils, pens, and notebooks? When it comes to office supplies, Staples (SPLS ) is the analysts' current pet, with a better average recommendation than smaller rival Office Depot (ODP ). The Framingham (Mass.)-based retailer offers a positive long-term story despite rising paper costs, analysts say.

Chalk up some of the appeal to strong revenues. After softening in May, Staples' same-store sales likely accelerated into July, boosted by targeted advertising and better merchandising, says Citigroup analyst Bill Sims, who rates the stock a buy. "Staples continues to see strength in key categories such as office supplies, copy center, digital imaging, and accessories," he wrote in a July 30 report. (Citigroup has a significant financial interest in and an investment banking relationship with Staples, and also makes a market in the company's securities.)

Solid demand seen in Office Depot's recent earnings report also bodes well for Staples, which posts its quarterly results Aug. 15, according to Bear Stearns analyst Christopher Horvers, who has an outperform recommendation on the stock. Shares were $21.53 in afternoon trading Aug. 2, down 22.3% from a 52-week high touched on May 11. (Bear Stearns has a non-investment-banking relationship with Staples and makes a market in the company's securities.)

A company spokesperson says Staples expects "terrific" back-to-school sales this year, though she declined to go into specific numbers. "Staples has pumped up the color and fun in our back-to-school assortment," the spokesperson says. "We think it's really going to resonate with teens and students of all ages."

3. Gap
The dawn of the new school year brings the chance for a fresh start for students and teachers. Venerable clothing retailer Gap (GPS) could use one of those this fall, following a dismal 2005 for its Gap, Old Navy, and Banana Republic stores. Adjusted for dividends, shares of the San Francisco-based company have fallen 2.6% since the start of 2006, to $17.03 in afternoon trading Aug. 2.

So far, apparel watchers are keen on Gap's back-to-school merchandise. The stores' new denim, sportswear, and active wear are nicely in line with current styles, according to Jane Hali, vice-president and director of retail consulting at Coleman Research Group. "This is the first month of good product," Hali says.

Gap may be at a turning point, analysts say. "It is too soon to write this company off," notes Morningstar analyst Joseph Beaulieu, who gives the stock a four-star rating out of five. While Gap is coming off seven straight quarters of slowing sales growth, Beaulieu points out that Abercrombie & Fitch (ANF ) once recovered from nearly four years of negative comparisons.

A big question mark for the company is the loss of Jenny Ming, president of the Old Navy division, whose upcoming departure was announced July 11. Amid general macroeconomic uncertainty, Gap's ongoing turnaround story is fraught with risks. In keeping with the back-to-school spirit, investors should do their homework.

4. Centex Corp.
Retail companies aren't the only ones poised to earn from a growing population of young scholars. Centex Corp. (CTX), with about $200 million in revenues from education construction, could be one residential builder that can weather the cooling real estate market (see, 7/23/06, "Five Ways to Play the Housing Slump"). Shares edged up to $47.80 in afternoon trading Aug. 2, down 33% for the year, adjusted for dividends.

Standard & Poor's equity analyst William Mack says the Dallas-based construction company is his only buy recommendation among builders. Centex's business lines and geographic markets are more diverse than those of its competitors, according to Mack. "We think the company is prepared to weather this cyclical downturn better than its peers by aggressively reducing its share count and cautiously managing its land holdings," he wrote in a June 21 report.

However, opinions on Centex are decidedly mixed. Despite some modest positives from a recent earnings call, the company's outlook for the rest of the fiscal year is dubious, according to J.P. Morgan analyst Michael Rehaut, who has an underweight recommendation on the stock. (J.P. Morgan has an investment banking relationship with Centex and has acted as manager in a public offering of the company's securities.)

S&P's Mack forecasts traditional homebuilding revenues to account for roughly 85% of Centex revenue, a smaller share than for the other homebuilders. Meanwhile, Centex is in the midst of a massive share repurchase program, which will boost earnings per share. Even a casual student of the economy knows the housing market is slowing, but despite real risks, Centex may reward patient investors. A Centex spokesperson was unable to comment immediately on the company's school-building prospects.

5. Laidlaw International
The wheels on the bus go round and round, but the stock of school transportation outfit Laidlaw International (LI) has been on a straight climb this year. Laidlaw derives half of its revenue from Laidlaw Education Services, a student transportation provider with a fleet of more than 40,000 buses. While the stock is only sparsely covered, at least one analyst hails the outfit's shares, which were trading at $26.90 late Aug. 2, up 17.2% for the year when adjusted for dividends.

Best known for its Greyhound Lines inter-city buses, Naperville (Ill.)-based Laidlaw emerged from bankruptcy in 2003. Amid solid results from Greyhound and Education Services, Laidlaw could reach a one-year target of $33 based on an estimated 2007 price-to-earnings ratio of 14.8%, according to RBC Capital Markets analyst Nick Morton, who has an outperform recommendation on the stock. The company also recently announced a $380 million share buyback program.

However, others are more cautious on the stock. Oppenheimer & Co. analyst Ian Zaffino, using a slightly lower p-e estimate, has a neutral recommendation on Laidlaw shares. On July 7, Laidlaw announced quarterly earnings that fell below analyst estimates, due to higher-than-expected tax costs from a Canadian subsidiary.

A sharp increase in energy prices or a severe downturn in consumer spending could cause these back-to-school stocks to be left back. In the meantime, though, these companies might remind investors that learning can be not only fun, but profitable, too.

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