November 1, 2006
Stocks That May Be Overstuffed Turkeys
With Thanksgiving dinner just around the corner, it's time for our list of well-known stocks that may be too richly valued
The stock market, as a whole, does not appear to be overvalued by historical measures. Even though the Dow Jones industrial average has touched all-time highs, it remains at significantly lower price-to-earnings levels than when the blue-chip benchmark last peaked six years ago. But there are still some big-cap stocks that could be trading at levels too rich for a savvy investor's blood.
To recap, investors use various valuation measures to determine how attractive a stock might be. A common way to measure a company's value is to determine its price-to-earnings ratio, or the share price divided by each share's annual earnings. The trick is determining whether stocks with relatively high p-e ratios, such as Google (GOOG) or Whole Foods Markets (WFMI), deserve to trade at such lofty premiums due to their growth potential, or whether investors would be better off foraging through the bargain bin.
And there's the rub. Some stocks may not justify the lofty levels the market has assigned them. Since it seems that the holiday season arrives sooner and sooner each year—Christmas decorations no longer wait for Halloween to make its exit before appearing on store shelves—we thought we'd mark Thanksgiving a little early this time around by trotting out some birds that might be overstuffed.
This Five for the Money looks at the five members of the Standard & Poor's 500 index with the highest 12-month forward p-e ratios as of the Oct. 30 close, according to data from Reuters Estimates. Pass the Alka-Seltzer.
1. Tenet Healthcare
Dallas-based health-care service provider Tenet Healthcare (THC) is in the midst of a turnaround, but investors' hopes for the revamp may be more optimistic than analysts' projections. The stock's 12-month forward p-e ratio of 106.98 leads the S&P 500 as of Oct. 30, according to Reuters Estimates. Shares dipped to $6.97 at the close Nov. 1, after Deutsche Bank downgraded the stock from hold to sell.
Tenet has emerged from a scandal that began in 2002 with a government investigation of Medicare billing practices. Still, some analysts continue to see challenges ahead for the company and its industry. Lack of operating margin improvement and strained relationships with doctors are but two of Tenet's hurdles, according to S&P analyst Cameron Lavey, who has a hold recommendation on the stock.
Others see a long but profitable road to recovery, despite a disappointing earnings preannouncement Oct. 30. "Even though Tenet is losing patients, we are not losing patience," says Prudential (PRU) analyst David Shove in an Oct. 30 report reiterating an overweight rating on the stock. "It is early in the process." A Tenet spokesperson declined to comment on the company's stock price.
2. Interpublic Group
New York-based advertising and marketing conglomerate Interpublic Group (IPG) is in the business of bolstering brand images. Investors must like Interpublic's look, too. They sent the stock's 12-month forward p-e ratio to 61.32 as of Oct. 30, according to Reuters Estimates. Shares slid to $10.63 on Nov. 1.
A late-'90s acquisition binge drove the company into debt and accounting troubles, but some analysts see better days ahead. Morningstar (MORN) analyst Jonathan Schrader expects operating margins to improve from negative in 2005 to 11% by 2010, still behind rivals like Omnicom (OMC) and WPP Group (WPPGY). Interpublic's "darkest days are now in the rearview mirror," says Schrader, who rates the stock four stars out of five, in an Aug. 9 report.
In another positive for Interpublic, its Draft FBC unit recently won Wal-Mart's (WMT) $580 million advertising account. The move could be a big step toward improving Interpublic's fortunes, according to Bear Stearns analyst Alexi Quadrani, who has a peer perform recommendation on the stock. However, Quadrani notes in an Oct. 25 report that "meaningful upside may be limited" as the company still faces a "long uphill battle." A spokesperson for Interpublic was unavailable prior to deadline.
As Internet retailer Amazon.com continues to post solid sales numbers, investors are also snapping up its stock. Profits may not be keeping pace, however, as the Seattle-based company's 12-month forward p-e ratio was 56.57 as of Oct. 30, according to Reuters Estimates. Shares fell to $37.56 on Nov. 1.
Analysts give Amazon tepid marks. S&P analyst Jason Asaeda, who has a hold recommendation on the stock, raised his 2006 earnings estimate for the company on Oct. 25, following unexpectedly strong fourth-quarter guidance. The pace of Amazon's technology and content investments is slowing, Asaeda notes.
However, the company hasn't curbed its spending as much as some analysts would like. "While we continued to believe in the long-term model, the continued decline in margins and free cash flow along with the stock's premium valuation relative to the group will limit any outperformance," says Credit Suisse (CS) analyst Heath Terry in an Oct. 24 report. Terry has a neutral rating on the shares. An Amazon spokesperson was unavailable prior to deadline. (Credit Suisse has an investment banking relationship with Amazon and makes a market in the company's securities.)
Gaithersburg (Md.)-based biotechnology company MedImmune (MEDI) has developed its own case of uncommonly high valuation. The stock's 12-month forward p-e ratio was 44.25 as of Oct. 30, according to Reuters Estimates. Shares finished at $32.17 on Nov. 1.
On Oct. 26, MedImmune reported a narrower third-quarter loss on weaker-than-consensus revenues. The stock remains less attractive than rivals Genentech (DNA) or Gilead Sciences (GILD), according to S&P analyst Jeffrey Loo, who has a hold recommendation on MedImmune shares. "Trends suggest [MedImmune] may be engineering an earnings turnaround, but we remain cautious ahead of sales from 2007-2008 flu season," Loo says in an Oct. 26 note.
MedImmune has staked out a solid niche in childhood illnesses, despite a narrow economic moat, according to Morningstar analyst Karen Anderson, who rates the stock four out of five stars. Improved versions of the company's key Synagis and FluMist drugs and other new drugs in the pipeline should help MedImmune continue to expand, Anderson says in an Oct. 20 report. She pegs the shares' fair value at $42. A MedImmune spokesperson was unavailable prior to deadline.
Shares of Sunnyvale (Calif.)-based Yahoo! (YHOO) have fallen this year, but investors are still searching for stronger earnings than the Street projects. CEO Terry Semel's Internet media company has a 12-month forward p-e of 44.1 as of Oct. 30, according to Reuters Estimates. On Nov. 1, shares dropped to $25.99.
Some analysts say Yahoo's position looks similar to AOL's (TWX) in an earlier dot-com era. "First, Yahoo's strong early wins in the ad market allowed the company to grow faster than the overall market and may have made the company too comfortable with its strategy," says Piper Jaffray (PJC) analyst Safa Rashtchy on Oct. 23. "Second, the company was too late to react to the increasing fragmentation of traffic from video to social networking." Rashtchy rates the stock market perform, but says Yahoo! may be able to adapt to its changing environment.
Others point to Yahoo's launch of a new search technology upgrade called Panama. Credit Suisse's Terry has an outperform rating on the stock, with Panama as the main catalyst. (Credit Suisse has an investment banking relationship with Yahoo! and makes a market in the company's securities.)
Aside from Panama, though, the company's fundamentals are weakening, according to JP Morgan (JPM) analyst Imran Kahn, who has a neutral rating on the stock. Kahn sees softer advertising growth and poor traffic quality as troubling trends. (JP Morgan has an investment banking relationship with Yahoo! and makes a market in the company's securities.) A Yahoo! spokesperson was unavailable prior to deadline.
A hefty p-e ratio doesn't necessarily mean a stock is overvalued, but it probably means it isn't cheap. Investors should make sure highly valued companies can grow into their prices. Better to let Aunt Tillie's mince pie—and not the too-pricey issues in your portfolio—be the cause of your Thanksgiving indigestion.