Sunday, March 26, 2006

8 Stocks To Either Dump or Trim Back On

With the Dow recently hitting a 5 year high, investors may be feeling unstoppable right now, perchance chucking money at businesses whose prospects are dark. A good story can definitely lift a stock over the short term, but ultimately, a stock price catches up with the operating fundamentals underneath it.

Here are 8 companies whose underlying problems may harm shareholders in 2006.

Guitar Center (GTRC) the musical instrument retailer possesses some of the best management in the business, but we are disconcerted by the explosion of online competitor that's been pulling customers away from Guitar Center. Because of some astute acquisitions and capital expenditures, Guitar Center has been able to average 15%+ sales growth over the last 5 years. As its internet rivals continue to promote heavily, we can't see how Guitar Center will maintain the margins its had up until now. Guitar Center holds 8 times as much debt as it does cash and insiders hold roughly 3% of the shares outstanding. Buying Guitar Center on the dips could be a disaster-in-hiding.

Cost Plus (CPWM) Home furnishings? Yucky business to be in, we think. Cost Plus has a unique business model, but this stock is nothing but a migraine when our economy cools. Recently, Cost Plus has been whacked by management turnover, rampant short selling, and disturbingly low insider ownership. Top line growth in the past has been impressive, but competition from Target (TGT), Pier One (PIF), and Bombay (BBA) is increasingly crippling this firm's margins. On top of that, you have a new CEO who has zero home furnishing experience. Although CPWM's last quarter wasn't as horrendous as previous ones (declining inventory figures reported on 3/20), the odds are stacked against this company as well as the industry it belongs to -- stay away from it.

Tyson Foods (TSN) Fears related to the avian flu virus have body slammed Tyson's stock price. The chicken and beef processor is suffering on all fronts: Its poultry business is seeing low export demand. Its beef division is under the weight of exportation bans. Its pork business isn't as good as Smithfield Foods' (SFD). Overall, you have a company whose beef Japan no longer wants and an ugly pricing milieu that makes it harder for Tyson to leverage its size and brand visibility. Even with industry-leading market share, Tyson is essentially a commodity-driven business -- that bothers us, not to mention the fact that management owns 80% of the voting stock, sometimes at the expense of average shareholders. We'd shy away from this stock until 2007, at least.

Netease (NTES) -- Our forecast for this Chinese internet gamer is mildly bearish. Netease derives revenues from 2 sources: subscriptions for its games and advertising from its site. A couple of things make us uneasy: rival Shanda (SNDA) recently announced that it'll provide free content (and charge for ancillary services); Netease only spits out 2 games, which leaves plenty of room for new entrants or existing competitors to put forth better titles; the Chinese government has limited the number of hours video game enthusiasts can play each day; and piracy is eating into Netease's dominance. Internet penetration in China should remain robust, but it'll be hard for Netease to enjoy the same level of success (50% operating margins) it did over the last couple of years. Not a stock to sell entirely, but surely not one to chase at nosebleed multiples, either. Wait for a deep pullback before pulling the trigger again.

Jack in the Box (JBX) -- This is a burger chain whose falling margins are gradually weighing on earnings. There's plenty of room for the chain to grow (it has yet to penetrate the Northeast, for example), but since Jack is pinned against big boys like Wendy's and McDonald's (MCD), we'd think twice about buying into this stock. As a quick service restaurant stock, Jack in the Box is vulnerable to fluctuating commodity costs. Ultimately, Jack is another beef peddler, so Jack get no play from us until mad cow related headlines take a much-needed lunch break.

Payless Shoe Source (PSS) -- Sales and margins at the popular footwear retailer have sunk ever since it decided to close several underperforming stores. Even if profitability improves in the future, we don't see this name hitting a home run anytime soon. Although Payless ended 05 with 2x as much cash as it had in 03, sales are looking anemic due to Payless' weak brand portfolio. Additionally, price wars between discounters, specialty shops, and megastores (Walmart) will most likely handicap future performance. Lastly, as Payless already has over 4,000 outlets across the US, we don't see much room for it to expand. Sell immediately and swap into something with higher brand appeal and better merchandising. Risks to our thesis: new CEO Matt Rubel (formally head honcho at Cole Hann) restructures the firm faster than anyone would've thought and blows pessimists like us out the water.

Harley Davidson (HDI) -- Harley has held the motorcycle category in a headlock for 100 years. While Harley's #1 competitive advantage -- its brand -- faces little risk, Harley's core market seems to have hit a saturation point. Bikes in general have a long life cycle and the average Harley customer is between 35 and 55 years old. Recent studies suggest that these people are unlikely to buy a second bike, either now or in the afterlife. Because of the aging Baby Boomer population, Harley's top line story could be adversely impacted, even if operating margins remain robust. Wait to see how the company does in foreign markets before picking up shares.

The Sports Authority (TSA) -- The Sports Authority became the largest sporting goods retailer in the US mainly through acquisition, something we both appreciate and look suspiciously upon. The firm is reporting negative free cash flow and its stock trades at less than .4 x book. Because TSA will have to spend the next couple of years paying down a $300M debt load, we don't see any major catalysts in our 12-18 month window. More troublesome is the fact that TSA's largest rival, (the industry is highly fragmented) Dick's Sporting Goods (DKS), recently announced it has plans to expand on the West Coast, which happens to be TSA's largest market. 18 analysts cover the stock; all of them are glued to a hold rating -- we wish we could be as sanguine as they are.

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