Friday, April 14, 2006

Talkin' Smack: 3 Stocks That Make Us Nervous

Wall Street'd be a pretty boring place if investors never mispriced securities or hyped up stocks like there was no tomorrow. You can't blame the Street for acting like a manic cheerleader sometimes -- growth is Wall Street's version of crack, and investors will take it wherever they can get it.

Growth sells the same way sex does. Here are three stocks with sexy stories, but futures so uncertain we actually toss and turn at night wondering what to make of them.

Aquantive (AQNT) This is an online advertising company that's grown mainly through acquisition -- that's one red flag. We don't look too lightly upon management's generous use of options, nor do we like how Aquantive's main revenue driver -- a technology unit that helps customers track the efficacy of ad campaigns -- lacks patent protection. The shift to ad spending on the internet is obviously a plus for AQNT, but what's good can also be onerous: unfortunately, Aquantive's business is marked by low switching costs. Aquantive's sales are lumpy, and although they've picked up some traction over the last few years, we'd wait until Aquantive creates a moat around its business before loading the boat with shares. Today, AQNT fetches for 50x current earnings and 6x book value.

Hologic Inc (HOLX) Hologic is spearheading the shift to digital mammography machines. While the market potential is huge, Hologic is up against GE, perhaps the most powerful company on the planet (sorry, Exxon). While demand for tomosynthetical machines -- they reduce breast cancer mortality by as much as 30% -- should increase rapidly, there's no guarantee that rivals, with much deeper pockets, will let Hologic operate as is. The valuation for Hologic is a bit nauseating, we think: HOLX is exchanging hands for 77x current earnings, 8x sales, and 44x trailing 12 month EBITDA. With valuation like that, investors will drop Hologic like a hot potato on even the faintest of bad news. Massachusetts-based Hologic, which is followed by only 5 analysts, reports on April 25th. If Hologic smokes estimates, the company could become a potential acquisition candidate, if it isn't already.

Martek Biosciences (MATK) Market makes microalgae-based nutritional oils for the infant formula market. Our primary concern is that Martek only sells one product in one category. The valuation buttressing the stock means investors are quite confident in the name's ability to penetrate new markets, such as the food and beverage category (which Martek is already poking its stick in). The main risk is that Martek won't find ancillary markets to support the niche it already controls and/or that its key products will lose patent.

The name of the game is Cross or Die: To survive, Martek will have to become the biggest fish in a small pond. We believe it can do this through the bowling pin effect, which is what happens when first movers facilitate entry into adjacent niches. Martek can't afford to wait for the market to adopt its products -- on the contrary, it must organize the same market it looks to penetrate and create barriers to entry so that competitors view the oil-for-formulas market in unattractive terms.

The company has also experienced some painful supply chain issues lately, so investors will also want to keep that under close watch. Lastly, Martek's CEO is retiring later this year. Let's hope his replacement can fatten up this fatty-acid-purveyor's top line. MATK trades at 31 times next year EPS, 4.5x sales, and 26x operating cash flow. With a tight float of 30 million shares, Martek is incredibly vulnerable to dizzying price swings.

Analyst Summary All three of the aforementioned names are characterized by tremendous growth opportunities but questionable valuations. Depending on one's risk tolerance, one may or may not want to jump on board these ships today. The seas they navigate will be anything but calm over the next 12 months.

We'd like to wish all our readers, subscribers, and first-time visitors a happy holiday -- we'll be back on Monday with a look at the sportswear group. Premium content subscribers will receive their weekly PDFs as expected. If you'd like to become a subscriber, shoot us an email at

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