News Analysis date published New: 
Tuesday, August 14, 2012 - 10:30
New Date created: 
Tuesday, August 14, 2012 - 11:38
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Tuesday, August 14, 2012 - 10:30

These Cheap Stocks are Building Serious Profit Momentum...

Tuesday, August 14, 2012 10:30 AM

As we start to close the books on the second-quarter earnings season, a clear trend is now official: companies have struggled to boost sales and profit margins appear to have peaked, which has led to a higher-than-usual amount of lowered guidance for the quarters ahead.

Yet, there are always exceptions to the rule, and if you dig deep enough, you'll find stocks that managed to deliver blowout results. Either analysts were simply too bearish in their forecasts, or these companies are truly finding more ways to squeeze out growth. Either way, surpassing profit forecasts by 30% to 40% or more is no mean feat.

But that doesn't make these stocks a bargain. Sometimes investors get carried away, extrapolating current strength well into the future, and boosting these stocks up into a "can't miss" level. That is to say, these stocks are now so richly valued, that they dare not miss future earnings per share (EPS) forecasts, or their shares will take a tumble. Case in point: these 12 stocks delivered robust second-quarter profits, but their price-to-earnings ratio on projected 2013 profits may now be too rich for this market. Each stock trades for a higher forward multiple than the average multiple of stocks in the S&P 500.

That's why it's wise to focus on stocks that show clear profit momentum -- relative to analysts' forecasts -- and sport decent valuations. In late July, I profiled stocks that were delivering robust profits as earnings season was getting underway, which you can read about here.

Though bank stocks were the most intriguing names back then, the crop of estimate beaters that have delivered results since have shown no clear theme.

Of course, you have to dig into the reasons why a stock is delivering very strong profits. In the case of investment firm Kohlberg, Kravis & Roberts (NYSE: KKR), an upward valuation in of its portfolio holdings, Alliance Boots, accounts for almost all of the upside. That's obviously a one-time event.

Computer disk-drive maker Western Digital (NYSE: WDC) repeatedly delivers robust quarters: EPS has topped the consensus by at least 35% for each of the past three-quarters. Yet, analysts still say traditional hard disk-drives will lose market share to solid-state (flash memory) drives over the long haul, and they foresee a steady erosion in sales for Western Digital beginning next year.

Two stocks to consider
But some stocks deserve credit for holding up well, even if its industry conditions remain difficult. For example, apparel retailer Jones Group (NYSE: JNY) is struggling with weak foot traffic in its stores. Sales are likely to be flat this year at around $3.8 billion, millions less than what the company generated in the middle of the last decade. But management has kept a tight lid on overhead, and its merchandise selections are leading to solid gross margins, which have allowed the Jones Group to surpass EPS forecasts handily. You can only assume profits will be even stronger as the economy improves. Meanwhile, shares trade for a reasonable valuation in this era of depressed results.

The profit upside from wireless services provider MetroPCS (NYSE: PCS) came from a tight control on costs as well. The company's value-oriented approach has enabled it to retain its subscriber base, even as rivals have moved more quickly to offer more advanced voice and data networks. But the decision to focus on cash flow and not sales growth has lead some to think that this company is primed to be acquired.

Bigger players such as Sprint (NYSE: S), Verizon (NYSE: VZ) and AT&T (NYSE: T), are dealing with a fairly mature market and have hinted that deal-making may be part of its growth plans. Merrill Lynch doesn't expect that "a buyer emerges through the end of the year, at least because of the chaotic state of current spectrum environment." Right now, a number of firms are looking to buy, sell or trade their wireless spectrum to optimize coverage.

Sprint is the most likely buyer and the company is getting into a stronger competitive position, which I profiled here.

Though Sprint concedes that it doesn't want to look at deals until its own network upgrade and expansion efforts are completed next spring.

But for now, MetroPCS remains focused on delivering robust cash flow, which should support shares in advance of any potential future buyout.

Risks to Consider: MetroPCS and Jones Group have long-term catalysts in place, but must deliver good results in the near-term. Each of these firms' focus on costs and margins have been quite helpful, but those inputs are now baked into analysts' models, potentially capping further upside relative to forecasts.

Action to Take --> Delivering estimate-beating results in a challenged economy sets the foundation for even more impressive bottom line results during the next few years when the economy is finally on the mend. Though the stocks in the first table of this column appear a bit pricey now, keep an eye on them as a sharp market pullback would likely bring them into value territory, which could be helpful if they deliver estimate-beating results in the next quarter as well. The stocks in the second table, however, appear cheap despite their recent estimate-beating results. The two stocks I mentioned earlier, in addition to others in this table, might be worthy portfolio candidates.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.