These Contrarian Picks Could Have 50%-70% Upside

I look forward to every earnings season. It’s a time when companies on my watch list may stumble, placing them squarely into value territory. As long as the long-term investment thesis is intact, you’ve got a rare chance to step in when shares are 20%, 30% or even 40% off recent highs.

To be sure, any company that stumbles in an earnings season goes into the penalty box and doesn’t come back for at least another quarter or two. So these earnings season casualties may be range-bound for a bit, but their long-term potential is compelling. I looked at a dozen names that have taken a recent hit and a handful caught my eye.

Company (Ticker) Recent Price Market Cap. ($M) Fall from 52-week high 2011 P/E
Power-One Inc. (NASDAQ: PWER) $8.73 $908 33% 6.9
HHGregg Inc. (NYSE: HGG) $17.70 $702 43% 12.2
Coinstar Inc. (NYSE: CSTR) $41.82 $1,330 38% 14.9
Mueller Water Products (NYSE: MWA) $3.81 $596 36% neg.
Tellabs Inc. (NYSE: TLAB) $5.61 $2,040 41% N/A
*estimates for fiscal 2012 that begins in April

1. Tellabs (Nasdaq: TLAB)
Tellabs represents a conundrum for investors. It has a respectable market share in the telecom equipment business, though it lacks the scale to currently generate strong profits and is subject to the discretionary spending habits of key customers. Results have been lumpy and shares have fallen steadily during the past five years. But patient investors will likely be rewarded at current levels.

The company’s $1.1 billion net cash balance now represents more than half of the company’s value, so there is a clear floor for the stock. A sale of the company, which has long been rumored, may be the best exit strategy and the recent share price weakness has heightened that chatter once again. A purchase price, net of that cash, could be up to 1.5 times sales, yielding up to 50% upside in the stock.

#-ad_banner-#2. Power-One (Nasdaq: PWER)
In a similar vein, Power-One also toils in an industry characterized by lumpy demand. And right now, demand has slowed a bit, pushing shares off sharply. Power-One makes a range of electrical equipment from power supplies to inverters to modulators. The company invested heavily in research and development a few years ago, a move that finally paid off as sales more than doubled in 2010. Investors had been expecting continued scorching growth in 2011, but a slowdown in the clean energy sector has led to bulging inventories of Power-One’s products among customers. Sales now look set to rise 20% or 30% this year, just half the rate of some of the most bullish forecasts discussed prior to recently-released more sober guidance.

Nevertheless, this looks like a deep-value play, trading at around seven times 2011 profit forecasts. But there are a few caveats: First, shares may not rebound until later in the year as management has noted that the inventory glut will take a while to work off. Second, the company had to issue a large chunk of preferred stock when it was in distress a few years ago. When converted into common shares, the share count could rise by 40 million to 50 million. This is certainly name for your watch list, if not a compelling buy at the moment.

3. Coinstar (Nasdaq: CSTR)
Coinstar has a history of disproving its doubters, and it is once again in defensive mode. When Coinstar first installed coin-collecting kiosks in supermarkets, short-sellers contended that the company’s future was very limited. The coin business turned out to be quite effective and quite profitable. When Coinstar then opted to put DVD rental boxes (known as RedBox) next to those coin counters, short-sellers again smelled a losing idea. But it turned out to be a great idea, undercutting Blockbuster on price and perhaps helping to catalyze that retailer’s eventual slow demise. (Not dead yet, but on its way…)

Coinstar’s sales shot up from $300 million in 2007 to $1.4 billion in 2010. Shares eventually soared toward the $70 mark by the end of 2010, but have since collapsed to around $40. Blame it on a subpar quarter. For a host of reasons, including delayed DVD releases from Hollywood studios, to poor inventory management at the kiosk level, Coinstar trailed the $0.84 earnings per share (EPS) consensus by roughly 20%.

Yet that’s not what has aroused short-seller’s interest this time. Instead, they predict that Coinstar will soon fall victim to the transition to downloaded movies, especially as Hollywood may try to capture more DVD rental profits at the expense of Coinstar and Netflix (Nasdaq: NFLX).

At least Netflix has a digital streaming strategy, the short-sellers aver. That’s why Feb. 16 is an important date to note. That’s when Coinstar will hold a day-long set of meetings with analysts, at which time the company may announce an alliance with a digital partner. In one fell swoop, the company could allay those concerns and future-proof the business model.

Yet the kiosk-based business hasn’t hit a wall just yet. The company expanded its slate of DVD kiosks form 22,400 in 2009 to 30,200 in 2010. And thanks to recently signed deals with Kroger (NYSE: KR) and CVS (NYSE: CVS), that figure could expand to 27,000 or 28,000 in 2011. That’s why analysts are modeling for a 20% to 25% gain in sales and a 40% jump in profits in 2011.

Meanwhile, shares now trade for around four times projected 2011 EBITDA. By my math, the company could stumble badly in its digital transition and still find support at such a low valuation. And if the digital streaming strategy is a winner, then shares may zoom right back to their 52-week high of $67, which is roughly 60% above current levels.

Action to Take –> Stocks that are in favor are harder-pressed to boost their image and their stock price. The stocks mentioned above hold great appeal for contrarians that like to focus on “hated” stocks. It’s precisely these kinds of stocks that can capture sharp upside.