Three Stocks for the Lean Times

With everybody happy all of a sudden about the prospects for the market and the economy, what's an unreconstructed bear to do?

Well, you can start by doing your homework and looking for stocks that will thrive in an economic rough patch. In fact, I've done some homework of my own, digging up three stocks that looked poised for strong performance. And if the economy turns south, they'll do even better.

Banking on Bankruptcy

Little-known Epiq Systems (EPIQ Quote) of Kansas City, Kan., is one company whose business model seems assured to benefit from a decelerating economy. Through an exclusive marketing alliance with Bank of America (BAC Quote), Epiq provides proprietary case management software to Chapter 7 (liquidation) personal bankruptcy trustees for free. In return, Epiq receives recurring revenue based, in part, upon a percentage of total deposited funds managed by each trustee during asset liquidation. Such deposit accounts can last for years, and the company has trustee relationships with $800 million of the estimated $3 billion worth of Chapter 7 assets managed at any one time.

Similarly, Epiq's CasePower software is used by Chapter 13 (repayment plan) trustees and earns fees based on the number of cases trustees manage. Such monthly recurring revenue streams offer excellent earnings visibility going forward (another Epiq division helps corporate clients, like credit-card issuer Visa, secure, format and route business-critical data files).

Chairman and CEO Thom Olofson, along with his son, Chris, the president and COO, have delivered steady growth, with revenue, net income and earnings per share all improving yearly since Epiq's low-profile 1997 IPO .

Niche-oriented and thinly traded, Epiq remains largely unknown to investors. Yet it has consistently delivered robust growth, with top- and bottom-line three-year combined annual growth rates of 40% and 33%, respectively, based mostly on its bread-and-butter Chapter 7 software. Last year 1.25 million bankruptcies were filed, 70% of those under Chapter 7, and a slowing economy should precipitate more such filings.

Epiq ranked 83rd on Forbes "200 Best Small Companies" list and ended 2000 with record revenue of $23.3 million, up 57% over the previous year's results. Net income ($2.6 million) and earnings per share (55 cents) were also records and surpassed their year-ago benchmarks by 43% and 45%, respectively.

But the recent passage of the Bankruptcy Reform Act, the largest overhaul of the federal bankruptcy system in nearly 25 years, may cloud Epiq's immediate future. By tightening Chapter 7 filing requirements and shifting people into more onerous Chapter 13 settlements, the new law could alter Epiq's revenue mix. The strategy of pursuing Chapter 7 trustee market share served Epiq well; adjusting to lower-margin, document-intensive Chapter 13 work may prove challenging. However, Sue Johnson, Epiq's investor relations manager, argues that it may actually improve the company's earnings as it would replace so-called no-asset Chapter 7 liquidations with fee-producing Chapter 13 cases. Time will tell.

Epiq's stock has had a smart run-up of late, more than doubling since the beginning of the year alone, and the company sports a lofty trailing price-to-earnings ratio of 68, but the stock still looks like a solid long-term buy.

Starting Over or Starting Out

Meeting the needs of those newly laid off, downsized, starting over or just plain starting out, is Rent-A-Center (RCII Quote). Based in Plano, Texas, Rent-A-Center is the leading operator in the rent-to-own market for items like televisions and refrigerators with 2,174 company-owned stores and through its ColorTyme subsidiary, 365 franchised units. Regardless of the Fed's interest-rate moves, the Nasdaq's convolutions or changes in the job market, people will always need their "stuff," and ways must be found to provide for it.

Rent-A-Center caters to people with little or no credit, providing flexible rental-purchase agreements offering eventual ownership of modern household essentials (TVs, refrigerators, washer-dryers, computers, etc.) from high-quality brand names like Sony, Whirlpool and Dell. Rentals of home electronics account for 40% of the company's revenue, furniture and accessories 30%, appliances and computers 18% and 10%, respectively. Charge-offs from unrecoverable merchandise account for a mere 2.5% of revenue -- proving once again that the most conscientious bill payers are often those who have very little.

Following a string of recent acquisitions, involving some 60 separate transactions, Rent-A-Center has emerged as the dominant player in this industry, with a 27% market share measured by store count. Serving a market estimated at 3.3 million U.S. households that are largely ignored by traditional retailers has paid off: Rent-A-Center boasts three-year combined annual growth rates in sales and earnings per share of 81% and 34%, respectively. Return on equity is 39% and gross margins are exceptional, standing at 92%. Rent-A-Center delivered record sales and net earnings in 2000 and seems likely to benefit from any continued economic uncertainty.

Yet one price of the company's rapid growth has been a spate of lawsuits, some by former employees alleging gender and race discrimination. Peter Bates, vice president of finance, acknowledges this is terrible publicity for the company, but insists such complaints stem from disgruntled employees absorbed during acquisitions and subsequently laid off for underperformance. Investors should keep a wary eye on this matter because any legal judgment against the company could wreak havoc with earnings and seriously alienate the very customer base it has sought to cultivate.

Rent-A-Center's shares closed at $39.75 Friday, up about 9% this year. The stock sports a trailing P/E of 13.

Come Back to the Five & Dime

At first glance, discount general merchandise retailers like Dollar Tree (DLTR Quote), 99 Cents Only (NDN Quote) and Family Dollar (FDO Quote) would seem like obvious beneficiaries for lean times. As their names imply, they appeal to price-conscious consumers.

Yet these modern "five & dime" chains have suffered, too: Chesapeake, Va.-based Dollar Tree lost a quarter of its market value on March 15 alone on an earnings warning. Reduced foot traffic due in part to heavy snows in the first quarter was extending into the second quarter, the company warned. (Another competitor, Dollar General (DG Quote), has suffered for a different reason: The company disclosed in April that it would have to restate earnings downward.)

Dollar Tree's strip-center and mall-enclosed stores sell a wide variety of houseware, candy, food, toys and health and beauty products (much of it imported from China) in more than 1,700 stores in 36 states. Offering staples and impulse items, stores typically pay for themselves in 12 months, and the business was thought to be recession resistant. But by sticking to its $1 price point, analysts now fear Dollar Tree may be unable to deep discount slow-moving inventory, possibly delaying an earnings turnaround. Inexplicably, management seemed reluctant to discuss the company's prospects, despite past strong fundamentals. Dollar Tree shares are now more than 50% off their 52-week high of $48.25, closing Friday at $23.50. Are they nearing a turning point?