One Stock to Buy, One to Shun
This alert was sent to subscribers of TheStreet.com Stocks Under $10 at 11:57 a.m. EST on March 7.
Part of the stock-picking methodology we employ in the Stocks Under $10 service involves researching broken stocks that are out of favor with investors. The goal is either to find value that others may be dismissing or to avoid potential value traps that are cheap for a reason and often lead to losses for investors fooled by low valuations.
Occasionally, we come across really great ideas, like natural gas play
El Paso
(EP)
, which we picked up near $7 a share in June and were able to sell for a 40% gain in February. And we've also steered investors away from potential value traps in ne'er-do-wells like
Rite Aid
(RAD) - Get Report
, which subsequently declined 28% over the next five months following our story that warned investors to stay away despite the stock's low price.
With new names constantly moving in and out of the Under $10 space, we are always on the lookout for special-situations stocks, which we call inflection points, to add to the portfolio. Two new companies have recently fallen below $10 a share,
Krispy Kreme Doughnuts
(KKD)
and
Elan
(ELN)
. Our analysis of these two stocks: Elan should be sold as soon as you read this, but Krispy Kreme has a place in your speculative portfolio.
We are not adding Krispy Kreme to our model portfolio because of its speculative nature, but if you can handle the risk and would like a stock for a short-term trade, Krispy Kreme is worth considering.
Shares of Krispy Kreme Doughnuts have tumbled some 87% since reaching their all-time high of about $50 a share in August 2003. We have read the creative headlines from various news outlets about their "being holes" in this doughnut maker's story, or "the dough isn't rising fast enough" for Krispy Kreme. And while it was very easy to knock this company for management missteps and financial blunders following the stock's rise after going public in April 2000, the company has managed to build a recognizable brand with a differentiated product that can be purchased in 390 branded stores in 44 different states in the U.S.
Krispy Kreme has the distinction of being a favorite among doughnut lovers, but investors have a different opinion of the company. A perfect storm of accounting shenanigans, inept management, overexpansion and a low-carbohydrate craze led to declining financial results and the firing of its CEO in January. In fact, the stock is so hated, short interest is sitting at an all-time high of about 53% of its float, and it would take about seven days for all of these positions to be covered.
To date, these short-sellers have been right to bet against the stock. For instance, last month the company narrowly avoided defaulting on its $150 million credit facility by failing to file its 10-Q with the
Securities and Exchange Commission
. Luckily, Krispy Kreme was able to persuade its lenders to agree to an extension to March 25. And the company is on the prowl for more financing to fund further expansion and current operations. For the quarter ended Aug. 1, 2004, the company had only $20 million in cash to pay off $133.63 million in long-term debt.
So why are we highlighting this destroyer of shareholder value? For one, at some point the shorts will come in take their profits. With the company reining in costs a bit with its recent announcement of $10 million in annual cost savings, we believe short-sellers staring at large gains may look to monetize them.
Additionally, there is a value to the brand and a possible acquirer may surface and look to turn around the company's operations and build upon its brand strength. Take
Wal-Mart
(WMT) - Get Report
, which has been testing Krispy Kreme outlets inside its Supercenter stores. Or
Costco
(COST) - Get Report
, which already sells pizza and hot dogs inside its stores. Given the incredibly competitive, low-margin nature of the supermarket business, executives in that sector could be looking to obtain a well-known, premium-priced brand like Krispy Kreme.
We wouldn't put our retirement savings in Krispy Kreme, but good news could light a fire under the shorts and be good for a couple of quick points in the stock. Of course, we would be foolish to dismiss the federal investigation into the company's accounting practices, and would keep a tight stop loss on any position in Krispy Kreme.
While we believe Krispy Kreme has potential, we aren't so optimistic about Elan, a specialty pharmaceutical company. Elan's shares are trading 82% off their Feb. 25 close of $26.90. The company, along with its partner
Biogen Idec
(BIIB) - Get Report
, pulled its recently approved multiple sclerosis (MS) treatment Tysabri from the market after two patients taking the drug became ill with a neurological disease.
Elan has come a long way since 2002, when it was divesting companies to raise cash and shares changed hands at $1.03 a share. Much of Elan's recent success -- before the Tysabri withdrawal, the stock had been up about 400% since January 2004 -- is due to the lofty Tysabri expectations. Tysabri was widely expected to have peak annual sales of $3.8 billion, and Elan would have split the windfall with Biogen. Initial studies of the drug were so promising that the Food and Drug Administration gave it a seal of approval before final studies were even completed.
But Tysabri is now off the market, and even if it does make its way back, we expect investors to take a different view of Elan. For one, there is competition in the market with
Serono's
(SRA)
MS drug Rebif. And doctors may be hesitant to prescribe Tysabri. Patients, who are now more active in choosing what medications they take thanks to large advertising budgets at the pharmaceutical companies, may be less likely to take the drug as evidenced by the steady declines in sales of the Cox-2 class -- which includes Vioxx, Celebrex and Bextra -- since December.
With or without Tysabri, Elan was never in great shape. In the fourth quarter, Elan lost 22 cents a share vs. expectations for a loss of 28 cents a share, and Wall Street is modeling for losses in each of the next three years. (Elan did not return our call seeking comment.)
Even if Tysabri eventually returns to the market and makes 50% of the $1 billion in sales the Street was expecting in 2009, Elan still could find it difficult to come up with the cash to fund the $130 million to $140 million in annual interest payments it has been making on its $2.26 billion in total debt. Without Tysabri, the company will likely have sales of just $300 million in 2009, and with its current market cap of $2.3 billion, we don't believe there is much upside in the stock from here and would avoid the temptation to speculate.
As originally published, this column contained errors. Please see
Corrections and Clarifications.
William Gabrielski is a research associate at TheStreet.com and is accredited with a Series 7 license. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks.
David Peltier is a research associate at TheStreet.com In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. They welcome your feedback and invite you to send your comments to
stocksunderten@thestreet.com.