This column was originally published on RealMoney on Sept. 11 at 2:10 p.m. EDT. It's being republished as a bonus for TheStreet.com readers.
One way to decide whether a stock is a buy is to cut through the reported earnings rigmarole and get a handle on how much true value managers create for shareholders.
Borrowing a concept from consulting, the New York-based quant shop Matrix USA does this by calculating the "economic value" added, or EVA, by managers.
It then blends in valuation and volatility measures to cook up stock ratings.
This system has a good record, as I wrote
two weeks ago.
In that column, we looked at two stocks panned by the shop. Now let's take a look at three it considers buys in an odd combination of sectors involving romance and the military.
sells diamond engagement rings online, while
sell military equipment.
Is it because all is fair in love and war and accounting? Who knows, but here's a closer look at these companies.
For a generation of Internet surfers accustomed to pursuing love on dating sites like Match.com, shopping for something as personal as an engagement ring on the Web is, like, no problem.
For proof, look no further than the robust sales growth at Blue Nile, an online jeweler that caters to Web-savvy romantics hunting for some bling to express their amore.
Blue Nile sales shot up 29% last quarter.
But investors are flocking to Blue Nile for another reason as well. Blue Nile has a business model that drives capital costs down to almost nothing. Because of special arrangements with jewelry suppliers, Blue Nile carries virtually no inventory. Instead, after making a sale, Blue Nile places orders with suppliers. "Their cost of capital is almost zero, so their return on capital is almost infinite," says Ivan Feinseth, the director of research at Matrix.
Besides creating impressive EVA for shareholders, this business model produces healthy cash flow. That explains why the company has no debt and about $3.50 a share in cash. Blue Nile also just extended its stock-buyback program by an additional $50 million over two years. This is on top of an existing $100 million share repurchase program, of which $47 million remains.
One concern about Blue Nile is that it juiced sales in the most recent quarter by cutting prices. That knocked gross margins down to 20% from nearly 23% a year ago. But the company was able to keep operating margins in check by controlling expenses. So Morningstar analyst Kimberly Picciola isn't too worried about the price cutting. "Given the nascent market for purchasing diamond jewelry online, we think Blue Nile's emphasis on building its brand and gaining share through competitive pricing while continuing to focus on profitability is prudent," says Picciola.
What about the risk that
will stomp this upstart founded by former Bain & Company consultant Mark Vadon? Picciola thinks Blue Nile's exclusive agreements with diamond manufacturers and its premium brand offer some protection. She projects average annual sales growth of 22% over the next five years.
Defense contractor Armor Holdings is the leading U.S. supplier of vehicle and body armor to protect troops, cops and VIPs with a streak of paranoia.
Despite strong demand for armor plating to upgrade Humvees and other military vehicles in Iraq, Armor Holdings shares recently sold off sharply to $53 from above $65 last April. That decline has placed Armor Holdings in the bottom 20% of Russell 3000 stocks for valuation, according to Matrix calculations. Yet a return on capital of 15.7% compared to capital costs of 6.2% -- plus 67% sales growth -- place Armor in the top 20% for fundamentals. That combo adds up to a strong buy rating from Matrix.
Investors have been selling Armor Holdings because the company recently lowered its 2006 revenue guidance, due to mistakes in calculating sales growth at the recently acquired military truck maker Stewart & Stevenson. However, Goldman Sachs analyst Richard Safran isn't troubled by the change of heart among investors.
"Given management's history of conservative guidance, we believe it will revise 2007 guidance upward in the second half," says Safran. He recently added Armor Holdings to Goldman's "America's Conviction Buy List" with a six-month price target of $65. The stock was also recently upgraded by Prudential Securities' Byron Callan.
Potential catalysts include synergies from the Stewart & Stevenson acquisition and continued strong demand for armor, which should come into sharper focus in the coming months as the 2007 Department of Defense funding bill shapes up. Callan believes the 2007 budget may contain several billion dollars worth of additional funding to pay for upgrades to military vehicles. An ongoing military truck replacement cycle should also help the company.
When L-3 Communications' charismatic leader Frank Lanza suddenly passed away in early June, the shares of this defense contractor moved up as investors speculated the company might be a takeover target.
Then reality set in as potential buyers signaled they weren't interested. By August, the stock had slipped well below $70 from above $80 right after Lanza's demise.
Since then, L-3 shares have recovered to around $75, partly because of an alleged terrorist plot in London to smuggle explosive liquids onto planes. Among other things, L-3 makes bomb detection and X-ray equipment used in airports.
Despite the sharp advance from its August lows, L-3 is still well below its March highs of $88.50. At $75, it still looks cheap enough, given its respectable fundamentals, to merit a strong buy rating from Matrix. The stock ranks in the 80th percentile among Russell 3000 stocks for fundamental performance. That's because of sales growth north of 40% and a return on capital of 8.1% compared to a cost of capital of 5.9%.
Yet L-3 trades well below Russell 3000 stocks and defense names in valuation. That's a discount that should go away over time as L-3 appoints a permanent CEO and investors become more confident that the company won't be haunted by options backdating, which L-3 says isn't a problem.
"We think L-3's fundamental business mix should justify a valuation at least in line with its large-cap defense peer group," says Banc of America Securities analyst Robert Stallard, who recently upgraded the stock. Stallard has a 12-month price target of $81 on the stock.
At the time of publication, Brush held none of the stocks mentioned, although positions may change at any time.
Brush is an award-winning New York-based financial writer. In addition to writing for
, he has a weekly market column on
called Company Focus, and a column called Insiders Corner at InvestorIdeas.com. Brush has covered business and investing for
The New York Times
magazine and the Economist Group. He studied at Columbia Business School in the Knight-Bagehot Fellowship program and the Johns Hopkins School of Advanced International Studies. He is the author of
Lessons From the Front Line
, a book that offers insights on investing and the markets based on the experiences of professional money managers.
Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Brush appreciates your feedback;
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