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2 Cheap Stocks Trading at “Deal of the Century” Prices


2 Cheap Stocks Trading at “Deal of the Century” Prices

Source: patpitchaya / Shutterstock.com

This article is excerpted from Tom Yeung’s Profit & Protection newsletter. To make sure you don’t miss any of Tom’s picks, subscribe to his mailing list here.

The Market Rout Has Made Deals of the Century

Let me tell you something:

I hate deal hunting.

No matter how long I look for a bargain, I’ll find a cheaper version the moment I’ve finished paying.

Want to buy a used car? Just wait until my friend finally sells me his 2004 Bentley. That’s guaranteed to crash the prices of used land yachts across the country.

The latest smartphone? Airline tickets? A house? You bet it’s the same story.

But when it comes to stocks, all that changes.

The lower share prices go, the more excited I get.

That’s because my investment system has a nose for good deals.

Some companies have abnormally large cash hoards. Today no fewer than 368 companies have negative enterprise values, an atypical case where a firm’s cash on hand exceeds the value of their debt plus equity.

Others have assets hiding in plain sight. Midstream energy firms like Martin Midstream Partners (NASDAQ:MMLP) and Summit Midstream Partners (NYSE:SMLP) are forced to value their assets as if oil were still trading at $50 per barrel (accounting standards don’t allow these assets to get marked to market).

Perhaps I will buy that old Bentley after all. Even if I lose money on the car, there’s so much more to be made in “Bentleys” of stocks.

An illustration of a yellow convertible.

Source: Andrey Vyrypaev / Shutterstock.com

The Cheap “Bentleys” of Wall Street

This week, I’ve focused on the “value” part of the Profit & Protection system.

Truth be told, it’s been a bit of a disappointment.

Unlike growth — an all-weather source of alpha — simple value metrics are provenly bad at generating consistent returns. Cheap P/E stocks took such beatings in 2015 and 2020 that their outperformance in the intervening years since 2013 was entirely wiped out.

But my analysis also unveiled some good news.

Price-to-sales ratios did show some outperformance, as did value in general during periods of rising consumer demand.

Now, I have a special end-of-week surprise:

Two deep-value stocks flying under Wall Street’s radar.

These are companies that simple P/E ratios fail to capture because of 1) hidden assets and 2) future cash flows.

Desktop Metal (DM)

Last month, I wrote about Desktop Metal (NYSE:DM), a 3D printing company that was trading “within a spitting distance of its $1.50 estimated acquisition value.”

There was already plenty to love about the company. Desktop Metal has an extraordinarily fast growth rate; analysts expect revenues to rise 5.4x to $608 million by 2024. And a new directive from the White House has put 3D printing back on the map. The AM Forward Initiative has already pressured defense suppliers from General Electric (NYSE:GE) to Raytheon (NYSE:RTX) to make “public commitments to purchase additively produced parts from smaller U.S.-based suppliers.”

Now that we’ve been talking about value investing all week, DM’s rock-bottom $2 share price deserves another look.

Pedal to the Metal

First, let me be clear:

DM is cheap because it’s burning through $60 million of cash every quarter.

No matter how fast a company is growing, no firm can survive running out of money.

Negative margins and sentiment have also compounded DM’s issue. In Q1 2022, the firm reported a 3-cent gross loss for every $1 of revenue. Shares are down 62% for the year.

As they said during the dot-com era, you can’t make a business selling dollar bills for 90 cents.

But hidden in DM’s terrible financials are two amazing assets:

  • Cash from services. Much like General Electric and other “land and expand” plays, Desktop Metal generates most of its profits from after-market services. Last quarter, the firm generated $1.1 million in gross profits from services, compared to a -$2.4 million loss in product sales. Think of it as a “razorblade” business model for industrial-scale manufacturing.As the number of in-service printers rises, the amount of recurring revenue DM generates from these aftermarket sales will too. Analysts project DM’s gross margins will expand to 50% by 2024, generating $300 million of gross income for the firm. These cash flows are worth around $7 per share, according to my 2-stage DCF models.
  • Intellectual Property. Accounting rules force every company to expense R&D spending, rather than keep the asset on the books. Such practices can obscure the value of a firm’s intellectual property. Consider ExOne, the 3D printing firm Desktop Metal acquired in 2021. Its $561.3 million acquisition price valued ExOne at 3.5x higher than its tangible equity value. A similar valuation would put Desktop Metal at $1.9 billion, or $6 per share.

Taken together, this suggests that DM’s fair value is around $6.50, or 225% upside from today’s levels.

Investors should remain cautious. Desktop Metal only has enough cash for around 18 more months of operations. “Investors should mentally prepare for a secondary offering,” I warned in early May before its devastating Q1 earnings report.

But at $2, even conservative investors could consider taking a small bite.

A chart showing DM tangible price-to-book.

Bausch Companies: The Unbelievably Cheap “Protection” Play

In financial theory, the Law of One Price dictates that the price of a particular asset or commodity should be the same everywhere, regardless of location, once certain factors are considered.

In other words, arbitrage opportunities shouldn’t exist. The price of gold… oil… GameStop (NYSE:GME) stock… all should trade at a single price across different markets.

Yet, we all know that prices can temporarily move from fair value. Options market makers generate millions from writing contracts and immediately selling them to exchanges (and watch me lose 20% of my investment the moment I buy my friend’s Bentley).

That’s because these “certain factors” can cover everything from risk to the weather outside (One study found that rainy days can depress the price of stocks in New York).

A similar factor is now weighing on Bausch’s share price.

A Temporary Setback

Earlier last month, Bausch Companies IPO’d its eyecare subsidiary, Bausch & Lomb (NYSE:BLCO).

Savvy investors will immediately sense an opportunity.

That’s because the subsidiary BLCO now trades at $16, valuing Bausch’s remaining 315 million shares at $5 billion.

And the value of the parent company?

$3.5 billion.

In other words, every share of BHC you buy at $9 comes with $14.2 of BLCO shares, a seemingly impossible breach of the Law of One Price.

Thoughtful investors will immediately point to Bausch’s large $22 billion debt and its ongoing lawsuit with the California State Teachers’ Retirement System. Such factors can easily decrease the value of a company.

As credit analysts have long quipped, a company’s asset value might be uncertain, but the firm’s bankers will always know the value of its debts.

But neither point adequately explains why the remainder of Bausch’s business should be worth negative $1.5 billion. Bond markets price BHC’s 2025 secured debts at a 7.3% yield — far better than other firms with a “B” credit rating. And analysts at Morningstar believe “it is unlikely Bausch will pay any amount greater than $100 million to the claimants” due to a related suit that was settled for CAD 94 million.

Meanwhile, Bausch’s non-eyecare business generates strong cash flows. Blockbuster drug Xifaxan is patent protected through 2029 and generates around $1.3 billion in profits per year. International Rx and other drugs contribute another $1.2 billion per year.

Together, that suggests BHC’s $9 price is too low. A 2-stage DCF model (which considers debt risk) puts BHC’s fair value at $14, a reasonable 55% return. Meanwhile, a multiples-based valuation that ignores debt risk gives a $25 price target.

A chart showing BHC forward price-to-sales from 2019 to 2022 with 1.5x standard deviation bands marked.

Ultimately, deals like this won’t last forever. And when you hear people talk about “being greedy when others are fearful,” companies like Bausch and Desktop Metal are the types they’re talking about.

The EV/S Ratio

Earlier this week, I noted how the price-to-sales ratio was the only common valuation metric that showed signs of alpha.

A chart showing the 1-year return of stocks by P/S ratio quintile.

But it’s hard to take action on these findings. Low P/S companies like Bed Bath & Beyond (NASDAQ:BBBY) and Rite Aid (NYSE:RAD) that drive the quintile’s performance also tend to have high leverage, making them risky bets.

But one uncommon metric of the Profit & Protection system does show better promise:

Enterprise value to sales.

This metric accounts for the value of debt — a hidden force that can bankrupt risky firms.

A chart showing the 1-year return of stocks by EV/S ratio quintile.

By adding in the value of debts and deducting cash-on-hand, we get the downward-sloping graph that value investors would expect (i.e., cheaper quintiles sequentially outperforming expensive ones).

Next week, we’ll cover the Profit & Protection concept of quality, the confounding factor that creates these distortions and helps strategies like the Perpetual Money Machine pick stocks that go up 1,000%.

P.S. Do you want to hear more about cryptocurrencies? Penny stocks? Options? Leave me a note at feedback@investorplace.com or connect with me on LinkedIn and let me know what you’d like to see.

On the date of publication, Tom Yeung did not have (either directly or indirectly) any positions in the securities mentioned in this article.

Tom Yeung, CFA, is a registered investment advisor on a mission to bring simplicity to the world of investing.

Tom Yeung is a market analyst and portfolio manager of the Omnia Portfolio, the highest-tier subscription at InvestorPlace. He is the former editor of Tom Yeung’s Profit & Protection, a free e-letter about investing to profit in good times and protecting gains during the bad.

Article printed from InvestorPlace Media, https://investorplace.com/2022/06/2-cheap-stocks-trading-at-deal-of-the-century-prices/.

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