A solid start to earnings season helped push share prices higher earlier this week, and the Standard & Poor’s 500 index crept toward 17 times forward earnings estimates. A handful of shares remain deeply discounted, however. A recent search for stocks selling for around half or less of the index’s valuation turned up just over a dozen names.
On its own, a valuation that low isn’t necessarily a promising sign. Sometimes it’s a signal that a company faces deep structural challenges, and sometimes it means its profits could be near a cyclical peak. For example, Viacom (ticker: VIAB), at 7.4 times earnings, owns a badly slumping movie studio, Paramount Pictures, and cable-television networks that skew young, such as Comedy Central, Nickelodeon, and MTV. The young are a valuable audience to advertisers, but they have also deserted TV for the internet, causing ratings to crater.
Micron Technology (MU), the cheapest stock in the S&P 500, at 4.7 times forward earnings projections, has the other problem. Its earnings per share, which last peaked around $3 four years ago, are expected to top $10 this fiscal year through August. But key memory prices have begun falling on higher production, and analysts expect earnings for Micron to fall in coming years.
We looked over remaining companies in the half-price bin for ones that don’t face obvious threats of structural decline, and don’t appear to be hitting cyclical peaks—at least not judging by Wall Street estimates.
Delta Air Lines (DAL) made the list, just barely, at 8.6 times earnings. The pessimistic valuation is surely owed to the sector’s long history of booms, followed by capacity increases, price wars, and busts. But consolidation has left only a handful of key players, and Delta faces less competition in key markets than some of its peers. Beyond this year, Wall Street predicts the company’s EPS will rise 22% cumulatively, by 2020.
In a Friday note, Morgan Stanley analyst Rajeev Lalwani called Delta’s valuation “just too low,” and argued that shares should trade at 11 times earnings. His price target of $72 implies 30% upside.
Goodyear Tire & Rubber (GT) made the valuation cutoff, at 7.3 times earnings, and so did General Motors (GM), at 5.9 times. We’ll call GM a company at a cyclical peak, because vehicle sales in the key North America market have stopped rising, although forward estimates suggest a plateauing of earnings, not a plunge.
Goodyear might be a different story. It’s benefiting from a shift among car makers toward trucks, because tires for those are particularly profitable. It also makes money from replacement tires, two-thirds of which it distributes itself to big retailers and wholesale clubs, and one-third of which it sells through independent distributors to smaller outlets.
Goodyear recently announced a joint venture with Bridgestone (5108.Japan), called TireHub, with the goal of handling more of its own distribution, thereby improving profit margins. After this year, EPS is projected to rise at mid-teen percentages in 2019 and 2020.
Lincoln National (LNC) collects more than half its earnings from annuities, which are insurance products that can be used for savings and income generation. Those come in two main forms: fixed rate, where the returns are known in advance, and variable, where returns are generally linked to the stock market. Variable annuities have been in decline for so long that it’s unclear whether they will ever regain favor. Even more worrisome is that last year, industrywide fixed-annuity sales declined for the first time since 2010.
Yet Lincoln’s EPS is expected to rise by 8% to 11% this year and each of the two following years. Rising interest rates could help reverse a long margin squeeze for Lincoln. A strong stock market has increased management fees. And a long runway for workers entering retirement could support demand for savings products. Stock buybacks could help, too: Lincoln National has reduced its share count by 18% since 2013.
There’s a dark cloud over Navient (NAVI), the country’s largest student-loan servicer, which was split off in 2014 from SLM (SLM), commonly known as Sallie Mae. Shares of Navient have fallen 18% in a year, and traded recently at seven times projected 2018 earnings. Student debt has more than doubled from a decade ago, to over $1.4 trillion as of last fall. Investors fear a default crisis. A January report by the Brookings Institution predicts that by 2024, default rates for students who took out federal loans in 2004 will rise to nearly 40%. For comparison, the delinquency rate for single-family mortgages peaked at just under 12% in 2010.
Still, at the current price, contrarians should have a look. The Brookings study concluded that “the main problem isn’t high levels of debt per student (in fact, defaults are lower among those who borrow more, since this typically indicates higher levels of college attainment), but rather the low earnings of dropout and for-profit students, who have high rates of default even on relatively small debts.”
Navient’s earnings are for the moment dominated by a run-off portfolio of federally guaranteed loans, which means its potential losses on those loans is limited, and its cash flow is robust. Until last year, Navient spent richly to buy back its shares. It has suspended buybacks to shore up excess capital through the end of this year, which is when a noncompete agreement with Sallie Mae for private student-loan originations expires.
After that, Navient will be able to grow its loan book, using what recent data have shown about where risk lurks for student lenders. It is also growing fees in other businesses, like payment processing for state and local governments and hospitals. Earnings have stalled in recent years, but are seen growing at a single-digit yearly pace through 2020. Over the long term, shares could creep closer to Sallie Mae’s valuation of 12 times earnings. Meanwhile, Navient pays a 4.8% dividend yield.
