Spencer Platt
Investors have overlooked the inherent value of the following five companies, which receive five-star ratings from Morningstar. Still, they have many challenges. Morningstar predicts the stocks could more than double as business fundamentals improve. Below, they are ordered by potential return, from great to best.
5. GenOn Energy is an independent power producer, with exposure to volatile commodity markets. It was formed through the all-stock merger of Mirant and RRI. The combined entity boasts a stronger balance sheet and competitive position. Both companies struggled after the peak of the last commodity cycle, with Mirant entering bankruptcy and RRI selling its retail business to NRG Energy. Independent power producers are "price-takers" and low natural gas prices have hurt GenOn's higher-cost coal plants. Energy prices remain low.
GenOn has invested more than peers in cleaning, or "greening," its coal plants and operates an efficient fleet. Coal remains one of the cheapest ways to generate electricity. Morningstar views the stock as a "call option on higher natural gas prices and energy demand." With expected cost savings of $150-million a year, as a result of the merger, Morningstar values GenOn's stock at $7 (U.S.). That price target suggests an impressive 90% return. But, it is 50 cents less than Morningstar's net asset value estimate of $7.50. This is a volatile stock, but worth consideration.=
4. Range Resources is an oil and gas exploration and production company, with a market value of $6.9 billion. Natural-gas-focused Range has suffered a 16% stock price drop in 2010 amid a "high cost/low gas price environment." Morningstar expects the earnings outlook to rebound in 2011. Service-provider Halliburton just debuted discount offerings to dry-gas-focused producers, like Range, confirming Morningstar's view of the current difficult operating environment as temporary. Range's position in the Marcellus shale region renders it attractive.
Range holds nearly one million acres in Marcellus under low-cost leases, which will allow for production, reserve and profit growth into the foreseeable future. It was a first-mover in the region and, consequently, its property is cheap, based on lease and royalty fees, and has outstanding geophysical characteristics. Its other property investments, mostly in Virgina, are promising. Risks include higher taxes in Pennsylvania, regulatory interference, dependence on MarkWest for midstream access and lower oil and gas prices. Non-core property sales assure financial stability going forward.
3. NRG Energy , like GenOn, is an undervalued independent power producer. Its success is similarly dependent upon power demand, which has remained at depressed levels since the recession. Morningstar describes its fleet of coal and nuclear power plants as "ultra low-cost." So, should power demand rebound, which is expected as the economy grows, NRG will see a jump in demand and earnings. It retrofitted plants to burn Powder River Basin coal, a more efficient input, elevating coal-fired margins. Still, Morningstar views this as a risky pick.
Like GenOn, NRG has high "fair-value uncertainty." It trades at a discount to other industry investments because it is subject to a variety of risks. If natural gas prices fail to rise in line with expectations, the economy falters, electricity demand stagnates or Washington imposes new emissions standards, then NRG's shares will drop in value. Further, Morningstar expects margin deterioration through 2012 and then a pickup as growth accelerates. A recent deal to purchase assets from Dynegy fell through when the company rejected a contingent buyout from Blackstone Group.
2. TOP Ships owns tanker and dry-bulk ships, which it rents on multi-year, fixed-rate contracts. The dry-bulk industry, considered an economic bellwether, was one of the hardest hit amid recession. And TOP's small stature and unfavourable financial position left it exposed. The company has a market value of roughly $31-million, making it a micro-cap stock, a volatile asset class. Its long-term contracts insulate it from pricing cyclicality and a recent move to outsource ship maintenance will boost profit margins in 2011 and beyond, according to Morningstar.
Morningstar used discrete scenario analysis to generate a fair value estimate of $2, consistent with a 111% return. It views $3 as a conceivable top threshold, implying a potential 213% return. Its worst case scenario entails further write-downs and a forced sale of vessels by the company's bondholders. It awards that scenario a 33% probability. Its $2 base includes lower average daily pricing over the next few years, but a stable operating margin in the 25% range due to lower expenses and cost controls. As debt falls, investors will become comfortable with the stock.
1. Sprint Nextel is the third wheel to wireless telecom giants Verizon and AT&T. However, it lacks their landline legacy businesses and has significantly less wireless market share. The former is a positive, the latter a negative that Sprint is working to overcome. As wireless and data come to dominate telecom going forward, Sprint's partnership with 4G WiMax and LTE builder ClearWire will remain of paramount importance. But, in recent weeks, ClearWire voiced a need for more capital. Sprint had solid quarterly customer adds, at 644,000.
Still, its service is considered inferior to the big two and margins are falling. The operating spread narrowed two points to 16% in the latest quarter. Also, churn is notably higher than that of the other two majors. Morningstar forecasts tepid sales growth of 3% through 2014. Its profit-per-customer is a clear opportunity for improvement. Verizon generates $280, whereas Sprint generates just $100. As the debt balance is high, Sprint has been neglecting capital expenditure to boost cash and pay down debt. This is an unsustainable strategy as investment is critical to Sprint's long-run viability.