NEW YORK (Money Magazine) -
Corporations don't lie, cheat or steal. The people who work for them sometimes do.
This is important to keep in mind as you read the latest news about $2 million toga parties, incriminating e-mails or cooked books.
Fact is, many of the companies rocked by scandal in the past couple of years aren't like Enron -- they are fundamentally sound businesses. Once their lousy CEOs or unscrupulous employees have been led out the door, these firms still have their product lines, physical assets, market share and even some cash, all of which ought to be worth something to investors.
And now they're on sale. "Pessimism produces good prices," says Robert Olstein, manager of the Olstein Financial Alert Fund, which specializes in buying bad-news stocks. "But you can't just be a contrarian, buying what everyone else is negative on. You need to look beyond what's going on now and think in terms of what could be."
With that advice in mind, MONEY set out to find the very best of this bad bunch. We started with a long list of companies whose executives have been accused of improprieties ranging from outright stealing to wildly bad judgment.
We looked for stocks trading below their pre-scandal highs, with strong free cash flow and low P/Es.
Free cash flow -- the amount of cash a company has left after it has met all its expenses -- is a key measure of financial health for any company, and it's especially vital for those mired in lawsuits or investigations. A cash cushion helps a company weather the storm while covering added costs such as legal bills or restructurings.
We also wanted stocks that would make good long-term holdings, not just short-term trading opportunities.
So we searched for companies that are No. 1 or No. 2 in their businesses or are making significant changes to put themselves back on track. And we talked with some of the best fund managers and private investors in the business to see what they're buying.
Here's a look at the most promising picks we found among scandal stocks.
Tyco
There's more to Tyco than former CEO Dennis Kozlowski's $6,000 shower curtain and that Roman-themed party on Sardinia.
Even as Kozlowski and his deputies are on trial for looting $600 million from the company and using questionable accounting to hide their actions, a who's who of value investors -- including Olstein, Legg Mason Value's Bill Miller and fund legend Michael Price (now a private investment manager) -- are all betting on the Tyco stock (TYC: Research, Estimates).
Why?
Price says the company is poised to reap the benefits of its 1990s acquisition spree, which created a $36 billion (in sales) industrial conglomerate.
Though many analysts think Kozlowski overpaid for some of these businesses, the fact remains that Tyco is a market leader in each of its five segments: electronic components, medical devices, fire and security, plastics and adhesives, and engineered products such as sprinklers and valves.
Tyco's new management team, led by respected Motorola veteran Edward Breen, gets high marks. "They've cleaned things up a lot and their businesses will start to grow again," says Price.
Tyco restated its earnings back to 1998 and replaced its entire board of directors. The company is also attacking the huge debt load it took on to acquire all those companies, cutting $3.2 billion from its $24.2 billion debt in the past year. (It has also more than tripled its free cash flow.)
Price says that Tyco's medical-products business -- a broad line of medical devices and disposable products such as needles -- is a "gem," with a presence in nearly every country in the world.
Tyco trades at just 12 times estimated 2004 earnings vs. 18 for the S&P 500. Though the stock has doubled in the past year, to $22, Price thinks it's still undervalued.
Freddie Mac
Once known as Steady Freddie because of its predictable and stable earnings, Freddie Mac shocked investors by dumping not one but two CEOs this year.
The company understated profits by billions of dollars to smooth out earnings and is now in the process of restating financial results going back to 2000. It faces probes from the Securities and Exchange Commission and the Office of Federal Housing Enterprise Oversight.
Freddie, which was created by the government in 1970 to provide stability and liquidity in the housing market, buys and sells mortgages from lenders; it keeps some of the mortgages and repackages others as securities.
Freddie has had relatively easy access to capital because of the perception that the government will bail it out of financial trouble, and it enjoys a line of credit from the Treasury.
But some in the Bush administration and Congress are talking about putting Freddie Mac under the stricter eye of the Treasury rather than the Department of Housing and Urban Development, and even revoking that line of credit.
Still, few analysts are betting that any regulatory changes will happen soon, thanks to the lender's powerful and well-funded lobbying operations.
And politicians are loath to go after any company that ensures stability in the housing market, one of the bright spots in the economy in the past three years.
Meanwhile, Freddie (FRE: Research, Estimates) has a strong cash position and a wide net profit margin of 37 percent. (The S&P 500 average is 7.5 percent.)
"The basic business model for Freddie is not broken," says James Gipson of the Clipper fund, which has Freddie as one of its top holdings.
Another fan, David Dreman of the Scudder Dreman High Return Equity fund, notes that Freddie's 15 percent long-term growth rate is double that of the S&P 500.
Citigroup
Citigroup has been sullied by several scandals. The star analyst of its Salomon Smith Barney brokerage, Jack Grubman, was banned from the securities industry for making rosy stock recommendations to win investment banking business.
Citi paid $400 million to settle government charges that it issued fraudulent research reports and engaged in IPO shenanigans. And it paid $145 million to settle investigations into its dealings with Enron and Dynegy.
Citi has since split Salomon Smith Barney, separating research from investment banking to avoid conflicts of interest. Citi's new CEO, Charles Prince, took over in October. (Sandy Weill will stay on as chairman until 2006.)
Citi remains a profit-generating juggernaut. It produced $30 billion in cash last year and $15 billion in net income. That's $3 billion more in earnings than its closest competitor Bank of America -- even after accounting for B of A's recently announced acquisition of FleetBoston.
It is at or near the top in virtually every business it's in: credit cards, retail banking, brokerage services and corporate lending, just to name a few.
It raised its annual dividend twice this year (recent yield: 3 percent).
Though Citi stock (C: Research, Estimates) is up 34 percent this year, Bill Fries of Thornburg Value Fund notes that it trades at a still reasonable 13 times 2004 earnings.
"There's a nice package of businesses where they are a leader, the stock is priced right, and you get a good yield," says Fries, who waited to buy the stock until he was confident that the scandals wouldn't have any effect on operations.
Tenet Healthcare
Tenet, one of the largest hospital chains in the country, has been roiled by charges of Medicare billing fraud and allegations that it paid kickbacks to physicians who practice at its hospitals.
Three top executives were booted from Tenet, which also owns and operates outpatient surgery centers, home health agencies and long-term-care facilities.
Tenet (THC: Research, Estimates) suffered an additional blow in October after announcing that it would miss fourth-quarter earnings estimates because of unpaid debts of uninsured patients. But both Olstein and Clipper's Gipson remain believers in the hospital giant.
"There's a lot of headline risk in this stock right now," admits Olstein. But he says Tenet's story is simple: a limited supply of hospital beds and increasing demand fueled by aging boomers.
New CEO Trevor Fetter expects to cut $350 million in annual costs and plans to raise $738 million by selling 10 hospitals. "We think we can double our money in two to three years in this stock," says Olstein, who picked up Tenet at $14.
Xerox
After teetering on the edge of bankruptcy two years ago, Xerox appears to be making a comeback.
Following SEC charges that it inflated revenue and earnings, Xerox paid a $10 million fine and restated earnings from 1997 through 2000.
In June four of its top executives, including former CEO Paul Allaire and Richard Thoman, settled sec civil charges and paid $22 million in fines and interest.
Though some former Xerox executives remain under criminal investigation and the firm faces potentially costly shareholder lawsuits, the company has gotten its balance sheet in order under new CEO Anne Mulcahy.
Xerox has shed unprofitable businesses and cut costs by outsourcing manufacturing and cutting nearly 25,000 jobs, saving $1 billion a year. It still leads in digital and color copiers and printers, trades at just 15 times 2004 earnings and generated free cash flow of $1.6 billion last year.
Jim Benson of Oakmark funds, where Xerox is a top 10 holding in Oakmark Select, says Xerox has put its accounting issues behind it: "What you see now is pretty clean. As they enter 2004, Xerox has a solid balance sheet, leaner cost structure and lots of free cash flow."
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