When Stocks Get Smacked
The headlines are full of big-time companies rocked by scandal or missteps. Which ones look ready for a comeback?
(MONEY Magazine) – The hits just keep on coming. Over the past 12 months a number of big-name companies have been caught up in scandals or blunders—maybe not Enron-bad, but bad enough to keep investors off-kilter. Two of the world's largest drugmakers have revealed serious safety concerns about some of their best-selling pills. Regulators have told the politically connected mortgage giant Fannie Mae to restate past earnings, which could wipe away $9 billion in profits. And insurer AIG, led by Wall Street legend Hank Greenberg, got tangled up in an investigation into the grubby bid-rigging games played by some insurance brokers.
Has all this turmoil produced a crop of bargain stocks? The answer is a qualified yes. There are plenty of depressed, out-of-favor stocks in the market, and many of those shares not only are cheap but also look poised for a rebound. Mixed in with them, however, are companies that look cheap on paper but are still vulnerable to a few more blows. The trick is telling the difference.
That's never easy. But there are some basic principles every contrarian can follow. For a start, make sure that a company's underlying businesses are solid and still capable of growth. One example of this is Tyco International, which is expected to grow earnings at an annual rate of 16% and has more than doubled in value since its top executive was charged with fraud in September 2002. But Tyco also illustrates another rule: When it comes to companies facing big legal or accounting worries, wait until you're convinced that the worst really is over—or at least that it's accounted for in the stock's price. Investors who tried to make contrarian bets on Tyco earlier in 2002, when questions about the company's accounting first knocked the stock down, still haven't gotten back to even. Finally, examine your comeback kid's balance sheet. A company has more time to execute a turnaround when it doesn't have a lot of debt on its books.
That's the theory—now for the practice. On the following pages, you'll get the skinny on six major stocks that suffered nasty headlines and big sell-offs within the past year. Four look like they're still real contenders. The other two are likely to stay on the ropes for a while.
ONE-YEAR RETURN: -2.6%
In October, New York State attorney general Eliot Spitzer brought a suit against the largest U.S. insurance broker, Marsh & McLennan, charging that it essentially rigged bids on corporate insurance policies. AIG was one of the companies that Spitzer claimed played along, and two of its employees pleaded guilty to criminal charges related to the case. At about the same time, AIG also became the target of a federal investigation into insurance policies that allegedly helped corporations manipulate their earnings.
The Spitzer investigation is by far the more serious worry. The politically savvy prosecutor is not just chasing down isolated abuses. He's determined to alter the way the entire industry does business. That's a huge threat to some firms—notably Marsh & McLennan—but on balance the risk to AIG looks manageable. AIG gets about 20% of its operating income from the sorts of policies that are under discussion. And the new scrutiny of brokerage practices will only partially reduce AIG's profits on that business. The company is trying to get the problem out of the way as quickly as possible by promising to cooperate with Spitzer, and it has also agreed to a $126 million settlement with the Securities and Exchange Commission and the Department of Justice that completes the settlement of the other probes. That's not a painfully high price for a company with revenue of more than $95 billion a year and nearly $11 billion in net income. Even after analysts reduced their earnings estimates, the stock trades at just 12.7 times expected profits. That price/earnings ratio is 20% below that of the broad market, even though Wall Street analysts expect AIG's earnings growth to outpace that of both the average blue chip and the property/casualty insurance industry.
CONTENDER AIG's legal woes won't hurt earnings much, and the company is growing faster than the market.
ONE-YEAR RETURN: 0.5%
Since Chuck Prince took over as CEO from Sandy Weill a little over a year ago, Citigroup has suffered one embarrassment after another. In May, Citi was fined as much as $70 million by the Federal Reserve for alleged abuses in its consumer-finance division, such as improperly requiring cosigners on some loans and overcharging some subprime borrowers. The company also suspended two executives in China for allegedly lying to regulators. But Citigroup's greatest fiasco last year occurred in Japan, where the company's private-banking division was shut down by regulators over violations that included misleading sales practices and weak safeguards against money laundering.
Prince is making all the right noises now. He's fired three senior execs and even bowed in apology during a Tokyo press conference. If he can stop this steady drip, drip, drip of bad news, the market may forget all these messes quickly. None were big enough to have a material impact on the earnings of a company as large as Citigroup. And Citi has some big trends in its favor, such as a pickup in Wall Street mergers and acquisitions that should be a boon to its investment banking business. Since Citigroup has lagged the shares of other big banks, it now trades at a P/E of 11. At that price, the stock's 12% projected earnings growth and 3%-plus yield look attractive.
CONTENDER Embarrassing foul-ups don't diminish the appeal of an 11 P/E and a 3% yield.
ONE-YEAR RETURN: -1.7%
Fannie Mae is reeling. In December, CEO Franklin Raines was forced out largely because of charges that Fannie had manipulated its earnings. The SEC said Fannie's improper accounting, which involved complex questions about investments in derivative securities, overstated earnings by as much as $9 billion. But there are more fundamental problems. The corporation, which was created by Congress, was designed to keep the U.S. mortgage market functioning smoothly and to encourage home ownership by middle-class and working-class people. It buys home loans from banks and either sells them in the form of mortgage-backed securities or adds the loans to its own mortgage portfolio. Fannie can borrow cheaply to finance its enormous mortgage business, despite having relatively little capital, because creditors assume that the government stands behind the company. But Republican-controlled Washington is looking less favorably on all such government-sponsored programs. As banks merge and get larger, they also complain more vocally about the special treatment Fannie Mae enjoys. The accounting scandal just bolsters the critics' case.
Fannie has been allowing the size of its mortgage portfolio to grow rapidly—nearly 17% a year—because that contributes more to profits than repackaging mortgages does. But directly owning more loans also increases risk. The company will probably have to rein in its portfolio growth—either to manage down risk or because the government tells it to. To conserve cash and meet new capital requirements imposed by regulators, Fannie had to cut its dividend in January and will probably remain on a tight budget. And while the stock's P/E of less than 10 looks cheap, there are lots of big lenders with below-average P/Es that don't have Fannie's problems
PALOOKAVILLE Growth is likely to slow, and the business faces considerable political risk.
MERCK AND PFIZER
ONE-YEAR RETURN: -29% (MERCK) AND -26% (PFIZER)
After a clinical study found that its powerful painkiller Vioxx seemed to raise the risk of heart attacks, Merck withdrew the drug from the market on Sept. 30. Then came news that Pfizer's arthritis drugs Celebrex and Bextra also seemed to increase cardiovascular risk. But so far, the evidence against Pfizer's products has been less clear-cut than that against Merck's Vioxx. And so, instead of pulling the drugs from the market, Pfizer has halted advertising and issued additional warnings but continues to sell the two products. This strategy allows Pfizer to keep the two drugs alive, in the hope that further tests may clear them to some extent. By contrast, even before Merck received the test results that led it to pull Vioxx, there were signs that the drug might have serious side effects. In a worst-case scenario, that would increase Merck's liability. No one's sure what the amount will be, but many analysts put the potential toll above $10 billion. Based on what we know now, Merck is more vulnerable.
On the other hand, for risk-tolerant investors, there's a case for Pfizer. The pharmaceutical business is going through a tough time, but it remains one of America's top growth industries. And that will only intensify as baby boomers age and need pills for chronic ailments. Pfizer is the world's largest drugmaker, with deep financial resources and impressive research capability. Because Pfizer's price already reflects a risk of more bad news on Celebrex and Bextra, the stock costs less than 12 times this year's estimated earnings—slightly cheaper than Merck, with its P/E of 13.
PALOOKAVILLE Merck is still vulnerable to costly litigation over Vioxx.
CONTENDER Pfizer has vast research capabilities—and it's cheaper than Merck.
ONE-YEAR RETURN: -4.5%
This past year has been tough on the media conglomerate, and not just because of that "wardrobe malfunction" and the 60 Minutes Wednesday blowup over President Bush's National Guard records. In June, president Mel Karmazin departed because of ongoing friction with chief executive Sumner Redstone. Karmazin was heir apparent to the 81-year-old Redstone. Some of Viacom's businesses, such as its radio division, are underperforming. And credit rating agencies may downgrade Viacom's A-grade credit if the company takes on more debt.
But those problems sound worse than they are. Viacom's profits are estimated to have grown about 11% in 2004, and growth may accelerate this year. The firm's cable networks are doing well. CBS isn't suffering financially and should show better results as the advertising upturn continues. In addition, the company plans to continue buying back stock, which bolsters margins and growth in earnings per share. As for the company's debt rating, the agencies were reacting to Redstone's statement that he would be willing to take on more debt for the right acquisition. But don't worry—he's not one to throw money around. Consider that before spinning off the movie-rental chain Blockbuster, Viacom extracted a special dividend of more than $700 million. Redstone remains one of the shrewdest of dealmakers.
CONTENDER CBS mess and management turmoil can't obscure the upturn in TV and radio.
NOTES: Returns include dividends.  As of Jan. 18. SOURCE: Thomson/Baseline.