Overseas stock opportunities 2012 - Pt 2

In Overseas stock opportunities – Pt 1, we analysed five stocks that would help establish the foundation for a robust international portfolio; Apple and McDonald’s own two of the world’s most valuable brands; Goldman Sachs is the world’s pre-eminent investment bank; Henkel develops chemical-based products for industry and consumers and owns the Scwarzkopf and Purex brands, amongst others; and giant pharmaceuticals company GlaxoSmithKline pays an attractive dividend with increasing exposure to emerging markets.

Conservative investors, and those looking for income, are best advised to stick to the first five stocks in Ripe for the picking – Eight overseas stocks to buy now, supplemented with the stocks mentioned above.

If, however, you’re prepared to accept higher risks for potentially higher returns, then you might discover more value in the following five informal recommendations. But please, be sure to do your own homework before acting.

Oracle (NASDAQ: ORCL – $29.58)

Oracle develops software and hardware for the world’s largest corporations. Its products manage almost every aspect of a big business, from finance and sales to customer and supply chain management.

On almost any measure, Oracle is a financial powerhouse (see Table 1). It even holds 22% of its current market value in cash, an important consideration given many US-based companies are waiting for tax concessions that would allow them to repatriate overseas cash to potentially increase dividends and share buybacks.

Oracle has a lock, too. Once a company has spent millions installing one of its systems, the cost and complexity of replacing it with a competing system prevents many from doing so. That’s why the company collects a very high margin annual management fee typically worth over 20% of the cost of the installed system. Almost every customer pays it because to opt out and then return later is even more expensive. And besides, few companies want to risk losing sales due to a major system malfunction. Switching costs in this area are extremely high and high risk.

While the business model is easy to understand, the technology isn’t. IT is an industry subject to constant change and Oracle sceptics consider cloud computing a threat. Thus far, the company has successfully switched services to the cloud by hosting a client’s computer system, for example. Despite the rapidity of industry change, this hasn’t impacted Oracle’s profitability but we suggest you keep the portfolio limit to 5%.

JCPenney (NYSE: JCP – $20.02)

Due to an unsustainable discounting and coupon-driven promotional strategy, US discount department store JCPenney reported falling sales for several years.

US investor Bill Ackman—founder of hedge fund Pershing Square, which has amassed a 20% stake in JCPenney—has embarked on a turnaround strategy that involved poaching Ron Johnson from Apple. Johnson is lauded for his long tenure at Target and, more recently, developing Apple’s phenomenally successful retail stores.

Johnson has also made a personal $50m bet that he can turn JCPenney’s fortunes around. Real estate group Vornado Realty Trust (NYSE: VNO) has also taken a large position in the company, with its highly respected chief executive Steven Roth joining the board.

JCPenney owns 49% of its floor space and pays on average just $4 per square foot (psf) for the remainder. Sales are currently around $130psf, compared to over $600psf for JCPenney’s store-within-a-store concept Sephora. Starting in August Johnson plans to propogate this model by introducing ‘100 brand focused “shops within a shop”’, which includes Nike and Levi’s. By 2015, such brands should account for 75%-80% of sales, up from 45% currently.

Attracting a new audience is risky, though. Amidst much hype Johnson lured his former Target colleague Mike Francis to head JCPenney’s marketing, but recently ‘departed’ after just nine months when sales capitulated following a poor response to the new everyday low prices approach.

If sales can be increased to $177psm by 2015 with $900m of identified cost cuts, Pershing Square believes JCPenney can increase earnings per share to $6 (see Pershing’s recent presentation). That would put the stock on a price-to-earnings ratio of less than four. More optimistically, with sales of $200 psf earnings per share could increase to $9.25, making the current price a steal.

It’s important not to drink the Kool-Aid with turnaround situations like this. But JCPenney’s retail properties help protect the downside. You can currently buy shares for less than the average $26 that Ackman paid, with our suggested portfolio limit being 5%.

Halliburton (NYSE: HAL – $28.80)

Halliburton is an oil and gas services giant with a market value of $27bn. As you’d expect, the company’s profits are cyclical (see Table 3). Despite revenue almost doubling since 2009 and earnings per share almost tripling, the share price has almost halved since July 2011 as investors panic about the natural gas glut in the US, lower oil prices and a large potential legal payout due to the 2010 Deepwater Horizon disaster.

Nearly 80% of the company’s profits were produced in the US in 2011, but there is plenty of potential to increase margins and profits internationally. While Schlumberger is widely regarded as the best operator and is particularly strong outside the US, Halliburton is cheaper and boasts decent profit margins and returns on capital.

Lower natural gas drilling will scupper profits temporarily, but they should bounce back as staff are redeployed to rigs operating in oil and liquid natural gas fields. Those prepared for a rocky ride should stick to a portfolio limit of 3%-4%, providing room to move to 5% if lower oil and gas prices and a poor outcome from the Deepwater Horizon disaster provide a better buying opportunity.

Chesapeake (NYSE: CHK – $19.11)

Oil producer Chesapeake’s share price has fallen 71% since reaching $66.78 in July 2008 (see Chart 4). Co-founder, former chairman and chief executive Aubrey McClendon has built this $12bn company from the ground up. More recently, he’s been vilified for his lavish lifestyle, selling a personal art collection to the company (since undone) and signing a $100m pay deal after losing his leveraged stake in the company—once valued at $1.9bn—due to a margin call.

Lou Simpson, the former highly respected chief investment officer at insurance group GEICO, owned by Warren Buffett’s Berkshire Hathaway (NYSE: BRK.A), has been brought in to deal with the company’s corporate governance problems.

McClendon has created America’s finest portfolio of natural gas assets and expects Chesapeake to join the world’s top 10 oil producers. The problems include, but are not limited to, the company’s large amount of debt and that, with gas prices at record lows, spending on asset developments outweighs profits. Valuations for Chesapeake range from $35-$60 per share, with major shareholder Southeastern Asset Management suggesting it would be worth $100 with higher gas prices.

Relying on asset sales for financing is risky, especially if gas and oil prices keep falling and the company receives only low-ball bids. While the company could pause its rapid expansion plans to preserve cash, Southeastern and legendary investor Carl Icahn (who recently bought a 7.6% stake) have recommended the company look for a suitor at a price well above the current one. But we’d keep the portfolio limit to 4% of a risk-tolerant portfolio.

Joy Global (NYSE: JOY – $50.59)

Joy Global produces coal and surface-mining equipment for companies such as BHP Billiton. Ordinarily a tough, cyclical business, Joy Global collects a recurring revenue stream maintaining heavy-duty equipment where parts suffer extreme wear and tear, without needing to invest billions in the equipment itself. That helped keep the company’s earnings flat during the GFC, despite the share price falling 82% to a low of $15.85 (see Chart 5).

More recently, the share price halved due to a potential US gas revolution, although there should still be plenty of growth in coal mining and the use of coal-fuelled energy plants elsewhere around the world. China, for example, has recently become a net importer of coal, which produces 70% of its energy needs.

Joy Global is also one half of a duopoly in an industry that has high barriers to entry. As New York-based investor Alex Roepers recently explained in this interview, ‘No one else in the world can make these pieces of equipment. At Joy’s factory, in order to support the stamping equipment used to construct the equipment, JOY has a 200 feet deep concrete foundation beneath their machines. Regulators will not provide approval today for a plant requiring 200 feet of concrete.’

Roepers also believes the company, with low debt levels, is a takeover target. We highly recommend reading the full interview with Roepers and suggest a portfolio limit of 5%.