If beauty is in the eye of the beholder, then "cheap" surely lies in the judgement of the investor.
Some stocks which trade at an extremely low multiple of earnings can be thought of as undervalued -- meaning that the market has yet to realize their potential. Shares of other publicly traded companies can be "cheap" for good reason, and in many instances are best avoided.
Let's evaluate two very different stocks linked by the commonality of modest valuations: Ship Finance International Limited (SFL -0.67%), and El Pollo Loco Holdings Inc. (LOCO -0.35%). In both cases, the fact that they're cheap may indicate inherent value you can take advantage of.
The vagaries of trade on the high seas
Ship Finance Limited owns and charters commercial ocean vessels, including oil and chemical tankers, container vessels and car carriers, dry bulk vessels, and deepwater drilling units. The company was formed as a spin-off from Frontline Ltd. (FRO -3.00%) in June 2014.
Ship Finance trades at a forward one year price to earnings (PE) ratio of just 6.70. The current price of "SFL" sits at around $15.40 per share. That's about double the historical low which the stock hit during the financial crisis of 2008/2009, and one-half of the company's all time high of just over $31 per share, achieved in 2007.
Investors are cautious over Ship Finance as two primary business lines, oil exploration and dry bulk shipping, have decelerated due to the impact of lower oil prices and a weakening global economy, respectively.
Day rates paid for deepwater drilling rigs have declined due to the glut of oil on the market. Ship Finance has countered this by easing the leverage associated with its offshore rigs. The company has reduced borrowings of approximately $2 billion associated with its largest rigs to $1 billion. Ironically, oil prices are helping to boost tanker revenue, as the over supply of oil causes fuel traders and purchasers to use floating ocean tankers as temporary storage facilities.
As commodity demand orginiating from China has evaporated, dry bulk shipping rates have plummeted. The Baltic Dry Index, which measures the cost of shipping commodities over major sea routes, dropped to a historic low of 291 in February 2016. The index has recovered since then, hitting a recent level of 610 in June 2016.
While this subsector may continue to remain soft over the next several quarters, a recent snapshot of Ship Finance's revenue indicates that among major business lines, it has the least exposure to dry bulk commodity fluctuations:
Source: Ship Finance International Q1 2016 Investors Presentation
Ship Finance has also worked to trim its overall debt position. Over the last five years, the company has cut its debt-to-equity ratio nearly in half, to 1.34, although that's still above an optimal level of 1.0 or below. In the first quarter of the current year, the shipping specialist continued to reduce borrowings, redeeming $125 million of outstanding convertible bonds.
One of the enticing aspects of investing in Ship Finance is the company's generous dividend, which currenty yields 11.5%. The payout ratio on this dividend is quite high, at nearly 81% of net income. However, this ratio peaked at over 150% two years ago, and is heading back towards a historical level of near 60% as the company pays down its debt obligations and continues to stabilize cash flows due to growth in its contracted revenue. As of Q1 2016, Ship Finance boasts $4.2 billion in forward contracted revenue, with an average weighted contract length of nine years. For context, the company booked $407 million in operating revenue last year.
Though concerns over global economic conditions which influence the shipping industry's immediate prosperity hurt Ship Finance's valuation, it's nonetheless a conservatively run company which is structuring itself to weather the cyclicality of the ocean transport trade.
Perhaps the best investment case is found in the chart below. For those who have simply reinvested the company's generous dividend, "SFL" has quietly returned an eye-opening 24% annually since the company's spin-off twelve years ago:
Would investors be "loco" to consider these shares?
Like Ship Finance Limited, El Pollo Loco Holdings, a fast casual restaurant chain which specializes in fire grilled, citrus marinated chicken, can be labled cheap on a forward earnings basis.
El Pollo Loco trades for just 14 times forward earnings, which is extremely inexpensive compared to peers in the fast casual industry such as Zoe's Kitchen Inc (ZOES), which sells at 148 times forward earnings, and Shake Shack Inc (SHAK 0.08%), which sports a forward PE of 68.
Of course, Zoe's and Shake Shack have something investors have found lacking in El Pollo Loco, and that's appreciable revenue growth. Let's review a few figures from the first quarter of 2016 for each of these three companies:
| Q1 2016 Metrics | ZOES | SHAK | LOCO |
|---|---|---|---|
| Revenue Growth | 26.7% | 43.3% | 4.3% |
| Comparable Store Sales Growth | 8.1% | 9.9% | 0.7% |
| Net Income | $1.4 million | $1.5 million | $5.4 million |
| Profit Margin | 1.7% | 2.7% | 5.8% |
Source: Q1 2016 SEC company filings.
Zoe's and Shake Shack are expanding revenue at a much faster pace than El Pollo Loco. To its defense, El Pollo Loco is a chain that's been in business for over 36 years. Though it debuted on the public markets only recently, in July 2014, it hasn't generated quite as much sustained market buzz as the more recent IPOs of Zoes and Shake Shack have.
Still, El Pollo Loco has undoubtedly stagnated as of late, and this shows in its paltry 0.7% comparable store sales growth in the last quarter. The company should be growing comparable sales at least within spitting distance of its competitors.
Management's solution to driving "comps" is two-fold. First, the company is intensifying its marketing. El Pollo Loco named a new marketing agency of record in April, Harmelin Media, and it will be ramping up direct mail, radio and digital advertising, and even tweaking external store signage with the goal of better educating customers about its menu.
The chain has also begun testing a mobile app which will form the basis for a digital platform to more directly engage customers and build loyalty. Management has indicated that the app will move out of beta to a formal launch in 2016.
El Pollo Loco would gain much momentum from raising comps, as it's already increasing its location count at a fairly brisk clip. While Zoe's and Shake Shack will each grow their total restaurant bases by roughly 13% through the next three quarters of this year, El Pollo Loco's pace isn't that far behind for a company which is much older. If it hits the top of its projected store opening range, "Loco" will expand its store base by about 7% through the next three quarters of 2016.
Having lost 53% of its value since its IPO, El Pollo Loco is dismissed and discounted by the market, even given higher relative profitability to its peers. However, "Loco's" revenue issues aren't unsolvable, and while it may not sport Shake Shack's growth rate of 43%, it's capable of faster top-line improvement, and deserving of a higher multiple. In other words, El Pollo Loco may be cheap, but it's also very likely undervalued.
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