2 Stocks to Watch and 1 to Pass

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At the end of each earnings season, I run a screen against more than 2,200 companies, looking for a couple to add to my Messed-Up Expectations portfolio. The screen looks for companies whose stock price might be messed up by determining how much free cash flow growth is currently priced in. I'm looking for situations where that growth is very low, but the company is likely able to produce much more FCF growth than is currently expected. An example of this is Western Refining (NYS: WNR) . Its price last night shows significant shrinkage of the past year's FCF over the next 10 years, rather than growth, priced in. This time, the screen returned 98 companies.

The first candidate
CF Industries Holdings
(NYS: CF) produces nitrogen and phosphate fertilizers, primarily for mid-American fertilizer distributors that sell to farmers. Last year, it generated 85% of its revenue from the U.S. and another 7.8% from Canada, with the rest coming from overseas.

Positives:

  • For all but one year of the past 9.5 (all the data I have), cash flow from operations has been greater than net income, which is a good sign. Also, for all but one year of the same time period, CFFO has been growing year-over-year.
  • Margins remain high, even after the recession. Last year, net margin was less than 10%, but that was probably acquisition-related. Net margin has remained above 13% outside of that for the last 3.5 years and has climbed to a high of 19.8% for the trailing four quarters.
  • CF took on debt to acquire Terra Industries last year, but it's already paying that down and moving strongly back to a net cash position. Interest coverage ratio (operating income divided by interest expense) is 10 times, meaning it has no problem covering that obligation.

Negatives:

  • In buying Terra Industries, it used cash and stock. Share count increased by 46.7% as a result.
  • The company hasn't raised its dividend in over three years and the current payout ratio is less than 1%.

Verdict:Look further into this one. See how well its Terra acquisition is going. Look at fertilizer prices and the likelihood of sustaining them at this profitable level.

The second stock to watch
Freeport McMoRan Copper & Gold
(NYS: FCX) is a gold and copper miner with mines in South America and Indonesia, as well as properties in Africa and North America. It also sells molybdenum, a component of steel alloys.

Positives:

  • Lots of FCF -- about $4.5 billion over the past year.
  • Lots of copper and gold reserves.
  • Lots of cash on the books (some $4.4 billion), up over $700 million in just the past six months.
  • Took on $7.2 billion in debt back in 2007 to help finance its purchase of Phelps Dodge. That now sits at $3.5 billion, so it's now in a net cash position.

Negatives:

  • The company is dealing with labor disputes in Peru and Indonesia, though Peruvian labor issues seem to be yearly events.
  • It's facing a tax/tariff from Indonesia on exporting unprocessed ore in a bid by that government to create more processing in the country. Newmont Mining (NYS: NEM) would also be affected by this.
  • There are significant worries about copper and gold pricing, especially if China's demand for copper begins to dry up.

Verdict:
Definitely look at this one more closely, as I believe there is still opportunity in the mining sector. It's doing things right by aggressively paying down its debt and it has plenty of cash to do some nice acquisitions of some of the "junior" miners and their properties. Taseko Mines (NYS: TGB) might be a good one for Freeport McMoRan to look at more closely. And then there's potential for organic growth from further exploration of its own properties. Concern about metal prices and future Chinese demand is quite possibly the reason for the price weakness which could signal a great opportunity.

1 stock to pass
Lamar Advertising (NAS: LAMR) owns and advertises on tens of thousands of billboards, over a thousand digital billboards, and many thousands of transit placards (sides of buses, inside trains) around the U.S., Canada, and Puerto Rico.

Positives:

  • Throws off cash like crazy. Cash flow from operations is greater than net income for the past decade and more.
  • Net losses are decreasing, and if the trend continues, it has a good chance of being profitable this year.

Negatives:

  • Has a ton of debt, with the debt-to-equity ratio currently sitting at 2.75.
  • Interest coverage ratio is less than one, meaning it cannot even cover its interest payments out of operating income. This ratio has not been above 1.8 back through 2000.
  • This is reflected in the very low net margin compared to operating margin. In 2008, the last profitable year, it had operating margin of 14.3% and net margin of 0.2%, with the drop being mostly due to interest payments.
  • This is also holding down its return on equity and return on assets to low single digits when the company is profitable.
  • Revenue growth has not been outstanding, rarely topping 10% year over year and not showing a five-year average above 10% since 2004.

Verdict:
Pass, mostly because of the debt, but also because of obvious ties to economic cycles in earnings. I'd be more interested if it were clearer that we were strongly coming out of a recession and the market hadn't quite caught up on that, but that debt load still bothers me.

Final thoughts
Using a screen is just the first step in finding good companies to invest in. Looking at recent financial information lets you quickly choose to continue researching or to pass. And writing down your reasons to proceed or pass lets you revisit the decision in the future in order to improve the process.

Come and discuss these and other investments on my Messed-Up Expectations discussion board, or follow me on Twitter.

If you're interested in precious metals, especially gold, check out our special free report:"The Tiny Gold Stock Digging Up Massive Profits."

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