2 cheap stocks are trading at ‘deal of the century’ prices

This article is excerpted from Tom Yeung’s Profit & Protection newsletter. To be sure not to miss anything of Tom’s picks, subscribe to his mailing list here.

Market rout made deals of the century

Let me tell you something:

I hate bargain hunting.

No matter how long I search for a good deal, I’ll find a cheaper version as soon as I’m done paying.

Do you want to buy a used car? Wait until my friend finally sells me his 2004 Bentley. It’s guaranteed to drive down the prices of used land yachts across the country.

The latest smartphone? Plane tickets? A house? You bet it’s the same story.

But when it comes to stocks, that all changes.

The lower the stock price, the more excited I am.

It’s because my investment system has a flair for good deals.

Some companies have abnormally large cash reserves. Today, as many as 368 companies have negative enterprise values, an atypical case where a company’s cash exceeds the value of its debt plus its equity.

Others have assets hidden in plain sight. Intermediate energy companies like Martin channel partners (NASDAQ:MMLP) and Summit Channel Partners (NYSE:SMLP) are forced to value their assets as if oil were still trading at $50 a barrel (accounting standards do not allow these assets to be marked to market).

Maybe I’ll buy that old Bentley after all. Even though I’m losing money on the car, there’s so much more to be gained in stock Bentleys.

Source: Andrey Vyrypaev / Shutterstock.com

The cheap “Bentleys” of Wall Street

This week, I focused on the “value” part of the Benefit & Protection system.

To be honest, it was a bit disappointing.

Unlike growth – an all-weather source of alpha – simple value metrics have proven poor at generating consistent returns. Cheap P/E stocks were so beaten in 2015 and 2020 that their outperformance in the intervening years since 2013 was wiped out entirely.

But my analysis also revealed some good news.

Price-to-sales ratios have shown some outperformance, as has value in general during periods of rising consumer demand.

Now I have a special weekend surprise:

Two high-value stocks under Wall Street’s radar.

These are companies that simple P/E ratios fail to capture due to 1) hidden assets and 2) future cash flows.

Office Metal (DM)

Last month I wrote about Metal desk (NYSE:DM), a 3D printing company that was trading “within a hair’s breadth of its estimated acquisition value of $1.50”.

There was already a lot to love about the company. Desktop Metal has an extraordinarily fast growth rate; analysts expect revenue to grow 5.4x to $608 million by 2024. And a new directive from the White House has put 3D printing back on the map. The AM Forward initiative has already lobbied defense contractors to General Electric (NYSE:GE) at Raytheon (NYSE:RTX) to make “public commitments to purchase additively produced parts from small U.S.-based suppliers.”

Now that we’ve been talking about value investing all week, DM’s low $2 stock price is worth another look.

Pedal to the metal

First, let’s be clear:

DM is cheap as it consumes $60 million in cash every quarter.

No matter how fast a business grows, no business can survive short of cash.

Negative margins and sentiment also compounded the DM problem. In the first quarter of 2022, the company reported a gross loss of 3 cents for every dollar in revenue. Shares are down 62% for the year.

As they said back in the dot-com days, you can’t build a business selling dollar bills for 90 cents.

But hidden in DM’s terrible finances are two incredible assets:

  • Payment for Services. Like General Electric and other “land and expand” players, Desktop Metal generates most of its profits from aftermarket services. Last quarter, the company generated $1.1 million in gross profit from services, compared to a loss of -$2.4 million from product sales. Think of it as a “razor blade” business model for industrial-scale manufacturing.As the number of printers in service increases, the amount of recurring revenue that DM generates from these aftermarket sales will also increase. Analysts predict DM’s gross margins will grow to 50% by 2024, generating $300 million in gross revenue for the company. These cash flows are worth about $7 per share, according to my 2-step DCF models.
  • Intellectual property. Accounting rules require every company to account for R&D expenditure, rather than keeping the asset on the books. Such practices can obscure the value of a company’s intellectual property. Consider ExOne, the Desktop Metal 3D printing company acquired in 2021. Its acquisition price of $561.3 million valued ExOne at 3.5 times more than its actual net worth. A similar valuation would put Desktop Metal at $1.9 billion, or $6 per share.

Taken together, this suggests that DM’s fair value is around $6.50, or 225% above current levels.

Investors should remain cautious. Desktop Metal only has enough cash for about 18 more months of operation. “Investors need to mentally prepare for a secondary offering,” I warned in early May ahead of its devastating first-quarter earnings report.

But at $2, even conservative investors might consider taking a small bite.

A chart showing the price to tangible book value ratio of DM.

Bausch Companies: The Incredibly Cheap “Protection” Game

In financial theory, the law of one price dictates that the price of a particular asset or product must be the same everywhere, regardless of location, once certain factors are taken into account.

In other words, arbitrage opportunities should not exist. The price of gold…oil… GameStop (NYSE:EMG) stocks…all should trade at one price in different markets.

Yet we all know that prices can temporarily deviate from fair value. Options market makers make millions by writing contracts and immediately selling them on exchanges (and watch me lose 20% of my investment the moment I buy my friend’s Bentley).

That’s because these “certain factors” can cover everything from risk to the weather outside (a study found that rainy days can drive down New York stock prices).

A similar factor is now weighing on Bausch’s share price.

A temporary setback

Earlier last month, Bausch Companies floated its eye care subsidiary, Bausch & Lomb (NYSE:BLCO).

Sophisticated investors will immediately sense an opportunity.

Indeed, subsidiary BLCO now trades at $16, valuing the remaining 315 million shares of Bausch at $5 billion.

And the value of the parent company?

$3.5 billion.

In other words, each BHC share you buy at $9 comes with $14.2 worth of BLCO shares, a seemingly impossible violation of the law of one price.

Savvy investors will immediately point out Bausch’s massive $22 billion debt and ongoing lawsuit with the California State Teachers’ Retirement System. Such factors can easily diminish the value of a business.

As credit analysts have long said, the value of a company’s assets may be uncertain, but the company’s bankers will always know the value of its debts.

But neither of these points adequately explains why the rest of Bausch’s business should be worth less than $1.5 billion. Bond markets price BHC’s secured debt in 2025 at a yield of 7.3%, much better than other companies with a “B” credit rating. And Morningstar analysts say Bausch is “unlikely likely to pay plaintiffs more than $100 million” because of a related lawsuit that was settled for C$94 million.

Meanwhile, Bausch’s non-ophthalmology business is generating strong cash flow. The blockbuster drug Xifaxan is patent protected until 2029 and generates about $1.3 billion in profits annually. International Rx and other drugs contribute an additional $1.2 billion annually.

Together, this suggests that BHC’s $9 price is too low. A two-step DCF model (which accounts for leverage risk) puts BHC’s fair value at $14, a reasonable return of 55%. Meanwhile, a multiple-based valuation that ignores debt risk gives a price target of $25.

A chart showing the BHC futures price-to-sales ratio from 2019 to 2022 with 1.5x standard deviation bands marked.

Ultimately, deals like this won’t last forever. And when you hear people talk about “being greedy when others are scared,” companies like Bausch and Desktop Metal are the ones they’re talking about.

The EV/S ratio

Earlier this week, I noted that the price-to-sales ratio was the only common valuation metric that showed signs of alpha.

A chart showing the 1-year stock return by quintile of the P/S ratio.

But it is difficult to act on these results. Companies with low P/S like Bed bath and beyond (NASDAQ:BBBY) and Ritual Aid (NYSE:GDR) that determine quintile performance also tend to be highly leveraged, making them risky bets.

But an uncommon metric of Benefit & Protection the system is more promising:

Enterprise value to sales.

This measure represents the value of debt – a hidden force that can drive risky companies out of business.

A chart showing the 1-year stock return by quintile of the EV/S ratio.

Adding the value of debts and deducting cash, we get the downward-sloping chart that value investors would expect (i.e. the cheapest quintiles sequentially outperform the expensive ones).

Next week we will cover the Benefit & Protection concept of qualitythe confounding factor that creates these distortions and helps strategies like perpetual slot machine pick stocks that go up 1,000%.

PS Do you want to know more about cryptocurrencies? Penny shares? Choice ? Drop me a note at [email protected] or connect with me on LinkedIn and let me know what you’d like to see.

As of the date of publication, Tom Yeung had (neither directly nor indirectly) any position in the securities mentioned in this article.

Tom Yeung, CFA, is a Registered Investment Advisor on a mission to simplify the world of investing.

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