Stock Watch

8 Dirt-Cheap Stocks with Great Potential

These companies may be down on their luck, but mountains of cash prime them for a turnaround.

By Elizabeth Ody, Associate Editor, Kiplinger's Personal Finance

February 25, 2010

What’s better than a bunch of dirt-cheap stocks? A bunch of dirt-cheap stocks of companies stuffed to the brim with cash. Cash-rich companies can jump on new opportunities more easily than cash-poor firms can. And in the case of riskier, less financially fit firms such as the ones below, cash buys breathing room. It means they have time to work through short-term issues and get their houses in order. Each of these eight companies trades for less than $5 per share, but don’t let that mislead you into thinking they’re penny stocks -- each runs a substantial, mature business. And if animal spirits return to the market their stocks have plenty of room to run.

For Qwest Communications (symbol Q), a $2.4-billion pile of the green stuff, or $1.39 per share, is a lifeline while waiting for a takeover. One of the original “Baby Bells” spun off from the old AT&T in 1984, Qwest’s trouble is that “it’s basically a land-line phone company,” says George Putnam, editor of The Turnaround Letter, which ran the screen that generated the names in this story.

Qwest’s business has been in decline as cell-phone-toting customers dump their traditional phones. “Its business is like a slowly melting ice cube,” Putnam says. But he thinks the company, which generates $2 billion in annual sales and throws off about $3 billion in cash flow from its core business each year, can sustain its 32-cent-per-share annual dividend until a buyer turns up. At $4.45 a share, the stock yields a hefty 7.3% and trades for 13 times estimated 2010 profits per share of $0.33 (all share prices and related ratios are as of the February 23 close). Cash accounts for 31% of the D enver firm’s $7.8 billion market capitalization.

Square-shaped burgers, roast beef sandwiches and curly fries aren’t in long-term decline, but fast-food outlets such as Wendy’s/Arby’s Group (WEN) still have plenty of problems. Think of the last time you were in a fast-food restaurant. Was there a $1 menu? That kind of aggressive discounting cuts profits for restaurateurs who have to match rivals’ prices while coping with volatile commodity costs.

Wendy’s has struggled since 2002, when its lovable founder, Dave Thomas, passed away. In 2008, Arby’s owner at the time -- Triarc Companies, a holding company controlled by billionaire Nelson Peltz, who has a history of executing smart food-industry acquisitions and turnarounds -- acquired Wendy’s. So far, the company is on track for meeting its ambitious cost-cutting and efficiency targets, including boosting Wendy’s operating margins by five percentage points by the end of 2011 and slashing general and administrative costs. Peltz and partner Peter May together control about 22% of the joined company, which likely did about $3.6 billion in sales in 2009. At $4.87, Wendy’s/Arby’s trades for 23 times the $0.21 per share that analysts expect it to earn in 2010. Cash on the books, at $645 million, makes up more than one quarter of the firm’s $2.3 billion market capitalization.

It’s no accident that power-generator Dynegy Inc. (DYN) is sitting on $705 million, or $0.83 per share, in cash. Management has lately been selling assets in order to reduce debt and improve financial flexibility. Debt levels have been hovering at near-unmanageable levels for years, and some investors are still concerned that Dynegy could violate the terms on some of its loans.

Dynegy sells the power generated by its natural-gas and coal plants into the unregulated energy market. It’s a volatile business -- Dynegy is at the mercy of commodity prices, power prices and the weather, all of which can lead to unpredictable earnings and cash flows. But building new plants is a costly and laborious process, so long-term price trends will probably help Dynegy, as long as it can stay on top of its debt issues. Analysts expect Dynegy to lose money in 2010 . But at $1.65, the stock trades for just 0.38 times book value. And because cash accounts for half of Dynegy’s market capitalization, it’s as though investors are getting all of the firm’s assets, including its 20 power plants, for about $700 million.

Five more names for your consideration:

Alcatel-Lucent (ALU; $2.98)
What to love: The company’s broad range of telecommunications gear and global sales footprint. At $2.34 per-share, cash accounts for about 80% of the share price.

What to watch: Negative cash flow is gradually burning up the firm’s safety net.

E*Trade Financial (ETFC; $1.55)
What to love: A strong brokerage franchise and a 0.78 price-to-book-value ratio. The firm’s $5 billion of cash on the books could pay off its debt load in full.

What to watch: The company is still in the process of unwinding a disastrous venture into the mortgage business.

Internet Initiative Japan (IIJI; $4.61)
What to love: In Japan, as in the rest of the world, people are sending more data across the Internet and continually need to upgrade their Internet-access and networking gear. Cash-per-share of $1.25 accounts for more than one quarter of the share price.

What to watch: The company is a small fish in its market.

Sprint Nextel (S; $3.49)
What to love: A growing business in prepaid cell phones could attract a buyer to the company. Cash-per-share of $2.07 accounts for nearly 60% of the share price.

What to watch: Although the firm has nearly $4 billion on hand to pay the bills, it also has $21 billion in long-term debt.

Novell (NOVL; $4.84)
What to love: Cash accounts for 59% of the firm’s market cap and Novell carries no debt, so investors can essentially buy its proprietary software business and Linux operating system for about $700 million.

What to watch: Novell’s resources can hardly compare with those of competitors IBM and Microsoft.

• Got a question? E-mail me directly at investing@kiplinger.com. Want to be heard? Leave a reader comment below.

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