Don't Bet Your Chips on Intel, Micron

When it comes to semiconductors -- be wary of bets on PC memory -- so-called Dynamic Random Access Memory (DRAM) and bet on Flash -- used on the iPhone, iPad, and iPod -- instead. That does not mean that all PC chip bets are bad though. That's the takeaway from a look at semiconductor companies Micron Technology (NASDAQ: MU) and Intel (NASDAQ: INTC).

Late Thursday Micron reported an unexpected loss. In its report, Micron posted a $135 million loss of 14 cents a share for its fiscal fourth quarter. FactSet-polled analysts expected a penny a share of profit. Micron's 14% revenue drop to $2.14 billion from was slightly better than the expected $2.11 billion

The report is a mixture of bad news and good news. The bad news is that the revenues dropped due to Micron's dependence on DRAM -- where prices are dropping along with demand for PCs. The good news is that Micron has shifted its business mix in favor of the more profitable flash memory chips -- 41% of total sales. Its DRAM business is down to 36% of the total.

That's not to say that all bets on PC chips are off. Despite slowing PC sales, corporate PC demand has been stronger than many expected. And with its new PC Central Processing Unit (CPU) chip architecture -- dubbed Sandy Bridge. Intel's architecture combines "high-level graphics and CPUs integrated onto the same piece of silicon," according to eWeek.

That architecture has given Intel a phenomenal market share of 81.8% in the global processor market according to market research firm IHS iSuppli. And while the PC DRAM business features dropping prices, the CPU market remains a profit machine for the market king, Intel.

Despite slowing PC sales, corporate demand remains strong while consumer demand wanes. According to Matthew Wilkins, principal analyst for computer platforms research at IHS iSuppli, “Intel in the second quarter benefited from the combination of a recovery in PC demand and strong shipment growth for its new Sandy Bridge line of microprocessors. Strong corporate PC sales were particularly beneficial to Intel, as the enterprise computing segment has been outperforming the consumer market.”

Does this mean you should avoid Micron and buy Intel? I would avoid both but for different reasons:

• Micron: hard to predict earnings. Micron's latest report is a reversal after very strong 12 month results. During the previous 12 months, Micron revenues soared 77% to $9.1 billion while net income of $644 million was up 198% -- yielding a modest 7.1% profit margin. The stock is very cheap -- based on a Price-earnings-to-Growth ratio of 0.15 (1.0 is fair value). Micron's P/E is 8.9 on earnings forecast to grow at 58% to $0.88 in fiscal 2013. The problem for this stock is that the latest quarterly report is so much worse than expected that it throws into question the sustainability of its longer-term performance and the reliability of its forecasts.
• Intel: profitable, growing, expensive stock. Intel revenues are up 24% in the last year to $48 billion during which it posted a $12.3 billion profit, up 162% -- a whopping 25.6% net margin. The stock is expensive -- based on a Price-earnings-to-Growth ratio of 2.50. Intel's P/E is 10 on earnings forecast to grow at 4% to $2.45 in 2012. In its second quarter, Intel profit gained a mere 2% to $2.95 billion so despite its longer-term profit growth trends, its most recent results suggest that it may not be able to accelerate earnings growth.

While Intel is clearly a more solid company, neither looks like a great place to bet your investment chips.

Get to Know Cognizant, Accenture

The business of writing software in India has been booming. But some of the biggest providers -- Accenture (NYSE: ACN), Cognizant Technology Solutions (NYSE: CTSH), and Computer Sciences Corp. (NYSE: CSC) -- are getting nervous. Is this is a sign of trouble in these stocks or is there an opportunity to buy?

Why does all this matter? For decades, big organizations have decided that their computer systems are important but they simply can't afford to put top programmers on their staff. As a result, they hire outside companies to build systems to solve problems like keeping track of inventory or selling their products online.

This industry is big and growing. According to Canadian researcher, XMG Global, the global outsourcing industry is forecast to end 2011 at $464 billion -- 9.2% larger than in 2010 -- it grew 13.9%  last year. And the reason it's growing is simple -- companies need new computer systems, they have the budgets to build them but can't get the job done quickly and cheaply with their in-house staff.

But XMG believes that growth in the industry goes up in proportion to global economic growth. And now a feared slow down in global expansion is scaring some of the biggest outsources. For example, The top 20 IT companies in India account for over 60% of engineering job offers to students there, according to the Times of India.

And those big employers have made plenty of offers. So far in 2011, Indian outsourcers TCS hired 40,000 students, Infosys 30,000, Cognizant 28,000, Wipro 20,000 and HCL 8,000. They hired that many people based on two factors -- the number of big deals in their sales pipeline and the rate at which they expect programmers to quit or get fired.

But the attrition rate is falling as the number of job opportunities for experienced programmers dries up and the size of new deals is also declining. For example, in the last couple of quarters, the attrition rate has dropped from 25% to 15% and companies are no longer able to close deals bigger than $100 million.

As a result, students who received job offers do not yet know when they will start work. In India, students who are about to graduate regularly receive general offer letters that do not specify when they should report to work.

They later receive so-called appointment letters that tell them when to start. The Times of India reports that there are many who graduated in June but are nervously awaiting a letter -- perhaps in October or November -- that will tell them when they should start.

These delayed start dates are like the canary in the coal mine for the earnings prospects for the industry. But do they mean that you should avoid all of the stocks in the industry? Consider Cognizant and Accenture -- steer clear of CSC. Here's why:

• Cognizant: booming, profitable, fairly priced stock. Cognizant revenues soared 40% to $5.3 billion in the last year and its net income of $826 billion was up 37.1% -- yielding a fat 15.6% profit margin. Although it has a slim profit margin, the stock is fairly priced -- based on a Price-earnings-to-Growth ratio of 1.13. Cognizant's P/E is 24.5 on earnings forecast to grow at 21.7% to $3.40 in fiscal 2012. Cognizant's second quarter earnings rose 20.8% from the year earlier quarter while revenue was up 34.4% to $1.49 billion.
• Accenture: profitable, growing, moderately expensive stock. Walgreen revenues are up 18.4% in the last year to $27.4 billion during which it posted a $2.3 billion profit, up 27.9%. The stock is fairly expensive -- based on a Price-earnings-to-Growth ratio of 1.47 (1.0 is fair value). Accenture's P/E is 16 on earnings forecast to grow at 10.9% to $4.25 in fiscal 2013. In its fiscal fourth quarter -- reported Wednesday -- Accenture reported a 37% jump in earnings and a 23% revenue rise. If Accenture can continue this growth pace, its valuation looks low.
• CSC: barely profitable, fairly priced stock. CSC revenues barely budged, up 0.8% to $16.2 billion in the last year and its net income was $750 million was down 13.2% and it has a slim 5% profit margin. The stock is fairly priced -- based on a Price-earnings-to-Growth ratio of 0.95. CSC's P/E is 5.8 on earnings forecast to grow at 6.1% to $4.66 in fiscal 2013. 

Cognizant looks like the winner in this bunch due to its explosive growth and reasonable valuation. Accenture is also a strong player -- but not growing as fast (understandably given its size). CSC, despite its fair valuation, continues to be an also-ran. The concern for the first two is that those delayed appointment letters signal slower growth ahead.

Walgreen Can Cure What Ails Your Portfolio, CVS Not As Much

Do drugstores offer investment value? It's a tough question because drug store have changed along with the health care market. While CVS Caremark (NYSE: CVS) has merged with a pharmacy benefit manager (PBM) -- a company that negotiates with health care product and service providers on behalf of corporate health plans, Walgreen's (NYSE: WAG) has remained pretty much the same -- except that like CVS it offers in-store medical care.


In 2006, CVS merged with Caremark, a PBM, in a $26.5 billion deal that finally closed in 2007. The idea was to create a $75 billion drug distributor whose greater scale would enable it to negotiate bigger volume discounts with the pharmaceutical companies. This deal was intended to lower corporate health care costs while achieving cost savings to help pay back the price premium.

Meanwhile, Walgreen has stuck closer to its knitting. In 2010, it spent $1.1 billion to expand its presence in New York City by acquiring Duane Reade. The deal more than doubled the number of pharmacies that Walgreen operates in the city.

Meanwhile, both CVS and Walgreens began in-store health clinics staffed by nurse practitioners in 2009. These clinics allow patients to obtain care for relatively minor health problems without an appointment. And after they are treated, they can buy their prescriptions in the stores.

But do these trends make CVS and Walgreens attractive investments? Here's my take:

• Walgreen: profitable, growing, cheap stock. Walgreen revenues are up 6.4% in the last year to $71 billion during which it posted a $2.4 billion profit, up 4.2%. the stock is fairly priced -- based on a Price-earnings-to-Growth ratio of 1.02 (1.0 is fair value). Walgreen's P/E is 13.2 on earnings forecast to grow at 12.9% to $2.96 in fiscal 2012. Tuesday, Walgreen reported a 69% pop in net income but also terminated a $5.3 billion deal with Express Scripts (NYSE: ESRX) because Walgreen felt it was not getting paid enough to fill its prescriptions.
• CVS: profitable, fairly priced stock. CVS revenues fell 2.3% to $101 billion in the last year and its net income of $3.4 billion was down 7.4%. Although it has a slim profit margin, the stock is fairly priced -- based on a Price-earnings-to-Growth ratio of 0.98 (1.0 is fair value). CVS's P/E is 14 on earnings forecast to grow at 14.3% to $3.18 in fiscal 2012. CVS's second quarter adjusted earnings of 65 cents beat expectations by a penny and were the same as the previous year.Thanks to contract wins in its PBM sector, its revenues there were up 23.2% but its margins remain tight. 

I like Walgreen better than CVS because of its more rapid revenue and profit growth and its reasonable valuation.

Build Your Portfolio On NVR's Foundation -- Skip Toll Brothers, KB Home

The housing market has been in the doldrums for years. And since they are still around, they are unpopular among investors. But are their stocks under-valued? More specifically, is there any value in home builders such as KB Home (NYSE: KBH), NVR (NYSE: NVR) and Toll Brothers (NYSE: TOL)

How bad is the housing market? Here are four indicators:

• Millions of foreclosures. According to RealtyTrack more than 2.3 million houses have entered foreclosure since December 2007.
• Dropping prices. According to S&P, house prices at the end of May were 33% below their July 2006 peak,
• Breaking ground on new houses is at a low. According to the Commerce Department, housing starts dropped 5% in August,  the most since April 2011, to a seasonally adjusted annual rate of 571,000 units, and
• Housing sales are down from July 2011, lowest in six months. In August, sales of new single-family houses were down 2.3% to a seasonally adjusted annual rate of 295,000, according to the U.S. Census Bureau and the Department of Housing and Urban Development. The good news is that this is 6.1% percent above the August 2010 level.

With all this bad news, it's amazing that home builders are even adding to the supply. But all is not doom and gloom in this industry. Some are doing better than others. Here's my ranking of the three players I mentioned above:

• NVR: profitable, cheap stock. NVR's revenues rose 11% to $2.7 billion in the last year and its net income of $156 million was up 7.2%. But the good news is that the stock is cheap -- based on a Price-earnings-to-Growth ratio of 0.65 (1.0 is fair value). NVR's P/E is 23.6 on earnings forecast to grow at 36.4% to $36.15 in 2012.  
• Toll Brothers: barely profitable, cheap stock. Toll Brothers' revenues fell 15% to $1.45 billion in the last year and its net income of $75 million was up 100%. Although it has a slim profit margin the stock is cheap -- based on a Price-earnings-to-Growth ratio of 0.48 (1.0 is fair value). NVR's P/E is 32 on earnings forecast to grow at 66.5% to $0.34 in fiscal 2012.
• KB Home: unprofitable, high dividend yield. KB Home's revenues are down 13% in the last year to $1.3 billion during which it posted a $175 million loss. But the good news is that it has a high 4.23% dividend yield. And with 42% of its outstanding shares sold short, KB Home is the fifth most heavily shorted stock on the NYSE, according to Bloomberg. This suggests that KB Home's stock could drop which would raise its dividend yield -- if the company can keep paying a dividend.

If NVR achieves its expected 2012 profit growth, this solid company is looking awfully inexpensive. Toll Brothers has very slim profits and its contracting sales concern me. An KB Home's high short interest would scare me away from buying its shares.

Why Integrated Oil (Chevron) Is Up and Drillers Are Down

When it comes to the stock market, not all oil companies are created equal. For instance, drillers like Transocean (NYSE: RIG) and Diamond Offshore (NYSE: DO) have fallen 18% and 14% respectively in 2011 while integrated energy colossus Chevron (NYSE: CVX) has only dropped 1%. Why?

The answer can be found by looking at what drives their profits. For example, offshore drillers operate platforms that float over oil deposits beneath the ocean floor. Companies like BP (NYSE: BP) pay offshore drillers a daily rate to drill in search of oil. The goal of companies that hire the offshore drillers is to find the oil and get it pumped out as fast as possible so they can minimize the day-rate they're paying.

Of course, BP and Transocean got into a bit of trouble back in 2010 when a Transocean offshore oil rig, the Deepwater Horizon, that BP had hired blew up. This led to a massive cleanup and a moratorium on drilling in the Gulf of Mexico. That moratorium on drilling cut way back on the number of rig-days that Transocean and its competitor, Diamond Offshore, got paid.

The financial results are not pretty. In 2010, Transocean's net income plunged 69% to $988 million thanks to the loss of that rigs income and the moratorium in the Gulf. And in the second quarter of 2011, Transocean's net income plunged 50% to $155 million while only 55% of its fleet was being used.

The numbers for Diamond Offshore are not that much better. Its net has fallen 31% in the last year while its revenues are down 9%. But in the second quarter of 2011, it reported higher profits of $267 million -- up 8%. The bad news, that spooked its stock, is that management forecast more rig downtime -- 1,004 days in 2011 and 869 days in 2012.

Chevron is a different story. It has many different ways to make money -- including the refining and marketing of oil. If Chevron can keep its cost of buying crude oil low enough and keep its refineries operating close to full capacity then it will likely make a big profit when it subtracts these costs from the price it gets from consumers at the pump.

That spread worked quite nicely for Chevron in the second quarter. Its profit spiked 43% to $7.7 billion on revenue that climbed 31% to $66.7 billion as higher oil and gasoline prices made up for a decline in oil production.

But that's all history. Should you buy any of these stocks? Consider Chevron but avoid the offshore drillers. Here's why:

• Chevron: profitable company, expensive (?) stock. Chevron revenues are up 19% in the last year and it earns a solid 9.9% net profit margin. Yet its Price-earnings-to-growth ratio (PEG) is a high 3.95 -- 1.0 is fair value -- on a P/E of 7.9 on earnings forecast to grow 2% to $13.75 in fiscal 2012 after a 42% rise in 2011. If you think Chevron's 2012 earnings growth will be better, then the stock may be cheap.
• Transocean: unprofitable company, expensive stock. Transocean revenues loses money: it has -1% net profit margin. And its PEG is undefined because it trades at a P/E of -129 but its earnings are forecast to rise 63% in 2012 to $5.75. If you like betting on a turnaround -- this could be one to consider.
• Diamond Offshore: profitable company, over-priced stock. Diamond Offshore earns a whopping 29% net profit margin. And its PEG is undefined because it trades at a on a P/E of 8 on earnings forecast to tumble 20% in 2012 after a 10% decline in 2011.

If you had to bet on one of these, I'd go with Chevron. But if we have a recession coming up, then its earnings growth might be on the low end and that would make its stock over-priced. The offshore drillers look questionable unless demand for their services spikes.

Among Business Software Warriors Microsoft, Oracle, and Salesforce.com, Only Microsoft Will Boost Your Portfolio

In the battle for a share of corporate software budgets, winning depends on confidence. That is, a company will only spend its money on software if it believes your company will be around for years to come.

That's why it is so impressive that Salesforce.com (NASDAQ: CRM) was ever able to break into the market. Facing competitors like Oracle (NASDAQ: ORCL) and Microsoft (NASDAQ: MSFT), what Salesforce.com accomplished as an upstart is a great lesson for others. But should any of these companies be in your portfolio?

The global market for business software is huge. Ovum expects it to rise 8.2% in 2011 to end the year at $267 billion. And it will keep growing at a 7.7% annual rate to hit $358 billion in 2015. What's driving that growth is "exploding volumes of data, increased enterprise mobility, the transition to cloud computing models, and the emerging markets."

And the leaders in selling it have big names. Microsoft remained the world's top software vendor according to Ovum, retaining 20% of the market. Oracle, IBM (IBM) and SAP followed in that order. But Microsoft is not innovating enough to gain significant market share.

But what does it take to win that business? If its fiscal first quarter earnings report is any indication, Oracle is winning big. Its CEO, Larry Ellison, has spent $40 billion since 2005 on acquisitions of corporate hardware and software companies and has created bundles of products that boost corporate IT productivity.

The result is rapid sales and profit growth. Its sales for the quarter ending August 31, were up 12% to $8.37 billion meeting expectations. And net income was up 36% to $1.84 billion -- $50 million more than Wall Street expected.

The rise was due to increased corporate spending on its database programs and applications that help run businesses -- many of which combine the hardware Oracle got from its $7.4 billion acquisition of Sun Microsystems, according to Bloomberg.

Oracle wins for two reasons:

• Safety. Corporations see it as a safe choice so buying its products will not result in the head of corporate IT getting fired because the company goes out of business.
• New products that boost productivity. Oracle is acquiring the products that companies need to handle their information management challenges and getting them all to work together.But should you invest in any of these corporate software winners? You should consider Microsoft, but avoid Oracle and Salesforce.com. Here's why:

It is remarkable that any small companies have been able to grab business from Oracle. But former Ellison protege, Mark Benioff, and founder and CEO of Salesforce.com did just that. Benioff is a great salesman who used the contacts he developed while selling Oracle products to see an opportunity to give business customers the best of both worlds.

It lets companies pay a monthly fee to rent customer relationship management (CRM) software from Salesforce.com. This lets companies get the benefits of innovation -- since Salesforce.com is continuously improving the product -- while avoiding the fixed costs of buying hardware and software on which to run that software.

• Microsoft: profitable company, cheap stock. Microsoft revenues are up 12% in the last year and it earns a whopping 33% net profit margin. Yet its Price-earnings-to-growth ratio (PEG) is a low 0.78 -- 1.0 is fair value -- on a P/E of 9.7 on earnings forecast to grow 12.5% to $3.13 in fiscal 2013. 
• Oracle: profitable company, expensive stock. Oracle revenues are up 32.8% in the last year and it earns an impressive 25% net profit margin. Yet its PEG is a high 1.58 on a P/E of 17.1 on earnings forecast to grow 10.8% to $2.56 in fiscal 2013.
• Salesforce.com: barely profitable company, very over-priced stock. Salesforce.com revenues are up 27% in the last year but it earns a slim 1.5% net profit margin. And its PEG is a grossly over-valued 3.37 on a P/E of 633 on earnings forecast to grow 188% to 0.57 in fiscal 2013 -- after its earnings plummet 70% in fiscal 2012.

What is most interesting is that investors seem to like Oracle's faster sales growth and solid profitability more than Microsoft's slower growth but higher margins. Meanwhile, Salesforce.com may be doing an admirable job of attracting customers but it does not seem able to make a profit in the bargain.

BBT's a Bank You Can Bank On. B of A and Cirigroup, not so much

The U.S. government has invested hundreds of billions of dollars -- including the $750 billion Troubled Asset Recovery Program (TARP) -- to keep the world's biggest banks from failing -- some of those are based in the U.S. But if you're going to put your own money into bank stock, skip the ones that got bailed out -- like Bank of America (NYSE: BAC) and Citigroup (NYSE: C) and consider a stake in a profitable regional bank like BB&T (NYSE: BBT).

Banking used to be such an easy business. Bankers would roll into the office at 10am, take a few meetings, and be out on the golf course by 2pm. In between, they'd make a business or home loan and feel blissfully confident that they would get a nice solid paycheck every two weeks -- and attend a delightful Christmas party at the end of the year.

But starting in the mid-1970s that cozy world crumbled -- leading to a raft of changes that has made banking a terrible business for everyone associated with it except for a handful of traders. Here are the three most significant ruptures in the banking industry structure:

• Deregulation. In 1975, Washington allowed competitors to get into the stock brokerage business -- enabling discount brokers to take market share away from the so-called full-service brokerage houses like Merrill Lynch -- now a B of A subsidiary. Other deregulation let Savings & Loans (S&Ls), that had previously been bastions of safety, to speculate on interest rates. And in the 1990s, the rule that kept commercial (taking deposits and lending them out) and investment banking (issuing securities and advising on mergers) separate -- passed to keep another Great Depression from happening -- was repealed. All these changes ramped up the risks that bankers could take with government-guaranteed consumer deposits.
• Securitization. The 1980s featured the emergence of securitization -- selling financial assets like mortgages, credit card receivables, and commercial loans into a trust and then issuing securities based on the cash flows the assets generated. Securitization turned lenders into factories that mass-produced loans because the investment banks that engaged in securitization had an insatiable appetite for ever-bigger portfolios to boost their revenues and banker bonuses. As the volume of loans rose, the quality plummetted. But since ratings agencies competed to AAA-rate those dodgy loan bundles, investor around the world were eager to buy them. 
• Technology. Up until the invention of the ATM, banks conducted business through buildings on streets in cities where their customers lived and worked. Those bank branches are much more expensive to own and operate than an ATM. And with the emergence of secure ways to pass information and money on the Internet, people can conduct many banking transactions without even leaving their home or office. This leaves banks in an uncomfortable position of operating plenty of stores when a more convenient and cost-effective delivery mechanism is available to them at the same time.

All these changes led banks to take bigger risks as they struggled not to lose market share and the resulting bonuses to their more aggressive peers. And about once a decade, those risks led to a financial crisis:

• LDC loans. In the 1970s, there were big losses due to loans to so-called Lesser Developed Countries (LDCs);
• Oil patch lending. In the early 1980s, there was another collapse due to too much lending for oil and gas exploration and oil-patch real estate;
• LBOs. The 1980s ended with a collapse in loans for leveraged buyouts; and
• Sub-prime securitization. We are still suffering the after-effects of the 2008 financial collapse that resulted from institutional investors who bought bundles of subprime-mortgage backed securities on margin.

Among the biggest perpetrators of the latest financial crisis remain two zombie banks -- B of A and Citigroup. I call them zombie banks because if they were to adjust the value of their bad loans to their true current value, those banks would end up with a negative net worth. 

B of A has $222 billion in shareholders' equity and nearly $2 trillion in so-called Level 2 and Level 3 assets -- for which there is no way to value them in the market. That $2 trillion includes $1.4 trillion in so-called derivatives that Warren Buffett called financial weapons of mass destruction.

Since B of A's financial statements do not reflect the real-time value of those Level 2 and Level 3 assets, it is possible to think about scenarios of what they're really worth. And in one such scenario, a mere 11% drop in their value -- $222 billion divided by $2 trillion -- would wipe out B of A's net worth.

Surprisingly, not all banks are walking dead. BB&T, a North Carolina commercial bank with offices in North Carolina, Virginia, Florida, Georgia, Maryland, South Carolina, Alabama, Kentucky, West Virginia, Tennessee, Nevada, Texas, Washington D.C and Indiana, is doing well and it's stock is cheap.

The $15 billion (market capitalization) BB&T had $6.9 billion in sales and earned a nice 11.3% net profit margin. And it is screamingly cheap -- trading at a Price-Earnings to Growth ratio (1.0 is fair value) of 0.43 on a P/E of 16.3 and earnings forecast to grow 38% to $2.42 in 2012 (after 51% EPS growth expected for 2011). Citigroup has $176 billion in net worth but it has mysteriously avoided reporting for those Level 2 and Level 3 assets

BB&T stuck the traditional banking business and does it well. Most investors are too gloomy to notice this booming bank whose stock is selling at a discount.

Bristol Myers May Cure Your Portfolio Better Than Merck

The pharmaceuticals industry has been in a state of turmoil for decades. But some companies are handling it better than others. For example, Bristol Myers Squibb (NYSE: BMY) stock is up 15% so far this year and Merck (MRK) has lost 10% of its value. Why the difference? Should you invest in either of these companies?

Prior to the 1980s, the drug industry was one of the most profitable in the world -- a typical pharmaceutical company could earn a five-year average return on equity of nearly 40%. The reasons for that high profitability were powerful:

• Patented drugs. High R&D spending regularly yielded new drugs that a company would patent and then enjoy almost 20 years of unchallenged high profits with regular price increases
• Marketing to doctors. Doctors prescribed drugs with a strong push from drug company sales and marketing people who gave the doctors free samples and took their families on vacations that included some "medical education."
• Limited competition. Pharmaceutical companies were unchallenged by significant competition and hence they were able to operate in a way that maximized their shareholder returns without concern for price cutting.

But starting in the 1980s, all those profit enhancing industry forces collapsed -- sending the industry into a long period of greater turmoil with which it is still trying to cope. These changes have lowered the industry ROE to 22.2% -- below the S&P 500 average of 24.6%.

Here are the biggest profit reducing changes:

• Rise of Pharmacy Benefit Managers (PBMs). Companies offering health care created PBMs to use their negotiating leverage to take away some of doctors' drug prescribing power. Now, if a patient who gets corporate health coverage has a medical problem, the PBM will usually only pay for the lowest priced drug that solves the problem.
• Emergence of new competitors. Generic drug companies manufacture off-patent drugs at much lower costs than do the fully-integrated pharmaceuticals companies. Those generic manufacturers get the revenues when those PBMs require the prescription of a low priced drug. Moreover, biotechnology companies have come up with new approach es to drug development and their focus often gives them higher patented drug development success.
• Rising cost of developing new patented drugs. In the 1980s, it used to cost $400 million to develop a new drug -- now it costs an average of $1.3 billion (although some believe that figure is massively inflated). Big pharmaceuticals companies are increasingly finding that they are unable to discover blockbuster new patented drugs to replace the ones that come off patent. As a result, they are spending more money than ever to try, but they frequently fail and end up trying to make up for it by acquiring a biotechnology company that is further along in the development process.

Merck was formerly considered the gold standard of the industry -- it attracted the top people and made the most money. But that began to fall apart in the 1980s thanks to the rise of Medco Health Solutions (MHS) -- a mail-order drug company and PBM that Merck acquired in 1993 as I wrote in my book, The Technology Leaders, to try to get back control of the prescribing process. That did not work and Merck spun off Medco in 2003.

Now Merck faces the prospect of being one of the companies that will suffer $135 billion lower revenues if President Obama's deficit reductino plan goes into effect. That's because the plan would require makers of brand name drugs to give a 23% rebate to the U.S. government for low-income Medicare beneficiaries who get a subsidy to pay for coverage, according to Bloomberg.

Meanwhile Bristol Myers has been working on new drug development and has achieved some success. Monday Jeffries published a report that Bristol Myers could be an acquisition target on the strength of two of its drugs -- a skin cancer treatment and a heart drug awaiting U.S. approval. Jeffries also raised its price targe from $27 to $35.  Its skin cancer treatment Yervoy generated $95 million in second quarter sales -- beating sales expectations. And Jeffries raised expectations for its blood thinner Eliquis.

What does all this mean for investors? Should you buy or avoid Merck and Bristol Myers? Let's compare them based on valuation and recent earnings performance:

• Valuation -- Bristol Myers. Bristol Myers (1.69) has a lower Price-Earnings-to-Growth (PEG) ratio -- 1.0 is considered fair value -- than Merck (3.86) -- calculated based on 2011 earnings growth. Specifically, Bristol Myers has a P/E of 15.9 on earnings forecast to fall 9.8% to $2.05 in 2012 but will enjoy a 9.4% earnings boost in 2011. Merck has a P/E of 34.7 on earnings forecast to grow 2.9% to $3.84 in fiscal 2012 with 9% growth in 2011.
• Earnings reports -- Merck. Merck has met or exceeded expectations in all of the last five earnings reports while Bristol Myers has beaten expectations in only four of the last five earnings reports.

Given the headwinds facing the industry -- reflected in weak 2012 earnings expectations, neither of the two companies looks like a bargain. But if forced to choose, I would pick Bristol Myers because of its lower P/E and the possibility of a takeover.

99 Cents Only Stores Stock is No Bargain

99 Cents Only Stores (NYSE: NDN) stock popped 9.4% on Friday. Is it still a bargain?

99 Cents claims that it sells merchandise at or below 99.99 cents per item. By April, it operated 285 retail stores -- 211 in California, 35 in Texas, 27 in Arizona, and 12 in Nevada. On Friday, news emerged that Apollo Management planned to bid $22 to $24 a share for 99 Cents.

Has news of this bid taken all the upside opportunity out of investing in 99 Cents? Here are two reasons to consider an investment:

• Higher sales and profits and decent balance sheet. 99 Cents sales have grown at a 6.2% annual rate over the last five years from $1.1 billion (2007) to $1.4 billion (2011) and its net income has increased at a 64.9% annual rate from $10 million (2007) to $74 million (2011) -- yielding a solid 7% net margin. It has under $1 mllion in debt and its cash has grown at a 14.4% annual rate from $118 million (2007) to $202 million (2011).
• 99 Cents is earning more than its cost of capital – and it’s improving. How so? It’s producing positive EVA Momentum, which measures the change in “economic value added” (essentially, after-tax operating profit after deducting capital costs) divided by sales. In 2011, 99 Cents EVA momentum was 1%, based on 2010 revenue of $5.5 billion, and EVA that improved from 2010's $17 million to 2011's $25 million, using a 7% weighted average cost of capital.

Here are two reason to avoid it:

• High valuation. 99 Cents trades at a Price-Earnings-to-Growth ratio of 1.65 (1.0 is considered fair value) — a P/E of 19.3 on earnings forecast to grow 11.7% to $1.26 in fiscal 2012 -- and is expected to grow 9.3% in fiscal 2012.
• Mediocre earnings reports. 99 Cents has been able to beat analyst’s expectations in only two of its past five earnings reports and has missed expectations by over 7% in the last two reports.

If Apollo buys 99 Cents, the stock will rise another 5% to 10% from its current level. If not, it should plunge and stay in stock purgatory until it can accelerate its earnings growth.

No Stock Bargains at Dollar Tree, Wal-Mart

Deutsche Bank recently started covering a slew of retail stocks -- it put a buy on Dollar Tree (NASDAQ:DLTR) and a sell on Wal-Mart (NYSE:WMT) -- expecting it to drop to $48. Should you follow Deutsche Bank's advice?

In its September 14 report, Deutsche Bank expressed concern that Wal-Mart was losing market share "at a faster pace than at any point in its history - a phenomenon that we're not convinced the company can fix," according to StreetInsider. And Deutsche Bank expressed concern about the following trends:

• Falling same-store sales. Declining same-store sales for the last nine quarter suggests Wal-Mart's "low-price image" may be damaged;
• Failure to adapt to consumer preference for convenience. "despite the consumer's emerging preference for convenience, Wal-Mart has been slow to adopt a smaller store strategy..."; and
• Lower level of share buybacks. A new development as recently as this year, "acquisitions + inventory build + international = less buybacks."

By contrast, on September 15, Deutsche Bank set an $81 price target when it initiated coverage on Dollar Tree.  Deutsche Bank admires its rapid growth in the number of customers in its stores.  This so-called traffic grew at an average of 5.8 percent over the past 10 quarters—supporting 65% of the same store sales growth, according to StreetInsider.

The Deutsche Bank report also said that "while strong brand awareness and an attractive value proposition are key ingredients, Dollar Tree has augmented its tender offering along with food stamp acceptance. Looking ahead, given these traffic rates, we have greater confidence in the company’s ability to drive comps in 2H11 and 2012."

Is Deutsche Bank right? Should you buy Dollar Tree and sell Wal-Mart? When I wrote about Wal-Mart in August, I was negative on its stock because despite beating analysts' estimates, paying a decent dividend, and out-earning its cost of capital; the retailer was not growing earnings fast enough to justify its P/E. I still believe that -- Wal-Mart's Price-Earnings-to-Growth ratio (PEG) remains high -- 1.0 is fair value -- at 1.29 on a P/E of 12 with earnings growth of 9.3% to $4.89 in 2012.

But what about Dollar Tree? Here are three reasons in its favor

• Great earnings reports. Dollar Tree has been able to beat analyst’s expectations in all of its past five earnings reports.
• Higher sales and profits and decent balance sheet. Dollar Tree sales have grown at a 10.2% annual rate over the last five years from $4 billion (2007) to $5.9 billion (2011) and its net income has increased at a 19.9% annual rate from $192 million (2007) to $397 million (2011) -- yielding a solid 7% net margin. Its debt has remained constant at $250 million and its cash has grown at a 12.2% annual rate from $307 million (2007) to $486 million (2011). 
• Dollar Tree is earning more than its cost of capital – and it’s improving. How so? It’s producing positive EVA Momentum, which measures the change in “economic value added” (essentially, after-tax operating profit after deducting capital costs) divided by sales. In 2011, Dollar Tree's EVA momentum was 2%, based on six month annualized 2010 revenue of $5.5 billion, and EVA that improved from six months annualized 2010's $162 million to six months annualized 2011's $254 million, using a 7% weighted average cost of capital.

Here is one reason to avoid it:

• High valuation. Dollar Tree trades at a Price-Earnings-to-Growth ratio of 1.35 (1.0 is considered fair value) — a P/E of 21 on earnings forecast to grow 15.6% to $4.55 in 2012 -- but is expected to grow 21.8% in 2011.

Deutsche Bank is right on avoiding Wal-Mart and wrong on buying the over-priced Dollar Tree -- but if its stock price drops -- or analysts raise its 2012 growth forecast enough -- to get its PEG below 1.0, I would take a fresh look.

Lincoln National Can't Secure Your Net Worth

Annuity vendor, Lincoln National (NYSE: LNC) enjoyed an 8.2% pop in Thursday trading. Is it too late to join the party?

It's hard to figure out why Lincoln National stock was up. But one clue is record options trading volume in puts (the right but not the obligation to sell shares at a set price and date) and calls (the right but not the obligation to buy shares at a set price and date) on Lincoln National. Thursday, a new 3-month trading record was established on both -- 2,256 call and 2,084 put contracts.

What does this mean? Savvy institutional investors are poised to profit from a big move in Lincoln National  stock. And it looks like that bet is largely a bullish one. How so? According to Avafin, unusual put/call volume signals that big investors expect a big move in the stock. And the number of bullish call bets outweighed the number of bearish put bets -- specifically, there were 0.9 puts traded for each call contract yielding a 0.92 put/call ratio.

Does this mean you should buy Lincoln National stock? Here are three reasons to avoid it:

• High valuation. Lincoln National trades at a Price-Earnings-to-Growth ratio of 2.50 (1.0 is considered fair value) — a P/E of 5.6 on earnings forecast to grow 2% to $4.18 in 2012 -- but is expected to grow 31% in 2011.
• Fair earnings reports. Lincoln National has been able to beat analyst’s expectations in only three of its past five earnings reports.
• Higher sales and decent balance sheet but declining profits. Lincoln National sales have grown at a 4% annual rate over the last five years from $8.9 billion (2006) to $10.4 billion (2010) and its net income has declined at a 7.5% annual rate from $1.3 billion (2006) to $951 million (2010) -- yielding a solid 9% net margin. Its debt has risen -- but its cash has soared at a much higher rate. Specifically, its long term debt rose at a 11.5% annual rate from $3.5 billion (2006) to $5.4 billion (2010) while its cash climbed at a 13.9% annual rate from $1.6 billion (2006) to $2.7 billion (2010).
• Under-earning its cost of capital. Lincoln National  is earning less than its cost of capital – but it’s improving. How so? It’s producing positive EVA Momentum, which measures the change in “economic value added” (essentially, after-tax operating profit after deducting capital costs) divided by sales. In 2011,  Lincoln National 's EVA momentum was 2%, based on six month annualized 2010 revenue of $10.3 billion, and EVA that improved from six months annualized 2010's -$417 million to six months annualized 2011's -$198 million, using a 7% weighted average cost of capital.

I am not sure why investors want to own this stock -- but it did hit a 52 week low on September 6 and if Lincoln National enjoys an upside earnings surprise when it reports its third quarter results, the stock could pop.

You Can Clean Up On a DaVita Buy

Berkshire Hathaway (NYSE: BRK) CEO Warren Buffett's latest successor-in-training used to run a Peninsula Capital Advisors, a hedge fund. One of Peninsula's biggest investments, kidney dialysis center owner, DaVita (NYSE: DVA), caught my attention. Should you invest?

Like Apple's (NASDAQ: AAPL) Steve Jobs, Buffett is a business hero who shares a common feature with the rest of humanity -- he won't last forever. So Buffett has been hiring investment managers and giving them multi-billion dollar chunks of his portfolio to see how they do. His first was Todd Combs and now Buffett has hired Peninsula's manager, Ted Wechsler.

Wechsler won an anonymous bid to have lunch with Buffett in 2010 -- topping $2.6 million, according to Fortune. Peninsula put in a pretty good performance for its investors -- since its 2000 inception, it returned 1,236% -- far better than Berkshire B stock that gained a relatively small 146%. One of Wechsler's biggest bets as of earlier this year was DaVita.

But has Wechsler already taken full advantage of the profit opportunity in its stock? Here are three reasons to consider an investment:

• Low valuation. DaVita trades at a Price-Earnings-to-Growth ratio of 0.71 — a P/E of 19.2 on earnings forecast to grow 27.1% to $6.13 in 2012.
• Good earnings reports. DaVita has been able to beat analyst’s expectations in four of its past five earnings reports.
• Higher sales and profits and decent balance sheet. DaVita sales have grown at a 6.9% annual rate over the last five years from $4.9 billion (2006) to $6.4 billion (2010) and its net income has increased at an 8.9% annual rate from $289 million (2006) to $406 million (2010) -- yielding a decent 6% net margin. Its debt has risen -- but its cash has soared at a much higher rate. Specifically, its long term debt rose at a 3.2% annual rate from $3.7 billion (2006) to $4.2 billion (2010) while its cash climbed at a 29.4% annual rate from $315 million (2006) to $883 million (2010).

One negative:

• Out-earning its cost of capital. DaVita is earning more than its cost of capital – but it’s not progressing. How so? It’s producing no EVA Momentum, which measures the change in “economic value added” (essentially, after-tax operating profit after deducting capital costs) divided by sales. In 2011, DaVita's EVA momentum was 0%, based on six month annualized 2010 revenue of $6.3 billion, and EVA that fell from six months annualized 2010's $110 million to six months annualized 2011's $121 million, using a 7% weighted average cost of capital.

DaVita looks like a solid investment given its financial strength and low valuation. And you didn't have to pay $2.6 million to learn about it.

Broadcom Can Accelerate Your Net Worth

Chip maker, Broadcom (NASDAQ: BRCM), is near the top of Fortune's list of big fastest-growing companies -- and is its 84th fastest growing company. Does that mean you should own its shares?

Broadcom recently announced a big networking chip maker for which it paid a big premium. The new addition is mobile network chip-maker, Netlogic Microsystems. At for $3.7 billion, the deal is Broadcom's biggest and is priced 39% above its market value. Fortune reports that analysts agree that Broadcom should expand in this market.

Is Broadcom's strategic expansion a good enough reason to buy its stock? Here are three reasons to consider it:

• Low valuation. Broadcom trades at a Price-Earnings-to-Growth ratio of 0.68 — a P/E of 19.5 on earnings forecast to grow 28.6% to $2.31 in 2012.
• Great earnings reports. Broadcom has been able meet or beat analysts' expectations in all of its past five earnings reports.
• Higher sales and profits and decent balance sheet. Broadcom sales have grown at a 16.4% annual rate over the last five years from $3.7 billion (2006) to $6.8 billion (2010) and its net income has increased at a 30.5% annual rate from $379 million (2006) to $1.1 billion (2010) -- yielding a solid 16% net margin. Its debt has risen -- but its cash remains solid. Specifically, its long term debt was $698 million in 2010 after previously being debt-free while its cash was unchanged over the five years at $2.7 billion.

One negative:

• Out-earning its cost of capital but getting worse. Broadcom is earning more than its cost of capital – but it’s falling behind. How so? It’s producing negative EVA Momentum, which measures the change in “economic value added” (essentially, after-tax operating profit after deducting capital costs) divided by sales. In 2011, Broadcom's EVA momentum was -3%, based on six months annualized 2010 revenue of $6.1 billion, and EVA that fell from six month annualized 2010's $222 million to six months annualized 2011's $60 million, using an 11% weighted average cost of capital.

It looks to me like the positives for Broadcom, outweigh its negative EVA momentum. If its 2012 EPS forecast is right, this fast-growing company is trading at a cheap price.

Newmont Mining Won't Dig Portfolio Gold

Gold producer, Newmont Mining (NYSE: NEM), is near the top of Fortune's list of big fastest-growing companies. Is that a good enough reason to buy its stock?

A look at Newmont's latest earnings suggests that fast growth does not necessarily mean high profitability. While Newmont is digging for gold around the world -- Ghana, North America, South America and the Asia Pacific region -- it looks like its costs are rising faster than gold prices.

With an 11% rise in revenues and an 18% profit boost, you'd think all's well at Newmont. But due to a spike in Newmont's cost to product gold -- from $507 an ounce in 2010 to $588 this year -- Newmont missed analysts' expectations by 10 cents a share (10% below expectations).

Is this a temporary problem that could make the stock more attractively priced? Or should you avoid Newmont altogether?

Here are two reasons to consider buying its shares:

• Low valuation. It trades at a Price-Earnings-to-Growth ratio of 0.80 (1.0 is fair value) — a P/E of 13.3 on earnings forecast to grow 16.6% to $5.63 in 2012.
• Higher sales and profits and decent balance sheet. Newmont sales have grown at an 18% annual rate over the last five years from $4.9 billion (2006) to $9.5 billion (2010) and its net income has surged at a 42.2% annual rate from $563 million (2006) to $2.3 billion (2010) -- yielding a wide 24% net margin. Its debt has risen -- but its cash is up faster. Specifically, its long term debt rose at a 23.6% annual rate from $1.8 billion (2006) to $4.2 billion (2010) while its cash climbed at a 34.1% annual rate from $1.3 billion (2006) to $4.2 billion (2010).

Two negatives:

• Unpredictable earnings reports. Newmont has been able beat analyst’s expectations in three of its past five earnings reports but when it misses, it misses big.
• Out-earning its cost of capital but getting worse. Newmont is earning more than its cost of capital – but it’s getting worse. How so? It’s producing negative EVA Momentum, which measures the change in “economic value added” (essentially, after-tax operating profit after deducting capital costs) divided by sales. In 2011, Newmont's EVA momentum was -3%, based on six month annualized 2010 revenue of $8.8 billion, and EVA that deteriorated from six months annualized 2010's $1.2 billion to six months annualized 2011's $964 million, using a 7% weighted average cost of capital.

What bothers me about Newmont is that it does not achieve economies of scale. It's getting much bigger, but its cost of producing gold is rising instead of falling. This means that it is not taking full advantage of the cost reduction opportunities that should go along with being bigger. The result is volatile results and an inability to generate positive EVA momentum.

Despite the low valuation, I would be wary of investing in this mining stock.

Don't Gamble on Wynn Resorts

Wynn Resorts (NYSE: WYNN) enjoyed a 208% rise in its second quarter earnings -- an impressive performance. Should you place a bet on its stock?

What's interesting about Wynn is that its been able to grow revenues over 33 times faster than the U.S.'s 0.7% rate of economic growth. This casino operator’s earnings growth was driven by a 22.8% increase in revenues including a 22% rise in room rates.

But is this fast growth enough of a reason to buy its stock? Here are two reasons to consider it:

• Decent earnings reports. Wynn has been able meet or beat analysts' expectations in three of its past five earnings reports and missed by a penny in the two others.
• Out-earning its cost of capital and getting better. Wynn is earning more than its cost of capital – and it’s improving. How so? It’s producing positive EVA Momentum, which measures the change in “economic value added” (essentially, after-tax operating profit after deducting capital costs) divided by sales. In 2011, Wynn 's EVA momentum was 12%, based on six month annualized 2010 revenue of $3.9 billion, and EVA that improved from six month annualized 2010's -$192 million to six month annualized 2011's $256 million, using a 12% weighted average cost of capital. Here are two reasons to pause:

Here are two reasons to avoid it:

• Very high valuation. It trades at a Price-Earnings-to-Growth ratio of 3.85 — a P/E of 50 on earnings forecast to grow 13% to $6.19 in 2012 after a 161% rise in 2011.
• Higher sales but plunging profits and more debt-laden balance sheet. Wynn sales have grown at a 31.6% annual rate over the last five years from $1.4 billion (2006) to $4.2 billion (2010) but its net income has plunged at a 29% annual rate from $629 million (2006) to $160 million (2010) -- yielding a thin 4% net margin. Its debt has risen -- but its cash is up faster. Specifically, its long term debt rose at an 8.4% annual rate from $2.4 billion (2006) to $3.3 billion (2010) while its cash climbed at a 13.3% annual rate from $789 million (2006) to $1.3 billion (2010).

If Wynn can keep up its rapid earnings growth over the longer run, then its current valuation will look cheap. But if earnings forecasts are accurate for 2012, this stock is very over-valued. Given its spotty record for beating expectations, I would consider buying Wynn at a lower price but avoid it for now.

At a Lower Price, Target Should Be in Your Sites

Target (NYSE: TGT) suffered an outage of its web site on Tuesday. The bad news was a result of too much demand and not enough supply as consumers were desperate to get their hands on the latest product innovation from Target. Is that enough of a reason to buy its stock?

Italian luxury knitwear designer Missoni sells consumer goods for very high prices -- as much as $1,500. But Tuesday it launched a 400-piece line of Missoni for Target -- a collection of bikes, luggage, clothes and housewares. This so-called "cheap chic retailer" featured Target's zigzag patterns for between $2.99 for stationary and $599.99 for patio furniture — far less than Missoni's real products that range in price between $595 and $1,500.

Target understands something essential about its customers -- they aspire to own elite brands but can't afford them. The celebrity-industrial-complex creates a deep popular hunger for what consumer can't attain. And then Target lowers the drawbridge and lets them in through these specialty sales. Even if it does not make money on these items, it does bring in many new customers who may buy other -- higher margin goods.

But is Target's success with Missoni reason enough to buy its stock?

• Great earnings reports. Target has been able meet or beat analysts' expectations in all of its past five earnings reports.
• Higher sales and profits and decent balance sheet. Target sales have grown at a 4.4% annual rate over the last five years from $58.5 billion (2007) to $69.5 billion (2011) and its net income rose slightly at a 0.9% annual rate from $2.8 billion (2007) to $2.9 billion (2011). Its debt has risen -- but its cash is up more. Specifically, its long term debt rose at a 15.7% annual rate from $8.7 billion (2007) to $15.6 billion (2011) while its cash climbed at a 20.3% annual rate from $813 million (2007) to $1.7 billion (2011).
• Out-earning its cost of capital and getting better. Target is earning more than its cost of capital – and it’s improving. How so? It’s producing positive EVA Momentum, which measures the change in “economic value added” (essentially, after-tax operating profit after deducting capital costs) divided by sales. In 2011, Target 's EVA momentum was 1%, based on 2010 revenue of $65.4 billion, and EVA that improved from 2010's $2 billion to 2011's $2.4 billion, using a 7% weighted average cost of capital.

One negative:

• Extremely high valuation. Target trades at a Price-Earnings-to-Growth ratio of 8.29 -- 1.0 is fair value – a forward P/E of 23.2 on earnings forecast to grow 2.8% to $4.33 in fiscal 2013.

For all Target's great stores, clever marketing, and solid financial performance, the stock price is way ahead of Target's earnings growth rate. Unless its price tumbles or its earnings growth spikes, Target stock is no value.

Cirrus Logic Will Make Sense of Your Net Worth

Fortune is out with its list of eight fastest growing technology companies. Second on the list is Cirrus Logic (NASDAQ: CRUS) that enjoyed 340% three-year annualized Earnings Per Share (EPS) growth thanks largely to its audio controller chips that account for 70% of its revenues.

But does rapid EPS growth mean Cirrus Logic stock is a sensible investment? Here are three reasons to consider it:

• Very low valuation. Cirrus Logic 's price-to-earnings-to-growth ratio of 0.25 (where a PEG of 1.0 is considered fairly priced) means its stock price is cheap. It currently has a P/E of 5.3, and its earnings per share are expected to grow 21.4% to $1.38 in fiscal 2013.
• Increasing sales and profits -- and decent balance sheet. Cirrus Logic has been increasing sales and profits. Its revenue has increased at a 19.4% annual rate from $182 million (2007) to $370 million (2011) while its net income has soared at a 64.3% rate from $28 million (2007) to $204 million (2011) — yielding a whopping 55% net profit margin due in part to a big tax credit. Its cash has fallen but is has almost no debt -- a mere $288,000. Specifically, its cash fell at a 7.2% annual rate from $266 million (2007) to $197 million (2011).
• Out-earning its cost of capital. Cirrus Logic is earning more than its cost of capital – and it’s making big progress. How so? It’s producing positive EVA Momentum, which measures the change in “economic value added” (essentially, after-tax operating profit after deducting capital costs) divided by sales. In 2011, Cirrus Logic 's EVA momentum was 16%, based on 2010 revenue of $221 million, and EVA that rose from 2010's $3 million to 2011's $39 million, using a 10% weighted average cost of capital. One reason not to invest:

One reason to avoid the stock:

• Poor earnings reports. Cirrus Logic has only been able beat analysts' expectations in two out of its past five earnings reports.

Cirrus Logic stock is at a low PEG and its actual earnings growth has been very high. But its high margins depend to a large extent on tax credits and it does not always exceed earnings expectations -- something that makes investors nervous. Nevertheless, as long as demand for its audio controller chip continues to rise, Cirrus Logic could make sense for your portfolio. 

Goodyear Could Put Your Portfolio on a Roll

Second quarter 2011 S&P 500 earnings hit an all-time record of $25.44. One of the fastest growing earners of the lot was Goodyear Tire and Rubber (NYSE: GT) whose EPS popped 442%.

This tire-maker’s earnings growth was driven by more than just cost cutting -- after all, in the second quarter, it reported a 24% sales increase. Here are two reasons to consider investing:

• Very low valuation. Goodyear trades at a Price-Earnings-to-Growth ratio of 0.10 -- 1.0 is fair value – a forward P/E of 4.6 on earnings forecast to grow 46% to $2.23 in 2012 and its price target of $22.17 is over twice its current price.
• Great earnings reports. Goodyear has been able beat analyst’s expectations in all of its past five earnings reports.

Two negatives:

• Flat sales and declining cash -- but lower losses and less debt-laden balance sheet. Goodyear sales have remained about the same at $18.8 billion over the last five years while its net loss has declined from -$373 million (2006) to -$216 million (2010). Its debt has fallen -- but its cash has declined faster. Specifically, its long term debt fell at a 10.2% annual rate from $6.6 billion (2006) to $4.3 billion (2010) while its cash dropped at a 15.4% annual rate from $3.9 billion (2006) to $2 billion (2010).
• Under-earning its cost of capital but getting better. Goodyear is earning less than its cost of capital – but it’s getting better. How so? It’s producing positive EVA Momentum, which measures the change in “economic value added” (essentially, after-tax operating profit after deducting capital costs) divided by sales. In the first half of 2011, Goodyear's EVA momentum was 2%, based on first six months’ annualized 2010 revenue of $17.6 billion, and EVA that improved from first six months’ 2010 annualized -$822 million to first six months’ 2011 annualized -$385 million, using a 9% weighted average cost of capital.

Whether to invest in Goodyear is a difficult call. Based on past performance, it looks like this company is a financial mess. However, if future forecasts are accurate, the stock is trading at a huge discount to its value -- giving investors a margin of error. Thanks to its track record of beating quarterly expectations, I'd give the edge to Goodyear's bullish case.

Nucor Could Build Your Portfolio

S&P recently published a report on second quarter 2011 earnings. It found eight companies that reported earnings growth that was higher than 200%. Among those was steel-maker, Nucor (NYSE: NUE), that reported second quarter earnings that rose 224%. That earnings growth was driven a 21% rise in average selling price per ton — although that’s expected to moderate.

Is this spectacular performance enough to make you invest in its stock? Here are three reasons to consider it:

• Low valuation. Nucor trades at a Price-Earnings-to-Growth ratio of 0.59 -- 1.0 is fair value – a P/E of 22.4 on earnings forecast to grow 38% to $3.68 in 2012.
• Decent earnings reports. Nucor has been able beat analyst’s expectations fairly consistently and has done so in four of its past five earnings reports.

Two negatives:

• Increasing sales but plunging profits and more debt-laden balance sheet. Nucor has been increasing sales while profits declined. Its revenue has increased at a 1.7% annual rate from $14.8 billion (2006) to $15.8 billion (2010) while its net income dropped at a 47.8% rate from $1.8 billion (2006) to $134 million (2010) — yielding a very low1% net profit margin. Its debt has been rising faster than its cash. Specifically, its long term debt increased at a 47% annual rate from $922 million (2006) to $4.3 billion (2010) while its cash rose at a 3.3% annual rate from $2.2 billion (2006) to $2.5 billion (2010).
• Under-earning its cost of capital but getting better. Nucor is earning less than its cost of capital – but it’s getting better. How so? It’s producing positive EVA Momentum, which measures the change in “economic value added” (essentially, after-tax operating profit after deducting capital costs) divided by sales. In the first half of 2011, Nucor's EVA momentum was 5%, based on first six months’ annualized 2010 revenue of $15.7 billion, and EVA that improved from first six months’ 2010 annualized -$2.1 million to first six months’ 2011 annualized -$1.4 million, using a 10% weighted average cost of capital.

The big question for investors is whether Nucor's turnaround in the second quarter will last. Since the company has already warned that price increases might slow down, it would be better to see what happens when it reports third quarter earnings before buying this stock.

Lockheed Martin Can Defend Your Net Worth

Lockheed Martin (NYSE: LMT) has rapidly risen to the be one of the top dogs in the terrorism industrial complex (TIC) -- the industry of helping government stop terrorism. But can buying its stock protect your portfolio?

It's hard to figure how big the TIC is, but one source estimates that by 2014 the Department of Homeland Security (DHS) will spend $85 billion -- mostly on information technology -- to protect against terrorism.

As I wrote, one of TIC's biggest players is Lockheed whose stock is up 87% in the last decade. It has scaled the ranks of DHS contract winners in the last few years. In 2005 it ranked 13th on a list of the Top 20 DHS contractors. By 2009, Lockheed had climbed to second place on that list, thanks to its big IT support presence at DHS headquarters.

But is that enough of a reason to add Lockheed to your portfolio? Here are four reasons to consider doing so:

• Low valuation. Lockheed's price-to-earnings-to-growth ratio of 0.59 (where a PEG of 1.0 is considered fairly priced) means its stock price is cheap. It currently has a P/E of 9.4, and its earnings per share are expected to grow 15.8% to $8.72 in 2012.
• Decent earnings reports. Lockheed has been able beat analyst’s expectations fairly consistently and has done so in four of its past five earnings reports.
• Increasing sales and profits -- and decent balance sheet. Lockheed has been increasing sales and profits. Its revenue has increased at a 3.7% annual rate from $39.6 billion (2006) to $45.8 billion (2010) while its net income has increased at a 1.9% rate from $2.5 billion (2006) to $2.7 billion (2010) — yielding a slim 6% net profit margin. Its cash has grown faster than its debt. Specifically, its cash rose at a 5% annual rate from $2.3 billion (2006) to $2.8 billion (2010) while its long term debt increased at a 3.3% annual rate from $4.4 billion (2006) to $5 billion (2010).
• Out-earning its cost of capital. Lockheed is earning more than its cost of capital – but it’s making limited progress. How so? It’s producing no EVA Momentum, which measures the change in “economic value added” (essentially, after-tax operating profit after deducting capital costs) divided by sales. In the first half of 2011, Lockheed's EVA momentum was 0%, based on first six months’ annualized 2010 revenue of $43.2 billion, and EVA that rose from first six months’ 2010 annualized $546 million to first six months’ 2011 annualized $665 million, using an 8% weighted average cost of capital.

This company looks like a winner to me -- thanks to its low valuation and strong financial performance. But with the broader market plunging, it may pay to wait to pick this one up at an even lower price.