A good way to spot promising stocks is to look where Wall Street isn’t. There are always solid companies out there selling for reasonable valuations, if you know where to look.
Here are three stocks that aren’t on Wall Street’s radar yet: LKQ (NASDAQ:LKQ), GrafTech International (NYSE:EAF), and Ferrari (NYSE:RACE). Whether you’re looking for an interesting value play, or looking for an undiscovered growth story, one of these stocks should pique your interest.
LKQ: There’s growth in vehicle repair parts
When a mechanical repair shop needs a part to fix a broken vehicle, it turns to LKQ — a leading provider of alternative parts for vehicle repair. It doesn’t manufacture parts, but instead, acquires parts directly from independent manufacturers and distributors. Repair shop customers, as well as insurance companies, love LKQ’s ability to source aftermarket products at a steep discount to buying new parts. LKQ is a leader in this market with operations spanning North America and Europe.
Revenue and earnings have grown at a fast clip since the company was founded in 1998. Management has smartly used acquisitions as a way to expand and gain market share. LKQ has grown into a large business with $12.5 billion in revenue and a vast distribution network.
It’s been tough lately, though, to keep revenue growing at the rates investors are used to. A soft economic environment in Europe and lower scrap prices weighed on growth in the last quarter. Management is calling for organic revenue growth (excluding acquisitions) to increase less than 1% this year. However, the focus on improving margins and free cash flow is paying off. Earnings per share jumped 17% last quarter, while operating cash flow soared 85% year over year.
Wall Street has definitely been asleep at the wheel here. The stock has been stuck in a trading range for the past four years despite growth in both revenue and free cash flow. Investors can currently buy the stock for a forward price-to-earnings ratio of 13.7 times next year’s earnings estimates.
GrafTech: A play on electric vehicles
GrafTech is a global-leading supplier of graphite electrodes, an essential component of producing electric arc furnace steel. The company reentered the public markets in 2018 after being taken private in 2015 by Brookfield Asset Management (NYSE: BAM).
As governments around the world focus on more stringent emissions standards, there is a push in the automotive industry to build electric vehicles. There is a lot of investment going toward building charging infrastructure and bringing costs down for electric cars.
One component essential to electric vehicles that is seeing soaring demand is lithium-ion batteries, a market that is estimated to double to $75 billion by 2025. GrafTech stands to benefit enormously from this booming demand.
The company is vertically integrated, which means it also supplies petroleum needle coke — a key ingredient for both graphite electrodes and lithium-ion batteries. This vertically integrated structure provides GrafTech a cost advantage and allows it to sign customers to long-term contracts, providing greater visibility to future profitability.
Besides the demand for lithium-ion batteries, GrafTech is also seeing stronger demand for steel as more countries adopt trade policies that support domestic steel production. Management sees a long-term growth trajectory taking shape as steel production rises and the shift to electric vehicles continue. The company has been expanding capacity to be ready for the demand.
Despite the favorable trends falling in place for the company, the stock is in the bargain bin, trading for a forward PE of just 6.3. The low valuation reflects the cyclical nature of the industry, but the market doesn’t appear to be factoring in a potential upswing in demand if the trends discussed above play out as management expects.
Investors should also be aware that the company is saddled with a high debt burden of slightly over $2 billion. Debt repayment is a priority for management. Over the last year, GrafTech generated $744 million in free cash flow and repaid $153 million of debt.
This is where the long-term contracts are very valuable to GrafTech’s business. These contracts lock in most of GrafTech’s expected production through 2022 at a price that will allow the business to generate profits and lowers the risk of a sudden drop in prices for graphite electrodes.
GrafTech is committed to returning about 50% of 2019 free cash flow to shareholders through dividends and share repurchases. The dividend yield is currently 2.45%.
Ferrari: The stock is just as sexy as the car
Many investors may not realize that the iconic sports car brand is publicly traded. Ferrari is a best-of-breed company in a cutthroat industry. It was spun off from Fiat Chrysler in 2014 and has seen sales and profits steadily march higher over the last five years.
The stock isn’t cheap, so investors may want to keep this one on a watch list before buying. The current valuation is a steep 36 times earnings. As that valuation suggests, Ferrari has more in common with a typical growth stock than a slow-growing car company.
The first thing that jumps out is that Ferrari is really a luxury goods brand. The company selectively licenses the brand for toys, video games, watches, and other luxury goods to reach a wider and younger audience. Ferrari even has branded theme parks, which generate a significant amount of its licensing revenue. Last year, Ferrari brought in $506 million from these licensing activities.
Ferrari generates about three-quarters of its revenue from selling cars. The company has had more consistent sales growth than other luxury car makers primarily because of its brand power and low-volume strategy. In 2018, Ferrari shipped only 9,251 cars, but generated $2.5 billion from these shipments. Doing the math reveals that the average selling price for one of these hot rides was $274,000.
When you have an iconic brand and can sell cars at a price that costs as much as a house, you can generate almost whatever profit margin you want. Ferrari generates an extremely high operating margin for a car manufacturer of 33% on an EBITDA basis. For perspective, Tesla‘s EBITDA margin was 13.8% in the third quarter.
Management continues to push Ferrari’s pricing power, expand the car lineup, and reduce the licensing categories it’s involved in to maintain its brand strength and improve margins. Management is currently calling for revenue to approach $5 billion by 2022, and for adjusted free cash flow to roughly triple to about $1.1 billion to $1.25 billion.
Ferrari is a great brand and a well-run business that doesn’t get a lot of attention compared to other car companies. I would be happy to buy shares on any pullback in the stock price.
