Monday - January 16, 2006

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Even with sales figures declining at a faster pace than expected in late 2005, construction companies themselves have held up rather well. We spoke with senior homebuilding analyst Mario Ricchio for his perspective on whether or not investors can expect this to continue into the next quarter or two, or if real change is on the way for the industry.

We keep hearing about a slowdown in construction, but many companies in the industry continue performing well. What do you make of this?

The outperformance in construction emanates within the public sector of the U.S. economy, not the private sector. I would call it a bifurcated industry. On the one hand, the private sector is weakening somewhat amid a deceleration in homebuilding activity.

On the other hand, companies exposed to public spending are still doing well. The U.S. federal government plans to increase expenditures on construction-related activities such as highway and road projects. In late 2005, President Bush signed a six-year highway bill worth approximately $286 billion intended to modernize the U.S. transportation system.

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Zacks Equity Research continued...

The construction companies expected to benefit from the bill are public contractors and publicly traded construction equipment companies. A couple good examples are Caterpillar (CAT) and Terex (TEX). The construction industry is also getting a short-term boost from the government’s rebuilding efforts to repair the damage done by Hurricanes Katrina and Rita. New home sales fell 11% last November. Should investors take this as a warning sign?

New home sales have been running at an annual pace of 1.8 million units. Investors should realize that, historically, these levels have correlated with peak residential construction activity. In this context, a retreat in home sales would not surprise us. The November figure came in worse than expected — down 11%. Investors should take this as a warning sign that high single-digit growth has come and gone. We believe new home sales have entered a period of 2%-5% annual growth, with a minor risk of a protracted cyclical downturn. What can construction companies do to help keep their profits high?

The homebuilders must use their scale to squeeze suppliers further on cost. In 2005, D.R. Horton saved more than $2,500 per unit due to economies of scale in purchasing land, materials, and labor (subcontractors). Lower costs are a means to boost profitability. Also, homebuilders would do well to sell more homes to the active-adult segment (age 55 and over). In general, selling to Baby Boomers entails greater pricing power and lower incentive use—both are important for keeping profits high.

Some construction analysts are predicting volatility in the new year. Do you concur?

After the huge run-up in house prices seen in major metro markets such as San Francisco, San Diego, Miami, Boston, and Manhattan, we would expect volatility in new and existing home sales as buyers wait on better prices. Buyers have begun to balk at higher prices. This is evident in the increasing inventory of homes unsold. If prices do moderate or decline slightly, sales to the first-time homebuyer are expected to bounce back. The timing is tricky, though, which explains why so many analysts expect volatility in the data from month to month.

What Buy and/or Sell recommendations would you make for us today?

Currently, I do not have any Buy or Sell recommendations among the large homebuilders. The builder stocks should consolidate as P/E multiples contract to reflect the future deceleration in residential housing activity and lower EPS growth.

As an indirect way to play the construction boom for roads and highways, I would recommend purchasing shares of Terex (TEX). The company should achieve 15% annual growth for at least the next couple years. The stock looks cheap, too, trading at a discount to peers.

Finally, what else should investors make sure to keep in mind about construction going forward?

Investors should pay attention to the level of interest rates. With home affordability measures declining, a sharp rise in borrowing costs would price out many more entry-level buyers. This would have negative implications for shareholders of D.R. Horton (DHI), Centex Homes (CTX), and KB Home (KBH), who cater extensively to the first-time homebuyer.

As for the public construction sector, we would pay attention to the rumblings out of Congress. With the U.S. federal deficit exploding, the president may be forced to rein in spending. The future level of expenditures on highways, roads and bridges could very well change.

Mario Ricchio is a senior analyst covering homebuilding and related construction industries for Zacks Equity Research.

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MORE FROM ZACKS EQUITY RESEARCH…

BULL OF THE DAY

Altera Corp. (ALTR) - Attractive Long-Term Valuation. For full Zacks research report, click here.

 
BEAR OF THE DAY

Cabot Microelectronics (CCMP) - No Clear Outlook. For full Zacks research report, click here.

 
ZACKS INDUSTRY OUTLOOK

Air Freighters Deliver

Pickup in global economy causes increase in demand for shipping. More...

 
EARNINGS & SECTOR UPDATE

Earnings growth expected to continue in 2007

The median firm in the S&P 500 is expected to grow by 12.4% in 2007, or roughly the same rate that is expected for 2006. More...

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Zacks.com is proud to share with you some of the best trading strategies that truly allow you to Profit from the Pros. Today we highlight...
 

Profit Tracks: Low Price Stocks

Many investors prefer stocks priced below $20 because the low prices allow them to accumulate more shares. Fortunately, lower prices do not necessarily mean lower quality.

This strategy identifies stocks priced below $20 that are trading at discount valuations and have a Zacks Rank of #1 ("Strong Buy") or #2 ("Buy"). The stocks identified by this search strategy trade at price-to-sales (P/S) multiples of 1.0 or below. The strong Zacks Rank is indicative of positive revisions in earnings estimates.

Combining these characteristics can result in high-dollar returns. In 2004, this strategy generated a stellar +54.8% return. Equally impressive, the strategy has a win ratio of nearly 75% for the past 4-1/2 years.

 
Here are four stocks that make the grade for the Low Price Stocks Profit Track:

AEGON N.V. (AEG), an insurance company, reported third-quarter earnings of 39 cents per share in early November. The result outperformed the year ago level. The company stated that in the U.S. there were notable increases in life sales to institutional clients as well as in AEGON's variable annuity business sold to individuals. The stock is currently trading around $16.00 per share, with a price-to-sales ratio of 0.36. AEG has earned $1.80 per share over the past 12 months. Continue your research on AEG at: http://at.zacks.com/?id=2254.

Mesa Air Group, Inc. (MESA) announced its fiscal fourth-quarter financial results in mid-November. Earnings per share were ahead of analysts’ expectations by nearly 17% and surpassed the prior year’s performance. Total operating revenues increased 18.9% year-over-year. The stock is currently trading around $11.50 per share, with a price-to-sales ratio of 0.29. The company has earned $1.30 per share over the past 12 months. Continue your research on MESA at: http://at.zacks.com/?id=2255.

Movado Group Inc. (MOV), a designer, manufacturer and distributor of quality watches, released fiscal third-quarter earnings in early December. Earnings per share of 54 cents topped the year ago total of 44 cents and exceeded the consensus estimate by 15%. Net sales increased 11.6% year-over-year. Comparable store sales increased 10.6% at the Company's Movado boutiques versus a 12.8% gain achieved last year. The stock is trading at nearly $19.00 per share, with a price-to-sales ratio of 0.75. The company has earned $1.19 per share over the past 12 months. Continue your research on MOV at: http://at.zacks.com/?id=2256.

Rex Stores Corp. (RSC) is a specialty retailer of consumer electronic products and appliances as well as a Zacks #1 Rank (Strong Buy) stock. The company recently announced that its merchandise sales for the fiscal 2005 fourth quarter-to-date through January 1, 2006 rose approximately 3.5% over the previous year’s result. Comparable store sales quarter-to-date rose approximately 7.5%. RSC, which has a price-to-sales ratio of 0.39, delivered solid fiscal third-quarter earnings per share that more than doubled the year ago performance. The earnings, which were reported in late November, also jumped ahead of the consensus estimate by about 20%. RSC’s shares currently trade around the $15.00 level and the company has realized earnings of $2.15 per share over the past 12 months. Continue your research on RSC at: http://at.zacks.com/?id=2257.

To see the full list of stocks that currently pass this winning screen, go to: http://at.zacks.com/?id=2258.

All the Profit Track strategies were created and backtested using the Research Wizard software from Zacks Investment Research. If you like this screening strategy, but want to narrow down the list of stocks and even improve the performance, then you should start a free trial to this powerful stock picking tool. Learn more about the Research Wizard free trial offer and our new special report “Top 10 Stock Screening Strategies” at: http://at.zacks.com/?id=2307

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SCREEN OF THE WEEK

Increasing Cash Flows

Kevin Matras looks at Cash Flows (and increasing Cash Flows) for a winning stock picking strategy: http://at.zacks.com/?id=2259.
 

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Every day on Zacks.com we highlight four Zacks Rank Buy stocks. Each individual stock is chosen based on how well they match the criteria for the four main schools of investing: Aggressive Growth, Momentum, Growth & Income and Value.
 

Aggressive Growth – Alpharma, Inc. (ALO)

Alpharma, Inc. (ALO) is enjoying substantial stock price gains due to new molecules and rising estimates. Read the full analysis on ALO at : http://at.zacks.com/?id=2510.
 

Growth & Income – Chesapeake Energy Corporation (CHK)

By exceeding analyst expectations for 13 consecutive quarters, coupled with production growth at or near the top of the industry for several years running, Chesapeake Energy Corporation (CHK) was one of four Growth & Income Zacks Rank Buy Stocks featured last week. Read the full analysis on CHK at: http://at.zacks.com/?id=2511.

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Zacks Rank continued...

Momentum – Papa John’s (PZZA)

After a season of turkey, American appetites turn to simpler fare, such as pizza. Investor appetites have been focused on Papa John’s (PZZA) for a long time now, as the stock has set new 52-week highs every trading session of 2006. In addition, analysts following PZZA have been revising their forecasts for 2005 and 2006 earnings upwards over the past 30 days. Read the full analysis on PZZA at: http://at.zacks.com/?id=2512.
 

Value – FedEx Corporation (FDX)

A recent increase in its EPS guidance for fiscal 2006 and increased capacity to some of the fastest growing economies in Europe and Asia made FedEx Corporation (FDX) one of four Value Zacks Rank Buy Stocks featured last week. Read the full analysis on FDX at: http://at.zacks.com/?id=2513.
 

Zacks Rank Resources

• View All Zacks #1 Rank stocks: Go to: http://at.zacks.com/?id=2266.
   
• Free Zacks Rank Guide: Learn how to use the Zacks Rank to pick more profitable stocks. Get the guide: http://at.zacks.com/?id=2267.
   
• Zacks Advisor: Discover Ben Zacks' hand picked #1 Rank stocks on his Timely Buys list at: http://at.zacks.com/?id=2538.
   
• Zacks Wealth Management: Own all the Zacks #1 Ranked stocks in a portfolio managed by Zacks. Learn more at: http://at.zacks.com/?id=2539.

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Here we cast the spotlight on a timely Featured Expert commentary that recently appeared on Zacks.com.

 
Richard Moroney, Editor of Dow Theory Forecasts

Over the last two years, the Forecasts has become increasingly attracted to large-capitalization stocks. In 2004 and 2005, companies with market values above $8 billion accounted for 72% of the stocks added to the Buy List or Focus List, up from 34% in 2002 and 2003.

That’s no accident.

From 1998 through most of 2003, smaller stocks tended to have higher Quadrix® scores than larger stocks, and the Forecasts frequently fished in the midcap and small-cap pools. But since late 2003, the average Quadrix Overall score for large-cap stocks has topped that of smaller stocks. The percentage of large-cap stocks with high scores is up. Driving the gain has been a steady improvement in relative valuations over the last two years, along with modest improvement in sales and profit growth.

For 2005, the S&P 500 Index returned 4.9%, versus 12.6% for the S&P MidCap 400 Index and 7.7% for the S&P SmallCap 600 Index. But large-cap stocks didn’t do as badly as the S&P 500’s return suggests; the poor performance of some megacaps weighed down the capitalization weighted index. While the largest 100 stocks in the S&P 500 averaged a 2005 return of 4.5% for the year, the average S&P 500 stock returned 9.4%.

Both the S&P 400 and the S&P 600 have outperformed the S&P 500 in each of the last six years. Since the end of 1999, the small-cap and midcap indexes are up more than 66%, versus a 15% decline for the S&P 500. The median S&P 500 stock gained 43% during that six-year period, versus 78% for the median S&P 400 stock and 91% for the median S&P 600 stock.

Small stocks are projected to deliver higher profit growth over the next year than large stocks, expectations reflected in their valuations. The median S&P 600 component trades at 17.4 times estimated forward earnings, while the median S&P 500 stock has a forward P/E of 16.1. In fact, neither small-cap, midcap, nor largecap stocks appear overly expensive or overly cheap right now.

Richard Moroney and his team are not advising investors to abandon small-caps and run to the big boys, but instead suggesting that large-caps deserve a good, long look this year.

Two of the favorites:

While other oil companies have invested aggressively in new production opportunities, Exxon Mobil (XOM) says it will not take on too many risks or sacrifice profitability to boost production. Case in point: Most competitors plan to accept Venezuela’s demand for higher royalties and more state control over oil projects. But Exxon sold its share of a Venezuelan operating contract to a Spanish rival, making it the only company not to sign a new deal with the South American country.

Oil prices rose 40% in 2005. Exxon’s operating cash flow jumped 42% to more than $50 billion in the 12 months ended September. Yet capital spending rose just 10% to $13.3 billion, well below the increases posted by most of its largest peers.

Exxon management has taken a conservative stance in part because it is not confident oil prices will remain high. Oil fell to $10 a barrel in 1985 following predictions it would reach $100. Futures markets price oil between $60 and $65 per barrel throughout 2006.

L-3 Communications (LLL), a leading maker of military and homeland-security electronics and surveillance gear, expands primarily through acquisitions. Yet management targets 8% to 10% annual revenue growth excluding acquisitions.

Concerns regarding internal growth have weighed on the stock in recent quarters, and L-3 underperformed both the S&P 500 Index and average stock in the aerospace and defense sector in 2005. But considering L-3’s profit momentum, robust cash flow, and attractive valuation, the stock has solid year-ahead capital gains potential.

 
About Richard Moroney’s Dow Theory Forecasts newsletter

Get clear Buy, Hold and, yes, SELL advice from one of the nation’s oldest and most successful investment newsletters. Our in-depth analysis and advice have been helping subscribers weather market volatility since 1946. http://at.zacks.com/?id=2406.

OTHER TOOLS FROM ZACKS

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At the heart of Zacks Investment Research is the Zacks Rank investment philosophy that continues to vastly outperform the market. Our Zacks #1 Ranked (Strong Buys) have produced the following results for investors:

• +33% average annual return since 1988 versus +11.8% for S&P 500
• Outperformed S&P 500 in 16 of the last 17 years
• +43.8% total return from 2000 to 2002 - the worst bear market in over 60 years.
• +18% in 2005 (through September 30)

And just as importantly, the Zacks #5 Rank stocks (Strong Sell) List has alerted investors as to which stocks to dump from Their portfolios to avoid unnecessary losses.

To truly take advantage of the Zacks Rank, you need to first understand how it works. That's why we created the free special report: Zacks Rank Guide: Harnessing the Power of Earnings Estimate Revisions. Download a free copy now to prosper in the years to come by visiting: http://at.zacks.com/?id=2309.

Or view the full list of Zacks #1 Ranked stocks at: http://at.zacks.com/?id=2266.

FREE PORTFOLIO TRACKER

Do you believe that these events affect stock prices?

• Broker Recommendation changes
• Earning Estimate revisions
• Earnings Announcements
• Zacks Rank changes

If you answered yes, then how are you staying on top of these changes for your stocks? If you are one of the 45,000 investors who wake up every morning to the Daily Portfolio Updates emails from Zacks.com, then you are all set. If not, then sign up now to get this vital information sent to you daily and improve your portfolio's performance. Did we mention it's free? Get started now by going to: http://at.zacks.com/?id=2310

We hope you enjoyed this issue of "Profit from the Pros", And we look forward to visiting with you again next week.

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Regards and Happy Investing,

Charles Rotblut, CFA

Senior Market Analyst
Zacks.com

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Disclaimer: Past performance does not guarantee future results. Investors should always research companies and securities before making any investments. Nothing herein should be construed as an offer or solicitation to buy or sell any security.

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