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Can You Identify the Turnaround Stock?

The following four stocks have been down and out for quite some time. Which one is the most likely turnaround stock candidate?

Magnifying Glass Financial Report Stock

Will it be Chipotle Mexican Grill (CMG), GameStop (GME), Target (TGT) or Whole Foods Market (WFM)? One of these stocks has been recommended by three Cabot analysts as a potential turnaround stock, and your challenge today is to guess which one it is—or better yet, don’t guess. Read my clues and decide for yourself!

A good turnaround stock, for the record, needs capable management in place with a good plan for reversing a decline in business. The turnaround needs to rekindle confidence among both customers and investors. It needs to revive revenue growth. And above all, it needs to spark real earnings growth.

So take a look. Which of these stocks is the best turnaround candidate?

Potential Turnaround Stock #1: Chipotle Mexican Grill (CMG)

Chipotle operates fast-casual Mexican restaurants that use as much fresh and organic food as possible, and I love their food, as do many other hungry Americans. But Chipotle’s last good year was 2014, when revenues grew 28% and earnings surged 40% to $14.13 per share.

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2015 started off on the same great growth track, but disaster struck in the second half, as outbreaks of E.coli, norovirus and Salmonella at the company’s restaurants scared off customers.

Revenues in 2016 fell 13% to $3.9 billion, but earnings were hit even worse, as the company scrambled to implement safer procedures for food preparation. Earnings plummeted to $1.32 per share, and the after-tax profit margin, which had frequently exceeded 10% (excellent for a restaurant chain), fell to about 2%.

By late 2016, CMG stock had lost 53% of its value!

2016 was a rough year for Chipotle (CMG). But now it's starting to look like a turnaround stock.

Today, the stock has recovered a third of that drop, but what about business? The company’s new systems are all in place, and no one has gotten sick, so that’s good. Also, the customers are coming back, but slowly.

The first sign of recovery came in the fourth quarter of 2016, when revenues were up 4% from the year before. But earnings were still suffering. As I write, the stock’s current price/earnings ratio is a sky-high 350, though if you look forward to analysts’ expected earnings of $8.15 per share this year, that price/earnings ratio drops to a more reasonable 57. (Note: First quarter earnings are due tomorrow.)

As the smallest company of these four companies as measured by revenues (and the only stock that doesn’t pay a dividend), Chipotle has the potential to grow the fastest. But does management have what it takes to make that happen?

Is Chipotle on the way to becoming a successful turnaround stock?

Potential Turnaround Stock #2: GameStop (GME)

GameStop is a bricks-and-mortar retailer of video games that has seen its revenue growth stagnate over the past decade, as customers turned to online vendors for their gaming needs. Revenue at the company peaked at $9.6 billion in fiscal 2010. Five years later, it was $8.6 billion, not a good trend.

But earnings have held up better, as management has diligently cut costs at the company’s 7,000 stores while expanding into more profitable online ventures. GameStop bought the online gaming site Kongregate in 2010, acquired ThinkGeek, a leading online seller of collectibles, in 2015, and has bought up various technology chain stores like AT&T, Cricket, Spring Mobile and Simply Mac, which primarily sell smartphones and other devices.

The turnaround plan, therefore, is fairly clear. Trouble is, the shrinkage at the bricks-and-mortar stores continues to outpace the growth at the online properties. In the quarter ended March 31, revenues were down 14% from the year before to $3.1 billion, while earnings were flat at $2.38 per share.

As for the stock, all that bad news has taken its toll; by late last year, the stock had fallen 65% from its 2013 high.

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But then there’s the dividend. GameStop has long been a cash flow machine, and management is currently steering a lot of that cash straight to shareholders. At the current low stock price, GME yields a whopping 6.6% annually.

Furthermore, the fact that earnings have held up pretty well means that GameStop has a current price/earnings ratio of 5. And that’s worth noting! It’s very rare for a company’s dividend yield to exceed its price/earning ratio. (Of course, if revenue doesn’t turn around soon, GameStop will have to cut the dividend, and that will send shareholders running for the hills.)

As the smallest of these four companies as measured by market cap, GameStop has the potential to see its stock rebound quickly. But does management have what it takes to make that happen?

Will GameStop be a successful turnaround stock?

Potential Turnaround Stock #3: Target (TGT)

Second only to Walmart (WMT) in the discount store business (as measured by revenue), Target is the biggest of these four companies, with revenues of nearly $70 million coming from more than 1,800 stores. Trouble is, revenues are now declining.

While all similar bricks-and-mortar retailers are under pressure from competition by Amazon (AMZN) and other online retailers, a substantial portion of Target’s revenue shrinkage can be traced to the company’s progressive bathroom policy that was announced in April 2016 that sparked boycotts from conservative groups.

Management has since responded by adding a third, private single-stall locking bathroom to many of its stores, but as I write, revenues show five consecutive quarters of decline vs. year-earlier figures.

Profit margins have been steady in the 4% range; the company’s current price/earnings ratio is a reasonable 11; and the dividend is a solid 4.5%, but if revenues don’t turn up soon, the stock …

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… which is already down 37%, could fall even lower.

As the biggest of the four companies, TGT has the most to lose. And given that management has already taken steps to repair its missteps on bathroom policy, it seems that something else is needed to get revenues growing again. But does management have what it takes?

Will TGT stock be a successful turnaround stock?

Potential Turnaround Stock #4: Whole Foods Market (WFM)

With 469 stores in the U.S., Canada and the U.K., Whole Foods is the largest vendor of organic food in the world. By opening new stores and constantly refining its sourcing and merchandising formulas, the store has grown revenues every year of the past decade.

As to earnings, the same was true until 2016, when slowing revenue growth and shrinking profit margins (down from 4.0% to 2.5%) saw earnings fall for three consecutive quarters compared to the year before. Adding insult to injury, now analysts are projecting that earnings will fall further in 2017 before flattening out in 2018.

So what’s the trouble? In short, competition. There’s nothing proprietary about Whole Foods’ business, so competitors who can supply the same goods at lower cost are finding eager customers.

And shareholders have been jumping ship as well.

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From its high in 2013, WFM fell 58% to its low last fall. But that was really just the lowest in a series of lows that stretched back a year—and formed a long solid bottom. And in early April, that base turned into a launching pad, when a private investment firm announced it had acquired 8.8% of Whole Foods stock on the open market over the previous 60 days.

This brief blastoff has retraced 20% of the stock’s loss, but it has a long way to go. In the meantime, the stock pays a solid dividend of 1.6% and the stock’s price/earnings ratio is 24.

Will Whole Foods be a successful turnaround stock?

Time will tell.

In the meantime, if you’d like to know which one of these four potential turnaround stocks has been recommended by three other Cabot analysts, your best bet is to become a regular reader of my Cabot Stock of the Week, where I recommend one high-potential stock every week. I recommended one of the above just a few weeks ago and I’d like you to join my profit-making readers. Click here to subscribe.

The sooner you start, the better.

And if you don’t want to wait for the name of the turnaround stock, send me an email and I will give it to you.
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Timothy Lutts is Chairman and Chief Investment Strategist of Cabot Wealth Network, leading a dedicated team of professionals who serve individual investors with high-quality investment advice based on time-tested Cabot systems.