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Merck and United Online are on the casualty list

My quarterly Casualty List contains stocks blasted in the preceding quarter that I think can stage a comeback.

This quarter, I'm featuring UTStarcom Inc. (Nasdsaq: UTSI), Merck & Co. (NYSE: MRK), United Online Inc. (Nasdaq: UNTD) and The Sports Authority Inc. (NYSE: TSA). Each, in my opinion, offers the potential for major gains.

The article you are reading is No. 18 in a series that began in mid-2000. From the time each column was written through Friday Oct. 1, the Casualty Lists have produced an average return of 67 percent.

Fifteen of the previous 17 Casualty Lists have produced a profit and beaten the Standard & Poor's 500 Index. The average return for the S&P 500 (over the various periods) has been 12 percent.

The two lists that have flopped so far are those from the fourth quarter of 2003 and the first quarter of 2004. They are down 17 percent and 18 percent respectively.

Measurement periods range from 3 months for the latest Casualty List to 51 months for the earliest. Performance figures are total returns including dividends. I used daily pricing to measure results for the four most recent lists, weekly pricing for older ones.

Buy on bad news

In the 17 previous Casualty Lists, I recommended a total of 75 stocks. Fifty-four, or 72 percent, have been profitable.

These results support the strategy of buying stocks on bad news. After all, the idea of investing is to buy low and sell high. If you can buy on bad news that's real but temporary, you have the first half of that equation licked.

And that brings us to the latest batch of bad news -- and possible buying opportunities.

UTStarcom, the largest maker of wireless phone equipment in China, dropped 47 percent last quarter. The company's U.S. headquarters is in Alameda, Calif.

For a while, analysts expected UTStarcom to post third-quarter profit of about 50 cents a share. In July the company said that profit actually will be about 34 to 35 cents a share.

In addition, UTStarcom has accounting problems, which contributed to the late filing of its second-quarter financial report.

Merck and Vioxx

Counterbalancing these woes, UTStarcom has shown rapid growth. Sales have risen to almost $2 billion in 2003 from $188 million in 1999. Earnings have grown to $202 million in 2003 from $11.5 million in 1999.

UTStarcom shares sell for only 10 times earnings, 1.5 times book value and 0.83 times revenue. My firm has been buying shares for our more daring clients in the past couple of months. I also own them personally.

Merck declined 30 percent last quarter, mostly on news that the company will recall Vioxx, a painkiller used by many arthritis sufferers.

Based in Whitehouse Station, N.J., Merck is the second largest U.S. drugmaker. On Sept. 30 it said it will withdraw Vioxx, which accounts for about 10 percent of its sales, because its studies show that long-term use of the drug increases the risk of heart attacks and strokes.

Some analysts estimate that Vioxx accounted for as much as 20 percent of Merck's profits. Others guess that the bad news may expose Merck to up to $10 billion in legal costs, including damages and attorneys' fees.

Overstating the problem

I owned Merck shares before this news came out. It seems to me that the 27 percent one-day decline in the stock price on Sept. 30 overstated the severity of the damage. I have been adding to holdings on weakness.

Merck earned a 40 percent return on stockholders' equity last year, and the stock offers a 4.4 percent dividend yield. The company has a long history of successfully finding new drugs. Lately, its pipeline has been relatively bare, but I believe that it will reassert its traditional research prowess.

United Online, of Westlake Village, Calif., stumbled 45 percent in the quarter. The owner of the Juno and NetZero Internet-access services said that second- quarter profits fell to 19 cents a share from 21 cents a year earlier. It also said third-quarter revenue will be below analysts' expectations.

Not so dire

I won't deny that the Internet service provider business is a highly competitive one. Yet I must ask, is a two-cent earnings shortfall really so dire?

United Online is trading at $10.35, after starting the third quarter at $16.71. At its slimmed-down price, it trades for 12 times the past four quarters' earnings, 2.9 times book value (assets minus liabilities per share) and 1.6 times revenue.

The company is debt-free and has swung from losses in 1998 through 2002 to a profit in 2003, with another profit predicted for 2004.

Sports Authority

For my final pick, I'll go with Sports Authority, a sporting goods retailer based in Englewood, Colo., that operates throughout the United States and in Japan.

It has posted a profit six of the past seven years, though earnings have bounced up and down. I was in a Sports Authority store recently and found some items that other local stores didn't have. However, I have to admit the store wasn't crowded.

Its stock took a 35 percent hit last quarter, as second-quarter sales and earnings were well below the levels the company had forecast. The company blamed cool, wet weather -- and weather-related excuses usually make me skeptical.

In this case, however, the stock is so cheap that I would be inclined to nibble. It sells for 12 times earnings, 1.3 times book value and 0.25 times revenue.

Dorfman is a columnist for Bloomberg News.

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