It pays to be skeptical of growth stocks that rely too heavily on acquisitions. That’s because the buyer of something rarely knows as much about it as the seller. So it follows that if a company makes enough acquisitions, it might eventually buy something that has hidden problems. At some point, those problems will come out into the open and hurt the buyer’s earnings.

Big acquisitions can mean big debts for growth stocks

Acquisitions, particularly big ones, can also push up debt, which leaves the buyer vulnerable to failure if it can’t meet the payments. They can also load the buyer’s balance sheet with goodwill, an intangible asset whose value can drop overnight if it turns out that the company made a bad acquisition. In that case the company has to write off all or part of the acquisition’s cost against current earnings. This can wipe out a year’s earnings for the growth stock and devastate its share price.

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Many companies have cut their spending on information technology while they wait for the economy to start growing again. At the same time, consumers are buying less computer equipment as job losses push up the unemployment rate and erode confidence. Still, we feel that high-quality junior tech stocks have a bright long-term outlook. Despite the recession, the best of them remain profitable, and they’ll benefit further from pent-up demand as the economy recovers.

Cyberplex: An “Internet survivor”

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When Inner Circle members ask us about specific investments and growth stock picks they’re considering buying or selling, we start by putting all the important information we know about a company into perspective. That new invention may be a marvel, but how does it compare to what the competition is doing? The new project sounds impressive, but how much impact will it really have on the company’s profit? The debt sounds high — will the company be able to keep up its agreed-upon interest and principal repayments? Investors intuitively understand this, but they often find it hard to apply when they are looking for strong growth stock picks. You can tackle the job with financial ratios, but the answers you get can be ambiguous, if not misleading.

Financial ratios can mislead

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H&R BLOCK INC. $17 (New York symbol HRB; Conservative Growth Portfolio, Finance sector; Shares outstanding: 334.1 million; Market cap: $5.7 billion; Price-to-sales ratio: 1.4; WSSF Rating: Above Average) is the world’s largest provider of income-tax-preparation services. It operates 12,923 offices in the U.S., as well as 1,193 in Canada and 378 in Australia. Franchisees own 34% of H&R Block’s U.S. tax-preparation offices. The tax-services division accounts for 74% of the company’s revenue. The company gets 22% of its revenue by selling tax-consulting and accounting services to businesses though subsidiary RSM McGladrey Inc. The remaining 4% comes from banking services, including chequing accounts, loans and credit cards that H&R Block issues to its tax-preparation clients. H&R Block’s earnings fell from $1.88 a share (or a total of $635.9 million) in 2005 to $1.15 a share (or $374.3 million) in 2007. (H&R Block’s fiscal year ends April 30.) The drop was mainly caused by losses at its Option One subsidiary, which specialized in subprime mortgages to H&R Block’s tax clients and other borrowers. In 2008, the company sold Option One, along with its brokerage and wealth-management subsidiary, as part of its plan to focus on its more profitable tax and accounting operations. These moves helped H&R Block’s earnings improve to $1.53 a share (or $513.1 million) in fiscal 2009. The company’s revenue rose from $4.4 billion in 2005 to $4.9 billion in 2006, but dropped to $4.0 billion in 2007. It recovered to $4.4 billion in 2008, but fell to $4.1 billion in 2009....

FPL GROUP INC. $57 (New York symbol FPL; Conservative Growth Portfolio, Utilities sector; Shares outstanding: 410.8 million; Market cap: $23.4 billion; Price-to-sales ratio: 1.4; WSSF Rating: Average) gets 70% of its revenue from wholly owned Florida Power and Light Co., a regulated utility with 4.5 million customers in eastern and southern Florida. FPL Group is also a leading producer of wind power. Its NextEra Energy Resources, subsidiary accounts for 25% of the U.S.’s wind-power capacity. NextEra also operates unregulated electrical-power plants in 25 states and Canada. It sells its power to wholesale customers, not individuals. In the three months ended June 30, 2009, FPL Group’s earnings rose 6.9%, to $400 million, or $0.99 a share, from $375 million, These figures do not include a charge the company incurred for losses on the hedging contracts it uses to lock in the price of fuel. FPL Group’s revenue rose 6.3%, to $3.8 billion from $3.6 billion. NextEra started up a number of new wind-power projects during the quarter; this increased its windpower capacity by 9%, and helped push up its earnings by $48 million. The new projects helped offset lower power output at its existing facilities due to lighter-than-normal winds. NextEra’s revenue rose 37.4% in the quarter....

THE BOEING CO. $43 (New York symbol BA; Conservative Growth Portfolio, Manufacturing & Industry sector; Shares outstanding: 726.4 million; Market cap: $31.2 billion; Price-to-sales ratio: 0.5; WSSF Rating: Above Average) is focusing on improving the fuel-efficiency of its passenger jets. That should help it increase sales to cost-conscious airlines. Boeing’s new 787 Dreamliner plane uses lightweight materials, like titanium and carbon fibre. That makes it 20% more fuel-efficient than current planes. The 787 also features new energy-efficient interior lighting systems, which will lower its operating costs further. However, Boeing had to delay the initial test flight last June because it found structural weakness where the plane’s wings connect to the body. The company feels it can fix this without redesigning the plane, and hopes to resume testing in the next few months. Despite this setback, Boeing still has 851 orders for the 787. These are worth around $151 billion....

TOYOTA MOTOR CO. ADRs $83 (New York symbol TM; Conservative Growth Portfolio, Manufacturing & Industry sector; ADRs outstanding: 1.6 billion; Market cap: $132.8 billion; Price-to-sales ratio: 0.6; WSSF Rating: Above Average) recently overtook General Motors as the world’s largest carmaker. That was partly due to its success with gasoline-electric hybrid cars. Toyota started selling its Prius mid-sized hybrid car in 1997, and now dominates this market. Besides the Prius, the company has launched hybrid versions of its larger cars and trucks. Hybrids account for less than 10% of Toyota’s sales, but they generate much higher profit margins than its gasoline-powered cars. The company owns patents on over 2,000 hybrid-engine parts. That makes it difficult for other carmakers to develop their own hybrids. As a result, many have licensed the technology from Toyota. This generates royalty income for the company. For example, Japanese carmaker Subaru (16% owned by Toyota), uses Toyota’s hybrid technology, and the company may be close to a deal with Mazda, as well. However, Nissan plans to end its deal with Toyota and develop its own systems....

GENERAL ELECTRIC CO. $12 (New York symbol GE; Conservative Growth Portfolio, Manufacturing & Industry sector; Shares outstanding: 10.6 billion; Market cap: $127.2 billion; Price-to-sales ratio: 0.8; WSSF Rating: Above Average) is one of the world’s largest makers of industrial equipment. Products include aircraft engines, medical-imaging scanners and locomotives. GE is also a major supplier of electrical infrastructure equipment, such as turbines, voltage regulators and fuses. These accounted for 21% of its 2008 revenue, and 23% of its profit. Moreover, as a leading maker of windmills and nuclear-power plants, GE is in a good position to profit from new environmental rules that limit greenhouse-gas emissions. In the three months ended June 30, 2009, GE’s revenue fell 16.6%, to $39.1 billion from $46.8 billion a year earlier. Revenue fell 29% at GE Capital, the company’s struggling finance business, but just 7% at its industrial operations. Earnings fell 48.4%, to $2.9 billion, or $0.26 a share, from $5.6 billion, or $0.54 a share....

ABB LTD. ADRs $17 (New York symbol ABB; Conservative Growth Portfolio, Manufacturing & Industry sector; ADRs outstanding: 2.3 billion; Market cap: $39.1 billion; Price-to-sales ratio: 1.2; WSSF Rating: Above Average) is a Swiss-based maker of transformers, transmission switches and other electricity-infrastructure equipment. In the three months ended June 30, 2009, ABB earned $728 million, or $0.29 per ADR. (Each American Depositary Receipt represents one ABB common share.) This figure included $120 million in restructuring costs. ABB aims to save a total of $2 billion a year by the end of 2010 by cutting an unspecified number of jobs, closing plants and buying more raw materials from low-cost countries. In the year-earlier quarter, ABB earned $1.1 billion, or $0.43 per ADR. Revenue fell 12.3%, to $7.9 billion from $9 billion. ABB holds cash of $8.1 billion, or roughly $3.55 per ADR. Its $2.1-billion long-term debt is just 5% of its market cap. That gives it plenty of flexibility to buy other related companies. In light of the recession, ABB could find some bargains. It’s particularly interested in China, where spreading industrialization has lifted demand for its products....

SUPERVALU INC. $14 (New York symbol SVU, Conservative Growth Portfolio, Consumer sector; Shares outstanding: 230 million; Market cap: $3.2 billion; Price-to-sales ratio: 0.1; WSSF Rating: Average) is the second-largest supermarket operator in the U.S. behind Kroger. Its 2,500 stores account for roughly 78% of its revenue. The remaining 22% comes from its food wholesale operations, which supply its own stores as well as more than 2,500 other grocery retailers. In its first fiscal quarter, which ended June 20, 2009, Supervalu earned $113 million, or $0.53 a share. That’s down 30.3% from $162 million, or $0.76 a share, a year earlier. Sales fell 4.7%, to $12.7 billion from $13.3 billion. Supervalu has been forced to lower its selling prices because of intense competition with large discount retailers like Wal-Mart. This has hurt its sales and profit margins. Separately, Supervalu will sell 36 of its stores in Utah. The company will realize a $150-million gain from the deal when it closes later this year. The company will probably earn $2.10 a share this year, and the stock trades at 6.7 times that estimate. The $0.70 dividend yields 5.0%....