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Friday, July 23, 1999

An Investment Opinion
by Warren Gump

Swooshing Into a Rebound

As a value-oriented investor, I spend a good deal of time sifting through companies that are among the biggest stock market losers over a period of time. While this probably sounds counterintuitive to many people, it can actually be quite profitable if I'm able to stumble upon good companies that have fallen on hard times.

Quite often, investors become overly pessimistic about the long-term prospects of a company when short-term problems are being encountered. If the challenges facing the company disappear or are addressed by management, the stock price can rebound sharply as investors reevaluate their outlook. Executing this type of strategy, however, requires extraordinary patience since the timing of when a turnaround will occur is virtually impossible to predict.

Another drawback to investing in a company in the midst of upheaval and uncertainty is that there can never be a guarantee that the firm will actually rebound from its spiral. This risk causes many people to shy away from a "fallen angel" investment strategy. CBRL Group (Nasdaq: CBRL), the operator of Cracker Barrel and Logan's Roadhouse, demonstrates the pitfalls of putting your money in a faltering horse. I wrote about the company in a column at the beginning of the year, noting how it had hit hard times, but was trying to regain its footing.

At the time of that article, CBRL management had projected flat to slightly increased profits for fiscal 1999, which ends next week. Over the past six months, however, CBRL has come out not once, but twice, to further reduce earnings expectations. In February, the company announced that it foresaw earnings per share (EPS) declining to $1.35-$1.45. That estimate was reduced earlier this week, with this year's per-share profit projected to be $1.16-$1.20, about 29% below results from last year. That's a darn far cry from the flat to slightly rising projection forecast at the beginning of the year. Not surprisingly, CBRL stock is now trading for $16, well shy of the $23 5/16 it was trading for on December 31.

Being a CBRL shareholder, I am quite disappointed with developments over the past six months. Nonetheless, I am sticking with the investment due to my belief that the company has a couple of terrific brands that can ultimately continue to grow and generate lots of cash. That being said, it is understandable why so many people wouldn't want to get near CBRL stock today. With expectations ratcheted down each of the past three quarters, a rational trend-follower will be braced for additional reductions. What's to stop the current $1.34 earnings estimate for fiscal 2000 from being knocked down to less than $1.00?

Successful implementation of operational changes will hopefully stop the slide, but until the company can release information suggesting that positive results are forthcoming, investors will be justifiably dubious about any projections. When good news comes, the stock will likely start a fairly sharp ascent from its beaten down levels. Unfortunately, its difficult to tell whether the ultimate bottom from which a rise will start is $16 in a couple of months or $10 three years from now. I hope that the former is closer to the truth, but no guarantees can be given, particularly with CBRL's recent track record.

Many people don't like the idea of investing in a stock with a higher-than-normal chance of seeing a near-term precipitous fall. For that reason, they approach beaten-down stocks in a slightly different manner. Instead of buying shares when bad news is still being reported, this investor waits until a turnaround is in progress. Holding off for positive developments -- say a couple of quarters of earnings or sales growth -- invariably means that an investor won't get in at a stock price's low. An equity security will often have risen 20% - 50% or more from its bottom by the time a recovery is obvious. Nonetheless, a sustained rebound can lead to considerable further gains. Boarding a stock when it's a "rebounding angel" can be quite a profitable endeavor.

I strive to mix "fallen angels" and "rebounding angels" in the value part of my portfolio. Although the tremendous potential gains from investing in a good company when no one else will touch it are alluring, the pitfalls of possibly getting in too early and experiencing a swift cut in value can be quite painful. To balance this risk out, I don't mind paying more for some companies that are already showing that things are on the mend. These companies can always see operations deteriorate once again, but the risk is much lower than with a company that is already in a free-fall.

One stock that has the glimmer of my eye as a potential rebounding superstar is Nike (NYSE: NKE), the athletic shoe and apparel giant. This stock was riding high earlier in the decade, but hit a bump in late 1997. After earning $2.68 per share in the fiscal year that ended in May 1997, earnings plunged to $1.62 in 1998 due to a slowdown in the U.S. market that was exacerbated by a decline in some sales to Asian markets.

Although the company originally expected a relatively quick international rebound, last year's worldwide economic turmoil derailed those forecasts. As a result of that and continued sluggishness in the U.S. market, earnings fell substantially in the first two quarters of fiscal 1999. In the latter half of the fiscal year, however, Nike earnings began improving on a year-over-year basis because of easy comparisons, strong cost-cutting efforts, and stabilization in some markets. When the final tally was reported, Nike's annual EPS number was once again $1.62 in fiscal 1999. A flat earnings comparison usually doesn't result in shouts of jubilation, but the number was actually pretty good considering that the company was down 40% at half-time.

The billion dollar question is will the turnaround continue and lead to sustainable earnings growth? The near-term outlook seems encouraging. Future orders, commitments for delivery over the next six months, increased 4% on a worldwide basis for the first time in quite a while last quarter. Although that's not a big rise, it's a far cry from the 4% decrease reported three months ago.

In addition, reduced selling of clearance items and lower operating expenses resulting from a business realignment should improve margins. Wall Street analysts also seem to believe the turnaround is real, with earnings projected to hit $2.01 in fiscal 2000 and $2.45 in fiscal 2001. While those numbers are still below 1997's banner year, they are a noticeable improvement over last year's results.

Since the nadir of Nike operations was hit months ago, the stock has moved substantially. Last September, the stock could be picked up for $31 per share, a huge discount to the $55 3/8 close today. Despite this surge, an investor today faces a markedly reduced risk that profits will deteriorate or the company will announce more bad news. Instead of fretting about whether the company will meet estimates, most analysts and investors are likely trying to guess by how much Nike will beat current projections. That more attractive psychological perspective is one of the prime benefits of investing in a rebounding angel.

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