Is This Company About to Fail?

It wasn't that long ago that the credit market was exceptionally tight. In spite of (or perhaps because of) Uncle Sam's help, almost no company that actually needed a loan was able to get one from a private lender at decent rates.

In fact, those that could get money at all were forced to pay outrageous interest for the privilege. General Electric, for instance, is paying Berkshire Hathaway 10% on its preferred shares, and GE had to sweeten the pot with warrants to get its rate that low.

And GE is a profitable industrial titan -- once the world's largest company -- which, even after its downgrade, still sports an impressive AA+ debt rating. When a company like that needed to dilute its shares to get a loan at double-digit rates, you know the credit market was tight. Although it was difficult and expensive, GE could borrow the cash it needed to operate. These days, not everyone is so lucky.

Who's the most at risk?
The credit market remains tricky. And in a tricky credit environment, companies that can't either roll over their debt or pay their debt and operate with what they have, are in danger of going under.

But with the possible exception of law firms that handle bankruptcies, nearly every company is feeling the pain of this economic downturn. So how can you tell whether a company is struggling just like everyone else -- or about to fail?

These three signs should make you sit up and take notice:

  • Substantial debt. Given this credit market, a company with significant debt that it can't pay off is a huge risk for shareholders.
  • Negative tangible book value. This means that a company's total worth is tied up in its brands, its goodwill, and its ability to generate cash, leaving nothing physical to borrow against.
  • Negative earnings. These signal that the company hasn't been able to run its business profitably in recent quarters.

When you put all three of those high-risk signs together, you get companies like these:

Company

Tangible Book Value
(in millions)

TTM Net Income
(in millions)

Total Debt
(in millions)

United Continental Holdings (Nasdaq: UAL  )

($5,172)

($106)

$9,174

SBA Communications (Nasdaq: SBAC  )

($1,036)

($215)

$2,807

Clear Channel Outdoor (NYSE: CCO  )

($276)

($148)

$2,562

AMR (NYSE: AMR  )

($4,904)

($1,219)

$11,497

Level 3 Communications (Nasdaq: LVLT  )

($1,829)

($759)

$6,264

Warner Music Group (NYSE: WMG  )

($2,489)

($115)

$1,936

Hovnanian Enterprises (NYSE: HOV  )

($344)

($116)

$1,731

Source: Capital IQ, a division of Standard & Poor's. TTM = trailing 12 months.

Of course, not every company that shares these traits is on the verge of failure, and I'm not suggesting that the above companies are literally about to fail.

SBA Communications, for instance, owes at least part of its losses to a charge related to early debt repayment. And Clear Channel Outdoor seems to be turning the corner, helped in large part by the stabilization of the advertizing market.

On the other hand, those three signs in combination often tell of darker days to come. United Continental and AMR are both airlines, and that industry has seen more than its fair share of bankruptcies. Similarly, as a homebuilder, Hovnanian needs that industry to recover to have any real chance of recovery, and given the music business' ongoing digitization, Warner Music may not be long for this world.

Likewise, Level 3's recent convertible debt offering isn't exactly a sign of corporate strength, as it showcases both the company's continuing weakness and the risks to shareholders of such dilutive financing.

If a company is in debt, doesn't have enough assets to borrow against, and isn't earning profits, then it's only a matter of time before its debt holders get tired of financing its business. That's especially true now.

Buy smarter
In general, companies that hemorrhage cash, have weak balance sheets, and are drowning in debt make lousy investments. On the flip side, those that gush cash, make smart use of debt, and have solid balance sheets backing up their businesses can be tremendous companies to own.

That's especially true during troubling times, when virtually every company has been knocked off its peak, and even some of the strongest ones are available at bargain-basement prices.

At Motley Fool Million Dollar Portfolio, we're actively scouring the market to find the solid companies whose shares have been left to rot alongside the truly damaged ones. When we find those diamonds in the rough, we share them with our members, who then have the opportunity to buy some of the world's greatest companies at bargain prices, as we invest the Fool's money alongside them.

If you're ready to avoid the companies teetering on the edge of failure, and instead focus on those with the fundamental strength to thrive in the long run, consider joining us at Million Dollar Portfolio, a real-money portfolio designed to help you craft a collection of investments that work together. Simply click here and enter your email address to learn more.

This article was originally published March 10, 2009. It has been updated.

At the time of publication, Fool contributor Chuck Saletta owned shares of General Electric. The Motley Fool owns shares of Berkshire Hathaway, which is both a Motley Fool Stock Advisor selection and a Motley Fool Inside Value pick. True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The Fool has a disclosure policy.


Read/Post Comments (5) | Recommend This Article (12)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 13, 2010, at 12:03 PM, michaeldimeglio wrote:

    Chuck,

    You write in generalities. If LVLT was in trouble they would have fired the CEO long ago. He remains in charge and is so widely respected that President Obama made him Chair of a committee to advise the president on telecom issues. True LVLT has had problems turning a profit. That is because they were busy building probably the most sophisticated IP network on the glove. These assets cost over $25B and are now not generating to their true potential. As more of the world gets on the internet and wants more and more speed and bandwidth for such things as uncompressed video (HD), streaming data and generally faster speeds, you will see the glut of current bandwidth reduce to a point that this company will enjoy a bright future. I don't think that the debt is difficult to handle. As an old Buddhist monk once said..."We'll See".

  • Report this Comment On October 13, 2010, at 2:28 PM, plange01 wrote:

    united /continental is a bankruptcy just waiting for a court date! this one is a disaster! a few other beautys hertz,blockbuster,kodak,riteaid and of course sirius!

  • Report this Comment On October 13, 2010, at 3:56 PM, mikecart1 wrote:

    Funny article. Only funny in that I have no doubt that at least 1 of the stocks on the table above will double at least within the next 3 years and be one of those stocks we all wished we bought. Cough*SIRI, LVS, C, BAC*Cough.

    Probably the best article of the week in that I will look more into these "bankrupt" companies muhahaah!!!

  • Report this Comment On October 13, 2010, at 4:32 PM, etherealle wrote:

    Who knew that President Obama is the bellwether of respect and success in private industry? Now I'm sold.... The old adage that the bandwidth boom is coming is what LVLT has survived on for what, a decade or more without even coming close to profitability? Well, we're all using that bandwidth now... and LVLT is still selling it below their own costs to try and blast the competition - which they do, occasionally. Now if only the quantity could push them over the edge.... Maybe my beloved 49er's could benefit from the principle: they lose every game, but man, they sure rack up a lot of points. isn't that worth a playoff spot?

  • Report this Comment On October 13, 2010, at 10:41 PM, macosgrove wrote:

    We'll see what you have to say after UAL earnings report comes out. They've beat earnings estimates all year. Their stock was $4 last year and hit $27 today and your thinging BK? All airlines generally carry debt and UAL is no exception. Until we get rid of the current administration and the incumbents in congress, all private companies are in trouble. Everyone on your staff bashes airlines and I don't know what you have against them.

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