3 Warning Signs to Watch For

When a company is failing, usually it's a slow and painful process. Products don't live up to expectations, finances begin to falter, and management usually asks why the market doesn't seem to like them. These steps lead to falling stock price and sometimes (gasp!) bankruptcy for these companies.

After a year and a half of predicting some of these failures, and getting my fair share right, I've identified a few commonalities failing companies have.

Unrealistic expectations
Every company thinks its products are the best thing since sliced bread, especially companies new to the market. Projections from inside the company are wildly inflated, projections from analysts see no end to the possibilities, and for a while investors buy into the hype. But eventually a weak product is exposed, and while expectations don't send a company to bankruptcy court, it's the first step in a long process.

Last year, I predicted that Energy Conversion Devices and Evergreen Solar were on their last legs because falling sales in a tough solar market showed that their products were inferior to the competition. The response from readers about my Energy Conversion Devices pick was less than enthusiastic. Fool community member StarlightPower said, "I can tell you factually that the Uni-Solar PVL solar laminates are the best performing PV modules in the world." And that was one of the nicer pieces of feedback I got. But eventually a low-efficiency, high-cost product was exposed when Energy Conversion Devices followed Evergreen's lead by filing for bankruptcy.

Hyperdynamics (NYSE: HDY  ) has had bulls and bears in a fervor for a long time over its potential, but after running into a dry well, the company is running low on cash. As a result, the hype around Hyperdynamics' potential is leaking air along with its stock price. That doesn't mean bankruptcy is imminent, but at the very least, investors will probably continue to be diluted before the company strikes black gold.

New products can come with especially high expectations and long falls from the hype if sales fall short. That doesn't bode well for some companies today. Fisker can't seem to get its first product off to a strong start, dragging battery maker A123 Systems (Nasdaq: AONE  ) down with it. The two companies planned on massive demand, and when sales have fallen short, their finances have suffered.

Pacific Biosciences of California (Nasdaq: PACB  ) came to the market with extremely high expectations in mapping genomes, but that hasn't translated to enough sales for investors, and the stock has plunged. Even older companies can run into this problem. Remember when BlackBerrys were known as Crackberrys? Research In Motion's (Nasdaq: RIMM  ) latest attempts to overtake the iPhone are failing to inspire customers, and the company is in serious trouble, even with intellectual property worth enough to keep it out of insolvency.

No matter how it manifests, unrealistic expectations are the first warning sign investors should look for.

Restructuring solves everything
When sales are falling and losses are piling up, the first thing management does is reorganize the business. Of course, the hope is that this will solve all of its problems because there's a new "focus on the customer" or "elimination of waste."

Evergreen Solar, one of the solar industry's first casualties, attempted to restructure its business around manufacturing in China. The theory went that a superior manufacturing method -- another overhyped technology -- combined with lower labor costs would save the company. The company's Devens facility in Massachusetts was closed. That move didn't end well.

Rose-colored glasses
The key for any manager careening toward bankruptcy is to stay fervently optimistic about the future, no matter how bad things look. In March of last year, Evergreen Solar's management said that after moving to China, "we are now better positioned to facilitate a rapid transition to a strategic supplier of low cost multi-crystalline silicon wafers." Six months later, the company filed for bankruptcy.

Despite missing debt payments, Energy Conversion Devices said it was "not currently experiencing significant liquidity constrains," and was instead "repositioning its solar business." Just over a month later, the company was in bankruptcy court.

MF Global and Lehman Brothers may be two of the worst cases of denial before bankruptcy. Lehman CEO Richard Fuld was defiant even after the company had filed bankruptcy. MF Global CEO Jon Corzine ended his final earnings conference call with investors on a defiant note, saying, "With a modicum of market normalcy, I believe we will deliver for our shareholders in the quarters ahead." Less than a week later, the company was in bankruptcy.

Bottom line: The debt market will tell you when it's over
The three steps above are common in most of the bankruptcies I've seen recently. But there's a canary in the coal mine you should keep an eye on. Equity investors should watch the bond market, because it's an indication that a company may be failing, even before stock investors realize it.

Bond investors demand higher yield for high-risk investments, and as companies move closer to failure, yields increase. If you've been watching the debt crisis in Europe, you know that yields in Greece have gone so high that the market has been predicting some sort of default or restructuring for some time.

The move isn't sudden. Bond yields increase over time. For example, Caesars Entertainment (Nasdaq: CZR  ) , which I've called out recently as a high-risk investment, has 2018 bond yields of around 12.2%, while competitor Wynn Resorts has a 2020 yield of around 6.5%. This shows that debt investors are demanding a lot of extra yield from Caesars' bonds, indicating substantial fear of failure.

Not every failing company looks the same. But by staying aware of some common themes, you can hopefully avoid losing money on a company that eventually goes bankrupt.

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Fool contributor Travis Hoium does not have a position in any company mentioned. You can follow Travis on Twitter at @FlushDrawFool, check out his personal stock holdings or follow his CAPS picks at TMFFlushDraw.

Motley Fool newsletter services have recommended buying shares of Pacific Biosciences of California. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (3) | Recommend This Article (1)

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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 March 09, 2012, at 2:09 PM, cp757 wrote:

    Travis I love your article .You really get into the detail's and its easy to see the point. I do see that the debt needs to be addressed with these company's to get them off the death watch.You have written about this over and over but I don't think some investors get it. Caesars Entertainment has 2018 bond yields of around 12.2% and Wynn Resorts has a 2020 yield of around 6.5% .That 12.2% is just a high risk loan that will bankrupt them in the end. I know you didn't mention anything about Las Vegas Sands in this story but they announced that they had elected to redeem all of their outstanding 6.375% Senior Notes due February 2015 three years early. That's because they have 3.9 billion cash in the bank and they are paying $800.000,000 million out in dividends this year. You can see the strength in a good company. You have told people that your Las Vegas Sands stock , (that you have in your Motley Fool portfolio) is one of your best calls and I can see why.

  • Report this Comment On March 11, 2012, at 12:45 AM, cp757 wrote:

    This is the three year anniversary of the bottom of the stock market crash . Thirty six months for Las Vegas Sands share's to go from 1.38 cents a share to 54.83 dollars. That means if you had $13,800 dollars at the bottom of the crash on 03/09/2009 and you bought 10,000 shares you would now have $548,300 dollars on 03/09/2012. With 10,000 shares you would be paid $10,000 dollars on your dividend every year. That's a 72% return of the money you invested 36 months earlier, and that's just on the dividend, and over a 3,500% increase in your stock price. No other stock did that .

  • Report this Comment On March 12, 2012, at 10:12 AM, cp757 wrote:

    Travis I have a problem with CZR's IPO.I like to watch Myth Busters with Adam and Jamie some times because it challenges the things I thought where true. It got me thinking what if Adam and Jamie with Myth Busters did a show on CZR and started to talk about the IPO. They would get out their chalk board and start to talk about the main premise of the myth which is that it was a successful IPO and the stock went up because of huge demand for the stock The company must have value or the people would not have paid that much for the stock. First they would put up the number of shares offered in the IPO so that would be 125.34 million shares plus the insider shares that said they would sell, that gives you 22.3 million shares for a total of 147.64 million shares. We could add in the hundreds of millions of shares all the other insiders have but that would only confuse things. So we start with 147.64 million shares minus the shares sold so far which is calculated by the number of days traded times Average daily volume or 21 X 1,088,340 = 22,855,140 million shares traded. That means in one month the market makers could not sell one fifth of the shares brought to market and they have not even started on the insiders 22.3 million shares. Wouldn't it be funny if they sold the insiders shares first and they hadn't even started selling the IPO yet. I have to think that Adam and Jamie would say that the CZR IPO myth was busted and the company was so bad that no one wanted to buy the stock but we should have Adam and Jamie look at one more thing. What does the volume say about CZR now and going forward. On 03/09/2012 CZR traded 67,680 thousand shares, penny stocks trade more than that. If CZR continues to trade 67,680 a day that will be 338,400 thousand shares a week and the only way to fix that is price. The price will not go up when everyone figures this out and runs for the door. I have seen nothing that shows me what Loveman would do with the IPO money or even how much it would be. Do you think Loveman knows something?

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