4 Warning Signs of Dying Companies

We're all aware of our own mortality, and we often take preventative measures to fight against it. Similarly, there are many ways that companies can die, and if we're smart, we'll be on the lookout for some of the warning signs as we assess interesting companies we run across.

In a recent issue of Outstanding Investor Digest, respected fund manager Bruce Berkowitz offered a handy list of how companies can die:

Here are the ways you implode: You don't generate cash, you burn cash, you're overleveraged, you play Russian roulette, you have idiots for management, you have a bad board, you de-worsify, you buy your stock too high, you lie with GAAP [Generally Accepted Accounting Principles] accounting... But you can't lie about how much cash you have.

Let's take a closer look at these warning signs and how they play out in some real-life examples.

Bad boards
Bad signs for a board of directors include things like lack of experience in a particular industry, as well as when directors have too many commitments, including sitting on a number of other corporate boards. Bill Ackman, currently engaged in a proxy fight with Target (NYSE: TGT  ) , recently criticized its board, arguing that none of its directors have executive-level knowledge about either the retail industry or credit cards and real estate, which are crucial to Target's operations. Ackman also pointed out that directors serving on as many as four corporate boards left them overcommitted.

Similarly, when Bear Stearns collapsed last year, some of its directors had other companies to worry about as well. At the time, three of Bear Stearns' 12 directors served on the boards of at least four other public companies.

Warren Buffett has warned of boards where directors receive a substantial portion of their overall income from their board duty. In such cases, the director may be more interested in keeping that gig than in serving the best interests of the shareholders.

Too much leverage
Overleveraged companies are ones with hefty debt loads. That can crush a company by demanding much of its cash and preventing it from applying that cash to other important needs. Here are some companies that popped up when I ran a screen at our Motley Fool CAPS community for one- or two-star companies (out of a possible five stars) with debt-to-equity ratios of two or more:

Company

CAPS Rating

Total Debt-to-Equity

H&R Block (NYSE: HRB  )

*

3.34

Hershey (NYSE: HSY  )

**

5.39

Goodyear Tire (NYSE: GT  )

**

9.20

Las Vegas Sands (NYSE: LVS  )

**

2.23

Data: Motley Fool CAPS; Capital IQ, a division of Standard and Poor's.

Of course, not all debt-laden companies are in any imminent danger of going out of business. It's important, though, to keep an eye on companies with high debt levels, to make sure they earn enough to maintain their debt payments.

Cash flow problems
To learn how much money a company has, you can check its cash level on its most recent balance sheet. But that will only tell you part of the story. It's helpful to compare that with recent quarters and years, to see whether cash levels are rising or falling.

You can also check to see exactly where the company's cash is coming from -- its operations, financing activities, or investments -- by examining the cash flow statement. Calculate its free cash flow by taking the cash from operations and subtracting capital expenditures. If that's a negative number, consider that a red flag.

Subpar investments
You can also look at a host of other factors and numbers. Return on invested capital (ROIC), for example, reflects how effectively the company is investing its money, whether in new factories, additional advertising, acquisitions, or what-have-you. Below are some companies with ROIC numbers that are markedly different from their historical levels:

Company

Recent ROIC

5-Year ROIC Average

Charles Schwab (Nasdaq: SCHW  )

23.9%

10%

Amazon.com (Nasdaq: AMZN  )

23.3%

21.8%

FedEx

3.5%

8.8%

Sears Holdings

1%

7.2%

Data: MSNMoney.com.

What to do
Don't assume that any of these companies is dying. But at the same time, don't assume that any company you're looking at is totally healthy. Keep your eyes open for red flags and follow up with deeper digging.

Learn more:

Some companies that have been left for dead are actually good values. Want help finding them? Our Motley Fool Inside Value newsletter can help -- try it out free with a 30-day trial.

Longtime Fool contributor Selena Maranjian does not own shares of any companies mentioned in this article. Amazon.com, FedEx, and Charles Schwab are Motley Fool Stock Advisor recommendations. Sears Holdings is a Motley Fool Inside Value pick. Try our investing newsletters free for 30 days. The Motley Fool is Fools writing for Fools.


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  • Report this Comment On June 17, 2009, at 10:26 PM, depsee wrote:

    I have made a couple of random comments to articals in the first half of this year. Both involved possible bad things and my response was Sears in both cases. I don't recall the topic of the first discussion, but the most resent one was discussing the GM bankruptcy among others and the basic topic was "Who Is Next?". My input as a strong possible candidate was Sears, taking into account the "Ghost Town" environment I observerd at the local Sears and internet comments about Sears stores in other states. On top of that, I have been working the past couple of weeks in a town about a hour drive north of where I live that has a Sears. Guess what? "GHOST TOWN"! On top of that I rode my motorcycle by the local Sears store this evening and observed maybe a dozen cars in the parking lot. Most parked not near the doors (employees?).

    I am not shocked at all that Sears showed up in this artical as having recent ORIC numbers markedly different from historical levels, ON THE DOWN SIDE! Having never shorted a stock, fear has been the only thing holding me back, despite observations.

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