Avoid These Cash Machines

I love nothing better than finding a company that pours buckets of cash into my portfolio. Private-equity funds do, too, but often the cash they're angling for is yours. They love to make public companies into their own ATMs through a shrewd device that you should beware, and their plundering of companies offers a key lesson and a chance to profit for investors like us.

Like an ATM, but better
One legendary private equity shop, Kohlberg Kravis Roberts (KKR), has perfected the ability to extract exorbitant sums of cash from companies in a perfectly legal way. Take a look at the recent stunt it pulled on Dollar General (NYSE: DG).

KKR and fellow investors Citigroup (NYSE: C) and Goldman Sachs (NYSE: GS) took Dollar General private in July 2007 at a cost of $7.3 billion. They released the company back to the public markets this past November, offering about 10% of the shares in an IPO and retaining the rest. Also cashing out their share of the underwriting profits were Bank of America (NYSE: BAC) and JPMorgan Chase (NYSE: JPM). Investment banking comprises an exorbitant share of these big banks' revenue and profit.

Source: Capital IQ, a division of Standard & Poor's. *Bank of America's operating profit for this division well exceeded its total operating profit, i.e., its other segments lost money.

Following its launch, the company was valued at $7.2 billion. Now, it looks like Dollar General's investors lost $100 million on the deal, so where's all this profit I'm talking about?

For that, you have to examine how Dollar General was used while it was private. When KKR bought Dollar General in 2007, it and fellow investors put up just $2.8 billion and borrowed the remaining $4.5 billion. At that time, Dollar General had just $260 million in debt, the interest on which it could easily cover with its earnings.

Fast-forward to November 2009 and the IPO. Dollar General suddenly had about $4.2 billion in debt, and its ability to support its own debt is severely crimped. In fact, the business had to pay about 39% of its operating income just in interest. Ouch!

That sudden debt spike shows that KKR and its co-investors simply transferred their borrowings of $4.5 billion onto Dollar General's balance sheet. For their efforts, they took home a 150% paper profit (based on the IPO price), excluding fees and the costs of some rather minimal work they performed in reorganizing Dollar General -- much of which was charged to Dollar General.

As a final kick to the curb, just before making it a public company, the private-equity giant paid itself and other investors a fat dividend, to the tune of $239 million -- more than double what Dollar General earned in that quarter. As a public company, Dollar General doesn't even pay a dividend. And that's not the amazing part.

The amazing part
Of the IPO, Bloomberg quoted one analyst as saying, "It's a good price for investors." If by investors, he means KKR and its cronies, then this analyst is spot-on. But for individual investors like you and me, the deal is an awful mess.

What is utterly astounding, mystifying, and discombobulating about this whole process is that investors buy what KKR is selling. After all, no one's under duress to buy a second-tier retailer, and you could even more easily pick up shares in a slow-growing cash cow and be none the worse off.

So, again, why buy Dollar General? If you must have a retailer, there are quite a few financially sound organizations with good competitive advantages available at cheaper prices. Certainly, that's one reason superinvestor Warren Buffett bought shares of Wal-Mart (NYSE: WMT) instead of the latest IPO peddled by private-equity firms. The company's commitment to low costs and its python-like supply chain strangle costs out of the system.

The key lesson: Beware not only what you buy, but from whom you buy.

When Dollar General hit the markets again, it sported a 26.9 P/E ratio -- a stunning 77% higher than that of Wal-Mart, the world's biggest retailer. Even after it reported substantially increased quarterly income, Dollar General still trades at nearly than 25 times earnings, still higher than the well-heeled and more secure Target (NYSE: TGT). That's expensive for such a leveraged deep discounter.

It's little surprise that KKR waited until November 2009 to unleash Dollar General. After all, private equity sells when it estimates the market is highest, and KKR is a private-equity leader for just that very reason. And the unattractive position of Dollar General likely explains why KKR did not spin out the entire company: Investors simply wouldn't stomach this stinky investment in one gulp.

But you still might want to get involved with Dollar General.

Wait! Huh?
I didn't say buy the stock. There's more than one way to skin a retailer. And with Dollar General leveraged up at not exactly cheap interest rates, an operational slip-up could cause the retailer to falter. And that's precisely when investors could profit -- by short-selling the stock.

So when might that opportune moment arrive? If you see some of the following:

• Spiraling receivables -- The company is unable to collect on its accounts receivable from debtors and has to consistently extend payment terms because of the financial weakness of its customers
• Increasing inventories --The business slowly builds inventories, which eats up cash. Growing inventories also signal the company's inability to move product at its desired prices, which often leads to declining gross margins.
• Declining gross margins -- Declining gross margins signals the company's inability to maintain its pricing power, perhaps because of poor product choice or too much inventory.

Discovering several of these signs together could be the catalyst for an attractive short-selling candidate.

Whither my investment dollars?
If you're interested in protecting your portfolio from time bombs or in shorting stocks for big gains, enter your email in the box below. I'll send you a new report, "5 Red Flags -- How to Find the Big Short," by John Del Vecchio, CFA, a forensic accountant who has made a good deal of money identifying companies with low-quality earnings and weak financial conditions. Simply enter your email in the box below. The report is free.