In my previous article about Sierra Wireless (NASDAQ:SWIR), I concluded that, while the company initially appears like an easy ticket to ride the Next Big Thing, it actually proved to be more of a turnaround story with declining earnings in recent years. This article will focus on how to find potential winners -- and avoid potential losers -- among turnaround stocks.

First, check for non-starters
Researching a company can take a lot of your precious time, so it makes sense to find non-starters as quickly as possible. Let's start by following advice on turnaround plays offered by legendary investor Peter Lynch in his book, Beating the Street.

First, stay away from tragedies with immeasurable outcomes. For example, Lynch cites a 1984 accident at a Union Carbide facility in Bhopal, India that exposed half a million locals to 32 tons of toxic gases. Thousands were killed with far more seriously injured, and the health and environmental devastation continue to this day. This kind of terrible event is too much for a company to recover from, and fortunately, Sierra Wireless does not have any problems of this nature.

Second, can the company survive a raid by its creditors? Beating the Street notes that, for turnarounds, cash is king, and debt load and debt structure determine success more than any other factors.

As of the end of the first quarter, the company has about $100 million of cash and equivalents on the books. That cash amounts to just more than $3 per diluted share and about 12% of the current stock price. With no debt, Sierra Wireless passes this test handily.

Next, we should take a look at pre-tax profitability. Lynch points out that a company with poor margins relative to its industry peers has room for improvement and can do well in an upswing -- a positive for a turnaround stock.

Sierra Wireless has a problem ... and an opportunity
The company's pre-tax margin has been negative for five years, as shown in the chart below. The same can be said for income from continuing operations.  

Meanwhile, competitor Telit Communications has been posting positive, growing margins -- its operating margin expanded from 1.5% in 2011 to 4% in 2014. Also, pre-tax margin grew from 1.3% to 4.7% over the same period. Last year, Telit generated revenue of just $294 million, just over half what Sierra Wireless logged for its top line. Though this higher revenue failed to give margin-boosting economy of scale advantages, this does leave plenty of room for improvement at the company.

Swir Margins Y

SWIR data by YCharts

But wait, there is more
Here are a few more non-starters that Lynch suggests checking for when evaluating turnarounds:

  • What is left for shareholders if the company is bankrupt? Sierra Wireless is not bankrupt, so this does not apply.
  • Beware of excessive pension obligations. This is most common in older companies and is not a concern here.
  • Watch out for new share issuance that will dilute the value of the stock even if the company turns around. Shares outstanding have been steady at 31 million from 2010 to 2013 and 32 million in 2014. With $100 million of cash on hand, additional equity issuance should not be a near-term issue.

Lynch also suggests other potential non-starters for stocks in general, not just turnarounds, several of which are important considerations for this company: 

  • A company that gets 25% or more of its revenue from a single customer. The customer will have too much pricing power and other leverage. Sierra Wireless reported that in 2013 and 2014, "no customer accounted for more than 10% of our aggregated revenue, from continuing and discontinued operations." However, Sprint and AT&T each accounted for more than 10% of aggregated revenue (25% of aggregated revenue combined) in 2012, so investors should continue to watch this metric closely.
  • A diversification strategy where the company is paying too much for acquisitions and/or is diversifying outside of its core competencies or realm of understanding. Since the beginning of 2014, the company has made a series of acquisitions totaling less than $150 million. Markets reacted positively to the largest deal, the $90 million purchase of Wireless Maingate, which complemented its core strategy and aided with its European expansion. With a debt-free balance sheet, Sierra Wireless does not appear to be over-extending itself with M&A activity.
  • "Whisper" stocks, i.e., long shots with a great story and lots of sizzle, but no substance. Typically, these offer a very imaginative or complicated solution. Usually, the story has an emotional appeal, and the company is unprofitable. Sierra Wireless describes itself as the "mobile-to-mobile leader ... building the Internet of Things with intelligent wireless solutions." The IDC reported that the Internet of Things has already grown into a $650 billion market and should approach $1.7 trillion by 2020. The company is tying itself to a massive opportunity, but with its bottom line in the red, this merits further investigation.

Foolish conclusion
We have learned that Sierra Wireless has relatively low margins for its industry, giving it plenty of room to improve profitability. But can this turnaround make the necessary changes to become an attractive investment? My next article on the company will dig into that question, including a closer look at the possibility that Sierra Wireless may be a dangerous "whisper" stock.

Cindy Johnson has no position in any stocks mentioned. The Motley Fool recommends Sierra Wireless. 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.