The mission of Motley FoolInsideValue is simple: We want to find companies trading at prices below their fair value. In some cases, companies are below fair value simply because the market has failed to appreciate the sustainability of a company's competitive advantage. At other times, companies fall below their fair value during a crisis, when panicked investors flee. The latter case has the potential for quick returns, but it also brings greater risk. When looking at companies in crisis, it can be challenging to distinguish between a business suffering a flesh wound and one on its deathbed.
Consider Scientific-Atlanta
Not every turnaround is this successful, but multibaggers over the course of several years are easily within reach. The difficulty is determining who will survive and prosper and who won't. Investors in JDS Uniphase
Liquidity
In a crisis, cash gives a company the time and flexibility to survive a rough patch and reorganize its business. It's critical to get a good feeling for the degree to which cash on the balance sheet and future cash inflows are able to cover future cash outflows. Of course, the event causing the crisis often reduces operating cash flows, so using historical cash flow numbers can be deceptive. Instead, start with historical numbers and come up with a pessimistic approximation of the extent to which the negative event will affect cash flows, and how much cash outflows can be reduced over the short term through, say, delaying capital expenditures. If the company is close to the edge, there's a good chance it will topple over. In that case, avoid it.
Even if cash flow looks good, another liquidity issue to consider is debt. Even if it seems clear to shareholders that the company has enough cash to survive, banks and other lenders can be skittish. So it's a good idea to examine absolute levels of debt and future debt maturities. If the company is highly leveraged, or a substantial portion of its debt is coming due in the next few years, then it may be unable to roll that debt over to future maturities. Often, it's not the slow draining of cash resources that leads to bankruptcy, but rather a large debt maturity that the company is unable to roll over or repay.
Asset strength
When it comes to turnarounds, the balance sheet can count more than the income statement. Another factor to consider is the strength of the assets, because all assets are not equal. Cash is the best asset, since it gives maximum flexibility. Other good assets include securities and non-depreciating physical assets that can potentially be sold, such as real estate, which can be tricky to value because accounting rules tend to make it significantly undervalued on the balance sheet.
There are also bad assets that generally cannot easily be sold or generate cash. Such assets include goodwill and tax assets. Goodwill is useless because it's intangible, while tax assets can be converted into cash only when the company has operating profits -- something scarce during a crisis. So when considering a company's survival prospects, it's best to heavily discount the value of these assets.
Pfizer
The competitive position
Preferably, we buy a beaten-down company not just for its assets but also for its future operating performance. Ideally, the company is suffering from temporary bad news, but its long-term competitive position is intact. Maybe the company will show poor results for a year or two but is likely to prosper after that time. Perhaps the company has suffered a permanent setback but is still strong enough to be a viable business.
For example, many stocks fell after the terrorist attack of Sept. 11, 2001. The travel industry was hit particularly hard, yet the competitive position of many of the companies in this industry was still strong. Though it seemed probable that short-term results would be affected, it seemed likely that over the long term, the industry would rebound. Investors who took advantage of the opportunity by buying Royal Caribbean Cruises
Bringing it together
A good example of all these issues is National Health Investors, a REIT that primarily owns nursing homes. As you can see in this chart, National Health was flying along quite happily when it hit the perfect storm. The Balanced Budget Act of 1997 cut Medicare revenues to its nursing home operators, the companies that lease National Health's buildings. Consequently, many operators went bankrupt. Plus, it was affected by overbuilding and labor shortages. Finally, lawsuits in Florida were destroying the business there.
Confronted with these challenges, National Health collapsed like Mr. Bean sparring with Evander Holyfield. I became interested and bought shares at $15. This was a wee bit early, since it cratered below $5 when the company discontinued its dividend only six months later. But this wasn't a technology company. It had solid real estate assets in a time of falling interest rates. Cash flow was still positive. The entire industry was unlikely to vanish: Somehow, someone would take care of the elderly. So I bought more at $5, and it started to look like the industry was recovering.
But National Health owed money to the banks. And the banks panicked, demanding repayment. So National Health was forced to sell convertible preferred shares at a time when the stock was low, diluting existing shareholders. I bought more in the $6 range. Cash flow was still good, nursing home operators were coming out of bankruptcy, and the balance sheet, never really overleveraged to begin with, now looked quite clean. It was difficult to see how National Health could fail.
Now, four years later, the stock is trading around $28. That's lower than it would be if it hadn't been forced to issue the convertible, but it's still a decent return. For months, value investors bought in the $6 range, and those investors have seen a 400% return. What's more, since National Heath has a $1.80 dividend, investors at $6 are now seeing an annual dividend of 30% on their original investment. I sold at $22.
The key points in this case were that cash flow was positive, leverage was reasonable, the assets were strong, and there were signs that the industry would turn around. Even then, the debt maturity hurt shareholders significantly because nobody wanted to lend to companies in the sector. This is why, when analyzing these turnaround situations, it is critical to consider debt maturities.
Conclusion
Evaluating these factors can help you find and identify turnaround plays that lead to extraordinary profits. For instance, in 2002, both Philip Durell, Inside Value's chief analyst, and I independently recognized that Providian Financial had a decent chance of rebounding. I bought at about $4, while Philip bought for $2 and change. A few years later, Washington Mutual
This article was originally published on March 11, 2005. It has been updated.
Richard Gibbons , a member of the Inside Value team, owns shares of Washington Mutual that he acquired in the Providian acquisition. He does not own shares of any of the other stocks discussed in this article. Pfizer is an Inside Value recommendation. The Motley Fool isinvestors writing for investors.
