Even with the severe decline in the stock market over the past three years, I find it difficult to find significantly undervalued stocks among companies that are performing well. Instead, I am typically buying stocks of businesses that have issues -- generally ones in which earnings have fallen (or, at the very least, growth rates have slowed), either due to external factors such as the weak economy or a company's own missteps. I call the latter category "turnaround situations," which means that the company needs to fix certain internal problems in order to turn itself around.
Today, I'd like to share some thoughts what I look for when investing in turnaround situations. As case studies, I'm going to use BJ's Wholesale Club
When I've done well investing in turnarounds, most of the following characteristics have been true:
- A strong balance sheet
- Robust free cash flows
- Share buybacks
- Great management
- A strong competitive position
- The right strategy
- A really cheap stock
Let's take a closer look at each of these metrics and apply them to BJ's and Office Depot.
A strong balance sheet and robust free cash flows
The first question to ask in any turnaround situation is: Does the company have the financial strength to survive until it can turn itself around? Even the most brilliant turnaround plan is worthless if the company goes bankrupt before it can be implemented. So, look for a strong balance sheet or robust free cash flows -- preferably both.
At first glance, BJ's appears to score well in this area, but the picture isn't quite so rosy. While the company has $33 million of cash and no debt, it has leased most of its stores (rather than buying the land and building as, for example, Costco
Turning to cash flows, BJ's was free cash flow positive last year, with operating cash flow of $151 million and capital expenditures (capex) of $135 million. But it is planning a big increase in capex this year, to $215 million-$225 million, versus expected operating cash flow of $170 million-$190 million, such that the company will be free cash flow negative and end the year with $40 million-$50 million of debt. This is not an alarming amount, but the trend is worrisome and adding debt on top of the lease leverage is risky.
In January 2001, Office Depot didn't have a great balance sheet, with $378 million of net debt and even greater lease obligations. However, the company did have very healthy cash flows: in the first three quarters of FY 2000, its operating cash flow was $435 million vs. capex of only $181 million.
If the company is financially healthy, yet the stock is trading well below intrinsic value, then buying back stock can create tremendous shareholder value. It's critical, however, for management to be savvy in buying back stock only when it's at low levels.
BJ's management has failed miserably in this area. Last year, the wholesaler repurchased approximately 2.6 million shares of stock at an average cost of $31.51, and since 1998, when it began repurchase activities, has repurchased approximately 9.8 million shares at an average cost of $31.69 per share.
It's bad enough that it spent $310 million buying back stock at what turned out to be very high levels, but even worse is that, with the stock down by nearly two-thirds from the price at which it was aggressively buying back stock, it has essentially suspended its repurchase program.
Office Depot, in contrast, had repurchased $781 million of its stock in the previous four quarters (from Q4 '99 to Q3 '00), at an average cost of less than $10, reducing the share count by a whopping 27%.
Great management is critical for the long-term success of any company, but it's especially important in turnaround situations, in which there is often little margin for error. My rating of BJ's management is mixed at best. I think they are good operators but, as I discuss elsewhere in this column, poor capital allocators and strategists. In January 2001, Office Depot's CEO, Bruce Nelson, had been on the job less than a year, but had an excellent track record at Viking Office Products (which had been acquired by Office Depot) and had the right strategy for turning the company around (which I discussed in The Importance of Strategy).
Strong competitive position
Companies with strong -- ideally market-leading -- competitive positions generally have the best chances of successfully turning their businesses around. BJ's is much smaller than Costco and Sam's Club (a division of Wal-Mart
The right strategy
I have writtenthree columns on the importance of strategy, so I won't repeat myself here. It is in this area that I have the greatest concerns for BJ's. I believe it is fundamentally competitively disadvantaged relative to the larger warehouse clubs (Costco and Sam's Club), but fundamentally competitively advantaged versus supermarkets. (BJ's prices are 40% lower than supermarkets', according to one survey BJ's cited on its recent conference call.) Therefore, I agree entirely with its management's strategy outlined in the most recent earnings release and conference call: Focus on taking share from supermarkets and differentiate BJ's from Costco and Sam's Club to avoid their competitive onslaught.
But the actions BJ's recently announced are not consistent with this strategy. For example, if it is already 40% cheaper than supermarkets, the primary competitors they've identified, then why slash prices and kill margins and cash flow? And given the harsh competitive and economic environment, why is it ramping up capex by more than 60% this year? I think it may be making the classic mistake retailers often make: worrying more about the altar at which Wall Street worships, same-store sales, rather than far more important margins, profits and cash flows.
In contrast to BJ's' imprudent actions, Bruce Nelson had exactly the right strategy to turn around Office Depot in early 2001. Rather than investing in the low-margin North American retail store base, the company closed underperforming stores and improved operations, which generated cash that was then reinvested into the higher-margin, faster-growing catalog, contract, Internet, and international businesses, where it has real competitive advantages.
A really cheap stock
My general rule of thumb is that turnarounds, even if they work, take twice as long and cost twice as much as even the most conservative estimate. So, it's especially important that the stock's valuation reflects a huge margin of safety.
BJ's stock certainly appears cheap, trading at only 8.6 times this year's consensus EPS estimates of $1.28 per share, and at $8 in January 2001, Office Depot was trading at a similarly cheap 9.4 times trailing EPS.
Of the seven metrics I've laid out, Office Depot in early 2001 scored very highly in nearly every area, so it's not surprising that the stock did exceptionally well (it was among the three best-performing stocks in the S&P 500 in 2001). In contrast, my analysis of BJ's reveals major issues, which is why I don't recommend it despite its seemingly cheap price.
Whitney Tilson is a long-time guest columnist for The Motley Fool. He owned a position in Office Depot at press time, though positions may change anytime. Under no circumstances does this information represent a recommendation to buy, sell, or hold any security. Mr. Tilson appreciates your feedback on the Fool on the Hill discussion board or at Tilson@Tilsonfunds.com. The Motley Fool is investors writing for investors.