By Richard Gibbons
April 15, 2005
The mission of Motley Fool Inside Value is simple: We want to find companies trading at prices less than 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 also comes with greater risk. When looking at companies in crises, such as AIG and Doral Financial (NYSE: DRL) right now, it can be challenging distinguishing between a company just suffering a flesh wound and one on its deathbed.
When you do identify a potential turnaround, it can be quite lucrative. Consider Martha Stewart Living Omnimedia (NYSE: MSO). When Martha Stewart's insider-trading fiasco first made the news, it was possible to pick up shares at less than $7. These shares traded above $35 this year, for a pleasant 400% return. Much larger multibaggers over the course of years are easily within reach. The difficulty, though, is determining who will survive and prosper. With that goal in mind, here are some of the issues I consider when trying to profit from panic.
LiquidityIn 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 impact 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, so it should be avoided.
Even if the cash flow looks good, another liquidity issue to consider is debt. Even if it seems clear to shareholders that the company has enough cash flow 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 the company 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 strengthWhen it comes to turnarounds, the balance sheet can count more than the income statement. I've already talked about debt. 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. Because of the rules of accounting, real estate can be particularly strong because it may be listed on the balance sheet at significantly less than its present value.
However, 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 only be converted into cash when the company has operating profits, generally after the crisis has passed. So when considering a company's survival prospects, it's best to heavily discount the value of these assets.
The competitive positionPreferably, we're buying the 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. Or perhaps the company has suffered a permanent setback but is still strong enough to be a viable business.
In late 2001, terrorism fears hit the travel industry. At the time, people were talking about how far the airlines would fall, and which airlines would survive. But really, the travel recovery play wasn't in airlines. Sure, people who perfectly timed AMR's (NYSE: AMR) crisis in 2003 could have earned 500% returns. But they would have been assuming a lot of risk buying into an extremely volatile industry with fleeting competitive advantages.
Instead, the simple and safe travel industry play was the hotels. Hotels have competitive advantages both in terms of location and brand. Plus, hotels often own real estate that can provide a cushion to help avoid liquidity concerns. A September 2001 purchase of Starwood Hotels and Resorts (NYSE: HOT) or Hilton Hotels (NYSE: HLT), two of the largest hoteliers, would have returned 100% within a year, or 200% had you decided to hold until now.
Bringing it togetherA good example of all these issues is National Health Investors (NYSE: NHI), a REIT that primarily owns nursing homes. As you can see in this chart, National Heath Investors 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 Investors' 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 some 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 preferreds 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 $25. 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 out at $22.
The keys 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.ConclusionEvaluating 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 (NYSE: PVN) had a decent chance of rebounding, and we both bought well under $5. It's now around $17. If you want to learn about what Philip sees as the great value plays right now, and see all of his historical recommendations, a free 30-day trial is available. Or, for a limited time, Philip is offering Inside Value at a 25% discount to the regular price. To find out more, click here.