Investing In Turnarounds

The following was taken from a stock forum and if not mistaken it was from 'shareinvestor' forum. Many apologies because I have lost the link, so I cannot give the due credit.

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yes, let's not discriminate because the posting is made by one who is a hybird investor (ie one who based their strategy on TA and FA). Just give the following posting a read...

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How many times have you seen it...?

An otherwise great company admits it has a serious problem. Could be accounting. Or a boneheaded expansion program that’s gone awry. Or perhaps the problem is merely an aggressive acquisition that takes more than one quarter to “swallow.”

Often you’ll see stocks fall 80%-90%, even when the problems in the company have nothing to do with its core business or its most valuable assets. People simply panic. Not the insiders. They are ready to pounce, and will buy millions when no one wants the stock...and sell millions when they do!

The opportunity in these kinds of situations is enormous. Remember: when a stock falls by 90%, its shares have go up by 900% just to return to their original price. Take a $5.00 stock that’s fallen to 50c – down by 90%. If management can turn things around and the stock rebounds to a new high – say $5.50 – investors who bought at $5.00 will have made 11 times their money (or 1000%). And situations like this develop all the time, every year.

You just have to look for them.

But...how can you tell the difference between a company that’s going out of business...and a company that will soon “rebound,” making new investors, who bought near the bottom, a fortune?

Actually, it’s easy. In fact, it’s so easy, once you know how to do it, you’ll wonder why you don’t buy more rebound stocks.

This kind of investing is especially appropriate considering the current market conditions. The stock market as a whole is unlikely to go much of anywhere for the next several years as rising interest rates makes it next to impossible for the broad market to move higher. But, “rebound stocks” are not correlated to the market. They trade higher (or lower) according to their own internal restructuring plans. Find the right company, after its bottomed out and you can make better than the best bull market gains, no matter what happens in the stock market as a whole.

THREE STEPS TO IDENTIFYING SUCCESSFUL TURNAROUNDS

The most important thing to figure out before you invest in a turnaround situation is whether or not the company can afford to fix itself. Basically you have to answer one question: Are there enough assets on the balance sheet to finance a turnaround?

Fortunately, figuring this out is not hard to do. You just need to make some critical calculation. It’s really very simple. What you have to do is check the company’s latest balance sheet.

Step One: How to Determine If A Company Can Afford to Restructure

Check to see if its an asset rich company, despite its debt. Does it have some valuable operating businesses as a backbone? Are there properties it could sell, if absolutely necessary, to finance its turnaround? Can non-core assets be sold to pay off debts, leaving the company’s best assets, which, managed correctly, to produce positive results?

So, while the whiners and the wailers will be crying, you are developing a plan of action, backed by facts and figures. Other investors, after seeing the stock drop +90%, will be too scared to make a rational evaluation. They'd probably have sold in a panic, right at the bottom.

Step Two: Make Sure Excellent Management Is in Place

There’s more to life than money. And there’s also more to a successful turnaround than solid financing. The key is excellent management, ones who weren’t used to losing. A turnaround business needs new officers who are fresh, aggressive and who believe they can win.

You can’t fight a winning battle with leaders who are used to losing. Thus, the second most important key to rebound success is a winning management team. Make sure new, winning management has been recruited and is in place before you buy a rebound stock. Even better, to prove their commitment, this same management buys lots of company stock, at market prices (not just options).

Step Three: Make Sure the Business Model is Sound and the Product is Good

After money and leadership, you’ve got to have a business worth saving. The key questions investors must ask is: does this potential rebound stock have a valid business model, good assets, and does it have great products?

Make sure the business you’re trying to save has solid future prospects. Don’t invest in a troubled business that only has a mediocre future.

I’m sure you’ve noticed that the analysis required to evaluate a solid rebound stock isn’t that difficult. Yes, it does take time, but these things are not hard to do: you check the company’s finances, thoroughly. You take a detailed and in-depth look at management. And you make sure the business model is proven and sound. It’s not that hard, but it can be incredibly lucrative.

Most people don’t look this closely at stocks that have fallen by 80% or 90%. Most people simply panic when they see a stock fall that much. They don’t carefully evaluate a firm’s financial position. They don’t wait and see if new management can be successfully recruited. And they don’t consider the intrinsic value of the company’s ongoing business.

If you can learn to do these things, buying rebound stocks can be the most lucrative investing you’ve ever done.

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And the following is taken from Fools.com. Again I lost the link. :(


Here is an old Fools article..

Investing in Turnarounds

Whitney Tilson uses BJ's Wholesale Club and Office Depot as case studies to explain how he invests in companies that may be poised for a turnaround. Although both stocks are currently cheap, you would do well to look closer at the issues confronting the two companies and whether their strategies to overcome them are working.

By
March 28, 2003

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 (NYSE: BJ) as of today and compare it to Office Depot (NYSE: ODP) in January 2001 (a stock I bought then at $8, sold a year later at $17, and which I have recently repurchased).

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 (Nasdaq: COST) typically does). So, BJ's is on the hook over many years for more than $1.6 billion of operating leases, contingent lease obligations, and closed club lease obligations (as of its Q3 10-Q) -- a material amount for a company whose shareholders' equity and market cap are both under $800 million.

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.

Share buybacks
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
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 (NYSE: WMT), which means that it does not have comparable economies of scale, purchasing power, etc. Being a distant third in a three-horse race is not a good position. Office Depot, in contrast, is the world's largest seller of office products.

The right strategy
I have written three 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.

Conclusion
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.