Capitally Challenged Stocks That Could Be Diluted or Extinguished 32 comments
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As it became clear to me from the smell of napalm following the cataclysmic bombing the market endured in Q4, this time really is different. I suggested in December that new metrics are necessary for this new environment and urged any readers to try to shift away from any earnings-based or other traditional valuation methods to ones that incorporate balance-sheet or liquidity risk and asset-based valuation.
This is not an easy process, and, while I know that many market participants have begun to change the way they look at things, we still have lots of work to do collectively. This different way of thinking has clearly helped me to identify high-risk situations. In what I believe was one of my most popular blog postings to Seeking Alpha and which apparently continues to drive traffic to my websites (Dividends on Death Row), I shared a screen (using StockVal) that I constructed using some of the different metrics I have been discussing. The 22 stocks that met the screen's criteria fell an average of 12.5% and a median of 13.9% over the past 4 weeks, while the S&P 500 has declined in price by 8.5% despite some improvement on the huge rally this week.
At the end of 2007, my shift to a focus on the balance sheet led me to publish on Seeking Alpha "8 Balance Sheet Accidents Waiting to Happen". While the metrics I used at the time weren't as refined as the ones that I have been using lately, the list fell an average of 61% in 2008, well below the S&P 500's return of -38.5%. In fact, every one of those stocks fell in excess of the market. Impressively, not one of the stocks comes from the beleaguered Financials sector. The carnage continues, as you can see in the table below (click to enlarge):
While I have obviously found it helpful to have been early in changing how I view equities, I believe that we still have a way to go in terms of everyone being on the same page. I continue to see and hear too much talk about earnings. While solid companies, most of which will be very challenged, need to be contemplated with respect to "potential earnings" once the recovery begins (not soon!), shareholders of many companies won't have the luxury of participating in those profits. The ugly truth is that hundreds of publicly traded stocks will be either massively diluted or forced into bankruptcy before the recovery begins. Today, I am sharing further my thoughts about how one can avoid having one's stock stolen out from under him during this economic crisis.
Stepping back, I believe that many investors don't quite get a very simple concept: Equity. Owning common stock is essentially a call option on the future earnings of a company or the ability to participate in the upside over time. When I read articles that suggest that General Motors (GM) is "worth less than $2 billion", I realize that many mistakenly assume that the equity value is the same as the enterprise value or the real value of a company, but it's not. Equity can represent all of the value of a company, but the presence of debt or other securities in the capital structure, all of which are senior to equity, muddies the picture. GM is "worth" $1.7 billion PLUS the market value of the debt.
In any event, equity holders in publicly-traded companies are limited to 100% loss, like an option. The option can be very complicated when things go bad, and that is what is going on now. Equities as options aren't perpetual! There are events that can lead to their "early maturity". My guess is that the vast majority of professional equity investors not only didn't know about covenants a year ago, but they probably didn't even know where to find them! As credit contracts and the economy eats into profits and forces losses, equity holders in companies that are leveraged are facing serious challenges. What can companies in this situation do as they face maturing debt?
- Roll it over by refinancing it with public debt
- Renegotiate terms with banks
- Sell assets
- Cut the dividend
- Raise equity
- Swap debt for equity
- Seek bankruptcy protection
Unless one of the first four things happens, it's likely to be a very bad thing for equity holders. At a bare minimum in the good cases, they likely face lower earnings in the future, perhaps significantly, due to higher interest expense or less return on any productive asset that they dispose. Other solutions entail dilution, perhaps completely. There are many other secondary issues, such as management distraction, customer or supplier fear, ability to invest in the future, etc.
There are potential scenarios lurking that can heighten the risk to equity holders. Take the scenario where the bonds or bank-debt trade very cheaply and end up in the hands of vultures. They may very well WANT the company to go bankrupt, using their senior position to take control of the entire company. I have written about the potential for asset impairments to degrade balance sheets further and trigger covenant violations (Goodwill Hunting). As time passes, I learn more each day about how poor the position of equity holders in leveraged companies can be. If there was ever a time to exercise caution or at least be as informed as possible, it is now!
Before I go on, please allow me to share that I have severe limitations. I am going to provide the detail and output of a screen that I have created that will try to identify potential companies at risk, but a LOT of work is required to make a judgment regarding the probabilities of the potential outcomes as well as the potential valuations in different scenarios. In looking at these distressed equity situations, one has to be able to understand the entire capital structure and the types of entities that control the senior elements. If one doesn't know who controls the bonds (or bank debt) and doesn't know where publicly traded debt securities trade, it is impossible to make an informed judgment on the value of the equity.
While I think that there is a lot more differentiation to occur between companies with good balance sheets and those with risky ones, the low-hanging fruit has now been harvested. I mentioned above my own limitations (primarily as one who is not a full-time credit analyst), but even my screening system (and most likely all screening systems) doesn't have the data embedded necessary to really hone in. If I were designing the perfect screen, it would allow me to incorporate the debt maturity schedule over the next five years and would tell me if the banks still own the loans (dangerous if not, as that kills renegotiation). This information is available, but it is time-consuming to gather (note to self: this could be a good time to create a database and sell the output). In any event, this cut at identifying potential goose eggs is my latest iteration. The main addition to this model is to compare debt load to historical free cash-flow.
In earlier screens, I incorporated several different measures, including price to tangible equity, total liabilities to tangible equity, and liabilities to EBITDA. This enhancement takes the additional step of looking for claims on the EBITDA. Some companies must spend cash just to maintain their existence - they are "capital intensive". Some companies have only built and reinvested, showing economic profit but no cash to show for it. While there are some problems with looking back at FCF that can both understate or overstate its utility, I believe that this is a variable to consider nonetheless. Unfortunately, limitations of the screener and my concerns about data impacted this metric, so I shifted to comparing to operating cash flow. Again, there are problems (one-time charges or real losses can lead to operating losses and create a negative ratio), so I have included these metrics but not filtered upon them. As I have written in the past, many balance sheets understate their true risk due to the presence of liabilities that are beyond debt, so I focus on all liabilities rather than just the debt. Here is what I did and why:
- Universe: Russell 3000
- Market-Cap: >$250mm (get rid of tiny stocks)
- Price: >1 (story is already out!)
- Tangible Assets / Liabilities: <30% (identify obligations without hard assets backing)
- Liabilities / Current Assets: >3 (identify potential liquidity issues)
- Liablities / Adjusted Current Assets: >5 (haircut AR and Inventory to further define liquidity issues)
- Liabilities / EBITDA: >6 (identify long-term solvency concerns)
- Exclude Utilities (Many fit the parameters but are regulated and don't face the same risks)
Here is a link to the 43 names that meet the criteria: Download Capitally Challenged. You will note that I have highlighted 4 stocks that I have evaluated and agree should be on the list. The list isn't a prediction as much as both a potential starting point of names and/or a frame-work for evaluating stocks.
Caveats:
- Many of these companies are involved in businesses that could be viewed as resistant to the economic contraction
- Many of these stocks may already reflect the risks (especially the ones trading below tangible book value)
- There are probably multiples of companies out there that I have missed due to their possibly being excluded on the basis of just one factor.
The point of this exercise, again, is to encourage investors to look at things in a different light and to think about how companies will address debt refinancing events in the coming years. If the equity is a small sliver of the entire "value" of the company, it is a very volatile instrument. It can be wiped out through dilution or bankruptcy, but it can also be a huge gainer if the company emerges. Investors need to be aware of the risks and to be able to understand the potential opportunities.
What if one wants to own stocks but either can't do the work necessary to understand how the capital structure factors in or doesn't have the time to do so? Good news! There are plenty of stocks out there with little debt or even net cash, and they are beaten down in price too. As a firm believer that simplicity wins before complexity, at least initially, I have opted to invest in those types of names, many of which are deeply discounted to historic cash-flows or asset values. There are many risks and complexities here too, but not any different than the capitally challenged companies face as well. I won't mention them here, but, as always, I disclose my holdings daily on my company website and also allow the general public to see the holdings in my model portfolios. If, like me, you are operating under the assumption that the economy won't rebound robustly for quite some time due to the massive headwinds following decades of credit-growth induced economic expansion, I would use this rally to upgrade holdings by shifting to companies with better balance sheets. I don't believe we are anywhere close to the point where the valuations in aggregate for companies with "good" balance sheets and ones with "bad" ones efficiently reflect the future, but this is more anecdotal than tangible.
One of my favorite lines from a television show was the recurring advice from the Police Chief on Hill Street Blues, and it applies here: Let's be careful out there...
Disclosure: No position in any stock mentioned in this article
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This article has 32 comments:
With the Toxic Asset plan to be announced next week some of the intangibles are about to become a lot more tangible. If private investors do come on board, it is possible that banks will sell distressed assets, but it is likely that in grabbing some of the cash that they are so desperate for they may yet have to face up to write-downs far greater than they have admitted to date. With a huge pile of toxic assets to offload and a presumably limited amount of cash on offer this could trigger another race to the bottom.
More back on topic, the problem with asset valuation is that often it is hard to value the assets and secondly the assets values may in many cases be tumbling. If you could imagine the Dow Jones 30 all be cross-held, which of course they aren't to a very great extent, then a fall on one stock would precipitate falls in others which again would reflect in the value of the first stock thereby setting off a viscious circle of declines. Whilst the Dow Jones 30 is not really linked in this way to some extent the broader economy is. Whilst assets are still deflating rapidly, asset based valuations are extremely problematic. This is one of the reasons that expect the economy and markets to turn on a six pence are totally unrealistic. Even if the good news is out there it will take time to filter through onto Government statistics or corporate earnings. And whether companies are trading profitably or not they are going to have to write down on a broad range of assets that have not even been addressed at some point in time.
(a) Balance Sheets Rule the Day.
(b) Cash is King
(c) Debt is Death.
Unfortunately, many of our largest companies are managed by overpaid incompetents supervised by ignorant and irresponsible boards, who have failed to think through the sobering reality your article brings to light. Thus, they continue to embark on debt-fueled, cash-wasting mergers, ignoring the obvious lessons of a de-leveraging world. Dow Chemical was first, and has thus managed to morph, miraculously, from a US corporate powerhouse into a zombie on life support. Pfizer, then Merck followed close on Dow's heels, in an astonishing display of foolishness.
The lesson I learnt in the past few months, is that one has to apply a "mismanagement discount" to stocks, since the probability of arrogant managers demolishing the value of perfectly excellent companies has to be added to the other uncertainties of this complex market climate.
(disclosure: unhappy owner of shares in Dow, Pfizer, and Merck)
We are in time that requires we preserve capital first. I am investing in places where earnings are visible looking forward. Also I am investing in areas where I think the value is much higher than the current price and I want the stock for long term purposes.
In this market planning for a 20% drop is a smart move.
Shouldn't these criteria be ">"? I'm thinking that increasing liabilities and decreasing assets identifies potential liquidity issues.
Liabilities / Current Assets: <3 (identify potential liquidity issues)
Liablities / Adjusted Current Assets: < 5 (haircut AR and Inventory to further define liquidity issues)
Liabilities / EBITDA: < 6 (identify long-term solvency concerns)
DOW and MRK I've held for a long time, but I added PFE because of its sterling balance sheet only to see them blow it up not a month later. Liveris should be out of a job after the ROH deal. Him and Immelt should go find a banana republic somewhere to mismanage.
On Mar 14 10:11 PM prudentinvestor wrote:
> This is an excellent article and a prudent view of current valuation
> metrics:
> (a) Balance Sheets Rule the Day.
> (b) Cash is King
> (c) Debt is Death.
>
> Unfortunately, many of our largest companies are managed by overpaid
> incompetents supervised by ignorant and irresponsible boards, who
> have failed to think through the sobering reality your article brings
> to light. Thus, they continue to embark on debt-fueled, cash-wasting
> mergers, ignoring the obvious lessons of a de-leveraging world. Dow
> Chemical was first, and has thus managed to morph, miraculously,
> from a US corporate powerhouse into a zombie on life support. Pfizer,
> then Merck followed close on Dow's heels, in an astonishing display
> of foolishness.
>
> The lesson I learnt in the past few months, is that one has to apply
> a "mismanagement discount" to stocks, since the probability of arrogant
> managers demolishing the value of perfectly excellent companies has
> to be added to the other uncertainties of this complex market climate.
>
>
> (disclosure: unhappy owner of shares in Dow, Pfizer, and Merck)
On Mar 14 10:11 PM prudentinvestor wrote:
> This is an excellent article and a prudent view of current valuation
> metrics:
> (a) Balance Sheets Rule the Day.
> (b) Cash is King
> (c) Debt is Death.
>
> Unfortunately, many of our largest companies are managed by overpaid
> incompetents supervised by ignorant and irresponsible boards, who
> have failed to think through the sobering reality your article brings
> to light. Thus, they continue to embark on debt-fueled, cash-wasting
> mergers, ignoring the obvious lessons of a de-leveraging world. Dow
> Chemical was first, and has thus managed to morph, miraculously,
> from a US corporate powerhouse into a zombie on life support. Pfizer,
> then Merck followed close on Dow's heels, in an astonishing display
> of foolishness.
>
> The lesson I learnt in the past few months, is that one has to apply
> a "mismanagement discount" to stocks, since the probability of arrogant
> managers demolishing the value of perfectly excellent companies has
> to be added to the other uncertainties of this complex market climate.
>
>
> (disclosure: unhappy owner of shares in Dow, Pfizer, and Merck)
Why would anyone invest in any company unless they expect a return on their investment, be it dividends or capital gains.
In my opinion, once a company reaches consistent profitability they should pay a percent of those profits to the investors in the form of dividends even if the percentage of the profits is as low as 1%.
In the end all companies go to zero. No company lasts forever just ask GE and GM...lol
On Mar 15 08:31 AM JLarkin wrote:
> Alan,
>
> Shouldn't these criteria be ">"? I'm thinking that increasing liabilities
> and decreasing assets identifies potential liquidity issues.
>
> Liabilities / Current Assets: <3 (identify potential liquidity issues)
>
> Liablities / Adjusted Current Assets: < 5 (haircut AR and Inventory
> to further define liquidity issues)
> Liabilities / EBITDA: < 6 (identify long-term solvency concerns)
>
On Mar 15 03:27 PM Aalan wrote:
> " the vast majority of professional equity investors not only didn't
> know about covenants a year ago, but they probably didn't even know
> where to find them!" -- RIght, and I still don't know where to find
> them. I've invested in several dividend-producing companies that
> suddenly suspended dividends due to debt covenants that I didn't
> know anything about. Where do we find out about this so we can do
> our DD?
On Mar 15 05:13 PM Dikidikido wrote:
> Wasn't the Chief - was the day shift Desk Sgt.
"There are potential scenarios lurking that can heighten the risk to equity holders. Take the scenario where the bonds or bank-debt trade very cheaply and end up in the hands of vultures. They may very well WANT the company to go bankrupt, using their senior position to take control of the entire company. I have written about the potential for asset impairments to degrade balance sheets further and trigger covenant violations (Goodwill Hunting). As time passes, I learn more each day about how poor the position of equity holders in leveraged companies can be. If there was ever a time to exercise caution or at least be as informed as possible, it is now!
This is something a lot of equity holders should heed to in this deleveraging environment. Fortunately, most vultures are also financially strapped, nevertheless one should never underestimate the possibilities.
This is simple math, but if you can't type it correctly you lose all credability.
Sorry, just being honest.
On Mar 15 03:27 PM Aalan wrote:
> " the vast majority of professional equity investors not only didn't
> know about covenants a year ago, but they probably didn't even know
> where to find them!" -- RIght, and I still don't know where to find
> them. I've invested in several dividend-producing companies that
> suddenly suspended dividends due to debt covenants that I didn't
> know anything about. Where do we find out about this so we can do
> our DD?
COCA COLA on that list?? That made me do a double-take. Then I saw it was COKE, not KO. Whew!
It's a sad fact that many good operating companies have been taken down by too much debt, especially LBO-type debt. It looks like Kraft Foods (spun out of Philip Morris/Altria in 2007) may now be running that risk. Talk about a solid franchise. If EBITDA doesn't save them, I would be very surprised if someone doesn't step in and do something, which may or may not include a haircut or conversion option for debt holders.
Overall, I like your approach.
Don't forget, a lot of firms have another overhang - a need to contribute to defined-benefit pension funds for the first time in years, since the asset pools underlying those funds have possibly suffered erosion. WORSE - the assets in the funds are likely to keep eroding in this new era global financial pandemic.
I get a letter every year from an old employer, cryptically informing me that the assets "met actuarial standards". I'm wondering what circumlocution they will use this time, since it's pending...
On Mar 15 11:17 PM Laughing wrote:
> So we are supposed to trust some who can't even get the greater than,
> less than, or equal to signs correct to begin with?
>
> This is simple math, but if you can't type it correctly you lose
> all credability.
>
> Sorry, just being honest.
The bigger point is that bad things happen to good companies with lots of financial obligations in weak economies. We have stretched the definition of "lots of financial obligations", and we are pushing the extreme on "weak economy".
On Mar 16 01:28 AM headlocal wrote:
> AB - another excellent article.
>
> Don't forget, a lot of firms have another overhang - a need to contribute
> to defined-benefit pension funds for the first time in years, since
> the asset pools underlying those funds have possibly suffered erosion.
> WORSE - the assets in the funds are likely to keep eroding in this
> new era global financial pandemic.
>
> I get a letter every year from an old employer, cryptically informing
> me that the assets "met actuarial standards". I'm wondering what
> circumlocution they will use this time, since it's pending...
You have these wall street sleeze pumping balance sheet leverage to maximize returns. This is BS. Companies that generate ample free cashflows should not be piling on debt to make stock buybacks. It is bad policy. These companies should live within that fcf.
As one poster mentioned above, the board of directors are absoutely pathetic and spineless. They have failed in every way to represent and protect shareholder value.
Another thing, how do these boards continue to hand out loads of stock options after management missteps?IMO stock options should be abolished and a discounted 10% stock savings plan should be in its place. The only way to feel the pain is when you have to put up your hard earned money.
Finally, pension liabilites will be a big deal going forward. Check it out when buying a stock.
Imagine two companies have the same liabilities and the same EBITDA. Which company has the highest probability of long-term insolvency? Your screen would treat both the same, but in reality, the company with the most capital intensive operations is more likely to run into trouble, because EBITDA woul not be big enough to make up for the capital requirements.
So, I think this part of your screen should be:
LIABILITIES/ (EBITDA-CAPEX)
In any case, I think your screen is pointing in the right direction.
The bigger point that you make and upon which I can expand is that not all EBITDA is equal, with various claims from all sorts of places. Whether it's CapEx, DB pension contributions, higher interest expense, etc., there is no shortage of potential EBITDA snatching!
On Mar 16 01:48 PM ValueHuntr wrote:
> Great article Alan. My only comment is regarding the use of your
> Liabilities/EBITDA criteria. I understand its purpose is to identify
> long-term insolvency, but this is where my issue is:
>
> Imagine two companies have the same liabilities and the same EBITDA.
> Which company has the highest probability of long-term insolvency?
> Your screen would treat both the same, but in reality, the company
> with the most capital intensive operations is more likely to run
> into trouble, because EBITDA woul not be big enough to make up for
> the capital requirements.
>
> So, I think this part of your screen should be:
>
> LIABILITIES/ (EBITDA-CAPEX)
>
> In any case, I think your screen is pointing in the right direction.
I am not a dart thrower: more like a bowler!!
seekingalpha.com/artic...
i.e. credability
On Mar 15 11:17 PM Laughing wrote:
> So we are supposed to trust some who can't even get the greater than,
> less than, or equal to signs correct to begin with?
>
> This is simple math, but if you can't type it correctly you lose
> all credability.
>
> Sorry, just being honest.