Is Your Stock A Sinkhole Or A Geyser? Part I

Includes: GT, MSO, PEIX, RAD, WOLF
by: Hedge Fund Trading Academy

It's often been said that the two happiest days in a boat owner's life are the day that he buys his dream boat, and the day when he is finally able to sell it.

When I was growing up in the Pacific Northwest, our family shared a 34 foot Tollycraft powerboat with another family in our neighborhood. I have very fond memories of bouncing along the white caps, smelling the salt, and feeling the wind on my face. My father remembers hitting a submerged log, having to constantly repair the engine, and fighting the never-ending corrosive effects of salt water.

He always had a sense of humor about it, though. He had a wooden plaque mounted in the cabin that read: "Boat: [boht] noun, definition: A hole in the water, surrounded by wood, into which one pours money."

I've often thought of that definition when I look at businesses like Martha Stewart Living Omnimedia (NYSE:MSO), Rite Aid (NYSE:RAD), Goodyear Tire (NYSE:GT), Great Wolf Resorts (NASDAQ:WOLF), Pacific Ethanol (NASDAQ:PEIX), and any other number of what you might call "boat stocks," "black-hole stocks" or "sinkhole stocks." These companies are high-precision machines that have perfected the art of turning $1.00 into $0.90 or less. This is more difficult to do than one might expect. Even in the 1985 film Brewster's Millions, Richard Pryor is unable to burn through $30 million without realizing a positive return.

What MSO, RAD, GT, WOLF, and PEIX all have in common is that they have all generated negative free cash flow for many, many years: 10 years for MSO, RAD, GT, and 7 years for WOLF and PEIX. The last 7-10 years have seen huge booms and busts, but averaged over the complete economic cycle, these companies have been cash sinkholes.

If you have a business that is hemorrhaging cash, where do you turn? To the capital markets, of course. All five companies listed above have done a good job of diluting their shareholders by issuing more shares, and leveraging up unprofitable businesses by issuing more debt.

But, you may ask, isn't Goodyear a pretty shareholder-friendly company? After all, it has paid out $468 million in dividends over the last 10 years. Unfortunately, this cash was not created by actual business operations. The business itself was a furnace that managed to incinerate $268 million. The cash to pay dividends came rather from issuing $985 million in new debt and $987 million in new stock.

Miracles happen every day. Great Wolf Resorts is trying to license its brand and move away from its highly capital-intensive business model. Rite Aid may be able to reinvigorate its stores with its new "loyalty + wellness" program. J.C. Penney (NYSE:JCP) recently acquired a 16.6% stake in Martha Stewart Living Omnimedia, and may eventually buy the entire company.

If you own a sinkhole, there are two ways out: Either the sinkhole miraculously reverses itself and becomes a cash geyser, or a greater fool takes the property off your hands. After all, God's not making any more sinkholes, is he?

As for me, I'd dump the sinkhole and buy a boat. At least that way I'll get to enjoy the crisp, salty air.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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