|  | | Price | 13.450 | | | Change | -0.050 | |
Research Wizard
Add to MSN Stock List
Message Board
|  | | Price | 64.450 | | | Change | +0.230 | |
Research Wizard
Add to MSN Stock List
Message Board
|  | | Price | 0.000 | | | Change | unch | |
Research Wizard
Add to MSN Stock List
Message Board
Related Sites
The Turnaround Letter
Jubak's Journal
Recent articles:
• 8 ways to play a shaky market, 1/24/2003
• Earnings aren't bad, just not good enough, 1/23/2003
• Use charts to assess risk and reward, 1/21/2003
More...
| | Jubak's Journal
Find a turnaround with a shot at success
Investing in distressed companies can pay off in the biggest way. But it also can be disastrous. Here's how to find the most promising turnarounds.
By Jim Jubak
Its a sad fact of life that there are no free lunches from investing in turnarounds.
The way to make the biggest profit from a turnaround situation is to invest while everything still looks dark for a company and ignominious failure is a real possibility. Just look at turnaround investor George Putnam, who bought shares of Clean Harbors (CLHB, news, msgs) back in August 2001 when they traded for $2.20 -- and then earned a 429% return when the stock climbed back up.
But when you get in early on a turnaround story and youre wrong, you can take a bath. Putnams recommendation of Danskin (DANS, news, msgs) at $3.01 fell 98% from the time he first published it in October 1995 to November 2001, when he closed out the position at 7 cents a share. (I recommend Putnams newsletter The Turnaround Letter for anyone seriously interested in turnaround stocks and bankruptcy investing. You can check it out by using the link at left under "Related Sites." )
Now consider one of Putnams recent recommendations, generic drug-maker and distributor Andrx (ADRX, news, msgs). On the upside, the company has a huge pipeline of potential products, generic versions of already-off-patent drugs and still-patented drugs with $8 billion in 2001 sales, according to Putnams count.
Andrx: little company, huge potential
How did such a little company (Andrx has a market cap of just over $1 billion) develop such a huge pipeline of potential products? The key is Andrxs proprietary timed-release drug delivery technology. This ace-in-the-hole technology lets Andrx develop branded versions of existing drugs, even if theyre covered by patents.
The companys first branded drug, Altocor, a time-release medication for lowering cholesterol, hit the market in July 2002, and the company has just submitted an application for a second branded product, Metformin XT, for diabetes.
But the road hasnt been without major potholes. In October, a judge ruled that Andrxs version of Prilosec violated two of the patents of AstraZeneca (AZN, news, msgs), owner of the patent on the blockbuster ulcer drug Prilosec. Andrx remains confident that it will win on appeal, but an appeal is likely to take 12 to 18 months.
Some of the damage to Andrxs plans has been self-inflicted. The companys timetable for bringing its own forms of Tiazac and Wellbutrin to market have been pushed back well into 2003 as the company works to get the U.S. Food & Drug Administration to sign off on manufacturing procedures. Those delays and the legal setback involving Prilosec threaten to dry up the cash flow that Andrx needs to market its branded drugs. Andrx posted a negative net cash flow from operations of $26 million in the September quarter, so theres not a big cushion to fall back on.
This story of promise and then failed execution is only too familiar to anyone who watched the stock crater from a high near $95 to a low of $10.75. As of late January, Andrx shares changed hands at around $14.
The case for a turnaround at Andrx hinges on the ability of new CEO Richard Lane, a drug-industry veteran who most recently worked at Bristol-Myers Squibb (BMY, news, msgs). Wall Streets estimates for the companys future earnings are all over the block: The low estimate of 2003 earnings per share is $1.25 and the high $2.74. And even brokerage companies that recommend the stock for the next 12 months, such as A.G. Edwards, note that earnings could well collapse again in 2004.
But if the turnaround works? A.G. Edwards has a target price of $35 for sometime in 2003 before the stock pulls back to $22 on the potential drop in 2004 earnings. Thats a best case 140% gain and a less-best-case gain of 50%. And nothing in those projected gains hinges on the economy growing at any rate in particular.
Battery of problems at Gillette
Contrast all this to the turnaround now under way at Gillette (G, news, msgs). No one on Wall Street or in the financial press doubts that new CEO Jim Kilts can cut expenses and restore sales growth to a great company. Fortune magazines Dec. 30 story, for example, has a page of endorsements of Kilts, the man who has turned around everything from Kool-Aid to Kraft cheese to Oreos. Bob Eckert, the CEO who turned around Mattel (MAT, news, msgs) says, I buy stock whenever he goes to a company. Even Warren Buffett offers an endorsement of Kilts skill. And the early numbers look extremely promising. By focusing on execution, Kilts has cut inventory at Gillette to 108 days from 122 in 2000, and the company collects the money due to it in 81 days now, down from 100 days in 2000.
Despite all that, I dont think the turnaround at Gillette is nearly as much of a slam-dunk as Wall Street does. I cant figure out any way that Kilts or anyone else can fix Gillettes big structural problem, which is the Duracell battery business. The battery business is a no-brand-loyalty, low-margin business with cutthroat competition. And Duracells 10% margins drag down the margins at Gillette as a whole. In retrospect, the logic that led Gillette to purchase the brand was flawed, and Duracell just doesnt fit Gillettes model of charging higher-than-market prices for products with dominant market positions.
On the other hand, the success of Gillettes turnaround is a sure thing in comparison with all the uncertainty that surrounds the efforts at Andrx. But as a result of that, the potential returns from a turnaround at Gillette are relatively meager. Gillette, now trading around the $30 mark, trades at 31 times trailing 12-month earnings per share, a sizable premium to the price-to earnings ratio for the average consumer-products stock of 28. Even analysts who like the stock and the Gillette turnaround story put price targets of just $34 to $35 on the shares. Thats a best-case return of about 15% from here.
Is there a way to get the potential return from a turnaround stock to look more like that of an Andrx while keeping the risk closer to that of a Gillette?
McDonalds problems persist
Sticking with big names every investor recognizes, instead of no-names like Andrx, wont do the trick. Just look at McDonalds (MCD, news, msgs), a company that has tried so many turnarounds in the last few years that it ought to be mounted on wheels. Nobody believes in the newest turnaround plan because nobody can figure out how the company can bring more customers into the restaurants without cutting prices. Wall Street finds it laughable that improving the taste of McDonalds food in some nebulous way will do the trick.
Despite all the evidence that market saturation is part of the McDonalds problem, the company still plans to open 450 new outlets in 2003.
Ironically, the problems with the McDonalds turnaround point investors in the right direction, I think. To increase the profitability of a turnaround and to lower the risk, it sure helps to begin with a management that shows it grasps the seriousness of the situation and is prepared to do whatever needs to be done, no matter how tough.
A situation that puts management to just this test is shaping up at Noranda (NRD, news, msgs), the huge producer of nickel, copper and zinc. Noranda finds itself in a tough spot: The big Canadian company continued to expand production, financing the expansion with debt, even while the prices of the basic metals it produces were falling. Now prices for those metals have started to rise, but they havent climbed enough to produce the cash flow Noranda needs to fix its balance sheet.
Norandas debt-to-equity ratio stands at 1.36. In other words, the company owes 1.36 times as much as the stock market thinks the company is worth. Long-term debt stands at $2.8 billion, a significant amount for a company that wasnt cash-flow positive for a single quarter out of the last five. More pressing, the company faces $400 million in short-term debt. When Standard & Poors lowered the companys credit rating to negative from stable, the rating agency cited fears that Noranda would not be able to successfully refinance the debt coming due in June 2003.
This sets up a clear test of managements commitment to a turnaround at Noranda. If management passively waits in the hope that rising commodity prices will generate the cash flow to bail out the company, then I think were seeing an example of business as usual. In that case, I think the companys 5% dividend is in danger, and investors ought to avoid the stock unless they believe in a big enough surge in global economic growth to put Noranda in the black.
But on the other hand, if management carries out an aggressive program of postponing new investment in unprofitable metals such as zinc, and if the company zealously works to sell off non-core assets, then I think theres a turnaround story worth investing in at Noranda.
Norandas turnaround solution
There are some signs that that may be exactly whats happening. In mid-December, Noranda announced that it would postpone the development of its Perseverance zinc deposit in Quebec until at least 2005-2006. In addition, in recent speeches and interviews, CEO Derek Pannell has talked about focusing the company on copper and nickel mining and selling off assets in what would then be the non-core smelting and refining businesses. Norandas lead, aluminum and magnesium mines could also go on the block. The refocusing would help solve the companys balance sheet crisis and over the long term increase return on investment.
Investors have heard the turnaround talk. Now they need to see if the company will walk the turnaround talk.
Seeing Noranda actually begin to execute a turnaround plan would not be enough to eliminate all risk from the situation. Theres always the chance that the companys plan wont work or wont be implemented well enough to succeed.
But Ive got two suggestions for how to take that risk out of a turnaround situation.
Can Waste Management save itself?
First, you can wait for that moment when a turnaround is in place but is starting to lag. Waste Management (WMI, news, msgs) is a good example. CEO Maury Myers, who took over the company in 1999, has brought it back from accounting scandals and huge losses. You can see his good work in the numbers: Operating margins climbed to 15% in 2001 from just 10% in 1999. Free cash flow, which was just $362 million in 1999, hit $905 million in 2001.
But the job isnt finished, and Wall Street has started to doubt that the company can deliver the next round of cost cuts and operating efficiencies that would bring Waste Management to par with its industry. The industry average operating margin is 21%, 40% higher than Waste Managements margin now even after all Myers work.
Fortunately, the company seems to understand Wall Streets skepticism and may be prepared to do something about it. Myerss contract expires in November 2004, and last November the company began a search for a chief financial officer who would become one of the front-runners for the CEO job along with a couple of company insiders. The consensus on Wall Street is that the company needs a strong CFO with an established record of cost-cutting to get the job done and to move into the CEOs chair. That hire, expected sometime in the first half of 2003, could make the stock a hot turnaround story again. And it would easily justify a move in the stock toward a $35-a-share target price from the current $23, even if the economy doesnt pick up enough to increase waste volumes significantly.
The case for Comcast
And finally, take a look at what I call internal turnarounds like the one under way at Comcast (CMCSK, news, msgs). In an internal turnaround, an existing management team with a solid track record of acquiring and fixing badly run companies makes a major acquisition that gives it a chance to do it again. Thats exactly the situation at Comcast after the deal to acquire AT&T Broadband. Thats why I added that stock to Jubaks Picks on Dec. 12 with a target price of $34 by December 2003. (For my original reasoning on buying this stock, see my Dec. 12 column, Spot the winners, cut the whiners.)
An internal turnaround like that at Comcast isnt a free lunch. Theres still the risk that management wont execute this time, and the return isnt likely to be quite as high as if you had picked a pure turnaround winner. But in this market, I think this is about the best odds youll get.
New developments on past columns
E*Trade lesson Measure honesty along with P/E
Controversial E*Trade Group (ET, news, msgs) CEO and Chairman Christos Cotsakos resigned his positions on Jan. 24. Cotsakos had become a lightning rod for investors worried about inadequate corporate governance after he received a 2001 pay package valued at more than $80 million, making him the highest-paid CEO on Wall Street despite the relatively small size of E*Trade in comparison to, say Merrill Lynch (MER, news, msgs). Cotsakos returned about $20 million of that package, but even that act didnt put the issue to rest for shareholders who asked how the company board had agreed to pay the CEO that much in the first place. Cotsakos will be succeeded by Mitchell Caplan, currently E*Trades president and chief operating officer, who joined the company in 2000 when it bought Telebac Financial, which Caplan ran. In an effort to further strengthen corporate governance at E*Trade, CEO Caplan will not hold the chairmans job as well. That will go to current director George Hayter, who holds no other office at E*Trade. Splitting the CEO and chairmans jobs has been one major suggestion of reformers trying to strengthen board control over corporate managers.
Dont go hungry in the coming yield famine
In my Dec. 3 column I wrote that American Electric Power (AEP, news, msgs) was too risky for me despite its then 8% yield. With the company paying out $2.40 a share but earnings just $2.06, there was a good chance that the utility would have to cut its dividend to conserve cash. Well, thats exactly what the company announced on Jan. 24. Despite a 36% fourth quarter increase in revenue, the company posted an $837 million loss, or $2.47 a share, for the period. That compares with earnings of 16 cents a share in the fourth quarter of 2001. In an effort to prevent a downgrade in the companys credit rating, now three notches above junk bond status, that would raise the companys cost of borrowing, American Electric Power will sell or close two coal-fired power plants in England that it bought in 2001 and reduce its dividend to 35 cents a share from the current 60 cents. Shareholders will take a second hit from dilution as the company plans to sell more shares to raise cash to reduce its current $12 billion in debt. Investors trying to figure out how far up the food chain such dividend cuts might reach will get a critical data point when Duke Energy (DUK, news, msgs) reports today. If Duke cant hold the line on dividends, its likely that none of the big players in the utility sector can.
Editor's Note: A new Jubaks Journal is posted every Tuesday, Wednesday and Friday. The Wednesday edition stems from Jim's appearance on CNBCs Business Center most Wednesday nights at approximately 5:45 p.m. ET. Selected CNBC stories can be found in the TV Reports index.
At the time of publication, Jim Jubak owned or controlled shares in none of the equities mentioned in this column. He does not own short positions in any stock mentioned in this column.
|
