Pages

Turnarounds: cut expenses, or increase volume?


I don't generally think of myself as a turnaround investor, yet when I look at some of my investments they are clearly predicated on business conditions improving.  Even with all their warts many value stocks are priced for imminent death.  The attraction of many of these stocks is that with such negative sentiment if the future is only bad, instead of terrible the share price could rise, and rise dramatically.  

I've been thinking about turnarounds a lot recently, maybe because there aren't as many opportunities available anymore without a lot of problems as the market continues to rise.  Someone left a comment on a post in the last year that was extremely insightful regarding turnarounds, they mentioned a company that merely needs to cut costs has a brighter future than one that needs volume to increase.  I don't know who left it, probably someone anonymous, but thanks, it's had me thinking for months.

Many companies classified as in a turnaround state have followed a similar storyline.  The company was doing well for a period and then suddenly something changed, often something external, the housing bust or an industry shift.  The company couldn't, or didn't shift quick enough and they began to lose money.  At first management thought they could continue to do what they'd always done and the market would return.  Companies with a lot of cash on their balance sheet they can whither away much longer before management is forced into a corner.  Companies short on cash are often forced into a corner quickly, and usually restructure the quickest.  For some companies cutting costs is enough to bring stability, other companies require the market to turnaround.  When a company is waiting on the market the company needs to have a sizable cash hoard, or readily available line of credit.

I looked at two companies this week that each had compelling aspects, but the thought lingered as I passed on each: "They only need sales to increase a little bit.."  The first was a bank, deposits had been falling and costs appeared to be cut to the bone.  The problem was the bank's loans were rolling off, and the money to loan against was leaving quickly forcing their loan book to shrink.  It's hard to increase lending on a shrinking deposit base.

The second company was one a reader mentioned to me, Continental Materials (CUO).  The company is essentially the story of the American housing boom, they were earning between $1.34 and $1.72 from 2003 to 2007 before the bottom fell out.  Since 2007 the company hasn't been able to turn a profit.  Continental Materials makes roofing supplies, asphalt sheets, fiberboard, roofing nails, and bizarrely kitchen mops.

So how has the company survived with the continual losses?  They've whittled $3m in cash down to $600k and have become heavily reliant on credit lines and financing.  In other words they've exhausted their own capabilities and are now leaning on banks to make it through the housing bust.

Sales have drifted downward to $112m from a high of $168m in 2007.  The company has been able to raise prices, the only news on their site is nicely worded messages to their clients that asphalt roofing supply prices will be increasing 5-8%.  The news releases are once or twice a year; as while input costs have risen the company is passing them along nicely.  

To the point about turnarounds at the top of this article Continental Materials is the second type of turnaround, they need volume to increase.  The company's SG&A is $18m, which is slightly down from $20m in the boom years, but it's remained steady.  I don't know if their level of staffing is appropriate, but this isn't a services business that can be temporarily run out of a Starbucks in a pinch.  The company's gross margin has actually increased as manufacturing costs have been cut, but with falling sales the ever steady SG&A has come to consume a larger part of revenue moving from 12% to 16%.  The change from 12% to 16% doesn't seem that significant, but let me put things in perspective.  If the company's SG&A was back at 12% they would have earned $1.89 p/s for the TTM rather than losing $1.29 p/s.  

What made me take a look at the stock initially was the reader mentioned they had a $24m market cap, and just won a lawsuit that will result in a ~$6m settlement after taxes and fees.  A cash infusion equal to 25% of the market cap gets my attention.  Initially I thought maybe the company could use the cash to clean up the balance sheet and provide some stability.  Unfortunately the company needs more than just the elimination of interest expense to get them in the black.  Even if they paid off most of their debt they would only save $500k in interest expense, and when operating income is -$2.5m it's easy to see why the cash will be nice, but won't be a panacea.

This might be a nice stock to hold if you think housing, and roofing will be recovering anytime soon.  A 10% increase in sales would bring the company to break-even.  Anything above 10% would start to fall to the bottom line quickly.

The biggest risk is the $6m provides enough of a shot in the arm that management continues to wait out a housing recovery instead of investigating ways they can change their company to be more competitive.  Maybe that's why they diversified away from roofing into kitchen mops...


Disclosure: No position

6 comments:

  1. I think along similar lines is to say to yourself is this stock cheap today. Not if A happens, or B, or C but is this stock cheap now? If not wait. You will miss some winners but the vast majority of stocks will come to you because things take longer to turn around. This can be the case with the individual company turning around, or the sector the company is in, or the economy as a whole.

    Plus investors are generally too optimistic and think about the good things happening and discount the probability of bad things happening.

    ReplyDelete
  2. I believe the best current example of a potential turnaround company is 3U holding, a Cap of €17mln vs a liquid BV of €55mln,and no debt...
    in 2011 they made a profit of around €25mln by selling a subsidiary and the Cap reached
    for 2012 there's an expected loss of around €8mln because of an insolvency from a client who was expected to pay €6mln, + the instability of the feed tariffs from the German Government for a good amount of time( now there's an agreement of a slightly reduced tariff for Solar and PV modules)which influenced sales for the PV businesses ,+ the internal development for new subisidies in the PV and Cloud Computing business( mainly staff costs) which are going to generate external sales in the beginning of 2013 + the realization of the Adelebsen Solar Project which started to generate income from November '12( with an expected income of €1.7mln/year for the PV + the income from a future rent of a building for €0.5mln/year, vs a total cost of €22mln for the project)...
    the management is continuing with the buybacks and the minority shareholders are gathering together(now over 10%) to elect a member to the Supervisiory Board for the next AGM at May...
    Recently there has been a very positive meeting between the Board of Directors and the minority shareholders and there's a promise from the managers that for 2013 there will be a zero tolerance for losses...
    the Ceo is the major shareholder with a 25% stake, I find it a wonderful scenario because it's a big enough stake to align management with shareholder's interests,but small enough of a stake for total control of the company and with a "risk" of a takeover from a third party.

    ReplyDelete
  3. Charlie Munger always says - "Invert, always Invert".

    I try to push the company's financials through extreme distress and see if they will survive a great depression or crazy meltdown like 2009.

    Test if the Asset values hold up in such a scenario, even if the management is bad. See if the Assets can be sold/salvaged to a decent value. Intangibles should be set to 0 in such situations. I rarely look at income statements in such scenarios because they are going to be bad and I assume worst case scenarios.

    Warren always says that turnarounds almost never happen, financial engineering can happen, but turnarounds are rare. If financial engineering can get a value that is higher than current prices, then I feel it is justified to take a position.

    I also almost don't buy in turnarounds unless there is an activist investor who will push for asset sale or financial engineering, if things don't improve.

    ReplyDelete
    Replies
    1. Interesting point that turnarounds almost never happen, this is one of those gut feelings I agree with. Turnarounds and catalysts are two mirages that investors are always attracted to, and yet almost all of the time turn out to be just a mirage and nothing more.

      Delete
  4. Good discussion, Nate.

    For the category of turnarounds that need sales to increase, I think there is some different subcategories that might give some more clarity to the analysis. Some companies are experiencing problems with their core business that are difficult to fix. Some high profile examples I can think of are Sears, JCP and RIM. Sales dropped because they didn't keep up with their competitors, and they are going to have to overhaul their businesses in order to achieve that sales increase. It won't be easy. The bank you mention would probably fall into this category. A bank with a shrinking deposit bank is doing something wrong vis a vis its competitors and needs a real business turnaround to succeed.

    Second, there is the issue of secular decline - the classic buggy-whip company. The core business isn't coming back, so the company will have to do something different to increase sales. PCs makers (Dell, HP) and brick and mortar retail (BBY, RSH) would fit into this category. Really, anything that gets superseded by technology or innovation.

    I think both of these types of companies are frequently value traps. Sales are unlikely to recover lost levels, and will probably continue to decline. While the success stories can be enormously profitable, the downside is huge.

    In some cases, however, I think turnarounds are merely cyclicals. CUO appears to fit this category. CUO seems to fit this category. Just from your description, the primary problem with the company seems to be the housing market, not competitive position. They should see an increase in sales when the housing market recovers. So the question is when will the housing market turn, and can CUO last long enough to get there? It will happen eventually but timing is the issue. I do think these companies can be worthwhile investment if you have a long time horizon and are correct about balance sheet safety and competitive position. Personally, I'm putting CUO on my to do list.

    Doing some thinking out loud here, so curious about your thoughts on this.

    ReplyDelete
    Replies
    1. This is a great comment, you really took this post to the next level. You're absolutely right that a lot of turnarounds actually fall into the value trap category. A company such as BBY or RSH where the business model is impaired and sales aren't coming back.

      I think the more dangerous investment is actually the buggy-whip business, in a lot of these cases management gets the idea they can re-invent themselves, and with that thought a lot of shareholder value disappears.

      Cyclicals are tough, in a lot of cases they do come back without a problem, but there are cases where while at the down portion of the cycle the market changes. An example I'm thinking of is the American steel industry in the early 1980s. Since the 1920s there was a patterns where there'd be a downturn and a few years later things would come back. Everyone knew this was the case, and while demand was down management was hesitant to cut anyone knowing demand would roar back. Unfortunately in the late 1970s and early 1980s the market changed. Japan was able to compete at a lower cost and the American market never returned. This lull almost killed the industry as both management and the unions had their heads in the sand over the shift. They fought about benefits and pay not realizing that things would never return to how they were in the past.

      I really appreciate investors who can invest in cyclicals well. There is a LOT of money to be made doing that, I own a few, but it's really not my specialty. Maybe it's something I'll grow into.

      Delete