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6 rules for buying back-from-the dead stocks
Some big-name bankruptcy zombies are wandering the marketplace in search of investors. Here's how to tell a good zombie from a bad one.
By Michael Brush
Like spooky goblins knocking at your door on Halloween night, many companies fresh from the nether world of bankruptcy are trading in the market again, vying for a place in your portfolio.
But are they offering tricks or treats?
Its certainly tempting to buy shares of these back-from-the-dead companies. After all, given their scary histories, most investors shiver at the notion of investing in them. But that's exactly why they may be more attractive on the inside than they look on the outside.
Kmart (KMRT, news, msgs), for example, trades at a skimpy 0.1 times sales. Not bad, perhaps, for the countrys third-largest discount retailer -- now free of onerous debt loads and leases, thanks to Chapter 11 bankruptcy proceedings. (By comparison, rival Wal-Mart Stores (WMT, news, msgs) has a price-to-sales ratio of 1.)
Under the right circumstances, the shares of these zombie companies can come back with a vengeance, once investors become comfortable with new management or get a glimpse of friendly business trends. Shares of Allstream (ALLSA, news, msgs), the former AT&T Canada, have gained 68% to trade above $42 since coming out of bankruptcy at $25 in early April.
I would say on balance there can be some really good opportunities, says Michael Embler, who helps run the distressed-investment group at Franklin Mutual Advisors. But you have to have a longer time horizon, because you have to wait for the company to re-enter the investment mainstream, and it can take months or years.
Clearly, though, these goblin stocks sure can haunt your investment portfolio. Generally, I am very cautious about investing in reorganized companies. Companies that have been sick tend to remain sick, says William Rochelle, a bankruptcy lawyer in the New York office of Fulbright & Jaworski.
6 rules of the road
So how do you tell the difference between the good ones and the bad ones? A lot of it boils down to good old securities analysis, but there are some special rules to follow. Here are the six of them.
- Find companies that have actually fixed their business problems. Kmart seems tempting as an investment, with a powerful brand name, $1.2 billion in cash, and that low valuation. Plus, it is seeing some early success in experiments with new store formats. The company has signed up new stars -- beyond Martha Stewart -- to help with marketing, such as the Mexican pop singer Thalia, who should help Kmart appeal to Latinos.
But its not clear that Kmart is changing enough to stake out a distinct territory for itself in a discount-retailing field populated by giant competitors that have eaten Kmarts lunch, says Marcia Layton Turner, author of "Kmart's 10 Deadly Sins: How Incompetence Tainted an American Icon." Chief among them are Wal-Mart Stores and Target (TGT, news, msgs).
I am not convinced that they have a niche for themselves, agrees George Putnam III, editor of The Turnaround Letter, a Boston-based newsletter that specializes in examining turnaround plays. Wal-Mart is known for low prices, and Target is slightly upscale. But, if you ask me about Kmart, I cant tell you what its niche is. While they have shut down their less profitable stores and they are more efficient, I think they need something more to survive in their environment. And I just dont know whether they have it.
Many of the things that drove Kmart into bankruptcy are still problems, agrees Keith Alessi, a lecturer at the University of Michigan Business School. They are behind in infrastructure. They dont have the distribution system that Wal-Mart has. Ominously, the retail sector is littered with discount chains that came out of bankruptcy without making enough changes, only to go out of business for good -- like Bradleys, Ames and Hills department stores. Weak results this holiday season could push Kmart down the same road.
So, at this point, despite the company's well-known name and its impressive size, Kmart stock still doesn't get blue-light-special status.
- Look for solid companies that hit bankruptcy due to a one-time problem. One of the key things you want to see is that the main problem in the business was the balance sheet and not the business model, agrees Robert Chapman Jr. of Chapman Capital, an El Segundo, Calif., hedge fund that invests in distressed securities.
The construction company Washington Group International (WGII, news, msgs) may be a good play now because the chief problems that sent it into bankruptcy were unforeseen losses in a company it took over, Putnam says. Formerly known as Morrison Knudsen, Washington Group ran into trouble in 2000 when it became clear there were surprising losses in construction contracts held by Raytheon Engineers and Constructors, a construction company that had been purchased by Morrison Knudsen. Because of the big, unexpected losses, Washington Group filed for bankruptcy to shore up its balance sheet. It came out in January 2002.
Now, the prospects are looking brighter for the company, which now works in areas such as power plant construction, defense, nuclear and coal plant upgrades, and oil-production facilities, says Putnam. But the Boise, Idaho, -based company is still cheaper than many other construction companies. Except for making the mistake with the acquisition, Washington Group has a good history running construction companies, says Putnam. The early returns look good, and the backlog is good.
Many companies forced into bankruptcy because of asbestos liabilities will still be good businesses once they emerge from bankruptcy. One example: Federal-Mogul (FDMLQ, news, msgs), a big supplier in the auto industry.
- Look for new management. New managers are more likely to bring fresh solutions to old problems. For example, under CEO Cyrus Freidheim, the new management team at Chiquita Brands (CQB, news, msgs) is making several adjustments the prior management team did not pursue.
Theyre closing down unprofitable farms and selling non-core businesses at Chiquita, the second-largest banana producer in the world. Chiquita also is building on its brand name by going into the higher-margin, fresh-cut fruit business, a move that paid off well for Fresh Del Monte Produce (FDP, news, msgs) a few years ago.
- Look for low debt levels. Believe it or not, some companies come out of bankruptcy still carrying big debt loads. Its probably better to avoid these, says Chris Roberts, director of research at the Tejas Securities Group, an Austin, Texas, firm that invests in distressed securities. Look for a manageable amount of debt and liquidity on the balance sheet, he says. As a rule of thumb, cash flow that is 2.5 times expenses offers a good margin of safety.
McLeodUSA (MCLD, news, msgs), the Iowa telecom company, doesnt fit the bill, he says. McLeodUSA restructured its debt, but cash flow is not sufficient to cover interest expense and capital expenditures, Roberts says. It would not surprise me to see this company restructure again. They are still burning a lot of cash.
In contrast, some companies get an extra edge over competitors because they shed debt and come back to compete in an industry where rivals still have big debt loads. MCI, formerly WorldCom and due out of bankruptcy soon, is a good example.
- Look for the right names on the turnaround. One thing Kmart has going for it is that two of the sharper names in bankruptcy investing and turnaround plays are deeply involved. Eddie Lampert, of ESL Investments, owns over 40% of Kmart stock and is chairman of Kmarts board. Hes had big successes in retail investments -- most recently with AutoZone (AZO, news, msgs) and Sears (S, news, msgs). Both are up over 50% this year. And Marty Whitman, manager of the Third Avenue Value fund (TAVFX, news, msgs), also has about a 4.5% stake. A veteran value and turnaround investor, his fund is up 11.3% annually over the past five years. These funds own a big stake in Kmart stock now because they bought the debt cheap while it was going into bankruptcy. That debt was converted to Kmart stock when the old stock got wiped out.
Its no guarantee of success, but other names you want to see among the owners coming out are Appaloosa Management, Oaktree Capital Management, Franklin Mutual Advisors and Angelo, Gordon & Co.
Its good to see a few turnaround specialists like these holding big chunks of the stock. Because of their large holdings, theyll have better control over the changes needed to fix the company. Be careful with companies where bond funds or banks hold stock they got stuck with when debt they held pre-bankruptcy was converted into shares. They'll be selling any rallies, capping gains for everyone else until those positions are liquidated.
- Avoid pre-packaged bankruptcies. Known as pre-packs in the business, these are companies that went through Chapter 11 proceedings worked out in advance, so they could move quickly. They can be a success, but Rochelle, the Fulbright & Jaworski attorney, thinks they are suspect.
Prepacks don't afford enough time to fix the business, he says. Recent examples of prepacks include Essential Therapeutics (ETRXQ, news, msgs) and Magellan Health Services (MGLH, news, msgs) in health care and GenTek (GNKIQ, news, msgs), in telecom.
Risky plays
Based on the evidence laid out above, we have two Buys -- Washington Group and Chiquita -- and two Avoids -- Kmart and McLeod.
But these four represent only the most recent wave of zombie companies to warrant a close inspection. As the economy continues to move out of darker times, plenty more will emerge. And above all, as these enticingly cheap companies spring out of bankruptcy, remember that no matter how hard you look them over, they are still risky plays.
Ive seen all kinds of companies go into bankruptcy, and Ive seen all kinds of companies go out, says James McTevia, chairman of McTevia & Associates, an Eastpointe, Mich. company that has been offering consulting services in bankruptcy proceedings for 40 years. "And I have not seem many last once they go out. The success rate of companies that come out of bankruptcy isnt the greatest."
Coming out of bankruptcy, the success rate varies, agrees Putnam. They have the potential to be quite undervalued because most mainstream investors stay away either because they got burned before the bankruptcy, or there is not much news about them. The real question is, did they use the bankruptcy process to solve all their problems? Some do and some dont.
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