By Richard Gibbons | More Articles

The mission of Motley Fool Inside Value is simple: we want to find companies for less than their intrinsic value. In some cases, companies are below intrinsic value simply because the market has failed to appreciate the sustainability of a company’s competitive advantage. At other times, companies fall below their intrinsic value during a crisis, when panicked investors flee. The latter case has the potential for quick returns, but also comes with greater risk. It can be challenging to distinguish between a company just suffering a flesh wound and one on its deathbed.

When you do identify a potential turnaround, it can be quite lucrative. McDonald’s ( NYSE: MCD ) yielded a 250% return over the past few years — which is a fairly small return for a turnaround. Much larger multibaggers over the course of a few years are easily within reach. Elan ( NYSE: ELN ) has recently been crushed, but investors who bet on a turnaround in 2002 made money, and could have had a 10-bagger. The difficulty, though, is determining who will survive and prosper. With that goal in mind, here are some of the issues I consider when trying to profit from panic.

Liquidity

In a crisis, cash gives a company the time and flexibility to survive a rough patch and reorganize its business. It’s critical to get a good feeling for the degree to which cash on the balance sheet and future cash inflows are able to cover future cash outflows. Of course, the event causing the crisis often reduces operating cash flows, so using historical cash flow numbers can be deceptive. Instead, start with historical numbers and come up with a pessimistic approximation of the extent to which the negative event will impact cash flows, and how much cash outflows can be reduced over the short term, through, say, delaying capital expenditures. If the company is close to the edge, there’s a good chance it will topple over, so it should be avoided.

Even if the cash flow looks good, another liquidity issue to consider is debt. Even if it seems clear to shareholders that the company has enough cash flow to survive, banks and other lenders can be skittish. So it’s a good idea to examine absolute levels of debt and future debt maturities. If the company is highly leveraged, or a substantial portion of its debt is coming due in the next few years, then the company may be unable to roll that debt over to future maturities. Often, it’s not the slow draining of cash resources that leads to bankruptcy, but rather a large debt maturity that the company is unable to roll over or repay. Krispy Kreme ( NYSE: KKD ) is dealing with this issue now.

Asset strength

When it comes to turnarounds, the balance sheet can count more than the income statement. I’ve already talked about debt. Another factor to consider is the strength of the assets, because all assets are not equal. Cash is the best asset, since it gives maximum flexibility. Other good assets include securities and non-depreciating physical assets that can potentially be sold, such as real estate. Due to the rules of accounting, real estate can be particularly strong because it may be listed on the balance sheet at significantly less than its present value.

However, there are also bad assets that generally cannot easily be sold or generate cash. Such assets include goodwill and tax assets. Goodwill is useless because it’s intangible, while tax assets can only be converted into cash when the company has operating profits, generally after the crisis has passed. So when considering a company’s survival prospects, it’s best to heavily discount the value of these assets.

The competitive position

Preferably, we’re buying the beaten-down company not just for its assets but also for its future operating performance. Ideally, the company is suffering from temporary bad news, but has a long-term competitive position intact. Maybe the company will show poor results for a year or two, but is likely to prosper after that time. Or perhaps the company has suffered a permanent setback but is still strong enough to be a viable business.

An example of such a situation is Sunrise Senior Living ( NYSE: SRZ ) in late 1999. As the largest owner and operator of assisted living at the time, it was impacted by a bad acquisition, nursing labor shortages, and overbuilding. Panic drove the shares below $10. But Sunrise was the strongest operator in the industry, and while competitors were going bankrupt, Sunrise wasn’t even close to the edge. If anyone was going to survive, it was Sunrise. Sunrise’s competitive advantages relative to other assisted-living companies were still strong. In addition, its management still had credibility, which reduced refinancing risks. People who bought below $10 had a triple within a year, and the stock is now priced close to $50 — for a 400% return. I didn’t do quite as well, buying at $13, selling in the $30s.

Bringing it together

A good example of all these issues is National Health Investors ( NYSE: NHI ). a REIT that primarily owns nursing homes. As you can see in this chart. National Heath Investors was flying along quite happily when it hit the perfect storm. The Balanced Budget Act of 1997 cut Medicare revenues to its nursing home operators, the companies that lease National Health Investor’s buildings. Consequently, many operators went bankrupt. Plus, like Sunrise, it was affected by overbuilding and labor shortages. Finally, lawsuits in Florida were destroying the business there.

Confronted with these challenges, National Health collapsed like Mr. Bean sparring with Evander Holyfield. I became interested, and bought some at $15. This was a wee bit early, since it cratered below $5 when the company discontinued its dividend only six months later. But this wasn’t a technology company. It had solid real estate assets in a time of falling interest rates. Cash flow was still positive. The entire industry was unlikely to vanish: Somehow, someone would take care of the elderly. So I bought more at $5, and it started to look like the industry was recovering.

But National Health owed money to the banks. And the banks panicked, demanding repayment. So National Health was forced to sell convertible preferreds at a time when the stock was low, diluting existing shareholders. I bought more in the $6 range. Cash flow was still good, nursing home operators were coming out of bankruptcy, and the balance sheet, never really overleveraged to begin with, now looked quite clean. It was difficult to see how National Health could fail.

Now, four years later, the stock is trading around $27. That’s lower than it would be if it hadn’t been forced to issue the convertible, but it’s still a decent return. For months, value investors bought in the $6 range, and those investors have seen a 400% return. What’s more, since National Heath has a $1.80 dividend, investors at $6 are now seeing an annual dividend of 30% on their original investment. I sold out at $22.

The keys in this case were that cash flow was positive, leverage was reasonable, the assets were strong, and there were signs that the industry would turn around. Even then, the debt maturity hurt shareholders significantly, because nobody wanted to lend to companies in the sector. This is why, when analyzing these turnaround situations, it is critical to consider debt maturities.

Conclusion

Evaluating these factors can help you find and identify turnaround plays that lead to extraordinary profits. For instance, in 2002, both Philip Durell, Inside Value ‘s chief analyst, and I independently recognized that Providian Financial ( NYSE: PVN ) had a decent chance of rebounding, and we both bought well under $5. It’s now at about $18. If you want to learn more about Philip’s approach for identifying undervalued stocks or what he thinks is undervalued right now, Inside Value is offering a free 30-day trial. To find out more, click here .

Richard Gibbons. a member of the Inside Value team, owns Providian (though he’s considering punting it) and Krispy Kreme shares and calls (though he’s feeling deep fried). He owns none of the other stocks discussed in this article. The Motley Fool is investors writing for investors .