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