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In this next note in our continuing series on investing in distressed securities, The Turnaround Letter explores the next step as you evaluate your possible investment. After you’ve determined what got the company into trouble, you want to evaluate whether it can get out of trouble.
Highlights: When a company is distressed, its assets are probably worth less than its debts. The best indicator of whether a distressed company will recover is its willingness and speed in dealing directly with this reality. To get out of trouble, the company must find cash (to buy time) and improve the value of its assets.
First, look for sources of cash that the company can tap. Cash can come from selling operations and assets that aren’t critical to the company’s future and from money-losing businesses. Second, see if core operations can become more valuable. This usually requires new management and a credible plan. Make sure the plan is not merely doubling-down on the prior causes of distress.
Discussion: Distressed companies are upside-down: their assets aren’t worth enough to satisfy their debts. Without a doubt, the best indicator that a distressed company will recover is its willingness and speed in dealing directly with this reality. Pure luck may intervene to save the company, but don’t count on it – in nearly every distressed situation, ignoring reality is a strategy for failure.
Facing the new reality requires the company to find cash to give them time to complete the turnaround. It means looking objectively at every asset to find ways to maximize their value.
So, the first part of your analysis is to look for ways that the company can find cash. Assets and operations that aren’t critical to the company’s future can be sold and can plug cash drains. These can include non-core operations, money-losing divisions, under-utilized assets and real estate that would buy the company time and flexibility without noticeably harming the core operations. Even if a business loses money, someone will be willing to pay cash for it.
Second, see if core operations can become more valuable. Are there well-known brands and product lines that provide real value to customers and can serve as the foundation for recovery? Are overhead or research expenses unusually high? Is the business poorly managed, laden with outdated processes, stale products and weak customer service?
Improving the value of core operations usually requires new management and a credible plan. Since weak or dishonest management is the leading cause of distress, it is unlikely that the management team that got the company into trouble can extract it from trouble. Replacing senior management with capable leaders that approach problems with a fresh perspective and have no attachment to prior strategies or operations is a strong indicator that a company is serious about addressing its new reality.
A credible plan provides a roadmap to help you evaluate what a post-recovery company might look like. It includes strategic priorities, financial goals, specific plans to improve day-to-day operations and capital structure improvements. Some plans essentially amount to a doubling-down on the previously failed strategy. You want to avoid these – go with a strategy that reverses or at least avoids the prior causes of distress.
Importantly, a credible plan buys time with creditors and provides you, the possible investor, with milestones for measuring progress. Milestones also exert pressure on management to execute. There are other indicators that the turnaround might be successful:
- Supportive workforce – employees that remain loyal and focused, particularly for long-time and highly-regarded talent. If the company has a unionized workforce, the unions may need to adjust their compensation structure for the company to survive.
- Reasonably stable near-term environment – minimizes external challenges while the company focuses on improving its internal operations. This stability also supports the valuation of any operations and assets that might be divested.
- Opportunities for improvement – launching new products/services, increasing penetration of existing or new markets, eliminating costly/unnecessary business practices and other ways that a company can improve its cash flows and value.
If the company can find enough cash to provide time for a recovery and has a credible plan led by capable new management, it could be a good investment. Your next challenge is to figure out what all this is worth. We will explore this in our next note.