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Train Wrecks in the Stock Market

(Guest Commentary- November 3, 2005)

Dear Subscribers and Readers,

First of all, I apologize for this shameless self-promotion but subscribers may be interested to know that I have just been quoted in a New York Times article on whether the copper boom is ending.  For subscribers who would like to continue to discuss your thoughts or ideas on the commodity, please feel free to email me at hto@marketthoughts.com.  For now, this author does not have any position in the metal.  No doubt, the bullish sentiment in the metal is wild, but shorting the commodity via the futures market is a tricky thing.  It is not sufficient to get the direction right, but also the timing as well.  In light of the Refco and Jim Rogers debacle, please also make sure you have a reputable broker before even trying to dabble in the commodity markets.  I will discuss this and more in this weekend's commentary.

Note: The Dow Jones Transportation Average just made a new all-time high at the close today.  However, the Dow Jones Industrial Average is severely lagging.  Such a divergence has not been witnessed since October of last year (with the Dow Industrials ultimately reversing and following the Dow Transports on the upside).  Will history repeat itself?  Will the Dow Transports continue to lead?  It is certainly very possible - but for now, this author will continue to be cautious given the fact that this cyclical bull market is very mature and given that the Fed is continuing to tighten.  More details to come this weekend.  For now, we will remain completely neutral in our DJIA Timing System.

Okay, folks, most of you can probably only take so much of my writing.  If so, then don't despair, today is the time for a guest commentary.  Again, we have brought back Mr. Bill Rempel - who is now a regular guest commentator (his guest commentaries will appear regularly on our website during the first Wednesday evening of each month) for MarketThoughts. 

Bill is a true student of the markets, as well as individual companies - not just the financials but the stories behind each company as well.  His topic this month should no doubt be of interest to many of our readers - especially for those who purchase individual stocks (especially "value") on a regular basis.  It is with the utmost pleasure that I bring to you Bill's latest guest commentary on "Train Wrecks in the Stock Market" (which he had already sent to me by Tuesday afternoon).  First of all, following is biography of Bill:

Bill Rempel (aka nodoodahs) is an active poster on the MarketThoughts forum as well as a few others around the web. Bill has previously been a guest commentator on our website on a couple of occasions (see "Playing "Chicken" With the Market - Is It a Bright Idea" for his last guest commentary). Bill graduated from Caddo Magnet High School (a high school for nerds) in back in 1985 and proceeded to learn the hard way when he drank his way out of a scholarship to Tulane later that year. After a few years of sweating for a living, he decided to go back to school, and graduated from LSU-Shreveport in 1995 with a Bachelors in Mathematics - all the while working the overnight shift stocking shelves in a grocery store.

Post-college, Bill has been in the P&C insurance industry as an actuary, product manager, and pricing manager. Bill and his wife Millie are amateur investors with a variety of holdings, but they prefer to buy and hold value investments. Their current portfolio contains (in rough descending order of equity) real estate, individual value stocks, physical gold, a foreign-denominated bond fund, a bear fund, and a precious-metals mining fund. In typical "value" style, they live cheap, driving old cars and preferring to save or invest instead of buying fancy "stuff."

Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice.


Of the many "anomalies" that are documented in the financial research, probably the most boring are of the "balance sheet" variety.  Balance sheets just aren't sexy to most of us, and writing about financial statement anomalies just doesn't have the same panache as "Sell in May" or "the January Effect."  However, it has been demonstrated that certain items in the financial statements can be used to group stocks that out- or under-perform over time.  Gomez [1] loved to watch his stocks every day, but there's something else he loved to see, and that's a good train wreck.  Let's take a look at some recent train wrecks and see what we can find, but remember, train wrecks in the stock market happen in s l o w- m o t i o n.

As of October 31, www.bankruptcydata.com shows eleven corporate bankruptcies in 2005 where assets exceeded $1 billion.  The ones that got the most electrons on the MarketThoughts Forum over the last year are Delta Air Lines (DAL), Northwest (NWAC), Delphi Corporation (DPH), and Refco (RFXCQ).  Of these four, only Refco lacks a history of being publicly traded.  In addition, there are several other stocks that haven't filed for bankruptcy yet, but speculation is rampant, like General Motors (GM), Calpine (CPN), Krispy Kreme (KKD), and others.  I imagine if you were a corporate investor or index fund manager, you might have to hold some shares of these dogs.  But I think after reading a little bit longer, you'll see that no individual investor should have been caught dead investing in stocks like these.  Trading them, well, that might be a different story.  But investing in them?  Not!  We won't look at all of them, but we'll look at enough of them to show that warning signs were evident for all to see, well in advance.

Screening the financial statements of potential investments is an essential part of an investor's due diligence.  Below are four examples of companies that have hit the skids, and an examination of their finances before the other shoe dropped.  Key signs such as eroding book value, decreasing interest coverage, reliance on financing cash, increases in intangibles, accounts receivable, or inventories, and poor cash generating power are clues that a stock is due to implode.  Unfortunately the stock market often is very forgiving of these signs, until suddenly, it isn't - and you can never be sure when it will turn around.  The best bet for an investor is to stay away, and relegate companies of this ilk to trades only, if so inclined.

Delta Air Lines

Delta filed for bankruptcy on September 14, 2005, and currently is trading on the pinks for less than six bits.  The 52-week high was $8.17 and it wasn't that long ago Delta looked like a viable stock to invest in, at least, to the gullible.  How bad, how early, was DAL?

As of the year-end 2003 financial statements, the company had -$384 million in equity.  Just three years earlier, the company had $5.6 billion in equity!  What happened?  I thought only M.C. Hammer could burn cash that quickly!  DAL managed to have three consecutive years (2000, 2001, and 2003) of losses, culminating in negative equity, and still remained publicly traded.

Since many companies have negative income at some point in their lives without necessarily risking bankruptcy, I don't like to use the conventional definition of "interest coverage" as a financial ratio.  I typically will use a ratio defined as Interest Payments / [OCF + Interest Payments] as derived from a company's Cash Flow and Income Statements [2].  By watching trends in this statistic one can see whether a company's position is getting better, or getting worse.  By comparing this statistic to that of other players in the industry, one can judge the relative health of a company.  Lastly, by comparing this statistic to simple common sense, one can sometimes get a "stay the heck away from this stock" message, and this is the case with DAL.  2003 was the third consecutive year where DAL devoted more than 60% of their pre-interest operating cash flow towards making interest payments.  When anybody pays 60% of cash flow (not income, cash flow) to interest on debts, the bankruptcy risk is palpable.  And yet the stock continued to trade for almost two more years.

Earnings Quality [3] is a misnomer here, since earnings hadn't been seen since the previous century (yes, the year 2000 was the last year of last century), but this stock had all the signs of poor earnings quality, including persistent negative free cash flow, low Cash Generating Power [4], and a consistent Reliance on Financing Cash [5].

Bottom line: as early as 2003, it was plain to see that staying away was a good choice.

Delphi

Dateline: October 8 2005.  Delphi's (DPH) bankruptcy filing creates additional rumors and pressure surrounding GM's chimera-like turnaround plan.  Delphi went from a 52-week high of $9.28 to a price of 36 cents, the equivalent price of a package of cheese crackers from the office Roach Coach, which, incidentally, you might have better luck trading today.  Delphi had a few flags flying, mostly on the Balance Sheet.  If it weren't for the increase in "intangibles" the company would have burned through $3.8 billion in equity in three short years . not quite up to M.C. Hammer standards, but close, very close.

 

As of Year Ending

Ratio

2000

2001

2002

2003

2004

Total Assets Growth

n/a

0.4%

3.8%

8.2%

-20.6%

Total Liabilities Growth

n/a

10.4%

10.7%

7.2%

4.1%

Net Worth Growth

n/a

-38.6%

-44.7%

n/a

n/a

Book Value Per (Diluted) Share

6.70

4.09

1.03

-0.66

-9.67

Earnings Per (Diluted) Share

1.89

-0.65

0.61

-0.10

-8.41

Intangibles as Percent of Assets

0.0%

0.0%

3.6%

9.3%

11.6%

Inventory as Percent of Sales

5.9%

6.2%

6.4%

7.1%

6.8%

I am reminded that "the trouble with turnarounds is that they never turn" and tend to stay away from stocks with disturbing financials until I see clear signs of a reversal.

Part of the problem with examining stocks in bankruptcy is that quote and chart data seems to drop down the memory hole as soon as the stock is de-listed.  Maybe we should look at some stocks that are still solvent, for now.

General Motors

Check out these debt and interest ratios, and ask yourself how anybody can stay solvent with 1/3 to 1/2 of their cash flow going to interest service.

 

As of Year Ending

Ratio

2000

2001

2002

2003

2004

Total Liabilities / OCF

13.82

33.19

21.27

53.74

34.60

Current Liabilities / OCF

3.20

7.01

5.86

13.57

8.70

Interest / [OCF + Interest]

0.33

0.48

0.31

0.55

0.48

The General can't generate enough cash from operations, and is relying on increased financing for solvency.  Remember that GM's dividend depresses the Financing Cash metric - IMO their insistence on paying a dividend may be hastening their demise.  Perhaps they're playing chicken with the unions?  Interestingly, Moody's just cut GM's debt rating again [6], as I said in the forum, it's a miracle their debt wasn't considered junk years ago [7].

 

As of Year Ending

Ratio

2000

2001

2002

2003

2004

Cash Generating Power [should exceed 1.00]

0.602

0.295

0.391

0.120

0.438

Inventory as Percent of Sales

5.9%

5.7%

5.3%

5.9%

6.3%

Accounts Receivable as Percent of Sales

54.3%

79.8%

80.5%

104.4%

114.1%

Reliance on Financing Cash [should be negative]

4.3%

6.8%

7.2%

12.8%

3.5%

The increase in AR as a percent of sales is classic, it's indicative of their "zero down" and "zero interest" plans, which started high gear in late 2001.  When a company starts aggressively booking sales as sales, even though they haven't received payment yet, is that a good thing?

 

As of Year Ending

Ratio

2000

2001

2002

2003

2004

ROA [Net Income / Average Total Assets]

n/a

0.2%

0.5%

0.9%

0.6%

I wouldn't want to pitch an investment to a member of my family, if it had an ROA below 1%.  Would you?

 

As of Year Ending

Ratio

2000

2001

2002

2003

2004

Free Cash Flow Per (Diluted) Share

-166.45

-0.48

-5.45

-1.40

7.32

Persistent negative free cash flow.

GM certainly has its share of problems, and if I had to put down a turning point in the financials, I would say it was 2001, based on AR, Financing Cash, and Liabilities to OCF.  While some measures turned for the better at year-end 2004, most did not, and some turned for the worse, namely AR and Inventories as a percent of sales.  It's not coincidence that restatements of forward guidance shortly followed the rapidly spiking inventory and accounts receivable measurements.

General Motors

General Motors

As the charts show, this has pretty much been a wacky ride.  Astroworld is indeed open for business!  The stock has definitely been a poor investment, but could have been a very good trade, for those savvy enough to time their entries and exits over the last five years.  Other than the "Captain Kerk" bounce in 2005, it's been strictly downhill since the company's forward guidance returned to reality.

Krispy Kreme Doughnuts

OK, the first and biggest problem with this stock is the spelling.  It should be "donuts."  There.  I said it.

Krispy Kreme Doughnuts

Krispy Kreme Doughnuts

Charts first this time.  We need to look at the financials as of year-end 2003, I think.  The company definitely showed some ratios to be alarmed about, and the negative FCF, intangibles, and inventory to sales all spiked well before the glaze wore off in February 2004.

 

As of Year Ending

Ratio

2000

2001

2002

2003

Reliance on Financing Cash [should be negative]

0.4%

23.3%

10.2%

12.4%

Cash Generating Power [should exceed 1.00]

0.96

0.43

0.58

0.50

Free Cash Flow Per (Diluted) Share

-0.10

-0.04

-0.44

-0.72

Intangibles as Percent of Assets

0.0%

0.0%

6.5%

11.9%

Inventory as Percent of Sales

4.5%

4.0%

4.1%

5.0%


 

As of Year Ending

Ratio

2000

2001

2002

2003

Total Assets Growth

n/a

63.3%

48.9%

60.7%

Total Liabilities Growth

n/a

-19.9%

47.6%

103.0%

Could someone tell that 2004 would be "the" year, from the above tables?  Probably not.  Could someone guess that the time was coming, based on the above tables?  Probably so.

Summary

The financial statements give us information we can use to diagnose the health of a company.  If we know the symptoms, if we have a few simple tools, we can examine the company and ascertain its viability as an ongoing concern.  Does this tell us that the stock will go down, or up?  No, although statistically, in aggregate, the tendency is for stocks with strong balance sheet information to out-perform, and vice versa.  Unfortunately all these tools can do is give us a warning, but a warning that we really should heed. 

"Switchman's sleeping, train hundred and two is on the wrong track and headed for you." [8]

Notes

[1] Gomez Addams, that is.  The sequence where Gomez made the model trains collide and explode was filmed only once, and that shot was re-used every time it was needed.  Gomez was a lawyer, and in addition to his stock market investments, he had the most enviable collection of coroners' reports in the neighborhood.

[2] See "The Power of Cash Flow Ratios" By John R. Mills and Jeanne H. Yamamura for some interesting case studies (http://www.aicpa.org/pubs/jofa/oct98/mills.htm). They use the inverse as if it were interest coverage, but I find it more intuitive to express interest as a fraction of pre-interest cash flow, because I can equate it to a personal situation.  If I were like DAL, and 60% of my cash flow went to paying interest on my debt, I may consider bankruptcy as an option.

[3] I lifted the Earnings Quality metric from an accountant's publication targeted for auditors, and it really loses some usefulness when the company is losing money.  Sum net cash from operations, income taxes paid, and interest payments.  Divide that total by the sum of net income, income taxes paid, and interest payments.  In a company with income, where that income is generated by operations, this number should higher than 1.00.  A company that generates net income with an Earnings Quality of lower than 1.00 is using their accruals creatively, booking financing cash as income, or channel stuffing, none of which is a good thing.  Like all metrics, I look at the occasional instance differently than a persistent occurrence, and if I see several metrics pointing the same direction, I give them more credibility.

[4] Cash Generating Power is the OCF divided by the sum of OCF and Net Cash from Financing Activities (minus "Other Financing Charges").  This is a useful check of the company's ability to generate cash through operations, and part of its usefulness is that you only need to look up the Cash Flow Statement to calculate it.  Again, we like numbers that are higher than 1.00 on a consistent basis, occasional dips are viewed differently than a constant low number.  DAL had a number under 0.33 for three consecutive years as of year-end 2003. 

[5] Reliance on Financing Cash takes Net Cash from Financing Activities (minus "Other Financing Charges") and divides it by Total Assets.  While related to [3], this metric requires both the Balance Sheet and the Cash Flow Statement to calculate.  I lifted it from a research paper that documented the "anomaly" that, when companies are segmented into deciles based on this statistic, those with high Reliance on Financing Cash under-performed and those with a low statistic over-performed.

[6] http://news.google.com/news?hl=en&ned=us&q=moody+gm+debt+rating

[7] forum/viewtopic.php?t=230&start=15

[8] http://www.lyricsfreak.com/g/grateful-dead/62446.html

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