Down but not out

This theory is hard to argue with. Anyone hoping to make a handsome profit from reselling goods will look to buy when demand is low and the assets are cheap, with a view to selling them on when they’re back in fashion and commanding a much higher price tag. Apply this same logic to investing and you can’t go wrong, right? If only it were so simple.

Buying on the dips is a strategy that’s extremely difficult to execute, particularly for those investors brave enough to hunt down the biggest potential bargain opportunities. Determining whether the cheapest stocks in any given market have bottomed out or are poised to fall further is a gruelling task that has a nasty habit of leaving investors eventually holding on to shares that have little to no value left. More often than not, buying into and aggressively averaging down on contrarian convictions ends in misery. Only in a few isolated cases, such as those lucky enough to have stuck by the likes of Apple (US:AAPL), BP (BP), Starbucks (US:SBUX) and Sony (TYO:6758) during their darkest hours, did shareholders emerge from the process of deep value investing with significantly fatter wallets.

In hindsight, it’s easy to say which shares were overvalued and underpriced. Much less so when the company in question is in the midst of a crisis and battling against the forces of momentum.

Cheap for a reason

Investors on the lookout for shares with the potential to stage a comeback will discover that the lowest trading stocks are usually marked down for a good reason. If many before you judged the shares to be worth so little, don’t expect to suddenly stumble across wide economic moats and sustainable future growth. What you’re more likely to find is a series of poorly run companies operating in industries in structural decline. The stock market may occasionally be irrational, but it’s rarely stupid.

The key to differentiating a bargain from a value trap is to dig deep and hunt down any little nuggets of information that might have somehow been overlooked. Just as the herd mentality can overprice popular stocks, it can also excessively punish those out of favour.

The challenge is to identify cases where emotions have overshadowed fundamentals. What is the company’s share price implying about its future and has something, however small it may be, been left unnoticed? Chances are whatever you find is unlikely to dramatically change a stock’s long-term prospects. It could, however, suggest that the company is in a better condition than the rest of the market has given it credit for. And it’s amazing what even the tiniest bit of good news can do to a depressed share price.

Screening for value

Over the past three years, 65 companies across the FTSE All-Share and Aim All-Share have seen their share prices collapse by at least 60 per cent. To filter out the dogs from the potential bargains, I ran a series of screens to determine which stocks from this list might stand a better chance of bouncing back.

All candidates were tested against trusted valuation measures, such as price-to-book value (P/BV), Jim Slater’s price-to-earnings growth (PEG) and Algy Hall’s market-beating genuine value ratio (GV). Algy’s formula brings together various popular investing metrics to assess whether a company might be undervalued. They include looking at a stock's enterprise-value-to-operating-profit ratio, two-year average forecast earnings growth and dividend yield.

To help readers understand how to assess a company's recovery prospects, I'll discuss the turnaround hopes of three high-profile companies that scored highly in the screens.

Debenhams

Many of Debenhams’ (DEB) woes can be traced back to when a group of private equity firms pulled the retailer off the stock market in 2003. In the three years that followed, a consortium made up of CVC Partners, TPG Group and Merrill Lynch squeezed over £1bn out of the company, lining their own pockets while leaving Debenhams saddled with debt.

This classic asset-stripping operation left Debenhams, a company with an assortment of large fixed operating costs, in a perilous state when it refloated in 2006. The department store suddenly found itself facing a deadly global financial crisis and a drastic shift in consumer spending patterns with £1.2bn of debt weighing on its balance sheets. A look at the company’s share price tells you all you need to know about how this panned out.

The past decade or so hasn’t been kind on the traditional department store retail model. Changing shopping habits – consumers now prefer to buy their goods online – and increased competition from the likes of Amazon (US:AMZN) forced industry titans House of Fraser, Toys 'R' Us and America’s Sears into bankruptcy. Investors now appear to be pricing in the possibility that Debenhams, one of the UK’s oldest retailers, could be the next casualty.

Debenhams certainly ticks all the boxes of a company in danger of going bust. One of the first things that investors are taught is to avoid businesses with wafer thin profit margins and lots of debt. Debenhams is guilty of breaching both these rules.

The company’s operating margin narrowed by 3.7 percentage points over the past four years to 1.9 per cent, hardly a promising sign for a stock shackled with debt and crippling lease commitments. In 2005, Debenhams’ private equity backers sold 23 freeholds to British Land for £495m. These properties were then leased back to the company on inflexible deals lasting up to 35 years. Management said it paid £221m on rent in 2017, adding that two-thirds of its estate fork out above-market rates.

A look at Debenhams’ fixed charge cover, a ratio designed to establish how well earnings cover obligations such as leases and interest expenses, paints a worrying picture. A fixed charge cover of 1.3 times or less is a cause for concern: Debenhams’ stands at 1.14.

Led by its new chief executive, former Amazon executive Sergio Bucher, the company has mapped out a strategy to boost sagging profits and prevent debt from rising further. The dividend and margin-denting promotions have been scrapped, stores are being closed, refurbished or downsized. Its Danish department store, Magasin du Nord, has been put up for sale and capital is being invested to improve Debenhams’ online service.

Delivering on those pledges should be enough to stabilise profits before the retailer’s £200m bond and £320m revolving credit facility expire in 2021. But it won’t be easy. Buyers are currently not queuing up for retail assets, reducing the chance of flogging Magasin du Nord for a decent price. Then there are the leases. Mr Bucher wants to close up to 50 stores, but first must get the blessing of landlords, many of which have already been impacted by the closures of Carpetright (CPR), Mothercare (MTC) and New Look shops under company voluntary arrangements.

Investments must be carefully managed, too. The future of Debenhams hinges on its ability to make more online sales, revamp its clothing lines and refurbish dated stores. Given the precarious state of the company’s balance sheet, it’s important that these measures don’t go over budget.

Down but not out?: Debenhams is generating organic cash flow 

A lot else is riding on Debenhams’ survival, including whether its “experimental” shopping model – gyms, eateries and coffee shops are being added to stores to increase footfall – succeeds and if post-Brexit Britain can somehow lift wages, curb inflation and encourage shoppers to loosen their purse strings. Failing that, there’s still some glimmer of hope that shareholder Sports Direct (SPD) chief executive Mike Ashley pulls together a takeover move.

Is that all too much to ask for? Maybe so. Hedge funds certainly appear to believe that the end is nigh. The company is currently the fifth most shorted stock on the London exchange.

In its defence, Debenhams should have enough capital on tap to withstand another miserable festive season and avoid leaving shareholders with pretty much zilch – a substantial amount of the company’s assets are intangibles. Beyond that, there’s little margin for error if the retailer is to keep the same wolves that took House Of Fraser down at bay.

Encouragingly, Debenhams is generating organic cash flow and churning out a profit from most of its shops. But competition is fierce and only so many department stores can coexist in a world where Amazon and its competitive prices are accessible from an armchair. Debenhams has some interesting ideas, but none strong enough to guarantee its presence on UK high streets for years to come.

Kier

Companies that do construction work for the UK government are falling like dominoes. Carillion collapsed, Interserve (IRV) is on life support and investors are betting that Kier (KIE) could be next in line.

Not too long ago, analysts were gushing over contractors, claiming that they’d make a killing from the government’s big infrastructure spending plans. Then worries about the UK economy took hold, Carillion went bust and panic set in.

Investors should probably think twice about buying shares in companies that construct hospitals, schools and other infrastructure projects for the cash-strapped government. Building materials and labour costs are on the up, competition is fierce, contracts pay poorly and companies such as Kier are on the hook for any overruns. The upshot? Profit margins in this industry are dangerously thin and cash flows are under extreme pressure.

Somehow, only after Carillion’s meltdown did investors see through this madness. By late summer, the same short-sellers that bet against Carillion went after Kier, previously viewed as one of the most solid companies in the sector, with some irreversibly damning accusations.

At first, comparisons were made between the two companies’ problems with hospital contracts and insistence on paying big dividends, despite rocketing net debt and hundreds of millions of pounds of unpaid supply chain finance. It was also noted that both had a habit of acquiring businesses and then writing up goodwill at a much higher value than the purchase price.

From there, further red flags were spotted. Short-sellers claimed that Kier was recognising money in its accounts before even billing customers and booking tax credits as revenues.

Fishy accounting methods could only do so much to shield poor cash flow, though. Shortly after the allegations were made Kier dropped a bombshell, revealing that net debt had ballooned from £186m in June 2018 to £624m at the end of October.

A surge in reported debt, on top of all its hidden leverage, further fuelled speculation that Kier was heading the way of Carillion and Interserve. Management responded by launching a £254m rights issue, warning that banks were no longer queuing at the door to lend it money and that clients were becoming increasingly jittery about doling out work to financially unhealthy companies.

Investors, many of which shunned the call, are now pricing in that the dividend, long a key attraction for the stock, will be next to go. The rights issue was completed, thanks to the underwriters, and management continues to maintain that it has property assets it can flog if needs must.

But not everyone is convinced there’s enough capital available. At two-thirds of Kier’s share count, the rights issue was the maximum new stock that management could create without being obligated to hold a shareholder meeting. That’s raised concerns that Kier asked for as much as it can, rather than how much it actually needs, to dress up the balance sheet by the year end without facing awkward questions.

Fortunately, there are several signs to suggest that Kier isn’t another Carillion. The company boasts a much wider net of contracts than its defunct peer, greater customer diversification and better visibility of future cash flow.

That should perhaps give potential investors something to mull over, even if the threat of administration still looms. Whether it was enough or not, Kier has been given extra breathing room with its latest cash injection. The problem is that short-seller allegations and the rights issue fiasco have understandably created trust issues. Oh, and trading conditions are dire.

Kier said it’s confident of its prospects for the year to the end of June – a bold statement considering the current economic climate. Most economists agree that a chaotic Brexit will push the UK into a recession. If spending cuts are pursued by the government, Kier and its tarnished reputation might find itself with fewer projects, little cash in the register and difficulties offloading those real estate assets it keeps saving for a rainy day.

Reach

Value stock screens love Reach (RCH). The newspaper and magazine publisher, formerly known as Trinity Mirror, has been trading on one of the lowest valuations in the FTSE All-Share index for several years now. It would appear that its forward price/earnings (PE) ratio of 2 and dividend yield in excess of 9 per cent is struggling to find any takers.

A closer glance at the business explains why. Reach’s dirt-cheap PE ratio underestimates its massive pension deficit and ongoing liabilities linked to the phone hacking scandal.

Sentiment has also been rocked by the terminal decline of its end market. Newspaper sales are falling, print costs are rising and advertising revenues, the industry’s main source of income, are disintegrating fast. Nowadays, people prefer to get information from the web, prompting marketing executives to cosy up with internet giants Facebook (US:FB) and Alphabet’s (US:GOOGL) Google.

So where are the earnings and cash to fund the dividend coming from? In its defence, Reach has done a stellar job of making the best out of difficult circumstances. The owner of the Daily Mirror, Daily Express, Daily Star and numerous local media titles makes do as a consolidator, buying revenues at sensible prices and generating profits by cutting out duplicated costs.

Chief executive Simon Fox, the former boss of music store chain HMV, is proving to be a dab hand at milking whatever he can from a sinking ship. In the 2017 financial year, Mr Fox and his colleagues squeezed out £20m of savings, £5m ahead of initial targets, paving the way for an adjusted operating margin of 20 per cent – twice that of Reach’s larger rival, Daily Mail and General Trust (DMGT).

Future profitability now hinges on generating £20m of cost savings from Reach’s £127m takeover of the Daily Express and Daily Star. Management came out with a confident statement in December, claiming that the deal had already created more synergies than expected. Analysts previously predicted that extra revenues from lower costs would lift earnings per share by 19 per cent from 2019.

Still, questions remain over the sustainability of Reach’s business model. In the short term, cost savings should keep the publisher on track. In the longer term, investors want evidence that the company’s decision to double down on news content can generate revenues outside of cutting excess fat. Understandably, they worry that stripping everything to the bone will eventually undermine quality, leading the publisher to lose even more readers and precious advertising pounds.

Reach is banking on its digital business to step up to this task. Online sales currently account for 14 per cent of publishing revenues, so there is scope to grow. And they are growing, albeit not enough to get investors excited.

Digital turnover rose 17 per cent in the half year to 1 July. The problem is it generated just £48m. That figure shows how hard it is to make money from online content in a climate where Facebook and Google hoover up the majority of advertising revenues.

Reach has proved to be a master at consolidating, cutting costs and churning out enough cash to pay a big dividend. But its long-term future depends on its red-top tabloids beating off some seriously tough competition.

That’s not exactly the type of outlook that will attract regular buy-and-hold investors. Income investors looking for a quick score might have other ideas, though.

The high-yielding dividend looks surprisingly robust and will presumably remain well covered, so long as Reach can maintain its high profit margins and continue to generate lots of free cash flow. The balance sheet is also in better health, indicating that there’s scope to fund more acquisitions, comfortably finance pension obligations and even repurchase more shares.

Those prospects bode well for the dividend – for now at least.

Down but not out shares

Source: CapitalIQ. 

NTM = next 12 months. DY = dividend yield. EV = enterprise value. Ebit = earnings before interest and tax. GV = genuine value. P/BV = price-to-book value. FY = full year. EPS = earnings per share. LTM = last 12 months. RoE = return on equity.