Lessons for Turnaround Investors

The recent news from Motorola (MOT:NYSE - news - boards) brings up a topic that doesn't get much attention from analysts or investors: When is a company a turnaround -- and when is it just continuing to tumble down a very long set of stairs?

Motorola's latest warning brought to mind a recent discussion with a client about Xerox (XRX:NYSE - news - boards). He had called me several months ago urging me to take a look at the stock, which at that time had dropped to the low 20s from a high of around 64.

About the same time, I also received an email from a friend enthusiastically touting Xerox at 24. But there were several warning signs at Xerox that caused me to pass, thankfully, on the idea. As Xerox currently trades at around $5, it is worth the effort for investors, especially those interested in turnaround situations, to learn from the Xerox story. What I hope to do in discussing the lessons from Xerox, is to help investors avoid the cardinal sin in turnaround investing -- pulling the trigger prematurely.

1. Management changes signal longer turnarounds. Xerox changed CEOs earlier this year when I was evaluating the company. This is almost always a major negative. It is generally a signal that the problems are large, perhaps structural in nature, and are not easily cured. Also, a new CEO needs time to initiate change, sometimes a couple of quarters or more, so investors should be in no hurry to commit capital.

2. Always, always carefully review debt. Many turnarounds are delayed or prevented by excessive debt. In the case of Xerox, the debt level is mind-numbing. Its debt load of more than $17 billion against a revenue level of around $17 billion is excessive against any metric you want to use.

   In turnaround situations, management can lay off workers and shutter factories, but it cannot lay off or shutter debt. Xerox is currently seeking to sell off assets to pay down its debt, but the effort is problematic because some of these assets generated an important revenue stream for Xerox.

3. Review the history of the company's sales to its market capitalization. When I reviewed Xerox earlier this year, it was generating about $28 in sales per share, and the stock was trading at $23-$24, or more than 80% of sales. Looking at the stock's 10-year history, it was easy to see that this was hardly a bargain.

   Only a few years ago, it traded at less than 50% of sales, and as low as 20% of sales. Xerox currently trades at its historical low, or at about 20% of sales. This normally would put them on my radar screen, but when Xerox traded at those lower levels, it had dramatically lower debt than it does today.

4. Take a look at the peer group before investing in a turnaround stock. In the case of Xerox, this one was easy. Xerox's key competitors, Ikon Office Solutions (IKON:OTC BB - news - boards) and Danka Business Systems (DANKY:Nasdaq ADR - news - boards), had huge problems early in 1998, a full year before problems first began to surface at Xerox. If problems are unique or specific to a company, they can usually be fixed. But if the entire sector is in trouble, a near-term turnaround is a lot less likely.

5. Consider the environment in which a company competes. The competitive environment may change in a way that makes a turnaround unlikely, if not impossible. In the case of Xerox, it is a document-centric company. But the business environment surrounding creating, handling and moving documents has changed abruptly in the past few years. Documents are now being produced and moved via networks and the Internet in an increasingly paperless business environment. The degree to which Xerox is impacted is impossible to quantify. Suffice it to say, the trend is not going in a direction that favors Xerox.

Turnaround situations abound in today's market. The opportunities are ripe for large, outsize profits over the next several quarters for nimble investors. But to successfully engage in turnaround investing, you need a carefully crafted set of rules for analysis. And the primary objective needs to be to avoid companies that are about to turn down, as opposed to turn around.

Interested in turnaround investing? Then send us an e-mail , and we'll ask Arne to review other turnaround candidates for TSC readers.

---

Arne Alsin is the founder and principal of Alsin Capital Management, an Oregon-based investment advisor specializing in turnaround situations. At time of publication, ACM held no position in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Alsin appreciates your feedback and invites you to send it to [e-mail].