Investors piling into Kmart's ( KMRT) newly minted shares sense an opportunity to reap big gains from a company just out of Chapter 11.

Who can blame them, with memories of the 1,700% rise in Carl Icahn's restructured XO Communications ( XOCM) fresh in mind? With the therapeutic aspects of bankruptcy behind them, the argument goes, other of Chapter 11's fallen angels could also be ready to reascend.

But is it really a good idea to invest in these companies? The answer is a qualified yes, as long as certain conditions are met.

Zero to 60

First, it's necessary to define terms. The question is not how owners of shares prior to bankruptcy fare: Their stock almost always ends up worthless. And it's not about how professional turnaround specialists or so-called vulture investors fare by entering the proceeding after it begins.

This story focuses on the new shares of newly reorganized companies, the ones whose whittled-down debt load and cheaper financing make them a tempting bet to some.

"This is certainly the best time. At least better than the reverse, when they are going into bankruptcy," said Randye Soref, chairman of insolvency at Buchalter, Nemer, Fields & Younger, a law firm. "These companies have typically secured exit financing coupled with the extinction of a great deal of debt. They can come out as better competitors, much ahead of the game."

They can also fail just as miserably and return to bankruptcy, what experts refer to as "going Chapter 22." Discount retailer Bradlees ( BRADQ), for instance, got a temporary boost when it started trading, only to be liquidated less than two years later.

Hallmarks of Durability

While no analysis is foolproof, experts say viable turnaround candidates do share some habits. Perhaps most important is the amount of financing the company secures, and how it's spent. Is the company burning money to operate, or using it to pay down existing debt?

Take U.S. Airways ( USALA), which many feel is poised for success because of the $1 billion in private financing it received in its restructuring. The money became available via a federal loan guarantee program instituted in the wake of Sept. 11.

"They are much more healthy financially," said Jim Corridore, airline equity analyst at Standard & Poor's. "They have lower debt, lower ongoing liabilities, which enabled them to revamp their cost structure."

It's also crucial that a business be sized to its new reality. Often this means closing stores or offices, reducing manufacturing capacity or leaving unprofitable markets.

"Telecom companies which had overcapacity and excessive debt, for instance, used bankruptcy protection to reject leases for more equipment and are now emerging debt-free," said Stephen Marotta, a principal of Marotta Gund Budd & Dzera, a financial advisory firm.

Randall Eisenberg, chairman of the International Committee for the Turnaround Management Association, says airlines are also doing a good job shedding noncore assets. "They are using Chapter 11 to fix their capital structure and their business to be competitive."

Hard Stuff

Like it or not, the ability to cut jobs is often a sign a turnaround will take hold.

National Steel ( NSTLB), for instance, eliminated 20% of its workforce during bankruptcy protection. Kmart, the nation's third-largest discount retailer, is now 600 stores and 54,000 employees leaner and the stock began trading on the Nasdaq Tuesday.

Generally speaking, a company isn't going to succeed with business plans that aren't markedly different from the designs that led to the filing.

"These are generally weak companies, with fairly low earnings, and most just keep on doing what they were doing before, which led them to bankruptcy in the first place," said Lynn LoPucki, a law professor at UCLA Law School.

Margin of Safety

If survival seems likely, there's still the question of valuation. Investors want to know whether the price of newly minted stock is reasonable.

An example of a stock that seems to have been priced to sell is Kmart. After opening a month ago at $14 on the over-the-counter bulletin board, it recently traded at $20 on the Nasdaq, a 43% gain. While it's hard to derive a valuation metric from a company with no earnings expected in the near future, the shares look a little rich now, at more than 100 times cash flow. The company is also considered a viability risk by some.

"They could potentially go either way," said Marotta.

With one way pointing skyward and the other to oblivion, investors would be wise to think carefully before plunging into their own turnaround plays.

"There's great opportunity in buying companies emerging from Chapter 11, but you have to do the same amount of homework as for other companies," said Dominic DiNapoli, senior managing director and co-head of restructuring at FTI Consulting. "If the issues were dealt with effectively, these survivors get a new lease on life."

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