The Turnaround ChallengeFor many investors, one of the most frustrating investment concepts is handling a company's stock in a turnaround situation. Distressed fundamental situations often get much cheaper and take longer to resolve than investors anticipate. But once the market acknowledges a turnaround situation in progress, the shares become and remain expensive, well ahead of the actual turnaround process. As challenging and irritating as turnarounds can be, they can also be very lucrative. Let's take Tyco ( TYC) as an example. Tyco's well-documented management and fundamental problems surfaced in 2002. The shares plunged from the $60s to under $10 in by June of that year as profits dropped some 50%. The stock traded in a single-digit price-to-earnings ratio and was universally despised, especially by the shorts who maintained an active journal of the company's misdeeds and potential failure. Clearly the stock got much cheaper than many value investors expected it to.
Be SkepticalWhat actually happens to many stocks in this situation? We believe that company managements and analysts' published reports tend to underestimate changes in fundamental conditions, both positively and negatively. When things turn sour, corporate managements often deny the true scope of the problem. With bad managements, they may even be the problem. Analysts tend to give their companies the benefit of the doubt. It is only after the problems are severely obvious that the official party line finally changes. Investors, however, have long recognized that the fundamentals swing more rapidly. Therefore, they tend to factor a worst-case scenario into share prices as the problems develop. They place little emphasis on the party line or Wall Street forecasts. Once the fundamental issues have been corrected, they acknowledge normalized earnings power much faster than just-burned management or sell-side analysts. Investors realize that the "growth" of a successful turnaround is much higher and more visible than conventional growth. Growth and momentum investors place a premium valuation in highly visible recovery stories and keep the stocks ahead of the fundamentals.
Real ExamplesMotorola ( MOT), currently the subject of a hedgie bear raid, seems to present an interesting opportunity. After two quarters of strong revenue and profit gains, the market seems to doubt the staying power of this turnaround. But adjusting for its semiconductor spinout Freescale ( FSL), the stock trades for roughly $13.50. If Motorola continues progressing towards its 15% handset and corporate operating margin goals, the company could earn $1 per share in 2005. With double-digit revenue and earnings per share growth in store for next year, the shares should command a higher "turnaround" multiple. Why not the same 20 P/E multiple Tyco sports today? Solectron ( SLR) is another turnaround position my firm has established in its portfolio. The current $5 price seems expensive for a fiscal 2005 consensus EPS estimate of 26 cents untaxed. Here the market is in a normal turnaround valuation mode. My firm's estimate of "normalized" fully taxed profits, assuming 15% revenue growth over the next 2 years, is 50 cents per share. That run rate could be hit in six quarters. A prominent Wall Street firm recently reiterated its $10 price target on the stock over the next year. It would not surprise me to see the stock go from the outhouse to the penthouse in that short time. MRV Communications ( MRVC) has been unprofitable for so long, who knows what the stock will do when the company achieves GAAP profitability in 2005. The company is a leading manufacturer of optical systems and components and should benefit handsomely if and when the major telcos ever build out their FTTP (fiber to the premises) systems. The telcos have no choice but to replace their twisted pair "pipe" for an optical one or face complete obsolescence by the cable companies. At current prices, the shares trade for 70% enterprise value to 2005 estimated revenue. Most of their competitors trade for multiples of 2 to 5.
Please note that due to factors including low market capitalization and/or insufficient public float, we consider MRV Communications and Asyst Technologies to be small-cap stocks. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.