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Course 410
Distressed Stocks

Introduction

Investing in distressed companies is a journey to the distant frontiers of risk and return. These troubled outfits may be headed for the scrap heap. But if the down-and-out can stage a comeback, the rewards may be tremendous. Take Magna International MGA. In October 1990, this auto-parts maker fell into bankruptcy, crushed by debt and a recession. Earnings vanished, and Magna's stock price collapsed. In retrospect, it was a perfect time to buy. Magna and its creditors hammered out a restructuring plan, profits returned, and in the next five years, its stock price compounded at an annual rate of 83%. That's the upside. But there's also Pan Am. Remember that once-proud pioneer of international aviation? It was grounded by bankruptcy in 1991. Its shareholders got nothing. Some of the distressed companies in Morningstar's database are already bankrupt--in Chapter 11 reorganizations or Chapter 7 liquidations. The rest have been losing money consistently, have excessive debt on their balance sheets, or both. By asking some pointed questions about these troubled companies, we can try to distinguish the hopeless from the merely hobbled. Consider a well-known example in the distressed category: Silicon Graphics SGI. This former highflier makes high-end servers and workstations for graphics applications, but in recent years, it has fallen upon hard times. Revenues declined sharply in 1998 and 1999, and the company has been losing money in most quarters.

What Went Wrong?

Like an insurance adjuster, our first mission is to determine the cause of distress. The answer usually boils down to operating weakness or financial exhaustion. And the path to recovery is very different in each case. It may be that a company in financial distress is an attractive business but has collapsed under the weight of a poorly designed capital structure. Think of the leveraged-buyout era. In its 1989 buyout, RJR Nabisco's long-term debt increased from $5.5 billion to $25.2 billion. The tobacco and snack-food giant was earning a healthy operating profit, but interest expenses absorbed it all. In 1989 and 1990, the company lost a combined $1.6 billion. RJR later reduced its debt and returned to profitability, eventually selling and spinning off its tobacco businesses in 1999. RJR's business was never the problem. There is plenty of money to be made in cigarettes and Chips Ahoy cookies. But a debt-heavy capital structure drove it to distress. Silicon Graphics' problems are different. Its capital structure is reasonably solid (its financial leverage is in the normal range for computer-equipment makers, and it has reduced its long-term debt), but its operating results have been going downhill for several years. As the graphical capabilities of personal computers have become more and more powerful, demand for SGI's expensive proprietary workstations has plummeted. Coupled with high research-and-development costs, this has led to a string of operating losses as the company has struggled to reinvent itself.

How Bad Is It?

We have identified SGI's problems. The next step is to assess the damage to its finances. If operating distress has forced a company into financial distress, its prospects are especially bleak. SGI is obviously hurting: It lost money in eight of the previous 10 quarters through March 2000, and shareholders' equity has been declining. There are some potentially encouraging signs. The company made a profit in fiscal 1999 (which ended in June), but only because of a $250 million windfall from the spin-off of its MIPS Technologies MIPS subsidiary. From a strategic standpoint, SGI has been getting rid of some of its proprietary technologies and focusing more on more adaptable products based on widely used standards, such as Intel INTC chips and the Linux operating system. Executing this transition smoothly will not be easy, but at least SGI has identified its problems and is working to remedy them.

Is the Stock Despised?

There is a big risk that a hoped-for comeback will never materialize, so it is foolish to pay for anything resembling optimism. We want cheap--dirt-cheap. In this troubled corner of the market, we want to find a stock-price graph that looks like Niagara Falls. SGI's isn't quite that bad, but it's not pretty either. After trading as high as $42 in 1995, SGI's stock price slid downward with occasional bumps along the way, losing 50% of its value in 1997 and another 25% in 1999. At the end of 1999, it was trading for less than $10 a share.

How Cheap Is It?

SGI's valuations have been crunched, too. It had no price/earnings ratio at the end of 1999 because it had lost money over the previous four quarters, but based on stabler measures, such as price/book and price/sales ratios, SGI trades in the bargain basement. As of the end of 1999, its price/book ratio was about 1.5 and its price/sales ratio was 0.7, both about half what they were in 1995 and less than one fifth the S&P 500 average.

Conclusion: Putting It All Together

SGI's stock is beaten down, and its balance sheet will keep it out of bankruptcy--for a while, at least. Can it recover? That's impossible to answer. Still, we can draw some common-sense conclusions. The proprietary graphics-workstation market that SCI once dominated has been drying up in favor of powerful desktop PCs, but SCI is responding to this change by making its products less proprietary. It has been restructuring itself and rethinking its strategies--always a risky proposition, but SGI is trying to address the changing computer-graphics landscape. And remember what we can know with confidence: SGI is financially solid, and it has a lot of great technology and talented engineers under its wing. Its stock price already reflects much of the pessimism resulting from recent disappointing operating results. In analyzing distressed companies, avoiding the avoidable--a high stock price, a rickety balance sheet, and catatonic management--is the best we can do.

Quiz 410
There is only one correct answer to each question.

1 What is one advantage of investing in distressed stocks?
a. They are very risky.
b. They can't go bankrupt.
c. They offer potentially big rewards.
2 Which of the following is <em>not</em> a common cause of companies becoming distressed?
a. A crushing debt load.
b. Weak operating performance.
c. Low valuations.
3 Which of the following is <em>not</em> a common characteristic of distressed companies?
a. A stock price at or near its 52-week low.
b. Very high price multiples.
c. Major restructuring plans.
4 A distressed company with declining operating results:
a. Will inevitably go bankrupt.
b. Has a better chance of turning things around if its balance sheet is strong.
c. Should ideally have increasing financial leverage.
5 When analyzing distressed companies, an encouraging sign is:
a. Catatonic management.
b. A rickety balance sheet.
c. Declining long-term debt.
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