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What To Look For In A Profitable Turnaround

Published 14/10/2016, 01:09 pm
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Originally published by Cuffelinks

We are always on the lookout for opportunities the market may have missed, misdiagnosed or underappreciated. One type of stock that falls into this category is the ‘turnaround’. It can be defined in various ways, but in essence it involves a change from a poor quality company to a good one. This does not necessarily mean a company whose improvement relies on the economic cycle, such as a building stock benefiting from a housing construction boom. Instead, I mean corporate change that is more structural and enduring.

The upside

Turnarounds can be very rewarding for investors. Often the share price of a turnaround stock will reflect low expectations, extrapolating its difficult past without comprehending what it could possibly become. A successful turnaround can give rise to a double play. Firstly, the company materially improves profits, often dramatically so; and secondly, this leads to a turnaround in investors’ perceptions, leading to a re-rating of the company’s shares as the improvement proves sustainable and profits offer potential growth. This double play compounds returns for the shareholder, with for example a doubling of earnings and a doubling of the PE giving rise to a four-bagger (a rise in share price of four times).

In addition to the potential outsized returns, turnarounds can also offer diversification benefits. Turnarounds represent upside that is generally stock-specific, and as a result, performance has limited correlation with the rest of the market. The ups and downs of a turnaround stock will generally depend more on what is going on within the company than in the broader market.

The downside

On the other hand, turnarounds come with significant risk. A turnaround may not actually succeed as planned, it may waste considerable resources in its attempt, and underlying profitability may continue to deteriorate. In fact, this scenario is not uncommon and is best explained by Warren Buffett’s quip that “turnarounds seldom turn”. For this reason, turnarounds can become value traps, with the failure to turn further evidence of the company’s poor quality, justifying its lowly valuation.

There can often be a fine line between success and failure in any turnaround situation. That said, there are a number of attributes to look out for in identifying a potential turnaround success. In broad terms, one should consider what has been holding the company back, whether it can be changed, and as the turnaround strategy progresses, tangible signs of progress.

Sometimes they do turn

The first and perhaps most important attribute to look out for is the existence of a strong underlying business or assets that will allow the company to rise above its problems. One of Buffett’s greatest all-time trades was actually a turnaround situation called GEICO. The company is a US car insurer with a low-cost, direct-to-consumer model that allows it to price policies cheaper and earn decent margins. However, at the time of Buffett’s original purchase in 1975, it was facing near bankruptcy due to over-expansion, ill-disciplined underwriting, price controls in certain states it operated in, and an undercapitalised balance sheet. With a new CEO leading the charge, the company raised capital and embarked on a dramatic turnaround focused on reining in the expansion, returning underwriting discipline, and exiting operations in regulated and unprofitable states. From a position from which Buffett admitted there was a reasonable probability of losing his entire investment, GEICO slowly turned around and eventually made Buffett a mint (which it still does).

The key to the success was the strong underlying business that had lost its way, but was capable of re-finding its funk. It is much easier for a business with good bones to turnaround.

The rarity of operational turnarounds

It is also possible for an operational turnaround to succeed in making a fundamentally bad business good. However, structural reasons may make it nigh on impossible. As evidence, there are a large number of businesses forever trying to turnaround, with classic examples being CSR Ltd (AX:CSR), AMP Ltd (AX:AMP), Spotless Fp (AX:SPO) and Primary Health Care Ltd (AX:PRY). There are few that change fundamentally for the better.

One that has is Amcor Ltd (AX:AMC). For a long time the company struggled in the largely commoditised packaging industry, and reflecting this, its share price barely budged for decades. A decade ago, new CEO Ken McKenzie started out on a turnaround strategy that involved divesting low-returning businesses, scaling up more profitable ones via acquisitions that also consolidated relevant markets, plant rationalisation, and instilling a sales discipline that focused on margin rather than volume. Perhaps owing to its inglorious past, it took the market some time to recognise the change, but those who did have enjoyed strong investment returns since.

Leveraging valuable assets

Amcor’s strategy was text-book for a turnaround for a structurally challenged company, one that we see echoed in the turnaround currently being undertaken at Treasury Wine Estates Ltd (AX:TWE) by CEO Mike Clark. And in contrast to Amcor, Treasury has some valuable brands to work with.

In fact, as in the case of GEICO, most companies that can successfully execute a turnaround have something valuable to work with. For example, Coles’ turnaround under Wesfarmers Ltd (AX:WES) ownership starting in 2008 had the benefit of Coles’ large existing store network, with as many stores as Woolworths Ltd (AX:WOW), and sufficient scale through a meaningful sales base. New management came in, revived store formats, loudly marketed lower prices, and grew customer numbers and sales strongly, helped out of course by an accommodative competitor in Woolworths.

Likewise, Caltex Australia Ltd (AX:CTX) owned a very profitable fuel distribution business that was able to shine through once it reduced its low-returning and volatile oil refinery business; and TPG Telecom Ltd (AX:TPM) had an existing network and a decent customer base as it moved from loss-making to very profitable through scale-building acquisitions that also consolidated the broadband market.

What to look for

The examples suggest characteristics to look for in identifying when a turnaround might succeed:

  • a new CEO, often from outside of the company, carrying none of the company’s historical baggage and who can drive the turnaround strategy
  • a corporate restructuring, generally aimed at growing the higher-quality businesses, and exiting unprofitable ones
  • industry rationalisation, particularly as part of an attempt to beef up profitable businesses, with the added benefit of improving the industry structure
  • an accommodative industry, in which a struggling company is allowed to re-emerge, or where an industry as one works towards higher pricing and therefore profitability
  • a recapitalisation, with the effect of addressing an over-leveraged balance sheet, which affords the financial flexibility to get through any difficulties and allows investment in growth areas.

Conclusion

Turnarounds offer the opportunity to invest in quality that may not be readily apparent to most other investors, a scenario that generally presents value upside. Turnarounds, however, come with considerable risk, and it pays to stay close to the company in question. At BAEP, we invest where we have high levels of conviction. We will usually wait for genuine evidence that a turnaround is turning, most often through the company’s reported financials. Head fakes are common in this game. We’re happy to give up the first 20% or so if it means greater certainty. Generally, this still leaves plenty of upside as the market slowly starts to look at what the company may become.

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