What's the stock market got going for it?
Not economic growth, certainly, with the eurozone in or near
recession, Japan struggling to escape 15 years of no growth, the
United States stuck in a slower-than-normal recovery, and China
behaving as if the government doesn't want to return to the days of
9% or 10% growth.
Not rising incomes. Not an upswing in jobs. Not rising commodity
What global financial markets have going for them is cheap money,
and lots of it.
So doesn't it make sense to look for stocks of companies that are
positioned to get the biggest bang out of a cheap buck, yen, or
whatever? Doesn't it make sense to put at least a few balance sheet
babies among the stocks in your portfolio?
It makes sense, yes, but the fact that these balance sheet stories
are increasingly in favor in this market also gives me pause.
Efforts to use financial engineering to release value in a company
are often found near the end of a big rally, when other stories -
growth, for example - are looking fully valued.
I think taking a look at balance sheet babies makes sense in this
market, but even in this group I wouldn't abandon my metrics of
valuation, especially since this kind of financial engineering can
involve a trade-off between a company's long-term health and
short-term profit for traders.
So today I'm going to give you five stocks that are both rally age
indicators and - at the right price - potential stock picks.
Two Kinds of Balance Sheet Babies
What's a balance sheet baby?
I think there are two kinds in the current market. In this column
I'm going to describe the two types and give you five stocks to
check out, both as potential stocks to own - at the right price -
and as indicators of where we stand in this rally.
The first type of balance sheet baby is the offspring of the
financial restructuring that uses cheap cash to avoid disaster.
Let's start with an example:
). The building materials company almost went under during the
financial crisis because it had loaded up with debt to buy cement
maker Rinker for $14.2 billion.
Look what happened to Cemex's balance sheet as the financial crisis
led to the Great Recession and the collapse of the construction
sector in the United States. Short-term debt soared from $36.2
billion in 2007 to $95.3 billion in 2008. Interest expense climbed
from $10.2 billion in 2007 to $13.5 billion in 2009 to $16.6
billion in 2011.
Income before taxes plunged from $31.7 billion in 2007 to a loss of
$22.8 billion in 2008. The stock, which had traded as high as
$36.29 in June 2007, bottomed at $2.92 in September 2011.
And no wonder. The company had a pile of short-term debt and was
bleeding cash. Investors could only wonder if Cemex was headed
toward a bankruptcy that would certainly wipe out shareholders.
Instead of bankruptcy, though, what Cemex got was a restructuring.
The company was able to convert short-term debt that it would have
trouble paying today into long-term debt that its lenders believed
it would be able to pay tomorrow.
Short-term debt fell to $7.4 billion in 2009 from $95.3 billion in
2008. Long-term debt climbed to $203.8 billion in 2009 from $162.8
billion in 2007.
What the company had bought was time - not a guarantee that its
fortunes would turn around.
But time turned out to be exactly what Cemex needed. With the
recovery of the US housing sector, sales of cement in the United
States have climbed, even if the company's home market of Mexico
and export markets in the eurozone remain weak.
Net income has gone from a $1.5 billion loss in 2011 to a $616
million loss in 2012 to a projected loss of $178 million in 2013 to
a profit of $358 million in 2014.
That balance sheet turnaround at Cemex was good for a 90.4% gain in
2012. I don't expect a repeat of that in 2013; after all, the stock
and the company aren't starting from anything like their former
lows. I'd be very happy with 25% in 2013.
Some important things have to go right for that to happen. Volumes,
especially in the United States, need to continue to recover, and
price increases of 2.5% to 3% in the United States need to stick.
So far, things look good, and that's one of the reasons I've made
Cemex one of my
10 best picks for 2013
Examples With More Upside
You can find other balance sheet babies that are earlier in the
process than Cemex is now.
MGM Resorts International
) has restructured its balance sheet, but is still facing
skepticism about the recovery of its core Las Vegas gaming and
hotel market. The stock was ahead 11.6% in 2012, and is up, through
the May 8 close, 26.4% this year on good news from Las Vegas. I
think there's a good chance that this member of my
portfolio will outpace Cemex in 2013.
If you want to go back even further in the process, back to near
where Cemex was before it's restructuring, take a look at Mexican
Homex needs a financial restructuring in order to escape the trap
in which the only way the company can stay in the black is to cut
its revenue to the bone. Revenue collapsed between the fourth
quarter of 2012 (at $7.98 billion) and the first quarter of 2013
(at $3.3 billion), but operating income went from a loss of $30
million in the fourth quarter of 2012 to a profit of $215 million
in the first quarter of 2013.
How was that possible? Homex cut its cost of generating revenue
from $7.5 billion in the fourth quarter of 2012 to $2.6 billion in
the first quarter of 2013... by building and marketing fewer
That's not, obviously, a long-term solution, and even in the near
term it didn't stop the company's short-term debt from climbing to
$4.7 billion in the first quarter of 2013 from $2.3 billion in the
fourth quarter of 2012.
The next step came on April 19. Homex announced that it had sold
two prisons that it was building, for $325 million in cash. The
company said it would use half that cash for working capital and
the other half to pay down debt.
There's more restructuring to come, and I'd like to see some signs
of a revival in the Mexican housing market before I jump on Homex.
But it has the potential for a replay of the Cemex story, if things
break the company's way. The New York-traded ADRs (American
depositary receipts) of Homex were down 26% in 2012 and are down
another 58% this year through May 8.
A Different Type of Baby
We're further away from the darkest days of 2007-2008, and a lot of
companies that were flirting with disaster then have made progress
on their restructuring or completed it.
But that doesn't mean investors have run out of balance sheet
babies to study. It just means that we've moved on to a different
type of baby, one that's more typical of a maturing rally.
My next two balance sheet babies aren't companies on the edge of
disaster. Instead, they are companies with underleveraged balance
sheets that could use cheap cash to add debt to their books in
order to pay out a special dividend to shareholders or buy back
) is a by-the-numbers example of this kind of balance sheet baby.
The company sells eight out of ten cups of coffee sold in Canada
and showed an operating profit of $181,180 per Canadian store in
But its efforts to expand in the United States haven't paid off so
far. Per-store operating profit in the United States was just
$20,000 in 2012, according to Bloomberg.
So activist hedge fund Highfields Capital Management, which owns 4%
of the company, has urged management to kill the US push and use
that cash, plus money it would raise by leveraging its balance
sheet to something like the leverage at its peers, to either pay a
big dividend or increase share buybacks.
Net debt to EBITDA (earnings before interest, taxes, depreciation,
and amortization) at Tim Hortons is just 0.56. At
) that ratio is 5.1. Goldman Sachs estimates that if Tim Hortons
raised its net-debt-to-EBITDA ratio to 3, it would be able to pay
either a $6.50 a share special dividend or buy back 12% of its
Whether that move would be in the long-term interest of the company
or shareholders is another question. The Canadian consumer is
loaded up with debt right now, and that has raised fears of a
slowdown in consumer spending. The Canadian
net-debt-to-disposable-income ratio climbed to a record 165% in the
So Tim Hortons could be loading up with debt at just the wrong
point in the business cycle. That hasn't stopped the stock from
climbing 19% in 2013, however, as traders calculate the short-term
benefit of this bit of financial engineering.
A Fundamental Advantage
Personally, I like my financial engineering mixed with little bit
more of a fundamental growth story, so that the company stands a
better chance of avoiding a debt crisis after adding leverage.
That points me toward chemical maker
). The company is very under-leveraged, at a net-debt-to-EBITDA
ratio of 0.3. Credit Suisse calculates that the company could raise
this ratio to 1.5 or 2 without endangering its recently attained
BBB investment-grade rating.
I'd hope that the company would be conservative in its gearing.
LyondellBasell only emerged from bankruptcy in 2010.
The fundamental story rests on low US natural gas prices. For
example, when the company reported earnings for the three months
ended March 31 for its olefins and polyolefin Americas unit, it
showed a $121 million increase in EBITDA over the quarter that
ended in December 2012. Compared to the three months ended in March
2012, EBITDA rose by $303 million.
The cause? The company pointed to a price increase for products
such as ethylene and to a drop in the cost of production, driven
primarily by lower prices for natural gas liquids, in the first
quarter of 2013.
I anticipate that US prices for natural gas and natural gas liquids
will remain low at least through 2014. That will give US-centric
producers such as LyondellBasell a cost advantage in global
That's the kind of fundamental story I'd like to see to support any
increase in balance sheet leverage. Right now, however, I'd call
LyondellBasell pretty fully priced. I calculate a target price of
$72, not all that far away from the May 8 closing price of $62.84,
after the stock posted an 88.6% gain in 2012.
This puts the stock within 5% of its five-year high. Not that
unusual in this market, but something that gives me pause. I'd buy
this combination of potential leverage and fundamental story at a
lower price. For right now, though, I'll wait.
Editor's Note: This article was written by Jim Jubak of
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