Markets

This Simple Move Can Unlock Massive Gains

Near the end of 2012, investors began to question whether drugstore chain Rite Aid (NYSE:RAD) had much of a future.

#-ad_banner-#Shares traded for just $1 -- a price point that often signals possible bankruptcy ahead -- as the company's staggering $6.3 billion debt load looked set to eventually cripple the company.

Rite Aid had completed its fiscal year back in February 2012, and in that year, the company had just $128 million in operating income and $529 million in interest expense. Adding insult to injury, Rite Aid was in the midst of a sales slump, as revenues fell in three of the four years leading up to fiscal 2013. That's why even at just $1 a share, this was one of the most heavily shorted stocks on the market.

Yet Rite Aid never ended up in bankruptcy. Management pulled out every stop to ensure that operating profits would rise to the level of interest expense -- and then surpass it... which is the only way a debt-laden business can survive over the long term.

Rite Aid Takes Control Of Its Debt

Rising cash flow enabled Rite Aid to pay off roughly 10% of its $6.3 billion debt load while setting the stage for a debt restructuring at a lower interest rate. The impact on shares has been phenomenal: They've risen more than 500% in just the past few years.

Rite Aid is one of the last of a recent breed. At the peak of the financial crisis, dozens of solid firms such as , and all saw their shares move toward the $1 mark as investors focused on high levels of interest expense and weak or negative operating cash flow.

Rite Aid is one of the last of a recent breed. At the peak of the financial crisis, dozens of solid firms such as Ford (NYSE: F ) , Hertz (NYSE: HTZ ) and Domino's Pizza (NYSE: DPZ ) all saw their shares move toward the $1 mark as investors focused on high levels of interest expense and weak or negative operating cash flow.

Once the financial crisis eased, and these firms were able to pay down debt (or at least restructure their debt at better terms), these shares rose 500% or even 1,000% percent.

Though such dramatic moves, as we've recently seen with Rite Aid, are becoming more rare, you can still profit from stocks that will greatly benefit from a changing debt picture. I highlighted this phenomenon a month ago in my profile of Freeport-McMoRan (NYSE: FCX ) .

The logic of the investment: Debt is now quite high, but robust cash flow will take it steadily lower. Even as the company's enterprise value (market value plus debt minus cash) stays constant, the falling debt argues for a commensurate rise in the market value.

The Post-IPO Homebuilder

Another eventual beneficiary of a smaller debt load: Ply Gem Holdings (NYSE: PGEM ) . This homebuilder suffers a common flaw of some IPOs: The company's private equity backers loaded it up with debt -- and kept that debt in place, even as the company was brought public.

When Ply Gem went public one year ago, it had $11 million in cash against $1 billion in long-term debt. And when the company subsequently announced that sales growth had been anemic due to the too-slow housing recovery, it's no wonder this recent IPO turned ice cold.

But even a modest housing recovery should enable Ply Gem to steadily pay off debt and reduce risk -- and eventually be measured purely on the basis of its cash flow potential.

Ply Gem is actually copying the Rite Aid playbook. First, it has just given itself some breathing room by restructuring debt, which will lead to $22 million in interest savings. Ply Gem's debt formerly had a blended interest rate above 9%, but that figure has now dropped to 6.5%, thanks to the restructuring.

The next move is to boost operating cash flow. In recent quarters, weak demand has led to weak margins, and EBITDA (earnings before interest, taxes, depreciation and amortization) was negative in the quarter that ended in March.

Ply Gem now has $74 million in annual interest expense to cover, and cash flow is expected to reach nearly $200 million by 2016 -- nearly double 2013's $108 million -- as the housing recovery finally gets going, according to Goldman Sachs. That won't be enough to fully erase the company's debt load, but it will have a massive impact on the perception of this company's viability... just as was the case with Rite Aid.

The Gulf Coast Play

Another company that should benefit from a drop in debt is Energy XXI (Nasdaq: EXXI ) , which is a favorite stock of Dave Forest, the Chief Investment Strategist behind StreetAuthority's Junior Resource Advisor newsletter.

Dave loves this oil driller's positioning in the Gulf of Mexico. Energy XXI already has an impressive set of drilling sites being targeted, but it added to that asset base in March by announcing plans to acquire EPL Oil & Gas (NYSE: EPL ) for $1.5 billion.

Shares fell $2 on the news, to around $21 (where they languish today), on concerns that the company will have too much debt. Yet even if oil and gas prices fall sharply from here, EXXI's impressive cash flow generation should set the stage for a big debt paydown -- which, as in these other examples, should give a lot more breathing room for the equity.

Risks to Consider: These companies still carry considerable debt loads, and some it will need to be rolled over into new debt, which could become a problem if interest rates rise sharply.

Action to Take --> Investors tend to shun companies with a lot of debt. But they can create impressive investment opportunities, as we've seen with Rite Aid. Though these other firms are unlikely to have the remarkable upside that Rite Aid has scored (simply because they aren't selling at bankruptcy prices), they all could double from current levels if their debt paydown strategy works as planned.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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