Every year, the research team here at StreetAuthority looks over thousands of potential stock picks. We spend countless hours analyzing companies, looking for any signs that a stock is either a good or bad investment.
Most of the companies we research have both bullish and bearish factors to consider. But in a few rare instances -- literally less than 1% of the time -- we find a handful of stocks that boast some of the best business models on earth. These rare companies enjoy huge sustainable competitive advantages, pristine balance sheets, ample cash flow, and more often than not, they payhealthy dividends. When we find rare gems like these, we like to buy these stocks and hold them forever. In fact, we recently published an entire presentation on our 10 best "Forever" stocks, and it has become the single most popular piece of research in our company's decade-long history. [You can see that research here.]
But sometimes we find companies that fall on the other side of the spectrum. Companies that are in such poor shape that they are at risk of going bankrupt. These companies often sport unnaturally high debt levels compared to their capital base, and we think you should avoid these stocks at all costs. If by some means they've already ended up in your portfolio, you might want to consider dumping them now.
Below you'll find a list of a dozen companies that I believe are at risk of failing.
By far, this is the most controversial article I've ever published. I'm obviously not making any friends on Wall Street by exposing these names, and my publisher has already fielded a number of angry phone calls from some of the companies that appear on the list below.
That said, since I'm continuing to publish this information for the benefit of our valued StreetAuthority readers, I want to make sure that I cover ALL of my bases here.
First, there's a difference between a company that's "at risk" of failing and a company that's "guaranteed" to fail. The stocks I profile in this article are "at risk" of failing -- they're not "guaranteed" to fail. In fact, many of the stocks on my list below may not fail.
Second, the metric I'm using to determine a stock's level of "risk" is called the "current portion oflong-term debt." Specifically, I'm looking for companies that have debts due within the next 12 months that exceed the total cash balance that each company has on hand. This metric has proven to be a highly accurate indicator of a company's health. In fact, it's already helped me correctly identify several "at risk" stocks before they went on to fail. That's why I use it.
However, like any other financial metric out there, the "current portion of long-term debt" has its limitations. Although a company might have a high level of debt coming due in the next year, it does not guarantee that it will fail.
I'll explain more about this later in today's article. In the meantime, let's get started...
During the past generation, a reasonable level of debt has always been seen as appropriate, because balance sheets were able to withstand a typical recession. Yet all that changed in 2008. GM's (NYSE: GM) debt load crashed the company, forcing it into bankruptcy, while many other companies such as GE (NYSE: GE), Ford Motor (NYSE: F), Hertz (NYSE: HTZ) and Domino's Pizza (NYSE: DPZ) saw their stocks plunge on fears a bankruptcy filing would be necessary if economic conditions worsened.
Thankfully, many companies wised up and have been taking steps to strengthen their balance sheets. But not everyone got the message. Some companies still carry too much debt and might run into trouble if the U.S. economy slips back into recession. These companies will need to make large payments to handle their debt in coming periods, and right now they are at risk of not having enough cash to meet potential obligations. Typically, a company can simply roll over that debt and push out the time frame when debts come due. But a weak economy would make this task much harder as lenders grow skittish.
That's why it's so important to pay attention to balance sheets. Lots of debt is only a problem if the debts are soon coming due. For example, mattress maker Sealy Corp. (NYSE: ZZ) has a very weak balance sheet, with almost $800 million in debt and less than $100 million in cash. But management wisely sought to roll over debt while it could, and now the company faces no major repayments until 2014.
Yet if a company's "current portion of long-term debt" -- that is, debts due within the next 12 months -- exceeds cash on hand, you need to listen to how management plans to address the problem because these companies could be at risk of failing. I went in search of companies that may have just such a problem (less cash than near-term loan obligations) and added Canadian media firm Thomson Reuters (NYSE: TRI) to the mix (its weak balance sheet is just above that threshold). The table below highlights a group of companies that are at risk of having to declare bankruptcy in 2012 if their lenders are in no mood to extend them more loans. Take a look...
This is just a short list. These stocks had red flags on the balance sheet as of June 30. The current earnings season may bring more troubled companies into this group. And if the economy slips into recession, as some -- but not all -- economists anticipate, then the list will only grow in the coming months.
Some companies may be hard-pressed to avoid a date with a bankruptcy judge. Take American Apparel (AMEX: APP) as an example. The company is saddled with more than $100 million in debt, much of which is slated for repayment in the next few quarters, but it has less than $10 million in cash on hand. American Apparel generates roughly $70 million in gross profits every quarter, but has $80 million in quarterly overhead. As the losses pile up, American Apparel's balance sheet could weaken further.
American Apparel has already raised $22 million in fresh cash this year, but that might not be enough to keep the wolves at bay. Billionaire investor Ron Burkle is one of several investors said to be looking at acquiring some of the company's debt -- not equity. That's often a precursor to eventual hostile moves to take control of the company by calling in debts, wiping out existing shareholders in the process. Short sellers may also be anticipating an eventual bankruptcy filing, because they hold more than 5 million shares in short accounts.
Even seemingly healthy companies can get tripped up by a lousy economy. Right now, Thomson Reuters carries a hefty, but manageable, $7.5 billion in debt. This shouldn't be a problem, as noted by EBIT coverage of about 8 (which means Thomson Reuters' quarterly cash flow is eight times higher than its interest payments). But what if the economy stumbles and demand for the company's professional-grade subscription services starts to slump? EBIT coverage would quickly shrink, forcing the company to meet with lenders to make sure Thomson Reuters doesn't run out of cash. This scenario is quite unlikely in the next quarter or two, but bears close scrutiny in a worsening economic environment.
Risks to Consider: Some of these stocks already trade at levels that suggest imminent financial distress. If they're able to shore up their weak balance sheets, then short sellers may boost the stocks by short covering. And as I mentioned earlier, "current portion of long-term debt" is a good metric to consider, but it isn't perfect. It's important to realize that this metric only points to increased risk of financial trouble, and it does not imply that failure is imminent or inevitable.
Action to Take --> If you own any of the 12 "at risk" stocks we've identified above, then consider selling them now, because all of them could tumble in a hurry. Instead, we'd suggest looking at the rare 1% of companies in our coverage universe that fall on the entirely OPPOSITE end of the spectrum -- financially-stable companies that enjoy some of the best business models on earth. We call them "Forever" stocks. These stocks benefit from sustainable competitive advantages, pristine balance sheets and ample cash flows, and we think you can buy them today and hold for the rest of your life."
In fact, when we started to research "Forever" investments, we discovered something very unusual -- many of the world's richest, most successful investors, politicians and businessmen are loading up on "Forever" stocks. For example, one of our favorite "Forever" stocks has jumped 585% since it went public just a few years ago, and legendary investors like Warren Buffett are loading up on the stock. In fact, Buffett has bought more than 400,000 shares of this "Forever" stock in recent months. For more on these stocks -- including several names and ticker symbols -- we've put together a special presentation called "The 10 Best Stocks to Hold Forever." You can visit this link to watch now.
Disclosure: Neither D. Sterman nor StreetAuthority, LLC hold positions in any securities mentioned in this article.