Identifying turnaround stocks is fraught with danger. A “market darling” falls from $1 to 20 cents and naïve investors assume it is a bargain. Then it falls to 10 cents, wiping out half the new investor’s capital in a blink.
Confusing price and value is a sure-fire way to destroy capital. As is relying on share prices to form a view on company value and anchoring expectations to the past. Those who do, inevitably buy stocks whose share-price pattern resembles a tombstone, and ride them all the way to the corporate graveyard.
That does not mean investors should avoid all potential turnaround situations. The market sometimes overreacts to the slightest disappointment, leaving a stock badly oversold. Contrarians who recognise the value snap up incredible bargains.
The usual rules apply with turnaround situations: buying high-quality companies when they trade below their intrinsic or fair value. Also, a few extra steps can minimise the risk of being caught in a stock bloodbath, and maximise opportunities.
The first is avoiding most speculative turnaround situations. Stick to companies that have good balance sheets and capacity to raise extra capital through equity issuance, without excessive share-price dilution. Turnaround stories have enough risk as it is, without chasing companies at risk of running out of cash or breaching debt covenants.
Second, focus on the reasons for the share-price fall. Was it because of management incompetence or factors outside the company’s control? Imaging diagnostics provider Capitol Health is an example: it’s been hurt by heightened regulatory risk. More on it later.
Third, is there a near-term re-rating catalyst? It’s no good buying a turnaround stock if it takes years to recover. Many resource stocks fall into that category. Form a view on what could re-rate the stock and when. If a re-rating catalyst is hard to find, or years from eventuating, think twice about buying.
Fourth, combine fundamental and technical analysis with turnaround situations. I favour fundamental over technical analysis, but believe charting is especially useful in identifying when to buy turnaround situations. Identifying fallen stocks that spike higher after a long period of consolidation or sideways movement can be rewarding.
Fifth, understand the risks. Stocks in steep downtrends have a habit of falling further than the market expects and staying there longer. The first bout of bad news is rarely the last and it can take management years to rebuild market confidence. Often, new management and sometimes a new board is needed.
Caveats aside, here are some turnaround opportunities to consider.
1. South32
The mining company can justifiably dispute references to it as a “turnaround play”. Operationally, it has not done much wrong since being demerged from BHP Billiton last year, in the context of torrid resource-sector conditions. But the share price slumped from $2.25 to a low of 87 cents at the peak of the resource-sector rout and has since rebounded to $1.45. The price turnaround can continue in the next few years.
South32 (S32) copped plenty of flak during the market’s largest and most complex demerger. There was a view that BHP Billiton bundled up its weaker assets and dumped them on shareholders through an in specie share distribution.
Belatedly in some quarters, it has been recognised that BHP Billiton brought South32 to market in good shape. A balance sheet with low debt means South32 does not have the commodity and financial leverage that characterises too many resource stocks.
It has significant scope to buy mining assets during fire sales and potential to drive productivity gains through organisation restructuring. If all goes to plan, the well-run South32 will be well positioned to capitalise on a commodity-price recovery when it finally arrives.
Chart 1: South32
Source: Yahoo!7 Finance
2. CYBG Plc
It seems disingenuous to describe the United Kingdom-focused bank as a turnaround play when it only demerged from the National Australia Bank last month and has traded solidly since its debut.
But CYBG (CYB, or Clydesdale as it is better known), is a clear turnaround play. It consistently underperformed under NAB’s ownership and its uncommitted parent had long signalled it wanted to offload its troubled banking operations in Northern England.
Clydesdale has a new, revitalised management team and exposure to one of Europe’s stronger-performing economies. The UK financial services sector is ripe for further consolidation and Clydesdale should have a new lease of life as a standalone company. Its closest peers have delivered good returns and it can too as the business is restructured.
Do not expect a quick fix or big share-price gains. But there’s enough to suggest Clydesdale’s turnaround has a better chance as a standalone company, and that its exposure to the UK banking sector, which is likely to outperform Australia’s this decade, has merit.
Chart 2: CYBG Plc
Source: Yahoo!7 Finance
3. Austal
The ship builder has had a tough start to 2016. It was smashed late last year after announcing schedule and margin pressure on the Littoral Combat Ships (LCS), of which Austal (ASB) is the prime contractor.
Austal plunged from a 52-week high of $2.56 to 98 cents and has since recovered to $1.51. The turnaround should continue, but will take time.
Austal continues to win service work, most recently a US$13.9 million LCS servicing contract. The ability to build a large order book of LCS servicing work – it now has more than US$200 million worth – is one of Austal’s attractions. It can develop a growing, annuity-style income stream for servicing work that underpins medium-term earnings growth.
Like other reasonable turnaround plays, Austal has a strong balance sheet and significant opportunities in Australia and the United States. It bounced back from the disappointing profit warning – and the market’s overreaction to the news – with two service-contract wins this year.
My long-term thesis for Austal remains intact: it has scope to develop extra maintenance work from the US Navy and, in time, add a second navy as a client. Its relationship with the US Navy is a significant asset and a reason why Austal can recover.
Chart 3: Austal
Source: Yahoo!7 Finance
4. Lifehealthcare Group
Founded in 2006 through six acquisitions of medical-device companies, Lifehealthcare Group (LHC) distributes high-end medical devices in Australia and New Zealand and works closely with surgeons, hospitals, nurses and other medical specialists.
Unlike a Cochlear or a ResMed Inc, Lifehealthcare does not research, design or build devices, and mostly distributes high-end medical products made by others. Its competitive advantage is relationships with surgeons who use the devices it distributes, and its position in a network of medical-device suppliers, hospitals, surgeons, private health-insurance providers and patients.
Lifehealthcare raised $76.6 million through an Initial Public Offering in December 2013 at $2 a share. After peaking at $3.92 last year, it nosedived to a low of $1.26 in February before improving to $1.46.
A sharp fall in net profit for the first half of the 2016 financial year, mostly due to higher expenses, was the main culprit.
As with other healthcare stocks, the market was spooked by the Federal Government’s review of private health insurance and the price of prosthetics – a key product for Lifehealthcare. About 35% of its projected forward revenue relates to prosthetics. The interim dividend was cut from 7.5 cents to 5 cents.
It was a disappointing result, but not enough to justify the full extent of the share-price plunge. Lifehealthcare said full-year revenue for 2016 should be $113-116 million (it was $99.3 million in FY15) and that margins should be in line with historic performance.
Importantly, it said the capital-equipment pipeline for the second half of FY16 had “significantly strengthened” and that expenses had stabilised.
The key to Lifehealthcare’s long-term fortune is growth in its active surgeon customer base (key decision makers on its products) and higher revenue per surgeon. Surgeon numbers are growing solidly but average revenue per surgeon was down slightly because of reduced volumes in key accounts.
Make no mistake: industry risks for Lifehealthcare Group have risen. But I still like its business model and leverage to an ageing population that needs more medical devices.
Lifehealthcare is sticking to its target of around $200 million in revenue within five years. As a small-cap stock, it suits experienced investors comfortable with higher risk, but has merit as a long-term turnaround idea.
Chart 4: Lifehealthcare Group
Source: Yahoo!7 Finance
5. Capitol Health
I described the “small cap” as a healthcare stock worth following for the Super Switzer Report in early March, after its horrific share-price falls. It looks interesting on valuation grounds but comes with significant regulatory risk.
Capitol Health (CAJ) provides diagnostic-imaging facilities and services, such as general X-ray and magnetic resonance imaging (MRI) in Victoria and New South Wales. It had grown quickly by acquisitions and a year ago was among the higher-rated small caps with fund managers.
After soaring from 20 cents in April 2013 to $1.10 in April 2015, Capitol Health has plunged to 12 cents. It was especially hard hit by the Federal Government’s Medicare Benefits Schedule Review Taskforce, designed to reduce waste in healthcare and improve sector outcomes.
The review is affecting the behaviour of medical referrers sooner than expected, presumably to avoid government scrutiny of their treatment-referral patterns. CT scan and MRI volumes have dropped noticeably this financial year, Medicare data shows, after several years of strong growth.
That is bad news for Capitol Health. After-tax profit fell 52% for the first half of FY16 to $2.2 million and the interim dividend was suspended.
The main problem is debt. Capitol Health grew quickly by acquisitions on the basis of continued growth in demand for its key services. It had non-current loans and borrowings of $96 million at the end of December 2015 and total equity of $92.3 million. Net cash flow from operating activities of $94,585 at the end of December 2015, down from $7.7 million a year earlier, highlights Capitol Health’s challenges.
It’s a tough proposition for a company capitalised at $62 million and a key reason why Capitol’s total return is down 88% over 12 months, using Morningstar data.
Capitol Health is by far the highest-risk turnaround play on this list. Its fate is not entirely in its control because of the government healthcare review and its findings, expected later this year.
The good news is that Capital is taking decisive steps to fix its problems. It is investigating launching up to a $50 million capital raising in the second half of FY16 through a senior unsecured bond issue, which, if successful, would alleviate some balance-sheet pressure.
On demand for its services, the company last week said it had seen a stabilisation of referral patterns in the second half of FY16 and “signs of improvement” in trading. It expects the second half to be stronger than the first.
There’s media speculation that the Turnbull government is considering watering down some of the Abbott government’s healthcare cuts. It’s too early to know how this and the Medical benefits review will play out, but the market might have got ahead of itself with massive downgrades in healthcare-sector valuations, if referral patterns for healthcare are less affected than expected.
Longer term, I like the outlook for imaging diagnostics services amid an ageing population that will need more X-ray and CT scans. Capitol Health’s recent partnership with Enlitic to enhance its technology capabilities and lower costs has real merit. It should lift its productivity and margins and better align its cost base to lower revenue.
The consensus from a small group of analysts, who cover Capitol Health, is for a median share-price target of 21 cents. That suggests it is materially undervalued at 12 cents, but prospective investors are taking considerable risk in pursuit of that return.
Capitol Health is, at best, a punt at this stage – albeit among the more interesting in micro-cap land given the healthcare sector’s long-term outlook. Speculators might set a tight stop-loss level (a pre-determined point at which to sell) compared to the current share price, to minimise capital loss if it falls further. Be prepared to exit early.
Long-term investors could wait until Capitol forms a clear share-price base and consolidates in a sideways pattern as it resolves its issues. Then buy when it starts to move higher. Giving up some potential early share-price gains to lower risks makes sense.
It’s worth noting that Capitol Health breaks my first rule in turnaround plays: avoiding speculative situations and companies with strained balance sheets. I cannot emphasise enough that this stock does not suit conservative or inexperienced investors or those who cannot tolerate short-term capital losses. But every stock has its price and, occasionally, some beaten-up micro-caps are worth the risk.
Still, the experience of other small caps that grow quickly through acquisitions, such as Slater & Gordon, and load up on debt, shows how far the industry consolidators can fall when the music stops.
Chart 5: Capitol Health
Source: Yahoo!7 Finance
6. Other turnaround ideas
I intended to include RCR Tomlinson and Incitec Pivot in this list of turnaround ideas, but ran out of room after devoting extra coverage to Capitol Health in response to reader requests. They will be covered in future columns.
– Tony Featherstone is a former managing editor of BRW and Shares magazines. This column does not imply any stock recommendations or offer financial advice. Readers should do further research of their own or talk to their adviser before acting on themes in this article. All prices and analysis at 29 March 2016.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.
