Should You Invest in These Turnaround Stocks?

Sarfaraz is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Turnaround stocks represent companies that are on the verge of a possible u-turn, or a revival of their fortunes. Due to their inherent volatile nature, they are pure contrarian plays and are therefore not ideal for the fainthearted. While they lure investors with a possibility of monumental returns in the long run, they can also turn sour -- as in the case of investors who bought into the US Airways’ turnaround story in 2003 and ended up with enormous losses when the company filed for another bankruptcy just 12 months later.

These stocks are generally difficult to judge based on conventional metrics, such as price-to-earnings ratio (P/E) and PEG ratio, since either they are not making any profits or have just started eking out some income as their shares rally – which often results in a negative or an unusually large P/E ratio.

I believe that as a general rule, investors shouldn’t bet on a company’s turnaround which:

a) has a high debt-to-equity ratio, i.e. anything above 70%;

b) is operating in a dying industry

Companies that have reasonable debt levels, have delivered a history of solid performance in their ‘golden years’, and are operating in an industry with huge potential are a much safer and attractive bet. The three companies mentioned below could represent significant upside but potential investors should note that while investing in markets is risky, investing in turnaround stocks is even riskier. 

Bright outlook but heavy on debt

One such company eying a turnaround is the mortgage insurer MGIC Investment (NYSE: MTG) following its disastrous run during the global recession. In the last 12 months, the company has generated a loss per share $4.68 with a disappointing return on equity of -102.7%. However, its future is looking brighter due to improvements in the housing market, better quality of credit of its new business and an increase in its market share from the FHA.

In short, the company is one of the few survivors of the housing crisis and is in a good position to capitalize on the sector’s recovery. Despite the negative numbers mentioned above, the stock has been up an astounding 192% this year. Moreover, its most recent results announced on July 24 have also given more confidence to investors.

MGIC Investment surprised the market by reporting an operating profit of $0.04 per share, as opposed to the market’s expectations of a loss of $0.16 per share. The current results are the first profit since Q2 2010 and have come due to a fall in new notices and a lower claim rate of early stage delinquencies.

However, despite the rally and a bright outlook, I would rate MGIC a ‘hold’ rather than a ‘buy’ at the current post-earnings-release price levels. The company is operating under a heavy debt load with a total debt-to-equity ratio of 193%, far above my target of 70%. This when its competitor Radian has a debt-to-equity ratio of 113%, and even that is considerably above the sector’s average of 52.8%.

Struggling and undervalued former smartphone king

Perhaps no other company is more desperate for a turnaround of its fortune than the Canadian smartphone maker BlackBerry (NASDAQ: BBRY). It doesn’t have any trailing or forward P/E ratio since it has generated, and is expected to incur further negative EPS. Its recent earnings release was horrendous but the treatment which it got, a 30% sell-off, was certainly an overreaction. Its stock, which now trades at $8.98, is extremely cheap by any measure and represents more than a 50% discount to its book value.

The company is operating in an industry with enormous potential but is selling a product which the world wants to forget. Still, BlackBerry is pricing its phones at par with Samsung’s Galaxy S series, Apple’s iPhones or Nokia’s Lumias. With the management’s insistence to sell its below-average product at premium prices, the outlook for this smartphone maker is negative.

While the turnaround of this company is highly unlikely, I believe that BlackBerry is more valuable than what its current price indicates. The company has zero debt and hence a zero debt-to-equity ratio, about $2.8 billion of cash reserves and $3.7 billion more current assets than liabilities. But its market cap is just $4.7 billion. Analysts (such as here) have identified that the company is worth ~$7 billion.

If this undervalued phone-maker can figure out a way to “preserve” value, then it will eventually “create value” for its shareholders. This alone could result in a significant upside and we’re not even talking about any buyout offer from a tech giant (such as Lenovo) interested in purchasing the phone-maker. While I don’t think that BlackBerry will ever rise to its former glory, it could continue to operate as a low-volume phone-maker with high-margin software and service operations.

Bigger than just a daily deals website

The daily deals giant Groupon (NASDAQ: GRPN) has struggled under its former CEO with a disastrous IPO and restatements of earnings. The company is still not profitable yet, but since the departure of Andrew Mason, its shares have soared and are up 95% this year. Analyst at Deutsche Bank have identified that Groupon appears to be moving toward a “pull” strategy where customers visit Groupon through its website, apps or search engines and are then offered a rich inventory of personalized deals. This is opposed to a “push” strategy that relied on generating sales through mass emails.

It also reported impressive mobile numbers in its previous quarterly results when its mobile transactions in North America improved sequentially from below 40% in Q4 2012 to 45% in Q1 2013.

Long-term vs. short term

Moreover, for Groupon, its not just about daily deals anymore. The company is eyeing expansion in the e-commerce space and is actually becoming one of the most heavily mobile-penetrated e-commerce players. Furthermore, Groupon has zero debt levels and hence a zero debt-to-equity ratio. I believe that the long- term outlook of the firm is positive, particularly due to its move toward selling overstock items, which is shown in the strong performance of Groupon Goods.

But I don’t think Groupon is an attractive investment at the current price levels. Unlike BlackBerry mentioned above, Groupon is trading 8.0 times its book value when the industry’s average is just 5.4 times. Therefore, I would rate it as a ‘hold’.'

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Sarfaraz Khan has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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