Balance sheet babies: Both stock picks from cheap money and a warning indicator on a maturing rally

05/10/2013 8:30 am EST


Jim Jubak

Founder and Editor,

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 U.S. 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 prices.

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 find put at least a few balance sheet babies among the stock picks 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.

What’s a balance sheet baby?

I think there are two kinds of balance sheet babies to look for in the current market. In this post 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 financial restructuring that uses cheap cash to avoid disaster.

Let’s start with an example: CEMEX (CX). The company almost went under during the global 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 U.S. housing sector sales of cement in the U.S. 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. 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 that I’ve made CEMEX one of my 10 best picks for 2013 in my Jubak Picks 50 long-term portfolio

That balance sheet turn around 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.

You can find other balance sheet babies that are earlier in the process than CEMEX is now.

For example, MGM Resorts International (MGM) has restructured its balance sheet but it is still facing more skepticism about the recovery of its core Las Vegas gaming and hotel market than CEMEX does about a U.S. housing recovery. 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 Jubak’s Picks portfolio will outpace CEMEX in 2013.

If you want to go back even further in the process, back to near where CEMEX was before its restructuring, take a look at Mexican homebuilder Desarrolladora Homex (HXM in New York.) Homex needs a financial restructuring in order to escape the current 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 houses.

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 jumped on Homex. But it does have 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% in 2013 through the close on May 8.

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 these 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 in order to buy back stock.

Tim Hortons (THI in New York and Toronto) is a by the numbers example of this kind of balance sheet baby. The company sells 8 out of 10 cups of coffee sold in Canada and showed an operating profit of $181,180 per Canadian store in 2012. 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 U.S. push and to use that cash plus money that 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 buy backs. Net debt to EBITDA (earnings before interest, taxes, depreciation, and amortization) at Tim Hortons is just 0.56. At Dunkin Brands (DNKN) 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 shares.

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 first quarter. 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.

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 LyondellBasell Industries (LYB.) 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 the company’s recently attained BBB investment grade rating. I’d hope that the company would be conservative in its gearing—the company only emerged from bankruptcy in 2010.

The fundamental story rests on low U.S. natural gas prices. For example, when the company reported earnings for the three months ended March 31, 2013 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 some 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 U.S. prices for natural gas and natural gas liquids will remain low at least through 2013 and 2014. That will give U.S.-centric producers such as LyondellBasell a cost advantage in global markets.

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.

That puts the stock within 5% of its 5-year high. Not that unusual in this market—but something that does indeed give me pause. I’d buy this combination of potential leverage and fundamental story at a lower price. For right now, though, I’ll wait.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund , I liquidated all my individual stock holdings and put the money into the fund. The fund may or may not now own positions in any stock mentioned in this post. The fund did own shares of MGM Resorts at the end of March. For a full list of the stocks in the fund as of the end of March see the fund’s portfolio at
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