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The Best Ways To Profit From Bankruptcies

Monday, December 9, 2013 - 2:30pm

With the U.S. economy a half-decade removed from its last recession, there are relatively few bankruptcies these days. But they still occur.

Every few quarters another publicly traded company calls a timeout from its creditors, often leaving a worthless stock in its wake. These companies aren't hard to find. You can simply focus on firms with lots of debt and deeply negative cash flow.

That backdrop led me to predict back in the summer of 2011 that AMR, the parent company of American Airlines, would eventually need to file for bankruptcy. Six months later, that's exactly what AMR did.

I rarely go out on a limb with such predictions. After all, many companies in financially dire straits can snag a lifeline, avoiding bankruptcy. Indeed, OCZ Technology (Nasdaq: OCZ) raised fresh capital a few times after I suggested a year ago that it was headed for bankruptcy. "OCZ has a very short window to stop the bleeding," I predicted at the time. Fast-forward to last week, and OCZ finally relented and declared bankruptcy.

Shorting these kinds of stocks can deliver 100% upside if there shares eventually become worthless, but such a strategy can also cause real pain. Nearly two years ago, I cautioned that retailer American Apparel (NYSE: APP) was sporting some scary financial metrics.

But the company eventually got a capital injection, and shares rose more than 100%. Yet even with fresh money in hand, this retailer is again flashing warning signs.

The recent pullback in this stock is due to a disappointing financial performance. American Apparel has generated a paltry $11 million in EBITDA thought the first nine months of the year, on sales of $465 million. Trouble is, the company has racked up $29 million in interest expense this year, and even with the current holiday season strength, full-year EBITDA is unlikely to cover interest expense.

The company's banker, Capital One (NYSE: COF), has decided not to call in its loans at this time, despite the fact that American Apparel is outside of its loan covenants. The company notes that it is "in discussions with respect to a waiver or amendment for future periods." That's a tenuous way to live, and if Capital One decides to ask for its money back, then a bankruptcy filing is the only course of action.

The Next Blowup
So where can investors go to seek out financially distressed firms that may be headed for bankruptcy? There are several options. The first is to screen for stocks that have high debt loads and are expected to keep losing money. These companies are all in the S&P 400, 500 and 600.

Of course high debt levels are not by themselves a red flag. Cedar Realty Trust (NYSE: CDR), for example, would initially appear to be quite troubled, as its interest expense has exceeded its operating income for each of the past three years. But this real estate investment trust (REIT) owns more than $1 billion in assets and could unload some of them to keep lenders at bay.

In contrast, retailer J.C. Penney (NYSE: JCP) has been flashing all kinds of warning signs. The retailer has taken steps to raise cash over the past 12 months, but unless sales and profit trends start to rebound, then an eventual bankruptcy filing is possible.

Indeed, it's wise to look at struggling sectors to see if bankruptcy risks are emerging. Other retailers are facing lousy sales trends, and those with weak balance sheets could be headed for trouble. Coldwater Creek (Nasdaq: CWTR) is one example. The women's apparel and accessory retailer hasn't turned a profit since 2007, and more losses are expected this year and next as well. A recent round of cost cuts have bought the company time while it figures out its strategic options.

Bankers threw Coldwater Creek a lifeline in 2012, but even that money is running out. The company has $17 million in cash against $84 million in debt, and management will need to address the issue when quarterly results are released this week.

Another industry trouble spot: Many gold producers borrowed a lot of money a few years ago to snap up gold mines at decade-high prices, and their balance sheets are now ill-equipped to handle much lower gold prices.

Back in September, I took note of the high debt loads at Newmont Mining (NYSE: NEM), and though shares are down 25% since then, further drops in gold prices would ratchet up the pressure. It would take a catastrophic set of circumstances to actually push this miner into bankruptcy, but bullish investors need to track these kinds of balance sheet woes.

For that matter, many smaller gold miners that borrowed heavily to develop new mines may be hard pressed to pay back loans of gold prices keep slumping. This could be a fertile area for short-seeking investors in 2014 if gold prices fall further.

Risks to Consider: As an upside risk, many distressed companies can selectively sell prized assets that enable them to move back into lenders' covenants.

Action to Take --> The recent bankruptcy filing for OCZ Technologies had its root in problems that emerged more than a year ago. And the companies showing financial distress today could be the Chapter 11 candidates of 2014. If the U.S. economy fails to strengthen in 2014, then this issue is likely to take a more central focus for investors.

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David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.

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