Investing in turnaround stocks can be quite challenging. It takes a keen eye to ignore the current bad news and visualize how things will look a year or two from now. The upside: If you can spot a turnaround before the crowd, then you can reap significant profits by the time the good news has begun to flow.
As we noted six months ago, he started out with just $1 million in assets under management in 1996, and now oversees $4 billion in investments for his clients.
Einhorn knows full well that turnaround stocks can try your patience: One of his most recent turnaround picks has just delivered a fresh set of bad news, sending shares down to levels below his purchase price.
In the fourth quarter of 2013, Einhorn's firm acquired $60 million stake in oil services firm McDermott International (NYSE: MDR), at an average price of $7.80 a share. He's already underwater with this this pick. But a deeper look behind McDermott's woes reveals a set of fixable problems. And investors may be looking at 50% upside if they ride Einhorn's coattails.
McDermott, which traded for $25 a share in early 2011, has deep expertise in the construction of massive offshore energy platforms. Though that positioning was right at the core of industry trends as more drillers go offshore, management has really bungled this business. They developed a knack for signing contracts that turn into money-losers, mistakenly straying away from a core competence in shallow water drilling services and towards the trickier deep-water action.
Indeed, McDermott has been underperforming for quite some time. A simple benchmark: While other drilling services firms such as Schlumberger (NYSE: SLB) have seen shares rise in the past few years, this stock is down more than 40%. Thankfully, management was replaced a few months ago.
Still, even with new management in place, just-released fourth-quarter results represent the last straw for some long-suffering investors. McDermott has been missing profit forecasts for a number of quarters, but a series of one-time charges led fourth-quarter results to trail earnings per share (EPS) forecasts by nearly a $1 a share.
The massive shortfall was intentional. New CEO David Dickson, who took the reins in October, did what every new CEO does. He "cleared the decks," which means he took a charge against a wide range of projects, lowered investors' expectations for the timing of a turnaround, and told analysts that he wouldn't be giving any more revenue or profit guidance until all of the company's problems are being fixed.
|A deeper look behind McDermott's woes reveals a set of fixable problems. And investors may be looking at 50% upside if they ride Einhorn's coattails.|
Frankly, this company is badly in need of a total overhaul. Dickson "aims to increase accountability, improve customer relationships, and increase competitiveness," note UBS' Steven Fisher. And he's backing up that change in culture with specific remedies: His plan also "includes tangible actions (cost cuts, capital discipline/reducing capex, balance sheet improvement)," adds Fisher.
Yet Fisher adds that Dickson appears to have already made rapid progress in the four months he's been in charge, despite the just-released messy quarter. He's replaced many top executives, cut the company's runaway spending on several money-losing projects, and already insured that the most recent signing contracts will yield much better margins. Still, bad legacy projects are likely to impede profits for the rest of 2014. Analysts at Goldman Sachs (NYSE: GS) just lowered their 2014 EPS outlook nearly 63% to $0.15. (The 2015 EPS forecast has been trimmed by a nickel to $0.60.)
Fisher suspects that by pouring all of the bad news into the kitchen sink now, future quarters will be a lot quieter, in terms of restructuring charges. "We expect no new material charges in the next couple of quarters, and we think this will drive the stock towards our target (of $10)," he writes.
As just noted, McDermott is only bidding on contracts that offer good terms, and turning away deals that will pump up sales but bleed cash. But management still thinks there are plenty of good contracts up for bid. Over the next five quarters, they see $16 billion in potential projects to pursue.
Here's why you shouldn't wait: This stock has hit a floor, trading for just is now near a floor with a price-to-tangible-book (P/B) ratio of around 0.94. The price-to-sales (P/S) ratio of around 0.7 is equally appealing. That's a fair price to pay for a company with broken but fixable problems that still faces a sizable market opportunity as offshore energy exploration trends continue to strengthen.
To give a sense of what kind of profits this $7.40 stock can earn once operations have been, McDermott generated earned an average of $1.08 a share in 2005 through 2012. A focus on restoring margins should help EPS to rebound to those levels by 2015 or 2016, and when that happens, shares are likely to trade into the $10s. That's a far cry from the $25 seen just three years ago, but considerable upside form current levels.
Risks to Consider: As with any turnaround situation, patience will be required and this stock could take a number of quarters to fulfill its potential. As Goldman Sachs notes, "we are warming to the MDR story, but see no reason to rush in given the high likelihood for near-term operational (and financial) volatility as it execute its strategic vision. We therefore maintain our neutral rating, though it is increasingly compelling from a turnaround perspective."
Action to Take --> The main issue to assess when analyzing a turnaround situation is identifying whether a company's problems are intractable or fixable. McDermott's Dickson is not only capable of fixing the company's problems, but he's already taking swift action. He'll surely deliver at least a few more tough quarters, but with such a low valuation, investors can afford to be patient.