Bankruptcy Watch: Which of these 3 Stocks Will Head to Zero?

Just 14 months ago, the U.S. economic outlook appeared fairly dire, leading stocks to plunge in late July and early August 2011. As it turns out, it was a false alarm: The S&P 500 has risen 29% since then. This kind of move is all the more remarkable when you consider that the U.S. economy remains in a funk. With the exception of the fourth quarter of 2011, the U.S. economy has failed to grow in excess of 2%.

The 2% level is a crucial point for the U.S. economy. When the economy grows above this rate, companies’ sales and profits can expand. Equally important: Bankers start to relax, issuing more loans and showing more tolerance for companies that may be dealing with a too-high debt load.

Yet here’s the bad news: the economy started to slow in the second quarter of 2012, growing just 1.3%. This figure was just revised — economists initially thought the economy had grown at a 1.7% pace. And it’s unlikely to get better any time soon. The U.S. Commerce Department just announced that orders for durable goods fell 13% in August 2012 compared to a year ago. This is the biggest decrease since January 2009 and the lowest dollar figure for new orders since February 2011.

The outlook for gross domestic product growth in the quarters ahead: Weak. The U.S. economy is on track to post a mere 1.5% growth in 2012, and in light of the fiscal cliff and other headwinds, might do even more poorly in 2013. 

That may augur in a sea-change in the world of lending officers. Not only will those folks be less inclined to issue new loans, but they may look to pull the plug and call in existing loans if they slip out of legal restrictions, known as “debt covenants.”

Against such a backdrop, I think it’s prudent to start tracking the companies that are vulnerable to a weak economy. These are firms that carry too much debt (especially of the short-term kind) or too little cash to handle still-negative operating cash flows. If these companies hit a cash crunch, then the bankers may be of no help, pushing their stock prices toward zero.

Starting with this column, I’ll provide an ongoing look at some of our nation’s most vulnerable companies. I’ll also provide a handy gauge that anticipates just how likely a company is to tumble into bankruptcy. 

In this column, I’ll first take a brief look at potential bankruptcy candidates I’ve looked at in the past. And in coming weeks and months, I’ll be adding to this list, tracking all of them until they take steps to sharply improve their balance sheets, or the U.S. economy starts to grow at a more robust pace.

1. Clearwire (Nasdaq: CLWR)
Bankruptcy Score: 5

This stock slots in between the 4 and 6 readings laid out above. The troubled telecom service provider has managed to keep issuing debt and equity to help fund hundreds of millions in annual operating losses. I first profiled this company’s woes in August 2010 when its shares traded above $8. They fell below $1 in late July, which is often a key tell for a possible bankruptcy filing, but management has helped stem the bleeding for now by noting it its most recent 10-Q that it “had sufficient cash to fund near-term liquidity needs… for at least the next 12 months.” Shares currently trade around $1.30.

Also in its favor, Clearwire owns valuable wireless spectrum, which could be sold to pay off debts. Trouble is, Clearwire has more than $4 billion in debt (and annual interest expense of more than $500 million), and even such a big asset sale may not wipe out that debt load completely. The quarters ahead will be crucial: Clearwire needs to start taking dramatic action, such as an asset sale, if is to avoid a date with a bankruptcy judge.

2. American Apparel (NYSE: APP)
Bankruptcy Score: 4

I profiled the rising risk of bankruptcy for this retailer back in January, but shares have actually moved higher instead of lower, recently crossing $1.50 for the first time in 19 months. This turned out to be a tough stock to short, as furious recent short-covering activity can attest. The share price rebound is due to a series of management pronouncements that sales are rising and that 2012 EBITDA should be robust, perhaps approaching $40 million.

Yet despite appearances, this company is far from being out of the woods. Management likes to talk about surging cash flow, but the balance sheet looks ever weaker. Here’s a snapshot of the balance sheet in recent periods. 

As you can see, despite several quarters of bullish press releases about sales growth and rising EBITDA, the balance sheet is getting weaker. 

I’m feeling charitable and will give this retailer a “4,” which means significant shareholder dilution may lie ahead. But if the balance sheet gets any weaker, then this stock will quickly get bumped up to a “6.”

3. Coldwater Creek (Nasdaq: CWTR)
Bankruptcy Score: 5

This struggling retailer just bought itself more time after borrowing another $65 million to stay afloat in July 2012. It now has $45 million in the bank, removing any bankruptcy concerns for this year. But it’s imperative that sales trends start to improve. Same-store sales have been very weak for several years, leading management to close the weakest stores while sprucing up the merchandise in existing stores. 

Those steps need to show an immediate payoff. Coldwater Creek generated negative free cash flow of $32 million in fiscal (January) 2011 and another negative $53 million in fiscal 2012. A similar cash burn rate in the quarters ahead would cause that $45 million in cash to dissipate quickly, so it’s unlikely the company will then be able to line up yet more loans, as it did this summer.

Risks to Consider: As an upside risk, debt-burdened companies can look to sell stock to raise cash, though the dilution associated with such moves can push shares well lower.

Action to Take –> In this slow-growing economy, you need to watch corporate balance sheets more closely than ever. If a company’s debt load remains unaddressed while the economy remains weak, then shareholders could end up paying a stiff price. You wouldn’t want to own any of the stocks I’ve mentioned here, unless your research shows that a turnaround is possible and you’re willing to stomach the risk. That’s a risky proposition — even for the most risk-tolerant investors.