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Jim Jubak

Jubak's Journal4/21/2009 12:01 AM ET

5 shipshape stocks for the turnaround

When the recovery comes, healthy companies will bob up much faster than those battered by the recession. Here are 5 warnings -- and 5 companies ready to rise.

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By Jim Jubak
MSN Money

A rising tide may lift all boats, but those with gaping holes in their hulls won't float much higher.

In other words, no matter when you believe the economy and the stock market may turn, you should own shares in companies that are ready for the change in tide and avoid those so damaged that they'll spend the first year of the recovery simply patching holes.

In this column, I'm going to give you five danger signs that will help you avoid getting trapped in a stock that's going nowhere in a recovery. And I'm going to identify the stocks of five companies ready to take advantage of the economic recovery, whenever it comes.

The recovery is still more than six months away, in my opinion, and this rally will end in disappointment but is part of a bottoming process. Jubak's Picks is about 50% in cash and 50% in stocks, and I'm planning on staying that way for a while.

Mistakes can be an anchor

The truth is that some companies are unprepared for the turnaround no matter when it might come. Their stocks, after an initial bounce, will lag because these companies are still struggling to fix balance sheets, dispose of wrongheaded and expensive acquisitions, and prop up struggling suppliers.

Other companies managed their businesses better. They kept enough cash on hand or arranged enough in credit lines that they haven't had to stop investing in their own businesses during the downturn.

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They didn't make expensive acquisitions simply because an inflated stock price during the boom years made the prices seem cheap. (And now they aren't desperately seeking a buyer to cart away those turkeys.) They diversified their supply chains, kept key parts of their manufacturing and service operations under their own roofs, and, because they paid their bills on time, now don't have to bail out critical suppliers.

You don't have to be Warren Buffett to know which of these two kinds of companies you'd rather own shares in during any economic and stock market recovery.

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5 major missteps

The companies you don't want to own made mistakes during the boom that fall into one or more of five common types:

  1. Avoid companies that made expensive, wrongheaded or distracting acquisitions that they're now unwinding. Want an example? Take your pick in the banking sector. Did Bank of America (BAC, news, msgs), to take just one example, need to pay $50 billion to buy the sinking portfolio of Merrill Lynch while it was still digesting its purchase of the sinking mortgage portfolio of Countrywide Financial and trying to find capital to shore up the balance sheet of the core bank?

    Banks aren't the only culprits, however. How about eBay's (EBAY, news, msgs) purchase of Skype for $3.1 billion in 2005? The company recently wrote down Skype's value to $1.9 billion and not-so-subtly indicated the Internet telephone business is for sale. In retrospect, all the acquisition did was to divert management's attention from the growing problems in eBay's core online auction business.
  2. Avoid companies that believed cheap money justified a build-it-and-they-will-come strategy. In the boom, restaurant chains followed the same logic. The share of the family food budget spent in restaurants was climbing, from 40% in 2000 to 48% by the end of 2008, and because money for expansion was cheap, it made sense for chains to build more restaurants. Today, restaurant consultant Technomic estimates the industry needs to close roughly 20,000 restaurants. This is a big deal for companies such as DineEquity (DIN, news, msgs), the owner of the Applebee's and IHOP chains, Brinker International (EAT, news, msgs), the owner of Chili's, and OSI Restaurant Partners, which took the Outback Steakhouse chain private. The task at these companies is selling company-owned restaurants and closing restaurants to shrink the chains.
  3. Avoid companies that loaded up with debt to buy competitors or to take companies public. DineEquity and OSI Restaurant Partners aren't just shrinking their chains to right-size their businesses. They've also got a ton of debt to repay. The two companies ended 2008 with debt of $1.9 billion and $1.8 billion, respectively. Fortunately, none of that debt is set to mature in the near future, according to Fitch Ratings, but in an effort to cut its debt load, DineEquity has sold 66 restaurants in Texas and New Mexico, and suspended the dividend on its common shares.
  4. Avoid companies with nervous lenders. Itron (ITRI, news, msgs), for example, is a maker of automated utility meters and intelligent metering systems that I've owned in Jubak's Picks, and it remains profitable. At 1.17, the company's debt-to-equity ratio is high, but the company has been paying it down and reducing leverage in recent quarters -- but the banks want more. At the end of 2008, Itron's debt-to-EBITDA (earnings before interest, taxes, depreciation and amortization) ratio stood at 4.1, according to Janco Partners Equity Research. Later this year, loan covenants will tighten, and the company will have to reduce that ratio to 4.0. That's not a huge change, but at a time when capital is precious because it's so hard to get, deleveraging can reduce a company's ability to grow its business.
  5. Avoid companies where the credit crunch is hitting both suppliers and customers simultaneously. The credit crunch has delivered a megadose of this double whammy to entire industries. The obvious example is the auto industry, where tighter money has cut into the automakers' abilities to woo buyers with big incentives and has cut off working capital for suppliers already squeezed by carmakers' delays in paying their bills. But younger industries, such as solar, have been hit hard, too. The credit crunch has cut into financing for solar installations, so solar cell makers have seen demand for their product dry up. At the same time, the companies that supply solar wafers and the other raw materials used in the finished cells have seen financing for planned expansion disappear. Applied Materials (AMAT, news, msgs), for example, recently reported that a customer for its manufacturing equipment had cut a $1.9 billion order down to just $250 million due to a lack of financing.

Continued: 5 companies that have avoided missteps

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