During an industry downturn, it’s common for a company to experience weak operating performance, leading to a lower stock price. While these scenarios attract bargain hunters hoping to find diamonds in the rough, based on my experience of looking at such companies, such situations should be closely scrutinized for the company's weakened financial position and potential share dilution.
Consider a company with a solid balance sheet: a high working capital ratio, no short-term debt, no variable-rate debt, $10 million in cash, and $10 million in long-term debt due in five years. With no net debt, annual earnings of $1 million, and a price-to-earnings ratio of 10, the market value of the company is $10 million.
Now, assume the industry conditions deteriorate, and the company incurs a $3 million loss, accompanied by poor future guidance. The debt remains at $10 million, while cash decreases to $7 million ($10 million cash less $3 million loss). In such a scenario, the stock price could drop significantly, say by 50%, to $5 million. This will likely attract bargain hunters, as the stock is trading below the cash level on the balance sheet with no immediate net debt. However, there’s a potential risk that the nature of the debt could change.
For example, a breach of debt covenants due to operating losses or insufficient liquidity relative to credit lines might cause the long-term debt to be reclassified as short-term debt, requiring repayment within one year. This would significantly weaken the company’s balance sheet, leaving it with only $7 million in cash and $10 million in short-term obligations, while still facing operational losses.
If the downturn persists, lenders might pressure the company to strengthen its balance sheet by issuing warrants or shares at minimal prices, leading to substantial dilution for existing shareholders. I have seen cases of 15%+ potential dilution.
While bargain-priced stocks can present attractive opportunities, investors must thoroughly analyze the company’s financials, especially changes in current liabilities, the nature of debt, and the potential for share dilution. These details are often disclosed in the footnotes of filings such as 10-Ks and 10-Qs and require careful examination.
Abhay Srivastava is the Founder and Managing Member of AS Investment Partners LLC, a value investing firm (www.asinvpartners.com).
