On April 13, 2010, I found 10 companies that I thought were on their way to collapsing.
[Click here to see the original article: 10 Companies That May Be Ready to Collapse].
Five months later, I'm more convinced than ever that there is trouble ahead.
When putting together the original list, I used Altman's Z-score to help find the most vulnerable firms. Over time, the Z-score has proved to be one of the most reliable predictors of bankruptcy. In a series of tests covering 316 distressed companies from three time periods between 1969 and 1999, the Z-score was between 82% and 94% accurate in predicting future bankruptcies.
Of the 10 companies on my list, 8 saw their already weak Z-score deteriorate.
The Z-score incorporates a bunch of good information, including profitability, liquidity, solvency, efficiency, leverage and market confidence.Firms with a low Z-score are weak in these six crucial areas, and generally speaking, the lower a company's Z-score, the higher the chance of bankruptcy.
You may have been surprised by some of the companies on the list. General Electric, the last original DJIA member, has been a mainstay of American industry since the turn of the last century. Could it really fail? Alcoa, another Dow component, also looks like the walking dead to me. And I'll tell you why.
We need recessions to periodically flush out the system, clearing out the junk and making way for new beginnings. The Great Recession of 2008 did not feel like such a cathartic event. Instead, government largess was stuffed into the pipes, keeping the bad stuff from washing away. The companies on this list benefited from government programs to "jumpstart" the economy (Cash for Clunkers, Cash for Appliances, homebuyer tax credits, TARP, etc.) but all those programs provided was an incentive for consumers to do today what they may have done tomorrow.
Now these companies, like everyone else, are staring into a future where demand stagnates, top line growth dwindles, and mountains of debt continue to suffocate any chance of recovery.
I have no doubt that the global economy will recover once zombie companies like these are put out of their misery. But now, more than ever, I think the chance of all these companies surviving in their present form is next to nothing.
Anadarko, Pioneer Natural Resources, Devon Energy and El Paso Corp -- I've consolidated the four oil and natural gas companies on this list because they all face the same problems.
Most natural gas companies made huge investments in production from 2005-2008 as natural gas prices undulated between $8 and $14. The subsequent increase in production has pushed gas prices down to the $3-6 range. But even though prices have been kept low by production gluts, gas companies in the U.S. continue to pump at record levels.
John Richels, CEO of Devon Energy says, "I can see a period of significant consolidation in a couple of years." Increasing production and decreasing prices will continue to chip away at cash flow. Ultimately, financially-stressed companies will be forced to sell themselves.
And if firms aren't the hunters, they become the hunted.
High debt levels strain credit ratings and weaken firms' ability to finance future growth and capital expenditures. Poor credit ratings also make it difficult to acquire new business. After all, if a company has the choice between being purchased by a financially strong company versus one loaded with debt problems, which do you think it will choose?
General Electric -- I spend a lot of time thinking about General Electric (NYSE: GE) and whether it should be on this list. I understand the case for being bullish on GE. It's diversified. It's politically connected. It's an American icon. But it also has declining revenues (-4.3% in 2Q 2010) in an allegedly strengthening economy, and its balance sheet is absolutely atrocious. In fact, I'll just reiterate my point from April, because nothing has really changed since then:
"GE had an 85% debt ratio in December 2009 (and in June 2010), meaning that every dollar of assets was financed with 85 cents of debt. But to believe that ratio, you have to be willing to value almost $375 billion in loans and accounts receivable at $375 billion. In other words, you have to assume that GE made such good loans to its customers that if GE had to sell the receivables for cash today, it would get full price. I don't know about you, but I wouldn't pay full price for any loan portfolio these days.
If the economy continues to improve, GE may be able to continue paying down debts with profits. But if the assets listed on GE's balance sheet are overvalued by just 15%, then GE is already underwater. If there's another downturn, or even just a little wobble, GE's debt load may prove to be too heavy."
If you are bullish on the economy, then perhaps you should be bullish on GE. But if you're like me, and you see stormy seas ahead, stay away from this debt-ridden disaster waiting to happen.
U.S. Steel -- In April I pointed out that U.S. Steel (NYSE: X) shares had tripled off their March 2009 lows, with some analysts even calling for new all-time highs in 2010 based on the assumption that companies with the ability to raise prices for their products are the ideal hedge against inflation.
Today, those analysts can't be happy with the latest reports of too much production and too little demand driving down prices once again. On July 7, a Reuters report cited independent analyst Tom Stundza as saying, "The mood of the country is not all that terrific about manufacturing, there is no pickup in demand and there is unemployment." Stundza went on to say that hot rolled coil selling for $645 per ton in June is down to $620, "And I know you can get it from a mini-mill in the Midwest for $605, delivered in two weeks."
U.S. Steel has had five straight quarters of negative earnings. Not only has net income been negative for five quarters, but cash flow from operations has been negative during that same time period. U.S. Steel has been borrowing money for the privilege of selling steel at a loss. And that is not a viable long-term business plan.
Alcoa -- Alcoa (NYSE: AA) operates in a tough environment. Prices for inputs (electricity, caustic soda) continue to go up, but prices for the final product (refined aluminum) continue to go down. Some of its largest competitors are Chinese and Russian firms that exist only because of gigantic state subsidies. These subsidized companies have no incentive to stop producing, so the world is awash in aluminum. According to Rusal (EuroNext: RUSAL/RUAL), the world's largest aluminum producer, the aluminum market may have a surplus of 500,000-700,000 tonnes this year.
Just a quick note on the size of Alcoa's debt load: from March 31, 2009 to March 31, 2010, Alcoa paid $474 million in interest. That comes out to 20% of gross profit (Revenue - COGS) going to debt service before considering any other costs of doing business. It's absolutely unsustainable if low prices and high costs continue to put pressure on margins.
Weyerhaeuser -- Weyerhaeuser (NYSE: WY), the second-largest North American lumber producer, is preparing to become a timber real estate trust to reduce taxes on its investments in timberland. Earlier this month, the company declared a $5.6 billion special dividend, part of the process of becoming a REIT.
The company reported second-quarter net income of+$14 millioncompared with a year-earlier loss of -$106 million. But the July new home sales numbers aren't a good omen for the lumber producer. In fact, July new home sales of about 276,000 was a new record low for data that stretches back to the early 1960s.
As a REIT, Weyerhaeuser will not pay federal taxes at the corporate level, which will save it a chunk of cash every year. As a REIT, it also must pay out 90% of earnings as dividends. But you can't generate earnings growth without revenue growth. And you can't make a dent in your debt load without revenue growth, either.
Pulte Group -- It's not surprising to see a homebuilder on a list of bankruptcy candidates. Like Weyerhaeuser, Pulte (NYSE: PHM) will continue to suffer until housing turns around. And as this chart from the St. Louis Fed shows, things can't get much worse:
Textron -- Textron (NYSE: TXT) sells defense-related products and, as you may guess, their largest customer is the U.S. government. Many of Textron's orders were canceled in 2009, and the order pipeline for 2011-2015 isn't looking so hot, either. In late June, Defense Secretary Robert Gates reiterated plans to cut more than $100 billion from Pentagon spending over the next five years. And that's a best-case scenario; The Sustainable Defense Task Force advocated cutting $1 trillion.
The company's debt load is high, and their credit limit seems to have been reached as well. To stave off bankruptcy in 2009 and 2010, the firm used what it called its "ultimate backstop," a $3 billion line of credit due in 2012. With a total of $7.4 billion in net long-term debt, negative operating cash flow of -$88,000,000 in Q1 2010 and a weak outlook for its #1 customer, the U.S. Department of Defense, Textron may have too many obstacles to overcome.
There is a chance that none of these firms will be forced into bankruptcy in the near future. It's important to keep in mind that many firms do bounce back from tough financial circumstances.
However, the Z-score, with its oft-tested reliability in predicting bankruptcy, will probably end up claiming at least a few of the firms on the list.
If you would like to learn more about the Z-score and how it works, click here to see our educational article, Using the to Predict the Next Enron.