When a stock tumbles, the situation might lead to an opportunity of purchasing an undervalued company. Let’s consider several companies that haven’t performed well in the stock market in recent years, and see if these companies are a bargain.
Many investors believe in the efficient market hypothesis, which basically means that market prices of stocks represent the best estimate of companies’ value, based on the current available information. I won’t go into a whole debate over whether this notion is accurate or not. But, I will argue that in times of uncertainty, especially for specific companies, stocks might be undervalued because investors tend to move out of companies that have a high chance of going under.
In other words, investors might overestimate the potential risk of a company in dire straits. Before getting down to the brass tacks, you should know that whenever you go bargain hunting there is a risk of losing your money; a risk that shouldn’t be dismissed.
When considering purchasing a company that is in dire straits, you should ask several questions about the company in order to asses if it is a company worth investing:
- Is the company profitable?
- Is the industry the company operates in viable?
- Does it have enough assets to sell in case it needs to pull out of its dire situation?
- What’s the company’s cash flow and cash on hand situation?
I won’t say these are the only questions to ask, but these questions are a good starting point.
Let’s examine three companies that didn’t perform well in recent years and see, based on the above-mentioned questions, whether they are a bargain.
BP plc (ADR) (NYSE:BP)
The stock has lost more than 30% of its value in the past three years following the Gulf of Mexico oil spill. Since then, the company has shown signs of recovery. Last year, the company’s operating profitably was 6.6% (after adjusting for the goodwill provision), which is relatively low for its industry (e.g. Exxon Mobil Corporation (NYSE:XOM)’s profitability was 14% in 2012). But, the company is still making money and still has positive free cash flow that covers its dividend payment.
The market it works in is still very much viable and is likely to keep growing. In terms of cash, it holds more than $13.7 billion (part of it will be allocated to the company’s fund for covering the cost and fines of the 2010 oil spill). BP plc (ADR) (NYSE:BP) managed to sell several assets in order to reach its target of $42.2 billion dedicated to the costs and fines of the oil spill.
The company is still in court. BP plc (ADR) (NYSE:BP) is sued by several States and individuals for the damages related to the 2010 oil spill. The law suits will keep the uncertainty around the company’s future. But even if the company will eventually need to augment its oil spill fund, it still has ample assets to sell (just in case), or perhaps even reduce its currently high dividend or buyback program.
Chesapeake Energy Corporation (NYSE:CHK)
Shares of Chesapeake Energy Corporation (NYSE:CHK) have plummeted more than 40% in the past two years. One of the reasons for the company’s decline was due to its financial strain that stemmed from the sharp drop in the prices of natural gas. Nearly 50% of the company’s revenue is from natural gas.
The company sold several of its assets to cover the loans it had taken in 2011 and 2012. Even if the company repays its loans by 2013-14, its main problem will persist – low prices of natural gas. Even though the price of natural gas has rallied in recent months and is well above the historically low prices recorded in 2012, it is still low compared to previous years.
Moreover, the expected rise in production of natural gas in the U.S. is likely to keep the price from rising to higher levels recorded in the preceding years. Nonetheless, the company remains profitable. In 2012 its operating profitability (after adjusting for the goodwill provisions) reached 13.8%. Moreover, the company’s revenue rose 5.9% (year over year).
On the other hand, the company’s cash flow remains unfavorable with a negative free cash flow and only $287 million in cash. The company has many assets to sell in order to payoff its debt, but the company’s natural gas operations might put it in dire situation again in the future.
J.C. Penney Company, Inc. (NYSE:JCP)
Lately, this company has been in the news over the stepping down of its CEO, Ron Johnson, and the return of former CEO Myron Ullman to the helm. I always thought that bringing back a former CEO is like getting back to your former girl/boy friend — very soon you remember why it didn’t work in the past.
Besides this news, a close look at the company’s financial situation reveals the problems it faces besides in court. The company’s revenue dropped nearly 25% in 2012 (Y-o-Y), and its operating loss was nearly $1.3 billion. Moreover, not only the company’s FCF was negative in 2012, but also its operating cash flow was. This is another bad sign for the company.
J.C. Penney Company, Inc. (NYSE:JCP)’s cash also dwindled 40% last year (compared to 2011). The few positive notes worth mentioning are: the company has assets to sell that might help it float above water; the retail industry is slowly growing so the industry it works at is slowly expanding. But since the company is losing and its cash flow situation is dire, the risk vs. benefit might not be worth it.
The bottom line
I have reviewed in this post three companies: Two from the oil and gas industry and one from retail. Based on the questions I laid out, it seems that BP is a company worth considering for investment. Chesapeake Energy Corporation (NYSE:CHK) might not be worth entering (unless the company moves out of the natural gas market), and J.C. Penney Company, Inc. (NYSE:JCP) doesn’t seem worth investing when considering the risk-return trade off.
Lior Cohen has no position in any stocks mentioned. The Motley Fool has the following options: Long Jan 2014 $20 Calls on Chesapeake Energy, Long Jan 2014 $30 Calls on Chesapeake Energy, and Short Jan 2014 $15 Puts on Chesapeake Energy.
