The long-awaited correction appears to have finally arrived. Like a yo-yo that has climbed up sharply and is now heading back down, this fall will probably not be as sharp or as deep as many pundits would suggest. I am going with a SPY target of 87.50 to 92 as the most likely bottom for this move. For those that follow my work, you may recall that this happens to be the area that I initially thought would contain the rally from March. Clearly I was too conservative. I get to my zone using several different metrics, including Fibonacci retracements as well as charting and volume-at-a-price. To be very successful in the last few months, one had to set aside one's fundamental views in my opinion and roll with the liquidity. As long as interest rates aren't rising, I do believe the pullback will be orderly and contained, but the bear is back on if we can't finance our federal debt at a low cost.
Even though my expectations are that stocks in general have about 15% downside from here (two weeks or two months - who knows), I believe that many stocks have considerably more risk. In the past few months, companies with leveraged balance sheets have roared back as the capital markets have reopened. Many companies have addressed liquidity issues by extending their debt or issuing stock, but several others have not taken advantage of what I view as a good opportunity. I am cautious on companies in general that have high levels of debt relative to their potential to generate free cash flow, especially in an environment of economic weakness or stagnation at best. With that in mind, I want to share three ideas, all of which have lots of debt relative to FCF and short-interest that has come down significantly over the past several months. None of these companies had moved to address their weak capital structures.
Weight Watchers (WTW) is a broken company in my view. I have written about this one before, and it has had the least recovery of the three that I am discussing today. I think the tell is that it trades at 10PE - clearly big money doesn't believe those numbers. The problem is that if the numbers aren't right, the debt becomes a problem. They report next week, so we shall see. As of 6/30/09, the company had debt net of cash of about $1.5 billion. The company's FCF is essentially its net income, so this year, last year, next year and the year after all look about the same: $200mm. The company repurchased so much stock that it left its equity negative. In a harsher environment, the debt will become a burden in my opinion. I think that this one could see an earnings miss which could drive the price back down towards the 52-week low below 17.
Collective Brands has been more than a 5-bagger off the bottom, and I don't get it. Since April, the estimates for 2010 have increased 5% yet the stock has doubled. I do know that shoes had a good quarter on pent-up demand, but this is a company that can ill afford a weak economy. The company is spending significantly less in CapEx this year as it retrenches ($85mm, down $44mm), so FCF conversion will be healthy this year: NI of approximately $70mm, D&A of approximately $140mm and thus $125mm of FCF compared to $119mm last year. Not bad for earnings being down so much. The problem is that total debt less cash is about $500mm. If the FCF were sustainable, the burden wouldn't be that great, but the company is unlikely to grow if it continues to shrink. I look for this one to test 12.
My last pick for a potential sharp decline is Carnival Cruise Lines (CCL), which typically doesn't produce significant levels of FCF. The stock has rebounded 100% off the lows. I sense that this business will be challenged for years to come. While the $8 billion in debt seems to pale in comparison to the equity and the market cap, it is important to realize that the multiple of FCF is tremendous. I expect this one to test the 20 area again.
I do believe that this pullback won't be as indiscriminant as the decline earlier this year or the rally, with companies with better capital structures and less aggressive earnings ramps performing better. As always, you can check out my disclosure to learn more about what I am thinking from that perspective.
Disclosure: No position in any stock mentioned