With the market — until the recent meltdown — mostly enamoured of high-flying growth stocks, the art of the turnaround has been much neglected by investors.
This is understandable. After the momentum in large-cap stocks such as Naspers/Prosus, Anglo American, Remgro and Richemont — or even quality mid-caps such as Transaction Capital and Afrimat — simply backing a quality growth stock with fair prospects is a far less onerous task than having to constantly review the many external and internal factors that inform a company turnaround. And sometimes the trouble that companies — especially small caps — get themselves into is truly mind-boggling.
But it is possible to pick turnaround situations that are hugely rewarding — and there have been more than a few that have earned the legendary, portfolio-altering “10-bagger” status. Of course, risk has to be carefully assessed — and that is not always the easiest task for ordinary investors who might not, like institutional shareholders or banks, have an inside line to management.
IM recalls one of the greatest turnarounds yet managed. It was the old technology retailer the Connection Group (now part of a larger retail conglomerate). The group found itself in trouble shortly after listing in the late 1990s but famously turned itself around in a single financial year.
That’s rare, and investors usually have to exercise much more patience (or endure prolonged frustrations) when participating in a turnaround. The old Rainbow Chicken took forever to turnaround, even though now, as part of the RCL Group, it still suffers at the hands of an often vicious poultry cycle. Some groups — especially those involved in the commodity cycle — can sometimes never completely escape the turnaround game.
Some of the most rewarding turnarounds include empowerment group Brimstone, whose 18c low share price in 2001 has been covered more than tenfold by dividends over the years; Metrofile, which emerged from the MGX group wreck as a dependable cash flow generator; and technology groups Alviva and Adapt IT (since being bought out and delisted).
Brikor, which at one stage looked like it was flirting dangerously with business rescue, clawed its way back to viability and out of a suspended state on the JSE. Cabling group South Ocean Holdings also delivered on a long-awaited turnaround recently, adding a decent dividend payment to underline prospects for a sustained profit performance.
Right now, there are “slow burn” turnarounds under way at Grindrod, Nampak, Novus and York Timber. And turnarounds can take the most unexpected forms.
Take diamond miner Trans Hex, which was seemingly in a death spiral for the last few years of its long tenure on the JSE. When the company delisted, one of its main subsidiaries was being pushed into business rescue and the company looked devoid of even the smallest glimmer of hope. But a couple of years later, one of its main shareholders, JSE-listed investment counter Astoria, reports that Trans Hex is returning rather sumptuous dividends (and these are not proceeds from a liquidation) as well as an increase in intrinsic value.
Writing in Astoria’s annual report, CEO Jan van Niekerk said that since shifting out of the public eye, the Trans Hex management team had moved fast and effectively in restructuring the business. “Little did we know that positive operating results would occur so soon.”
He added that since Trans Hex delisted, management has had the freedom to transform the business. “No circulars, no drawn-out shareholding voting processes, no opportunistic shareholders holding the company to ransom because of arbitrary differences of opinion around valuation, etc. Just management rolling up their collective sleeves and getting on with the job, supported by shareholders who understand exactly what is happening, and are therefore prepared to take the risk of providing capital to management at a fair price to help them achieve their aims.”
But let’s be honest, so many turnaround contenders have fallen by the wayside, and some of the efforts have been truly painful for shareholders. Readers may remember African Glass, Gijima AST and Distribution & Warehousing Network (Dawn), where long turnaround efforts — aided by a good dose of fresh capital to grease creaking balance sheets — yielded little for long-suffering shareholders.
Property group Adrenna’s radical revamp as a private health-care play fell flat, and Nutritional Holdings’s cannabis plans appear to have gone up in smoke. Specialist services group Accentuate sputtered out, and delisted from the JSE.
But let’s be honest, so many turnaround contenders have fallen by the wayside, and some of the efforts have been truly painful for shareholders
So, how do investors play the turnaround game without getting slung to the wrong side of the field? Here are some pointers:
DEBT
Nothing drags a business down quite like debt, and especially if a business is not a consistent generator of cash flow to service interest payments and pay down debt. Make doubly sure there is a compelling plan to curb dent markedly, or to refinance the balance sheet to ensure a business has enough breathing space to execute a turnaround.
CASH FLOW
Historic cash flows are critical in determining whether a company can execute a turnaround. In instances where subsidiaries are sold off to raise proceeds to cull debt, make sure the remaining operations still have strong cash flow.
MANAGEMENT
The calibre of management must naturally be questioned, particularly if the same bunch that dragged the company into trouble are still overseeing the turnaround effort. Management with skin in the game always helps, and there is some reassurance in having executives rowing in the same boat as shareholders by having their success determined mainly by the share price rather than a generous salary.
DEEP-POCKETED SHAREHOLDERS
Turnarounds will inevitably have hitches. It helps enormously if the main shareholders have deep pockets and are willing to provide further support in times of need — which precludes the company seeking new investors at perhaps more desperate terms.
ASSET TEST
Determining the value (and, indeed, quality) of tangible assets (tangible NAV) can provide some reassurance that even if things don’t pan out, there is considerable value to be had on a break-up scenario.
OPERATIONAL REALITIES
This point speaks to the statement above. If operations are floundering, never underestimate the damage these can do in eroding tangible NAV; nor should you underestimate management’s stubbornness in keeping unviable operations going rather than locking up and looking for a value release. Ask any former Dorbyl shareholder how heaps of cash were unceremoniously burnt up by a loss-making operation.
NEW ASSETS
But also beware of companies that ditch unviable operations and then suddenly tag their turnaround prospects on veering into a new strategic take with newly acquired assets. Be doubly wary when these assets are acquired by issuing billions of new shares at almost no value at all. No-one sells solid, cash flow-generating assets for cheap scrip — not unless the deal gives them full control of the new company strategy and management oversight.
There are ‘slow burn’ turnarounds under way at Grindrod, Nampak, Novus and York Timber. And turnarounds can take the most unexpected forms
Now the key consideration: which struggling counters are worth considering as turnaround prospects? Here are the dirty dozen:
1. ISA Holdings
This security technology business was a dependable dividend payer — until its erstwhile software partner pulled the rug out from under its feet. The business has been reinvented with new software licensing arrangements, and the customer base is being reassuringly rebuilt. The asset-lite business model is cash flow generative with sturdy margins, and the management team has proved resilient through a serious crisis.
2. Choppies Enterprises
This retailer did not get into an operational fix but rather got waylaid by issues in the boardroom. The original founders are back in charge, and the business still seems to be churning decent revenue and operating profits. The big challenge is sorting out the debt — which, judging by the share buying by the two prime movers, could be tackled with some vigour in the short term.
3. Tongaat Hulett
Asset rich on paper with a new executive team in place. But a difficult investment while there is still uncertainty over the fate of a large rights issue and the intentions of an underwriter that is likely to become the influential shareholder. Operationally, Tongaat does not look to be in a sweet spot, and it could be years before the sprawling property portfolio yields appropriate value.
4. EOH
After some strenuous asset sales, there are still lingering questions around whether this slimmed-down technology conglomerate will embark on a rights issue to reboot growth prospects. The executive team tasked with the turnaround has performed well and — importantly — communicated well with the market.
5. Aveng
After rights issues, the balance sheet looks better reinforced, but the operational performance unexpectedly came up short of expectations. The chance to sell Trident Steel for a good price might have passed as well. But at current levels — less than 3c on a pre-consolidation basis — Aveng looks like interesting long-term value now that its ability to survive is no longer being questioned.
6. Advanced Health
This day clinics business might have initially been ahead of the curve, but now it faces competition from the established private hospital groups. Plenty of extra funding and some tough restructuring have been required to shift the business to sustainability in SA — but the better-established Australian business looks to have reached an interesting juncture.
7. Conduit Capital
Investors might be wary of smaller insurance companies on the JSE, but Conduit’s Constantia business is well established and carries some promise. A poor-performing investment portfolio has, however, caused some problems with statutory capital requirements at Constantia. A BEE deal to recapitalise the group is pending, but appears to be taking longer to finalise than initially anticipated.
8. Finbond
The “banking” business has seen its share price down almost 90% over three years as its core lending operations slipped into the red. The latest trading update suggests some gradual improvement. Finbond’s lending ventures into North America — which initially excited the market — have proved tricky of late with pesky changes to regulations.
9. Adcorp
This services conglomerate was once a market darling, before a heavy fall from grace. It could be argued that the turnaround was already secured when turnaround expert Phil Roux resigned from the business in early 2021, but the latest trading update for the year to end-February supports IM’s view that the turnaround is only just beginning to find real traction.
10. Luxe
After the old Taste group sold off its loss-making pizza and coffee operations (Domino’s and Starbucks), the company opted to carry on in the jewellery retailing field. Ironically, these are the very operations that were put up for sale when the group was aggressively pursuing its pizza and coffee ambitions. The share price has run up a bit lately, but IM suspects Luxe is worth more than the current market value of R57m.
11. Steinhoff
This retail conglomerate (see separate story in this issue) has some incredibly valuable parts — especially fashion retailers Pepkor and Pepco. But there is a clutter of non-operating issues clouding the real value in Steinhoff. Consequently, a turnaround play for those punters who can hold their nerve and stare at the longer-term horizon.
12. Cognition
This is a difficult business to assess — not quite a media company, not quite a tech company, not quite a services company. Much seems to rest on squeezing better returns from its online property acquisition (bought from anchor shareholder Caxton some years ago). IM believes this business might do better outside the public eye, and maybe Caxton will do the logical thing and pitch a decent buyout offer to minority shareholders and delist Cognition from the JSE.
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