Never Touch These Four Stocks Again

By TradeSmith Editorial Staff

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As Bob Dylan once famously wrote…

Times, they are a-changin’.

The era of easy money borne by a dovish Federal Reserve has come to an end.

Higher interest rates are forcing investors to look for profits and cash now as opposed to a promise of windfalls in the future.

Just take a look at the former Wall Street darling Carvana Co. (CVNA).

Disrupting the automobile sales industry by being an online-only used-car retailer, Carvana hid its horrid financials with booming growth.

The company’s total liabilities outweigh its current assets even as it burns nearly $2.7 billion in cash each year and another $695 million in capital expenditures.

Right now, Carvana forks over $210 million each year for interest payments.

And guess what happens when rates increase?

You bet it’ll have to pay more and could add on new debt. Given its current balance sheet, it will need to borrow more to survive.

I love the idea behind the business, but Carvana is in dire straits.

And Carvana isn’t the only company…

There are three others that I would never invest in unless they are able to turn things around and meet the metrics in what I am calling a stock Survival 101 guide.

Survival 101

History is littered with companies that turned a paper profit yet filed for bankruptcy.

The truth is, GAAP (generally accepted accounting principles) and non-GAAP earnings only explain so much and are easy to manipulate.

What you can’t fake are cash flows. You either generate more cash than you spend or you don’t.

Companies that spend more cash than they generate eat away at liquid assets.

And on top of that, many firms took on inordinate amounts of debt to survive the pandemic.

Now, larger companies, even Boeing Co. (BA) with its 12-month cash burn of $4.3 billion, aren’t in any serious danger yet.

Even though the company holds $56.7 billion in long-term debt, its name, credit rating, and size can help it borrow more.

But many smaller companies are in danger.

Any business that borrows money pays interest on that debt, which comes out of its cash.

When rates rise, so do those interest payments.

Now, those debt expenses don’t rise immediately. They only increase when a company takes on new debt.

If a company doesn’t have enough money to pay off the debt when it comes due, it needs to take out a new loan to pay off the old one. That new loan comes with a higher interest rate.

When a company is already losing money, higher interest expenses increase the rate of loss. Eventually, that pushes a business into bankruptcy.

That is what we want to suss out and avoid.

Calculating Survival

Tying this together, we come to a few conclusions:

  • Without positive operating cash flow, a business loses money over time.
  • Any business with lots of debt it can’t pay off will be forced to roll that debt at some point.
  • When a business rolls that debt, it will start paying higher interest expenses.
  • If a business continues to lose cash, eventually it will go bankrupt if it cannot get a loan.
This means we want to avoid companies with:

  • Heavy debt
  • Low cash on the balance sheet
  • Negative operating and/or free cash flows
To do that, I can screen for a few metrics to help identify these stocks:

  • Negative interest coverage
  • Negative operating or free cash flow
  • Debt-to-equity ratio < 0.5x
Using these stats, we get a few companies that pop up (besides Carvana):

SunPower Corp. (SPWR)

  • Interest coverage ratio (most recent quarter): 1.22x
  • Operating cash flow: -$113 million
  • Debt-to-equity ratio: 0.07x
SunPower has five-year revenue growth of -12.36% and hasn’t generated positive cash flow since 2014. Long-term debt sits at $424 million, costing the company $27 million each year.

The company’s interest coverage ratio for the most recent quarter looks good at 1.22x. However, digging into the details, it turns out an unusual non-cash item flipped an unprofitable quarter to a profitable one.

Since the company doesn’t generate cash from its operations, we can ignore that non-cash item.

Given inflation and global supply chain issues, it’s hard to see how SunPower will thrive, let alone survive.

Peloton Interactive Inc. (PTON)

  • Interest coverage ratio (most recent quarter): -51.71x
  • Operating cash flow: -$2.28 billion
  • Debt-to-equity ratio: 0.91x
Peloton has $1.6 billion in cash on its balance sheet, yet it just took out $830 million in long-term debt. Growth has slowed substantially. The scuttlebutt on Wall Street is the company is actively shopping for a buyer to avoid bankruptcy.

Lyft Inc. (LYFT)

  • Interest coverage ratio (most recent quarter): -16.58x
  • Operating cash flow: -$174 million
  • Debt-to-equity ratio: 0.85x
Unlike Uber, Lyft doesn’t generate positive operating cash flow. While the company does have $2.25 billion in cash compared to its $655 million in long-term debt, the total assets are barely more than the total liabilities.

Unless Lyft can turn a corner, it’s likely it’ll need to start reducing headcount to improve profitability.

Look to Microcaps

I selected some larger companies we’re all familiar with to help illustrate the point.

However, there are numerous small- and micro-cap companies in similar or far worse conditions.

That’s why you should always look at a company’s financial health, especially when a recession looms ahead.

What other companies do you think might not make it through a recession? Are you worried that some are lurking in your portfolio? Email me and let me know.