Targeting Turnaround Stories

Targeting Turnaround Stories

A few months ago, I published articles on Alcatel-Lucent and Hewlett-Packard, two companies that have viable strategies to turn their businesses around. Since publishing those articles, the stock prices for both have roughly doubled. These are just a few examples of the above-average returns that can be gained by picking the right turnarounds to bet on. While investing in any turnaround is not without its risks, they can be very rewarding, and it is for this reason Foolish investors should take a look at three potential turnaround stories.

To eliminate dozens of candidates I ensured that:

  1. Multiple catalysts exist (debt refinancing, new leadership, improved strategy, and similar factors.)

  2. A disruptive technology that will force the company to change its business model in order to survive does not exist (eliminating Kodak, Office Depot, Dell, and several other companies.)

  3. There is a positive, fundamental change taking place that suggests that it is a good time to get on board.

After a few screens, I chose to investigate three companies that I might invest in.

A controversial department store
J.C. Penney
had a simple yet effective strategy: relocate and develop stores that anchor shopping malls.

Over the years, J.C. Penney has adapted and innovated in order to survive. Consider the website, which covers J.C. Penney's exclusive brands and previews its upcoming product line. The site has grown into one of the largest apparel and home furnishing websites on the Internet.

J.C. Penney's innovative "store-within-a store" concept, which it effectively uses to launch new, high margin private brands and differentiate itself from its competition by creating a personalized shopping experience, is another example of this. Simply put, J.C. Penney has made some mistakes, especially with pricing. Everyday low pricing, for example, is something that works well for Wal-Mart, but not J.C. Penney.

But these mistakes are a lot easier to fix than you might think, given that J.C. Penney has the infrastructure in place. Especially since the company is bringing back a seasoned retailer, Mike Ullman, whose previous tenure at J.C. Penney was very solid. After visiting a few J.C. Penney stores and evaluating its merchandising, I have very high expectations for the holiday season. J.C. Penney is doing a great job focusing on its core customers and drawing traffic.

By bringing in new private brands such as Liz Claiborne and Arizona with specialty shops, Mr. Ullman is revitalizing the shopping experience, and J.C. Penney is connecting with its core customers. With high-margin merchandise and promotional events that will lead to high-inventory turns, J.C. Penney's same-store sales should approach the double digits. And J.C. Penney might become profitable faster than analysts expect.

Plus J.C. Penney has roughly $1.5 billion in cash on hand vs. a market cap of less than $2 billion -- and a lot of very attractive real estate. At under $9 per share, J.C. Penney offers at least a healthy 50% to 70% upside over the next year -- which implies a price point of around $15. That is why I recently doubled down on my position.

A retail drug store chain that had a lot of debt
Rite Aid
has managed to string together a few profitable quarters. A cursory look shows that Rite Aid's business has improved on several fronts: operating margins look good, cash flow remains positive, price momentum is strong, and analysts are starting to jump on the bandwagon, though not until after the stock has outperformed the market for some time. A huge catalyst for Rite Aid is that it has refinanced a large portion of its debt and improved its balance sheet.

Another catalyst is that Rite Aid has aggressively cut unnecessary expenses and improved its gross margin by bringing in more private label goods. And given that Rite Aid generates more than $28 per share in revenue, if it can continue to improve its margins and cut costs, then the company will dramatically improve its profitability.

Rite Aid can improve its margins by improving its product mix or by more effectively leveraging its alliance with GNC. Keep in mind that Rite Aid's turnaround is less dependent on an improvement in our economy than most companies. Still, it is a volatile stock. Even with its momentum and turnaround potential, Rite Aid trades at a forward earnings multiple of 8, well below the average of the sector. If I owned the stock, I would hold it.

A company with a new franchising plan
has an important driver of sustainable profitability: a new franchising plan. Wendy's plan to sell several of its restaurants as franchises should result in a stable and predictable earnings stream, since the franchisees will be the ones making the capital expenditures on things like remodeling. That move will increase royalties and free cash flow, and accelerate earnings growth. This is why Wendy's increased its quarterly dividend by 25%.

Add to that Wendy's aggressive yet realistic plan to utilize franchises to enable the company to enter and expand in existing international markets, and you have a turnaround story in the making. Perhaps more important to the bottom line, Wendy's is aggressively rebranding and focusing on delivering value to customers by having a menu that appeals to both price-conscious and quality-seeking diners.

Even though Wendy's future looks bright, the stock has made a nice run. If I owned the stock, I would take some profits now.

My Foolish take
These are three solid turnaround plays. Price matters, and I need a pullback before I consider Rite Aid or Wendy's. Of the three companies, J.C. Penney is the most attractive turnaround play of the bunch. You currently have the opportunity to buy shares of J.C. Penney, the way its customers buy merchandise -- at a deep discount.

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Ryan Peckyno owns shares of J.C. Penney. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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Originally published