In June 2001, just months before its historic collapse, Enron's share price sat at half the value it was six months earlier. Many investors held out hope that the fall in price was just temporary and the shares would recover. The credit ratings agencies still rated Enron "BBB," meaning they believed the firm was "investment-grade" and would make good on its debt obligations.
But there was one metric that forecasted a completely different outcome: the Z-score.
In June 2001, Enron's Z-score coincided with a company that should have a rating of "B" -- barely above junk status.
Sadly, ratings agencies had Enron listed at "BBB" until four days before it filed for bankruptcy. But those who paid attention to the Z-score were way ahead of Enron's collapse.
Screening for Ticking Time Bombs
Over time, the Z-score has proved to be one of the most reliable predictors of bankruptcy. In a series of tests covering 316 distressed companies from three time periods between 1969 and 1999, the Z-score was between 82% and 94% accurate in predicting future bankruptcies.
To get an idea of which companies may be in trouble today, we used the handy (and free) screener available at ADVFN.com to search for U.S.-based manufacturing companies listed on the S&P 500 with a market capitalization of over $4 billion and a Z-score of under 1.8.
The rule of thumb is that for a manufacturing company, a Z-score above 3.0 indicates financial soundness, but a score below 1.8 suggests a high likelihood of bankruptcy.
Here are the ten lowest scoring companies on the resulting list (as of April 12, 2010):
You may be surprised by some of the companies on this list. General Electric, the last original Dow Jones Industrial Average member, has been a mainstay of American industry since the turn of the last century. Could it really fail?
The Z-score incorporates a bunch of good information, including profitability, liquidity, solvency, efficiency, leverage and market confidence. To complement the Z-score results, we'll do a fly over from 30,000 feet to look at these companies' abilty to pay their bills (solvency) and generate income (profitability).
You'll probably notice that many of these firms have been selling assets to stay afloat. That strategy can work as a stop-gap measure if the assets fetch a decent price in the market and as long as the remaining assets can generate income for the firm. But remember: If a company is unable to point toward the time when it will start turning a profit again, then most likely it's time to pull the plug.
10. Textron – Textron (NYSE: TXT) is known for defense-related products and services. It relies on its ability to market and sell big-ticket items like helicopters, airplanes and marine craft to the U.S. government, but unfortunately, many of the orders Textron received in 2009 were canceled orders. Low revenues coupled with high administrative costs were not kind to earnings, and Textron was either unprofitable or just barely profitable in the five most recent quarters.
Textron raised cash in 2009 by selling off some of its divisions and by issuing debt. The cash has been socked away and should give the firm enough liquidity to wait out the downturn. But unless demand for helicopters, armored vehicles and Cessna airplanes picks up, the earnings outlook for Textron looks weak.
9. Anadarko – Anadarko (NYSE: APC) is the first of four oil and natural gas companies on this list. Only two of its last five quarters have been unprofitable, but its revenues have been almost halved during that same time period. Return on equity (ROE), which can be thought of as the amount of profit generated by each dollar of shareholder equity, has declined from +17.4% to 0.
Like Textron, Anadarko has been able to build up a cash cushion by borrowing, and it also raised $1.3 billion in May 2009 by selling additional stock. Its current assets currently stand at 1.6x current liabilities, which means it should be able to pay its bills for a while longer.
Eventually, though, Anadarko will have to start generating profits again. Like the other oil and gas firms in the list, revenues, and thereby profits, will grow or shrink depending on the future price of oil and natural gas.
8. Weyerhaeuser – Weyerhaeuser (NYSE: WY) grows and harvests trees, builds homes and makes forest products. As you can imagine, the collapse of the construction sector has not been good for the company. Weyerhaeuser has posted five straight quarters of negative earnings.
Weyerhaeuser sold a handful of mills and plants in 2009, raising about $6.4 billion. It's used the cash to pay back debt, pay dividends, and fund operations. It still has a good chunk of cash on its books (3.3x as much cash as is needed to pay current liabilities), presumably to ride out what promises to be a long road to recovery for the housing industry.
7. General Electric – The failure of this mega-conglomerate would impact the world economy with at least the same force as the implosion of AIG. With most analysts proposing that it would qualify as "too big to fail," maybe this is all much ado about nothing. But maybe not.
General Electric (NYSE: GE) is generally seen as a proxy of the entire U.S. economy, and coinciding with general opinion that the worst is over, GE stock has rallied +63% over the past year. GE has continually posted positive EPS, but it did have to cut its dividend in 2009 to conserve cash.
A) Because GE's business is so diversified, good news for GE is good news for the entire economy and vice versa (on that note, GE reports its first quarter results on Friday, April 16th).
B) GE is essentially a hedge fund pretending to be a blue-chip. The finance wing has made bad loans, bad decisions and has piled loads and loads of debt onto a tiny sliver of equity, leaving absolutely no room for error.
Before you make up your mind as to which school you're in, think about this: GE had an 85% debt ratio in December 2009, meaning that every dollar of assets was financed with 85 cents of debt. But to believe that ratio, you have to be willing to value almost $375 billion in loans and accounts receivable at $375 billion. In other words, you have to assume that GE made such good loans to its customers that if GE had to sell the receivables for cash today, it would get full price. I don't know about you, but I wouldn't pay full price for any loan portfolio these days.
If the economy continues to improve, GE may be able to continue paying down debts with profits. But if the assets listed on GE's balance sheet are overvalued by just 15%, then GE is already underwater. If there's another downturn, or even just a little wobble, GE's debt load may prove to be too heavy.
6. Pioneer Natural Resources – Pioneer (NYSE: PXD) is the second of four oil and natural gas companies on this list. Like the others, revenues have declined along with the price of oil and natural gas. In fact, Pioneer's revenues declined by -31.1% from the end of 2008 to the end of 2009.
Pioneer posted four quarters of negative EPS in 2008 and 2009, but eventually EPS turned positive at the end of 2009. At the same time, cash declined by -43% but accounts receivable increased by +60%. An increase in receivables may indicate that the company is extending credit to more customers, perhaps to grab market share from weaker competitors. The strategy will work if the customers end up paying.
5. Devon Energy – Devon Energy (NYSE: DVN) is another oil and natural gas company that has suffered through the recent slump in gas prices. It posted two horrendous quarters at the end of 2008 and beginning of 2009 (EPS of -$15.35 and -$8.92, respectively), but has since struggled to profitability, though barely.
At the end of 2009, Devon announced its plans to start selling assets to raise money for ongoing expenses, paying down debt and repurchasing shares. Since then, it has sold assets worth over $9 billion, hopefully giving them the liquidity needed to survive.
4. U.S. Steel – U.S. Steel (NYSE: X) has had four straight quarters of negative earnings, culminating in a dismal -$1.4 billion annual loss in 2009. Earnings outlooks for the first quarter 2010 are negative, too.
Unfortunately, U.S. Steel also appears to be running out of short-term capital with which to pay its bills. Working capital per share fell from $25.42 in December 2008 to $17.73 in December 2009, indicating that cash and short-term assets are being used up faster than they can be replaced. U.S. Steel borrowed $600 million in March 2010, which will be used to pay for business operations until profitability returns.
Even with all this awful news, a strange thing has happened. U.S. Steel shares have tripled in the past year. Some are even calling for new highs in 2010, not necessarily due to fundamentals, but due to the assumption that companies with the ability to raise prices for their products are the ideal hedge against inflation
3. Alcoa – Alcoa (NYSE: AA) kicked off the spring earning season on April 12th with a quarterly loss of $0.20 per share. The company has struggled with a worldwide slump in aluminum prices, posting losses in five of the last six quarters.
To raise much needed cash, Alcoa has been busy selling assets, refinancing debt, and cutting expenses, including shutting down one smelter in North Carolina and another in Maryland. Even with the massive restructuring and a recent bump in aluminum prices, Alcoa still has solvency issues, and it looks like Alcoa will continue to teeter on the brink.
2. Pulte Group – It's not surprising to see a homebuilder on a list of bankruptcy candidates. Pulte (NYSE: PHM) has posted five straight quarters of negative EPS, and forecasts for the housing market are not optimistic.
Of $6.8 billion in current assets as of the end of 2009, $4.9 billion was tied up in inventories. And in today's market, housing inventory, much like GE receivables, are of dubious value. Furthermore, Pulte has run through most of its liqid assets, with only 80% of its short-term obligations covered by short-term assets.
1. El Paso Corp – Like Anadarko, Devon Energy and Pioneer, El Paso Corp ( NYSE: EP) has been hit hard by slumping natural gas prices and a glut of gas production in the United States.
Since the end of 2008, El Paso's current assets have decreased by one-third, and its liquidity ratios are showing a large shortage of cash relative to the liabilities coming due. To raise money to stay alive, El Paso is selling assets, including a $810 million ownership interest in two companies that own natural gas terminals and pipelines.
There is a chance that none of these firms will be forced into bankruptcy in the near future. It's important to keep in mind that many firms do bounce back from tough financial circumstances.
However, the Z-score, with its oft-tested reliability in predicting bankruptcy, will probably end up claiming at least a few of the firms on the list.
If you would like to learn more about the Z-score and how it works, click here to see our educational article, Using the Z-Score to Predict the Next Enron.
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