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It was fun while it lasted, but access to cheap capital has now disappeared for all but the highest-quality companies.
Investors no longer tolerate the kind of “profitless growth” that, because of record low interest rates, defined the 2010s. For proof, just look at the tech sector; some of these stocks, which were at all-time highs as recently as early 2022, are down more than 90%.
As bad as this market has been for these companies, the carnage isn’t finished yet. Dozens of these firms are essentially “drawing dead,” to borrow a phrase from poker, and they’ll soon be dead – bankrupt, at zero - if they can’t raise more debt or equity, very tough things to do in this market.
Refinancing and recapitalizing is a tall order right now because, as the Fed continues to keep rates high and all while removing liquidity from the market through quantitative tightening, capital costs five and six times what it did during the freewheeling, easy-money 2010s. All the while, these companies face declining margins; they may be forced to default on interest payments without the possibility of refinancing.
As these “zombie” companies run out of the cash needed to stay afloat, risk premiums will rise across the market, which could further squeeze liquidity and create an escalating, expanding series of corporate defaults.
Think of it as a “zombie plague,” only this isn’t sci-fi, but cold, hard reality. We’re already seeing the fallout. Bed Bath & Beyond Inc. (NASDAQ: BBBY) just alerted shareholders to the risk of insolvency; the stock is down more than 87% since August. Party City Holdco Inc. (NYSE: PRTY) had its “debt doomsday” in late January 2023 when it declared bankruptcy – its shares are off more than 93% over the past year.
That “performance” is noteworthy, and fundamental traders will know why. That’s because, if you focused on fundamentals, you could have made a fortune on these stocks as they hurtled lower.
Just take a look at the results of our “Zombie Hunt”…
Just look at the names that came up on our screen in May of 2022. Some of these stocks were down 50%, and many dropped another 50% over the next few months – that’s a huge profit opportunity.
And we’ve found lots of them – here’s how…
How Our “Zombie Detector” Works
Our method of finding these opportunities uses dozens of inputs, but two of them are key:
- Negative free cash flow (FCF) over the past 12-month period
- Negative interest coverage ratio (earnings before interest and taxes [EBIT]/interest expense) or unmanageable debt
A negative interest coverage ratio tells us the company’s existing revenues are inadequate to repay its existing debt. This is very important in rising or high interest rate environments since refinancing becomes less of an option.
Negative free cash flow is also very telling. Simply put, when a business has more outgoing than incoming, expenses cannot be covered from sales alone. That business needs money from investments and financing to make up the difference.
Not surprisingly, the companies most at risk of seeing their stock price drop to $0 are the ones with a poor underlying business model. Importantly, this was massively overlooked – ignored, even – by investors during the 2020-2021 meme stock-driven market frenzy. Companies such as Carvana Co. (CVNA) and Peloton Interactive Inc. (PTON) saw their share prices surge even though they were burning cash with profitability nowhere in sight. These stocks have a real risk of dropping to zero and have already fallen more than 90% from their pandemic-era highs.
Now, stocks like PTON and CVNA are terrible, but, believe it or not, it can be even worse for stocks when you take another fundamental metric into account: valuation.
That’s right. There are zombie companies, and then there are overvalued zombie companies.
Overvalued Zombie Stocks Are the Riskiest
Stock valuations that embed high expectations for future profit growth add even more risk to owning shares of zombie companies with just a few months’ worth of cash left. For the riskiest zombie companies, not only does the stock price not reflect the short-term distress facing the company, but it also reflects unrealistically optimistic assumptions about the long-term profitability of the company.
Naturally, with these stocks, overvaluation risk is stacked on top of short-term cash flow risk – a zombie with two sets of teeth!
And here’s the thing. There are still millions of speculators out there rolling the dice on these stocks every day. Maybe they’re wild-eyed optimists, maybe they spend too much time on Reddit, but these stocks are in a shockingly high number of portfolios. In early January, BBBY shares popped 180%... before falling again.
That is why here at Money Morning, we’ve developed a framework for identifying these companies and sharing them with out readers so they know what stocks to stay away from or, aggressively, how to profit from them on the way down.
Redfin Corp (NASDAQ: RDFN): The Broker Is Going Broke
Companies with fast-depleting cash reserves are risky investments in any markets, but with interest rates high and rising, the real estate market can be brutally difficult. Most companies involved in this space took a big hit in 2022, and the Vanguard Real Estate Index Fund ETF (NYSEARCA: VNQ) experiencing a 30% drop.
In a sign of the times, we even saw Wells Fargo & Co. (NYSE: WFC), once the No. 1 player in mortgages, stepping back from the business that buys loans made by third-party lenders; Wells Fargo “significantly” shrank its mortgage-servicing portfolio through asset sales.
Redfin, a tech enabled real estate search and broker is a perennial money loser. You wouldn’t know if you just looked at revenue, which has actually grown nine years in a row. But that revenue means nothing – less than nothing, in fact - if it costs more to make it.
In fact, since 2018, Redfin has had just a handful of quarters where they were net income and cash flow positive. With revenue growing it never looked like they had a path to profitability and when interest rates started rising, they had no levers to pull to make money.
Redfin scaled back business lines and conducted major layoffs to no avail; that still couldn’t get the company to profitability. Now with high interest rates and a depressed housing market, Redfin could be in real trouble.
Right now, the company is burning through its small cash position of less than $500 million. Free cash flow is predicted to be negative through 2023, and there’s likely going to be a slowdown in revenue growth. Redfin could run into issue raising debt, which they did the last several years. Its net interest coverage ratio is deeply negative at -15.87, which means they may even have trouble paying off the debt they currently have.
That is why we are putting RDFN shares on our “Zombie Stocks” list. While the stock was trading near $100 in early 2021, it is now trading for less than $10 dollars. That doesn’t mean it can’t fall more and with a market cap of roughly $600 million, there could still be pain ahead as the housing market continues to struggle with the highest mortgage rates we’ve seen in years.
Our recommendation: Redfin does not have a path to profitability with an operating loss every year since 2014. Do not buy this stock, and sell it if you do own it. To profit on RDFN shares as the company “zombifies,” look to buy puts on any major pop in the stock.
Plug Power Inc (NASDAQ: PLUG): Time to Pull the Plug
Hydrogen power may very well be one of the fuels of the future as policy makers push to create new green initiatives, but Plug Power is not the way to play this trend. Plug Power is a manufacturer of hydrogen fuel cell systems that replace conventional batteries in equipment and vehicles, but the company hasn’t figured out how to scale its business into profitability. They’ve had several securities lawsuits over the years, too, which is yet another reason PLUG stock makes it onto the zombie stock list.
The markets have been supporting Plug Power since it went public in 2002 and it has never had a single year of positive free cash flow. Net income has also tracked a very similar trajectory. This puts the company on our radar – in a not-so-great way.
While in the last two years the company has started producing revenue, profitability continues to slip further away as cash from operations continues to sink. Just look at last quarter’s loss of $116.5 million on $188.6 million in revenue.
Analysts also see this trend getting worse and estimates expect Plug Power to lose money in 2023 and 2024, only become free cash flow positive in 2026. That’s a long way away and, it’s critical to note profitability will only happen in a best-case scenario.
Lawsuits have also been brought on the company accusing the firm of cashing in on “false and misleading statements.”
The company is still worth $10 billion, and in another context or market, that would be formidable, but as far as Plug Power’s concerned, it’s just a long way to fall.
Action to take: Sell this immediately if you’re speculating. Plug Power has seen lower lows after every major run the last several years and with the stock up almost 50% in January 2023, look to short-sell shares or trade puts on any breakdown.
Carnival Corp (NYSE: CCL): Still a Sinking Ship
Everyone saw the Carnival carnage as the stock tanked roughly 80% as COVID hit and basically shut down the industry. But, over 2021 the stock made a strong run, going up over 100%. Since then, however, it has dropped to prices it has not seen since the 1990s
While the price may be cheap, the stock isn’t, and I’ll tell you why.
Debt has cast a very negative outlook for Carnival – and its November 2022 convertible bond issue only darkens the picture. Over the last several years they’ve continued to raise debt and even as they narrow their operating losses, that comes at a huge price and also shows many signs of distress.
Before the pandemic Carnival was generating $20 billion a quarter in revenues, and earning roughly $3 billion in net income. While debt was high at roughly $12 billion, that is part of the business of owning cruise ships.
When the coronavirus hit, the business basically evaporated. 2022 was a year of recovery, but the company was nowhere near its pre-pandemic revenue. Revenue is back to where it was in 2006 and the company is losing over $5 billion a quarter in net income. With only $4 billion in cash on the balance sheet, Carnival has no choice but to raise more (expensive) debt and sell more shares.
That is exactly what has been happening. Long term debt has mushroomed from $12 billion to $34.55 billion and shares outstanding have ballooned from 700 million to 1.3 billion. That’s an astonishing level of dilution, making your shares worth significantly less than before the pandemic.
While some improvements can be expected in 2023 as COVID-19 becomes less of a story, its high cost to service its debt, inflation eating into profits, share dilution and lower consumer spend, any improvements are outweighed by the negatives and any investment here would need the company to restructure.
Our Play: Unload this stock right away if you own any, but look to short any negative news in the stock as we see momentum carrying this stock down. Put-trading makes a great alternative to short-selling.
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