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5 'Balance Sheet Babies' to Consider

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The use of financial engineering to unleash value is common in the late stages of a rally. The stocks can be tempting targets, but don't ignore valuations.

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What's the stock market got going for it?

Not economic growth, certainly, with the eurozone in or near recession, Japan struggling to escape 15 years of no growth, the United States stuck in a slower-than-normal recovery, and China behaving as if the government doesn't want to return to the days of 9% or 10% growth.

Not rising incomes. Not an upswing in jobs. Not rising commodity prices.

What global financial markets have going for them is cheap money, and lots of it.

So doesn't it make sense to look for stocks of companies that are positioned to get the biggest bang out of a cheap buck, yen, or whatever? Doesn't it make sense to put at least a few balance sheet babies among the stocks in your portfolio?

It makes sense, yes, but the fact that these balance sheet stories are increasingly in favor in this market also gives me pause. Efforts to use financial engineering to release value in a company are often found near the end of a big rally, when other stories - growth, for example - are looking fully valued.

I think taking a look at balance sheet babies makes sense in this market, but even in this group I wouldn't abandon my metrics of valuation, especially since this kind of financial engineering can involve a trade-off between a company's long-term health and short-term profit for traders.

So today I'm going to give you five stocks that are both rally age indicators and - at the right price - potential stock picks.

Two Kinds of Balance Sheet Babies

What's a balance sheet baby?

I think there are two kinds in the current market. In this column I'm going to describe the two types and give you five stocks to check out, both as potential stocks to own - at the right price - and as indicators of where we stand in this rally.

The first type of balance sheet baby is the offspring of the financial restructuring that uses cheap cash to avoid disaster. Let's start with an example: Cemex (NYSE:CX). The building materials company almost went under during the financial crisis because it had loaded up with debt to buy cement maker Rinker for $14.2 billion.

Look what happened to Cemex's balance sheet as the financial crisis led to the Great Recession and the collapse of the construction sector in the United States. Short-term debt soared from $36.2 billion in 2007 to $95.3 billion in 2008. Interest expense climbed from $10.2 billion in 2007 to $13.5 billion in 2009 to $16.6 billion in 2011.

Income before taxes plunged from $31.7 billion in 2007 to a loss of $22.8 billion in 2008. The stock, which had traded as high as $36.29 in June 2007, bottomed at $2.92 in September 2011.

And no wonder. The company had a pile of short-term debt and was bleeding cash. Investors could only wonder if Cemex was headed toward a bankruptcy that would certainly wipe out shareholders.

Instead of bankruptcy, though, what Cemex got was a restructuring. The company was able to convert short-term debt that it would have trouble paying today into long-term debt that its lenders believed it would be able to pay tomorrow.

Short-term debt fell to $7.4 billion in 2009 from $95.3 billion in 2008. Long-term debt climbed to $203.8 billion in 2009 from $162.8 billion in 2007.

Buying Time

What the company had bought was time - not a guarantee that its fortunes would turn around.

But time turned out to be exactly what Cemex needed. With the recovery of the US housing sector, sales of cement in the United States have climbed, even if the company's home market of Mexico and export markets in the eurozone remain weak.

Net income has gone from a $1.5 billion loss in 2011 to a $616 million loss in 2012 to a projected loss of $178 million in 2013 to a profit of $358 million in 2014.

That balance sheet turnaround at Cemex was good for a 90.4% gain in 2012. I don't expect a repeat of that in 2013; after all, the stock and the company aren't starting from anything like their former lows. I'd be very happy with 25% in 2013.

Some important things have to go right for that to happen. Volumes, especially in the United States, need to continue to recover, and price increases of 2.5% to 3% in the United States need to stick. So far, things look good, and that's one of the reasons I've made Cemex one of my 10 best picks for 2013.

Examples With More Upside

You can find other balance sheet babies that are earlier in the process than Cemex is now.

For example, MGM Resorts International (NYSE:MGM) has restructured its balance sheet, but is still facing skepticism about the recovery of its core Las Vegas gaming and hotel market. The stock was ahead 11.6% in 2012, and is up, through the May 8 close, 26.4% this year on good news from Las Vegas. I think there's a good chance that this member of my Jubak's Picks portfolio will outpace Cemex in 2013.

If you want to go back even further in the process, back to near where Cemex was before it's restructuring, take a look at Mexican homebuilder Desarrolladora Homex (OTCMKTS:DHMXF).

Homex needs a financial restructuring in order to escape the trap in which the only way the company can stay in the black is to cut its revenue to the bone. Revenue collapsed between the fourth quarter of 2012 (at $7.98 billion) and the first quarter of 2013 (at $3.3 billion), but operating income went from a loss of $30 million in the fourth quarter of 2012 to a profit of $215 million in the first quarter of 2013.

How was that possible? Homex cut its cost of generating revenue from $7.5 billion in the fourth quarter of 2012 to $2.6 billion in the first quarter of 2013... by building and marketing fewer houses.

That's not, obviously, a long-term solution, and even in the near term it didn't stop the company's short-term debt from climbing to $4.7 billion in the first quarter of 2013 from $2.3 billion in the fourth quarter of 2012.

The next step came on April 19. Homex announced that it had sold two prisons that it was building, for $325 million in cash. The company said it would use half that cash for working capital and the other half to pay down debt.

There's more restructuring to come, and I'd like to see some signs of a revival in the Mexican housing market before I jump on Homex. But it has the potential for a replay of the Cemex story, if things break the company's way. The New York-traded ADRs (American depositary receipts) of Homex were down 26% in 2012 and are down another 58% this year through May 8.
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No positions in stocks mentioned.
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