The long-awaited correction appears to have finally arrived. Like a yo-yo that has climbed up sharply and is now heading back down, this fall will probably not be as sharp or as deep as many pundits would suggest. I am going with a SPY target of 87.50 to 92 as the most likely bottom for this move. For those that follow my work, you may recall that this happens to be the area that I initially thought would contain the rally from March. Clearly I was too conservative. I get to my zone using several different metrics, including Fibonacci retracements as well as charting and volume-at-a-price. To be very successful in the last few months, one had to set aside one's fundamental views in my opinion and roll with the liquidity. As long as interest rates aren't rising, I do believe the pullback will be orderly and contained, but the bear is back on if we can't finance our federal debt at a low cost.
Even though my expectations are that stocks in general have about 15% downside from here (two weeks or two months - who knows), I believe that many stocks have considerably more risk. In the past few months, companies with leveraged balance sheets have roared back as the capital markets have reopened. Many companies have addressed liquidity issues by extending their debt or issuing stock, but several others have not taken advantage of what I view as a good opportunity. I am cautious on companies in general that have high levels of debt relative to their potential to generate free cash flow, especially in an environment of economic weakness or stagnation at best. With that in mind, I want to share three ideas, all of which have lots of debt relative to FCF and short-interest that has come down significantly over the past several months. None of these companies had moved to address their weak capital structures.
Weight Watchers (WTW) is a broken company in my view. I have written about this one before, and it has had the least recovery of the three that I am discussing today. I think the tell is that it trades at 10PE - clearly big money doesn't believe those numbers. The problem is that if the numbers aren't right, the debt becomes a problem. They report next week, so we shall see. As of 6/30/09, the company had debt net of cash of about $1.5 billion. The company's FCF is essentially its net income, so this year, last year, next year and the year after all look about the same: $200mm. The company repurchased so much stock that it left its equity negative. In a harsher environment, the debt will become a burden in my opinion. I think that this one could see an earnings miss which could drive the price back down towards the 52-week low below 17.
