Workouts and Turnarounds II: Global Restructuring Strategies for the Next Century: Insights from the Leading Authorities in the Field / Edition 1

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Although most businesses in the United States have remained relatively stable in the current economic environment, there are always instances when highly leveraged companies experience financial trouble and even bankruptcy. When faced with such situations, Workouts & Turnarounds II provides company managers, workout professionals, and other stakeholders with guidance and insights into all facets of corporate restructuring. Workouts & Turnarounds II gives practical advice and proven methodologies on the key issues involved in workouts and turnarounds from the leading authorities in the field of corporate restructuring and bankruptcy consulting. Providing proven methods for deciding the likelihood of a turnaround in a distressed company, this comprehensive reference identifies key factors your company needs to consider in order to make the decision to restructure, divest, or liquidate. In addition, you'll find valuable insights on:

* Legal and practical considerations of international restructuring

* Methods for analyzing company trends to determine the likelihood of a pending bankruptcy

* Industry perspectives and issues related to both in-court and out-of-court restructuring

* Helpful techniques for managing distressed situations from the perspective of the company and its creditor constituencies

* Evaluating underlying trends in the high-yield and equity markets

By analyzing case studies of turnarounds and bankruptcies, Workouts & Turnarounds II arms you with an overview of corporate restructuring from the strategic perspective of the debtor and secured or unsecured creditors. It provides insights as to how to prepare for bankruptcy, ways to manage your professionals, and what to expect from them throughout the restructuring process. Corporate leaders and middle-level managers need to understand the potential implications of having an underperforming division or a few downtrending quarters. Workouts & Turnarounds II provides corporate leaders with effective techniques and troubleshooting strategies to maximize shareholder value. This book is a must-have guide for companies considering a debt restructuring or seeking to perform a self-diagnosis to address the early warnings of underperformance which could lead to a potential failure.

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Product Details

  • ISBN-13: 9780471246367
  • Publisher: Wiley
  • Publication date: 10/14/1999
  • Edition description: New Edition
  • Edition number: 1
  • Pages: 480
  • Product dimensions: 9.21 (w) x 6.14 (h) x 1.06 (d)

Meet the Author

DOMINIC DINAPOLI is the partner-in-charge of PricewaterhouseCoopers LLP's North American Business Recovery Services practice.

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Read an Excerpt
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Table of Contents

Preface xxix

1 Trouble Spotting: Assessing the Likelihood of a Turnaround 1
Dominic DiNapoli and Elliot Fuhr
PricewaterhouseCoopers LLP

2 Looming Financial or Business Failure: Fix or File – A Legal Perspective 21
Harvey R. Miller
Weil, Gotshal & Manges LLP

3 Preparing for Bankruptcy: Building the War Chest 45
Joel Nitzberg
PricewaterhouseCoopers LLP

4 Business Regeneration: Early Detection – Early Intervention 54
R. Carter Pate
PricewaterhouseCoppers LLP

5 Spin Control: Managing Internal and External Communications 74
Michael S. Sitrick
Sitrick & Company

6 The Lawyer’s Role in Representing the Distressed Company 85
Lewis Kruger and Robin E. Keller
Stroock & Stroock & Laven LLP

7 At the Front of the Line: The Secured Creditor 108
Chaim J. Fortgang, Seth Gardner, and David R. Caro
Wachtell, Lipton, Rosen, & Katz

8 Representing the Unsecured Creditors’ Committee in Insolvency Restructurings 156
David S. Kurtz, Jeffrey W. Linstrom, and Timothy R. Pohl
Skadden, Arps, Slate, Meagher & Flom LLP

9 Lender Services: Let the Lender Beware! 191
Robert S. Paul and Kris Coghlan
PricewaterhouseCoopers LLP

10 Financing Alternatives for Troubled Companies 215
William C. Repko
The Chase Manhattan Bank, N.A.

11 Valuation of Companies within Workout and Turnaround Situations 225
Thomas J. Milton, Jr. and Shannon P. Pratt
Willamette Management Associates

12 Market Dynamic and Investments Performance of Distressed and Defaulted Debt Securities 238
Edward I. Altman
New York University

13 International Restructuring: Overcoming Cross-Border Hurdles in South America 253
Deborah M. Smith, PricewaterhouseCoopers LLP and Jeffrey A. Sell
The Chase Manhattan Bank, N.A.

14 Asian Markets 279
M. Freddie Reiss
PricewaterhouseCoopers LLP

15 The Accountant’s Role in the Workout Environment Beyond “Bean Counting” 303
DeLain E. Gray
PricewaterhouseCoopers LLP

16 Dealing with Employee Issues in a Bankruptcy Situation 328
Robert J. Rosenberg and David S. Heller
Latham & Watkins

17 Financial Aspects of Bankruptcy Disputes 349
Harvey R. Kelly and Daniel V. Dooley
PricewaterhouseCoopers LLP

18 Tax Planning in Corporate Reorganizations 378
Mitchel R. Aeder
PricewaterhouseCoopers LLP

19 The Retail Industry – Trends in the Next Century 399
Kevin Regan
PricewaterhouseCoopers LLP

20 A New Paradigm Emerges 416
Jack Barthell, Pat Leardo, and Mitch M. Roschelle
PricewaterhouseCoopers LLP

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First Chapter


Note: The Figures and/or Tables mentioned in this chapter do not appear on the web.

Trouble Spotting: Assessing the
Likelihood of a Turnaround

Dominic DiNapoli and Elliot Fuhr
PricewaterhouseCoopers LLP


Can It Be Fixed?

If this is your starting point, then you have probably waited too long. By this point in time, you have already heard from your vendors, shareholders, customers, and employees that the business has a problem. Collectively, these stakeholders are sorting through the wreckage seeking answers to questions ranging from "What's in it for me? to "What are my alternatives?" to "How did this happen and when do I get my money?" Behind these questions is each stakeholder's desire to assess:

  • The fundamental causes of the company's distress
  • Action steps required to affect a "turnaround"
  • Management's ability and related costs to execute a turnaround plan
  • Alternatives to a turnaround and the related costs
  • Goals of the various stakeholders
  • The value that can be realized from a turnaround, a sale or liquidation of the business

In the final analysis, value is the only thing that matters to stakeholders, as well as, of course, some timely cash or potential for capital appreciation. Value means different things to different stakeholders and may include cash repayment and new collateral for lenders and creditors; preservation of jobs and benefits for employees; or, alternatively, the avoidance of the opportunity cost of staying "inthe game" for all stakeholders. Regardless of the form of value, each stakeholder must have access to the necessary information to make an informed decision on the appropriate course of action.

The Turnaround

For purposes of this chapter, we will define turnaround as follows:

An all-encompassing plan that maximizes an underperforming company's value for the benefit of its stakeholders through a four-step process of stabilization, analysis, repositioning, and strengthening.

Rather than focus on the death spiral leading to a bankruptcy, our view of turnarounds begins much earlier in the business life cycle. It is the ability to detect and spot the signs of trouble early in the cycle that leads to a more rapid and successful turnaround. The business demise curve is graphically illustrated in Exhibit 1.1. In a later chapter, we will explore the early warning signs leading to trouble.

While there are several definitions and attributes one could ascribe to the concept of turnaround and underperformance, this chapter will focus on value as the key element of a turnaround. In almost any turnaround, whether in the context of a bankruptcy case or an out-of-court workout, the value of the company is what all stakeholders and investors wrestle with.

Today's real-time information, supplied to us by the Internet and 24-hour news channels, provide the astute stakeholder with an extraordinary amount of information to digest. Notwithstanding today's technical advantages over yester-year, our savvy stakeholder must still assess the likelihood of a turnaround in down market conditions, in industries as complex as high technology, to assessing the ramifications of a global economic meltdown on his or her stake.

We will address assessing the likelihood of a turnaround in a high-technology company later in this chapter. We will also consider the question of whether the company can be "saved" and what that means, including:

  • An analytical approach to shareholder value or destruction
  • Fixing the business with tools, a crisis manager, and hard work
  • Managing expectations, including assessing what can be done and making it happen

For now, however, we will explore some fundamental concepts in assessing a turnaround.


Did You Hear the One About ...

The performance excuses of companies in trouble have been repeated too many times to remember, but they usually go something like this:

  • "Although our results are disappointing, we are very excited about the new product line that we plan to bring to market."
  • "We will have improved results next quarter."
  • "Bankruptcy is just a hiccup; we have a fresh start, our future is bright."

If you have visited the insolvency abyss, these statements and their permutations probably sound all too familiar but provide little in the way of useful reference points for future business decisions by the lender or investor.

Why Do Businesses Fail?

Although the onset of a crisis may come as a surprise, the underlying situation has frequently affected the company for a long period of time. Indeed, a well-designed set of metrics focused on important drivers of value could save many businesses.

Management is often unable to discern whether it has a firm grasp on the link between the company's macro goals and the micro shareholder value drivers on a day-to-day basis. Although generic value drivers lack specificity and cannot be used effectively at the grassroots level, a well-designed program to implement drivers can help steer the business.

Poor management information systems typically receive the blame for the inability of management to "see it coming." In reality, most companies do not understand the value drivers that create shareholder value, which we will discuss further shortly.

Another crisis in the making is the product of today's volatile merger and acquisition (M& A) environment and the inappropriate expansions embarked on in search of the fabled synergies. We have all heard the "1 + 1 = 3" boardroom banter as the mantra for acquisitions. With the recent strength of the economies in the United States and continental Europe, chief executive officers (CEOs) may decide to pursue expansion strategies that involve acquisitions at high multiples. Although a deal might look good on paper, postmerger integration of the new acquisition can sometimes fail to go forward with the projected ease of execution, creating enormous problems for management. Such issues may not only place serious demands on senior management time, but there is the good possibility that they will involve additional costs, including debt that could expose the new company to shifts in business climate or interest rates. This does not bode well, since overaggressive financing at the end of a business cycle accounts for many company failures.

On another front, the global impact from the demise of once-thriving emerging markets in Korea, Thailand, and Indonesia is having a significant impact on U. S. companies. Once profitable joint-venture opportunities for U.S. companies may lead to underperforming investments, loss of production, and, in some instances, financial peril. This phenomenon has most notably affected semiconductor companies that rely on the Asian marketplace for its low-cost manufacturing base. We will explore the impact of these events as it affects the likelihood of a turnaround in the high-technology sector.

As Exhibit 1.2 1 indicates, the linkage of growth in highly leveraged transactions and the proportion on bankruptcy assets is quite strong, albeit time lagged. That is, as highly leveraged deals increase as a form of financing for companies, the natural growth in bankruptcies based on historic default rates is fairly evident. In particular, a 24-to 36-month lag from the time of issuance of the highly leveraged debt appears to boost the amount of corporate bankruptcies. Moreover, based on current indications, the amount of highly leveraged transactions appears to be approaching record levels that may in time lead to significant increases in assets experiencing bankruptcy.

There is a recurring pattern in business cycles that somehow manages to lure even the most sophisticated business people time and again.

  • As the cycle progresses, money chases deals ever more aggressively. Yes, participants comment on the excessive prices being paid for businesses, and, yes, lenders note that interest rate spreads have vanished.
  • By the time the cycle nears its peak, industry/strategic buyers are often out-bid by financial buyers, who focus on supposed growth prospects and efficiency gains to justify prices that would exceed the most extravagant synergy gains that an industry player could expect from a merger.
  • Cash flows tighten as the business cycle turns down, or markets simply fail to deliver forecasted growth.
  • Business decisions become less than optimal as investment in operating plant or new product development is curtailed, and the underlying value of the company is traded in for short-term survival.
  • Management and shareholders are put in a position where, if they do not address the situation, performance and value will begin to erode.
  • Eventually, businesses in which the situation is allowed to continue, face a funding crisis and potential failure.

Although the symptoms of distress can affect all companies from time to time, management's astute interpretation and diagnosis of these symptoms is critical to taking appropriate actions. In the distressed company, management typically is aware of the problems but unable to formulate and execute a strategic turnaround plan without outside assistance.

Outsiders, lenders, or investors must make their own assessments of the company's performance in order to judge whether current management is capable of determining the corrective actions to be taken, as well as implementing the resulting turnaround plan.

Two Classes of Problem

The company in trouble usually has two types of problemsÑ internal and external--although many would argue that the former are the cause of the latter.

Internal. In a recent survey on business failures conducted by Pricewater-houseCoopers, at the top of the list of internal woes is ineffective management. This is where the proverbial buck stops, because every failing company is theoretically under the control of the CEO, chief financial officer (CFO), and other senior executives. "Management failure" was cited as number 2 among primary causes of business failure, as well as the number 1 secondary factor (see Exhibit 1.3 for a summary of the causes of business failure).

The most common of the internal problems found on the road to bankruptcy--all leading back to ineffective or incompetent management--is excessive leveraging of company assets. The company is trying to do too much with too little. As a measure of a company's ability to stay in business, despite a variety of financial setbacks, capital is critical to offsetting losses without going out of business. Undercapitalization can be deadly, as the company performs a complex and endless balancing act. Who decides the appropriate level of debt and equity? Management!

Other internal problems frequently point to a lack of good internal controls, which may range from lack of planning and budgeting to poor management information systems. They may also stem from outmoded ideas about the way to do business today, such as concentrating customers in too narrow an unprotected niche or a failure to penetrate new markets.

A rigid organizational design can create obstacles to effective communication, forcing managers into decisions in a vacuum when important information is readily available within their own organization through a simple phone call. Weak middle management exacerbate organizational design problems as they often lack the creative problem-solving skills required to overcome such obstacles. Notwithstanding middle management, it is senior management that sets the tone, creates the organizational design, and sets the foundation for how effectively the organization communicates.

Whatever part the CEO may play in these potential calamities--and it is assumed to be a large one--he or she no longer takes all the blame for a company's downfall. While in decades past, corporate health was predominantly the charge of management, that is no longer the case. The board of directors today is expected to play an increasingly large role or face the consequences. An increasingly activist shareholder body, particularly among pension funds such as California Public Employees' Retirement System (CALPERS) and other institutional investors, has shown that there is no place to run or hide from the inadequacies of management or its boards.

External. From the external side, one could argue that the causes of a company's downfall are not always foreseeable. However, it could also be argued that the prescient CEO understands and develops contingency plans for the volatility of a company's environment, whether or not it is actually on the horizon. This would include:

  • The cyclical nature of business, including general industry conditions, foreign competition, shifting consumer preferences, declining market for products or services, obsolescent technology, global impacts
  • Economics, including labor problems, natural disasters, scarcity of strategic resources
  • Politics, including regulatory issues and other legislation relating to business in general or a specific industry

After the stakeholders have identified the root causes of the problem, the next step is to determine the action steps and costs required to affect a turnaround that sufficiently addresses the problems.


Rising from the Ashes: Shareholder Value and the Stakeholders

According to legend, when the mythical phoenix reached the end of its 500-year life, it set itself aflame and was reborn from its ashes. Can a company that has entered bankruptcy do the same? More specifically, can a troubled company's value be recreated once it has been destroyed?

To investigate the concept of recreating value, consider what constitutes value and how the stakeholders of a company perceive it (see Exhibit 1.4).

The Value of Value

Many companies today declare themselves to be on "a relentless quest for value." This might sound good on the cover of an annual report, but what exactly does it mean? From our point of view, the phrase simply means that the company wants its business to create, preserve, and realize value for all its stakeholders, ranging from owners to employees.

The shareholder value of a particular company may not always be clear, even to its principals, and they frequently look to outside consultants to help them conduct what we call shareholder value analysis, in order to help them develop a philosophy of value creation and position themselves to thrive in the global financial environment. At a basic level, this involves:

  • Understanding where they are (from a value creation perspective)
  • Develop strategies for improving their position
  • Establish a system of rewards for employees who play a role in these improvements

In today's marketplace, financial value is the key issue, specifically relating to cash that takes the form of:

  • The return it gives to shareholders
  • The cash flow that is the sign of a healthy company in the eyes of the marketplace

Who's Who Among a Company's Stakeholders

Among the factors to consider in determining whether a company can be regenerated into a strong, viable entity is an understanding of the motivational factors of all parties-in-interest and what they expect to receive from the entity.

Stakeholders. A company's stakeholders can be broken down into four basic categories:

  • Shareholders seek total returns in the form of dividends and capital appreciation.
  • Debtholders seek prompt repayment of their loans in the form of principal and interest (their profit).
  • Employees want higher wages and salaries as well as job satisfaction and security.
  • Customers and suppliers want a steady stream of goods and services at prices and terms that provide good value for their "investment."

They each have a stake in the continued health of the company, although certain of them might be happy to "take the money and run."

Shareholders. A company is owned and operated for the benefit of shareholders, whose liability is limited to the amount of their investment; therefore, their main concern will be total return--a combination of capital appreciation and dividends. Shareholders desire a return at least as great as that obtainable on an investment of similar risk elsewhere in the market, and to achieve these goals they delegate a business's operational authority and power to the management team.

The split between "church and state"--in this case, investors and management--traditionally meant a hands-off attitude on the part of many institutional shareholders. If they did not like the way one investment in their portfolio was performing relative to others, they would sell their shares in the company and perhaps buy those of a competitor.

This quiet disenchantment with the underperforming company's performance gradually gave rise to shareholder activism, with investors such as CALPERS, the California pension organization, and Mercury Asset Management, taking leading roles in questioning management decisions and seeking changes to protect their investments. Despite these efforts, shareholder claims on company assets are generally last in line in an insolvency situation. Therefore, it is investor mobility that serves as an important check on management power. In order to appease shareholders, companies may authorize substantial dividend payments, possibly in excess of what they can afford.

A good example of this approach comes from the U. K. recession of the 1990s, when 60 percent of companies maintained or increased dividends in the face of falling profits. By contrast, 28% cut dividends and only 12% of companies missed a dividend payment. Most evidence suggests that companies have a target payout rate for dividends and seek to maintain this even when business conditions are unfavorable (i. e., they are willing to sacrifice long-term shareholder value creation in favor of the short-term shareholder satisfaction).

Debtholders. Debtholders provide funds in the form of loans, generally receiving a return on their investment in the form of interest. A lender's primary risk is default--the risk that interest payments will be missed and the face value of the loan will not be repaid when due.

Debtholders have a more limited stake in a company than shareholders, with less upside potential, usually limited to interest margin and their return of principal. If all goes well, the debtholder repeats the process, potentially increasing the amount of principal loaned.

Management finds debt attractive for the very reason that debtholders have limited their upside potential. If the company has a high probability of success, management will seek to raise additional debt, because this will leave more gains for shareholders. If the likelihood of success is not as high, then management may seek equity capital to meet additional financing needs.

Management. While management is the appointed guardian of the company's assets on behalf of shareholders, some may suggest that a natural conflict exists. Fragmented shareholdings and an institutional hands-off policy can result in considerable power being absorbed by management, which can award itself a substantial part of value created by the company.

It is in reorganization situations that the interests of management can deviate most from those of the shareholders. Presumably, a company in difficulty is one that has already made a series of poor decisions. In a recent survey, "management failure" was cited as number 2 among primary causes of business failure, as well as the number 1 secondary factor, by a wide margin.

Although management can probably look forward to remaining in place during recovery, if the situation demands a turnaround manager, it is highly likely that management will be the first to be sacrificed as new strategies are introduced and implemented.

Employees. Employees represent the core of many businesses and collectively embody the know-how and human capital of the company. Increasingly, it is the company's ability to differentiate itself in this area that will create the conditions for long-term survival. Management has to ensure that crucial employees are retained, because their loss can jeopardize a recovery program.

Customers/Suppliers. In business reorganization situations, it is important that both suppliers and customers are convinced that they have a material interest in the company's continued operation. This is easier to do when the cost to the customers and suppliers of switching is high or when there are a few alternatives.

These relationships can be fortified with long-term contracts. The stake can become so high that the customer or supplier buys the other out. When that happens, a market transaction is replaced by an "insider" transaction and the company becomes more vertically integrated. This phenomenon appears to be weighted to industries that may have a high-technology component (i. e., telecommunications, computers, software, etc.).


In all but the most dire situations, there will be a number of choices available to stakeholders for retrieving their investments in an operation (see Exhibit 1.5).

  • Sell it. The first option is to dispose of the business as quickly as possible, in order to obtain reasonable fair value.

  • Liquidate it. A second option is the liquidation of the assets in the form of a "wind down." This course of action may be appropriate where the assets have significantly greater value to potential purchasers than to the current business operator. For example, a factory site with substantial real estate development value may have higher intrinsic value when sold to a mall developer than as an ongoing manufacturing operation. The liquidation option, while unappealing to employees and most business managers, may, in some instances, yield the highest value to its stakeholders.

  • Enhance it. A third option involves seeking short-term performance enhancements that could enable the business to generate enough cash to mollify creditors without concern for its long-term outlook. In this instance, the focus is typically on making improvements to the business, either by raising the effectiveness of business processes or by eliminating poorly performing operations, products, or customers. This option is not meant to set the business up for sale but to maintain the company's competitiveness through tighter controls, including more judicious spending on capital expenditures.

The Four Phases of the Turnaround

The option of pursuing a full turnaround is clearly the most far-reaching. Although it has the highest level of risk, it also offers the company the greatest opportunity to return to financial health. As depicted in Exhibit 1.6, every phase of the value recovery process, from stabilization to strategic repositioning and strengthening of operations, will be involved.

Phase I: Stabilize. In general, the first step in helping a troubled company is to assess the situation and take immediate actions to stabilize it. This is not a time of refined analysis; rather, it is a focused effort to stem losses, conserve cash, and take action. The focus of this phase is:

  • Increasing cash flow because "cash is king"
  • Reducing losses and cash demands of the business

The assessment must take place quickly, generally with the assistance of skilled turnaround professionals, in order to:

  • Reschedule payments
  • Reduce working capital demands
  • Renegotiate future commitments

Noncore assets may have to be sold to generate cash, and a sense of urgency must be instilled throughout the organization, from the top down. Foremost in the collective mind of management must be the survival axiom:


During this phase, it is critical to build credibility with lenders in order to buy the time necessary to put a long-term value creation plan into place.

Phase II: Analyze. Once immediate cash needs have been addressed and important stakeholders have bought into a restructuring process, the company needs to analyze its business prospects. Athorough business plan review must be conducted to determine, among other things:

  • What business results can be achieved?
  • What debt can be supported?
  • What unknown hurdles must be overcome?

During the course of this process, other factors may arise that give pause to even a seasoned turnaround professional. The company must nevertheless pursue a strategy to revitalize the company with vigor. The process of recreating value in the business, business regeneration, must focus on the strategic position of the company as well as its operational effectiveness. To assess the likelihood of the turnaround, the company must address:

  • The core competencies of the business and how they are being exploited
  • Which products and customers should be retained and which should be eliminated

This diagnostic phase should give stakeholders a better understanding of the business and choices available--alternatives focused around products or processes offering competitive advantage in selected markets.

In order to regenerate the business and unlock its value potential, the company must determine what resources are required, in terms of time, capital, and management. Generally, the turnaround will call for the addition of outside expertise, because it is unlikely that the current management team will be able to convince stakeholders that they can "do it right this time." After all, they are being called upon to re-create value that their earlier actions may have helped destroy.

Phases III and IV: Reposition and Strengthen. After the analysis phase, the next and most crucial phase will require the company to create a value recovery plan that needs buy-in from all major stakeholders. There will be a fine line between the resources the company can commit to the program from internal cash flow and additional resources needed from stakeholders. The management team, along with its advisors, must produce the actions necessary to create new growth.

The value plan will have two distinct parts:

Financial Restructuring. The first part of the value plan involves finan-cial restructuring, that is, taking a look at the company through the eyes of a financier. Management will seek to bring in new funds in the form of debt when a good outcome is reasonably certain, enabling upside poten-tial to be distributed to the shareholders.

A financial restructuring that involves raising more equity sends out contradictory signals to the market. As the most expensive form of fi-nancing in the long term, equity is something a company will look for when the outcome of its plans is uncertain.

Organizational Restructuring. Accompanying the financial restructuring package, as the second part of the value recovery plan, must be equally strong measures to strengthen the organization. The options could include:

  • A new management structure
  • Installation of a new executive compensation program that is heav-ily weighted to defined targets in the recovery plan
  • A dedicated effort to manage the key business drivers identified as part of the value chain

By combining new financial structures with new organizational initiatives, the sound basis for recovery and recreation of value can occur. As the recovery process continues, it may be possible to find a buyer who will pay a significant premium for the company reaping the most value to the organization.


The technology sector is a prime example of some of our concepts relative to turnaround and underperformance. The technology sector poses many interesting situations relative to defining adequate performance. Finding a margin of safety in companies that trade at 40 times book value and 10 times sales does require some creativity, if not antacid tablets. The technology sector of the U. S. economy is a major driving factor of gross national product (GNP) and a place where re-emerging companies tend to trade based on their prospects rather than general market direction.

In assessing a turnaround opportunity, investors tend to shy away from battered technology stocks for a variety of reasons. Growth investors tend to prefer companies with bright prospects and often believe that once a technology stock has fallen, it is very hard for them to regain their position. Value investors tend not to mind taking a chance on a fallen angel, particularly those companies that are not heavily covered on Wall Street (although most are covered closely).

Most value investors tend to favor predictable businesses. This tends to cause enormous problems for value investors in technology as rampant technical innovation creates enormous uncertainty for even comparatively healthy technology companies.

In attempting to assess the likelihood of a turnaround for a technology company, an investor should consider whether the company has enough cash to stay solvent while its managers figure out what is wrong and how to fix it. Consider our example for the assembly and test equipment companies in the integrated circuit manufacturing sector in Exhibit 1.7.

Companies operating in an environment in which the supply-and-demand factors are severely cyclical need enough cash and credit to survive the massive swings in the cycle. This phenomenon is quite curious as a smoothing of book-to-bill indicates that overall demand in this sector has been growing at over a 17% compounded annual growth rate. Interestingly, deep trough periods of 9 to 15 months have been experienced during the same period. This cyclical swing creates havoc for a short-term investor and does create uncertainty among shareholders as to whether the trough is really a cliff.

It is the management of these companies that must make the critical decisions on how best to survive the trough periods. Unlike most industrial companies, high-technology companies must continue to invest heavily in research and development (R& D) despite downturns in demand. Fortunately for most technology companies and unlike manufacturing companies, high-technology companies tend to have low fixed costs. That is, by reducing labor requirements during trough periods (layoffs), technology companies can reduce their variable costs low enough to withstand the down periods and buy the time to turn around the business. Of course, this logic does not help if the technology company has loaded itself up with debt and cannot meet debt service payments.

Fortunately for some technology companies, many have a monetary advantage as they may be flush with cash from a past initial public offering (IPO) or they may have raised additional funds in the form of preferred convertible securities or some other equity instruments when times were better.

Of relative importance in considering the likelihood of a turnaround in the technology sector is whether the company has another form of financial life support that it can rely on when its primary market is weak or under pressure. Things like service agreements, maintenance contracts, and software/hardware upgrades may provide enough revenue to help buy time.

Got Something to Sell?

Of course, as with any business, a key criterion to assess in technology companies is determining whether the company still has something to sell. Cash alone will not drive a technology stock's value up in the marketplace; one must determine whether it has niches and viable products. Unlike manufacturing companies, which tend to generate products that an investor can fundamentally understand, technology companies reinvent themselves on almost a daily basis. Therefore, it is important to assess a company's track record in bringing out products to market. If "research and development is the touchstone of a technology business," 5 then it is important to validate a company's ability to achieve significant returns from its R& D spending. The investment in R& D must be carefully scrutinized much as an investor in a manufacturing company looks at capital expenditures to determine whether management has been reinvesting in the business.

More importantly, when things are not going well for a technology company, consider whether the company has increased its R& D spending (generally in excess of 7% of sales) or whether the company has decreased these initiatives. Naturally, one needs to look at research and development spending relative to industry competitors to benchmark the situation.

Percentages of spending are not everything. You need to consider whether the R& D spending has been spent wisely. To assess this, we like to revisit the annual reports to see whether the company was able to deliver on projects it had under development in the past years. Moreover, one could consider what percentage of a company's revenues has come from products introduced in the past three years (hopefully at least 50%).

The Management Thing

Many high-technology companies faced with poor performance tend to need new management before a turnaround can begin. The boost a new CEO can give a company faced with first-time underperformance should not be underestimated. The return of Steve Jobs helped Apple Computer stock achieve a 118% total gain in the first half of 1998.

The key action a new manager can bring to an underperforming technology company is cost containment. When technology companies are thriving, management's focus tends to be on keeping the engineers happy, and cost control takes a backseat. When the company gets into trouble, management needs to be able to control costs. Many times, a new manager is brought in to do the layoffs and cost containment because prior management either did not recognize the problem or refused to do it.

While the major example is an American company, its ramifications reach much further, not only for U. S. companies considering business relationships with foreign partners, but for foreign businesses as well (despite the differences in their local laws).

Benchmarking Can Be Fun?

Perhaps a critical factor to assess in a high-technology company is whether the company's balance sheet is strong enough to withstand a down period. We like to do a sector chart analysis in which the company's balance sheet and income statement performance can be benchmarked relative to perceived competitors, as indicated in Exhibit 1.8.

The sector charts help one analyze his or her company versus the competition. For instance, in looking at the balance sheet performance, companies operating in the top right region of the Inventory Turns versus Return on Assets (ROA) charts are the strongest performing of the groups in terms of inventory utilization as their investment in inventory is minimized. For most high-technology companies, minimizing the investment in inventory can be a good thing because not only does it require less working capital financing, but the company minimizes an investment in a product which may becoming obsolete as new variants are seemingly created every day.

A company in the top left region of the Days of Sales versus ROA chart is not only yielding strong returns on balance sheet assets, but also is in a good position in terms of keeping customers on a tight leash. The further you yield credit to your customers, the more subject you are to a downturn in the economy. For instance, in the capital equipment sector of the integrated circuit industry, many customers are global and heavily concentrated in the Pacific Rim. Weakness in global economies and specifically in the Pacific Rim not only may make it more difficult for these customers to pay for product, but devaluation of their currency vis-à-vis a U. S. high-technology company exporter can further exacerbate a tenuous situation.

In considering the amount of SG& A (sales, general and administrative) expenses a high-technology company invests in, one has to understand the relative components of sales expense. Is the level of sales expense appropriate for the business? Will the investment in research and development bring immediate results? Therefore, careful scrutiny as to the underlying fundamentals involved in the income statement side of our analysis must be performed. High-technology companies in particular may in fact require incremental R& D spending even though the company is facing a liquidity crisis.

What Do the Analysts Say?

Of course, notwithstanding all the fundamental analysis in the world, when a company is in the technology sector, a successful turnaround must also be played out in the public arena. The CEO/ CFO team must direct a successful turnaround not only inside the company but also outside the company. The credibility of the management team should not be underestimated, particularly in technology companies that may not have a long track record. As the darlings of the investment community, technology companies are closely scrutinized and in many instances are valued far in excess of financial performance. With price to earnings ratio (P/ Es) in the stratospheric 40x range, it is no wonder that when the technology company announces weak or lower-than-expected results, the stock can plummet more than 50% of its market capitalization.

In assessing these situations, the management team cannot lose sight of what got them to this stage of demise. Rather, a rededication to the fundamental aspects of the business is critical. Typically, the CFO, "guardian of the numbers," must placate the technology community, analysts, and investors to drive a turn-around plan. Moreover, continued investment in R& D, the lifeblood of most technology businesses, must continue to be made. In these times, assessing the likelihood of a turnaround in the technology sector boils down to the key ingredient: Is management credible?

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