Trying to pick turnarounds stocks is a risky business. A company has usually fallen out of favour with the market for good reason, and trying to put the mistakes of the past behind it can be tougher than initially expected. Some businesses may never recover at all, which is why turnaround investing is a tricky business. Rather than making a fortune you may end up losing everything.
The first step in identifying the best turnaround candidates is to try and work out if the company is suffering from short-term problems or longer-term structural issues. Structural problems can impact a whole industry and make it tough for a company to instigate a turnaround. Short-term issues are far easier to navigate.
Cobham (LSE: COB) is one turnaround candidate that seems to be suffering from short-term headwinds rather than long-term structural issues. The company has issued five profit warnings over the past 15 months, and management has been forced to conduct rights issues to bolster the balance sheet. However, these problems are mainly the result of a botched acquisition, and the defence contractor’s underlying business operations continue to produce results.
Bad hangover
Cobham is suffering a bad hangover from a poorly thought out expansion strategy pursued by its previous management. The company’s former CEO pursued growth at any price, a strategy which has now come back to haunt the business. A wide-ranging balance sheet review conducted near the end of 2016 and beginning of 2017 led the group to book nearly £800m of impairments on acquired assets that have turned out to be less profitable than expected.
Still, even though Cobham has its problems, the group’s underlying business is not suffering from structural headwinds, which gives management headroom to implement its turnaround plan. The defence equipment market is only expanding, and Cobham is well placed to capitalise on this expansion within its circle of competence.
Bad news bonfire
It looks as if Cobham’s management has tried to get all of the company’s bad news out at once, which leads me to believe that over the next 12 months the company could issue positive earnings updates as its restructuring draws to a close. And if the group can recover just two-thirds of its historical peak operating margin of 15.6%, on revenues of £2bn, the shares could be worth 180p assuming a reasonable P/E of 13. This forecast might seem optimistic, but considering the defence industry tailwinds available to the company it’s not wholly unbelievable. If the company’s earnings growth or revenue growth is better than expected, a multiple of 14 times earnings may be more suitable, which implies a share price of nearly 200p up 45% from the current price.
The bottom line
So overall, as a turnaround play, Cobham looks attractive. The company is suffering from short-term headwinds, which management is working hard to correct. As restructuring progresses, margins should return to historical levels, great news for the share price.