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An investor’s primer on corporate losses

March 24, 2019

Stocks are relatively easy to understand when times are good. But times aren’t always good.

Last month, two major northeast Indiana employers, both publicly traded companies, reported annual losses. Understandably, losses can give markets, investors and employees the jitters. They wonder whether their jobs and retirement savings are safe.

Experts say, however, the reasons behind each loss tell the true tale.

Lutheran Health Network’s parent company, Community Health Systems, lost 2.4 billion.

Zimmer Biomet Holdings Inc.’s performance took a drastic turn into negative territory last year, resulting in a 1.81 billion in earnings.

Lutheran’s Network employs more than 7,000. Zimmer Biomet employed about 4,000 in Kosciusko County as of 2017 : and that’s not including all the people who work for the company’s suppliers. That translates to a lot of nervous people.

Profits can be spent lots of ways. They can be funneled into new equipment, locations, research, acquisitions and employee raises. Some corporate boards issue dividends, which put a share of profits in stockholders’ pockets.

But what happens when profits aren’t in the picture?

Q. When a company reports a loss, is it broke?

A. Losses don’t necessarily indicate financial trouble.

Maybe the economy just entered recession and management hasn’t had time to ratchet back production to match lower consumer spending. That could cause a relatively short-term setback.

Or maybe a manufacturer’s main factory was destroyed in a fire. During the time it takes to rebuild, customers could be lost to competitors, making it uncertain that the company will recapture market share, which could deliver a death blow.

Between those two extremes are numerous scenarios.

Let’s say the purchasing director stumbled across a great deal on raw materials from a supplier that’s going out of business. That large, unplanned expense this quarter might mean significant savings in coming quarters.

Investors, lenders, suppliers, customers and employees need to look beyond the headlines to understand why the loss happened and whether it’s likely to be repeated, experts say.

Management might have money tucked away to get through tough times. That could be in the form of cash, investments or other assets.

That was the case at Vera Bradley Inc. The local maker of women’s handbags, luggage and accessories in recent years reported two quarterly losses before adopting a strategic plan that included phasing out less popular items, reducing deep discounts and forging partnerships for new product lines.

The plan seems to be working. Vera Bradley’s fiscal 2019 earnings, reported last week, were $20.8 million, or 59 cents per diluted share. It also reported significant progress in enacting its strategic plan.

Q. What does a loss mean? How can an investor evaluate it?

A. A quarterly loss means that at the end of the three-month period, after paying interest, taxes and even one-time costs, the company spent more money than it took in.

John Boylan, a senior equity analyst for Edward Jones, stressed the importance of looking at a company’s cash flow statement to uncover what’s behind a reported loss.

“It may not affect their cash flow,” he said. “It may be more accounting-related.”

Andy Haddock, chief investment officer for Lake City Bank’s wealth advisory group, said the number that investors really should study is operating earnings. That’s also known as EBITDA : earnings before interest, taxes, depreciation and amortization.

“It’s vital that investors look at the cash flow of a company,” he said, adding that the number isn’t influenced by changes in tax policies or accounting rules, which might require an otherwise profitable company to report a loss to the Securities and Exchange Commission using Generally Accepted Accounting Principles.

Investopedia.com cautions that EBITDA can be misleading, however, “because it strips out the cost of capital investments like property, plant and equipment. This metric also excludes expenses associated with debt by adding back interest expense and taxes to earnings.”

Community Health Systems’ long-term debt of $13.4 billion has some investors worried, for example.

Haddock said a company with significant long-term debt, which is reported on a separate line in financial disclosures, “would certainly be higher risk” than some other, similar investments.

Uric Dufrene, who was once a finance professor, is executive vice chancellor for academic affairs at Indiana University Southeast in New Albany. He said some key lines an investor should look at in a company’s financial filing include long-term debt, special items, current assets and current liabilities.

Haddock’s evaluation includes looking at whether a company’s sales are cyclical. For example, a retailer might report lower revenue in the first quarter but a big boost in the fourth every year. He also looks at economic factors, such as whether an airline reported a loss because the price of fuel shot sky high during the quarter.

Zimmer Biomet Holdings, for example, reported an annual loss but has positive cash flow, said Boylan, who follows the company.

“We feel it has solid fundamentals,” he said, adding that Edward Jones has a buy rating on the stock.

Equity analysts evaluate a company’s fundamentals by looking at its product line, profitability, cash flow and the strength of assets on its balance sheet, Boylan said.

Q. When a publicly traded company reports a profit, sometimes stockholders receive a payout in the form of a dividend. If it reports a loss, do shareholders have to kick in enough money to cover that loss?

A. Luckily, no.

“That’s not the way it works. The shareholders are protected from” the corporation’s debts, said Jack Dever, a retired public accountant, who owned J. Lee Dever Accountancy Corp.

“General Motors, they get sued every day, but you and I, as shareholders, couldn’t care less,” he added.

Dufrene, who also holds IU-Southeast’s Sanders Chair in Business, said rules are different for closely held private companies, which could ask shareholders for money if the company suffers a loss. But that doesn’t happen with publicly traded companies.

That doesn’t mean shareholders can’t be affected by publicly traded companies’ losses, however. It depends how a company decides to raise money, assuming it doesn’t have enough cash on hand to cover the loss.

“The company might sell additional shares of equity to existing or new shareholders, and that could provide an equity or cash injection to the company,” Dufrene said in an email, adding that the action would send a negative signal to the stock market, probably causing stock prices to fall.

Borrowing money carries less stigma, so companies that resort to issuing more stock are signaling they don’t qualify for agreeable terms from a lender, he said.

Even when a company doesn’t sell more shares, unexpected losses will often send stock prices tumbling. Of course, if a shareholder holds onto the stock and the company rebounds, those losses aren’t realized.

Dever, the retired accountant, noted there are two share prices : the amount an investor paid, called the book value, and the amount the market is willing to pay now. If a company’s financial outlook is grim enough, the market value of the stock could be zero, he said.

“Unless there’s a market for it, who would buy it?” he asked.

Q. I’m invested in mutual funds. How can I sell stock in a troubled company if I’m not even sure whether I own any?

A. Don’t worry about it.

Mutual funds include many stocks : or other investments : in their portfolios. That diversification reduces investors’ risk in case an individual company : or even an entire sector : falls on hard times.

The mutual fund manager does all the buying and selling. If there’s no market for the stock, the manager might keep it in the portfolio in hopes that losses are short-term.

But even if the company is beyond rescuing, any well-managed mutual fund would invest only a small percentage in it : or any individual company.

Haddock estimated that any one stock would make up no more than 2 percent of a mutual fund’s holdings.

Q. If a company reports two or three consecutive quarterly losses, is it headed for bankruptcy?

A. A company hemorrhaging money might be headed for bankruptcy, but it’s not inevitable. If the business is navigating temporary challenges, crisis might be averted.

“That’s a turn-around situation, where a company needs to change management or location or something,” Dever said.

In a Chapter 11 filing, the company reorganizes its debt and, possibly, operations and remains in business. Several outcomes are possible.

The board can replace top leadership, preserving the company’s publicly traded status but sending it in a new direction.

Directors can vote to accept a takeover offer from a private equity firm, which wants to take the company private while making significant changes before selling it for a profit.

Or directors can issue preferred stock to the private equity firm, a move that dilutes the value of common stock but retains the company’s publicly traded status.

Dufrene doesn’t automatically consider bankruptcy a bad thing.

“A bankruptcy filing could allow the firm to restructure its obligations and emerge successfully as a going concern,” he said.

The effects of such a filing, including on the company’s reputation, depend on the types of goods and services it sells, Dufrene said.

“If products are highly specialized and require technical knowledge and service, a bankruptcy filing could send a very negative signal to future customers, and the firm might (experience) a decline in revenues as a result,” he said.

In a Chapter 7 bankruptcy, the company closes immediately and a trustee sells off anything of value, including real estate, inventory, machinery, raw materials and office furniture.

Q. What happens to shareholders if a company files for bankruptcy? What about bondholders?

A. Proceeds from a Chapter 7 business liquidation go into a fund that pays off debts, with secured creditors first in line. Bond holders are second. Preferred shareholders are next.

If you own common shares, you’re last in line and probably won’t get anything.

IU-Southeast’s Dufrene said shareholders can retain claims in a company that emerges from Chapter 11 bankruptcy, however.

“You will typically see the value of their claims to be considerably lower, but it is definitely possible for shareholders to retain value in the reorganized firm,” he said.

Bondholders’ claims take priority over shareholders’ claims, he said. But the terms of their payout aren’t always cut-and-dried.

“Sometimes, bondholders are willing to settle for less in order to avoid a long bankruptcy process,” Dufrene said. “The longer the bankruptcy, the greater chance of bondholders receiving less. So they are willing to accept less than the value of their claims in order to avoid a more costly bankruptcy process.”

Secured bondholders, he added, would typically receive more than unsecured.

Q. How long can a company stay in business after reporting repeated quarterly losses?

A. That depends on why it’s losing money and how many assets it has to fall back on.

Lake City’s Haddock said financially healthy companies retain earnings during the good times to cover one-time expenses during quarters when earnings won’t cover them.

One-time costs could be related to various situations, including mergers, acquisitions and litigation. A company might report thousands of dollars in severance costs, but those expenses might not be repeated. In addition, following quarters might also reflect lower payroll costs if jobs are left open.

Dufrene said specific circumstances determine whether one type of non-recurring expense is more acceptable than another.

“If one-time costs for an acquisition or merger will deliver value to shareholders, then it would be viewed as a favorable investment,” he said. “If a firm is acquired or if there is a merger, and shareholder value is destroyed, then those one-time costs would not be a good investment for shareholders.”

Boylan, the equity analyst following the orthopedics industry, believes Zimmer’s acquisition of Biomet has built a stronger company, despite short-term costs related to that deal.

Dever, the retired accountant, said evaluating reasons behind Community Health Network’s losses would be tough.

“That’s a huge, huge company,” he said. “That would be a real problem trying to sort that one out. My goodness.”

sslater@jg.net