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My top 2 turnaround stocks

Investors often consider investing in troubled companies at low prices because of the large returns available if these companies turn around their fortunes. A potential turnaround investment is viewed by the market as a company in decline. However, if such companies return to growth (especially if they can sustain that growth), the market often rewards holders with a sharp re-rating.

Cabcharge (ASX: CAB) is undoubtedly a company priced for decline. In FY 2013, Cabcharge made a profit of about $60 million and recorded operating cash flow of about $70 million. The company’s market capitalisation is now about $450 million. The company trades on a PE ratio of around 7, and its market capitalisation is just 6.5 times operating cash flow.

This is because planned legislative changes in Victoria will reduce the ‘service fee’ Cabcharge is allowed to charge. This will reduce the company’s revenue from such fees in Victoria from $22 million to $11 million. In 2013, taxi service fee income (from all states) was $90 million. In the past, Cabcharge MD Reg Kermode has proved adept at convincing politicians to preserve the company’s monopoly position, but he may be about to fail.

At the current price of about $3.75 per share, Cabcharge has a trailing yield of almost 8%. If the Victorian legislative changes can be contained to that state, it seems likely the company is currently undervalued. The big risk is that other state governments will follow that state, and reduce the allowable level of service fee from 10% to 5%. That’s not a risk that I can easily assess, so I’ll avoid the investment for now.

The second potential turnaround is SMS Management (ASX: SMX), an IT consulting firm. SMS grew profits every year (except 2009) from 2005-2012, and paid solid dividends in that time. However, perhaps because of the move to cloud services, the company’s revenue, margins, profits and cash flow were all down in FY 2013. Indeed, earnings per share dropped more than 30%, and the share price is down about 16% since the company reported.

At current prices, the company has a trailing yield of 5.6%, but the dividend is expected to drop. The company reported that it had $37 million in cash at the end of FY 2013. Since that time, SMS has used some of its cash reserves to make two EPS-accretive acquisitions. Further good news is that the Victorian business has seen improved sales in Q1 2014.

Last year, SMS started signing its first “Managed Services” contracts. These contracts bring in annuity-style revenue, rather than occasional lump sums. The acquisition of Indicium (for $22 million, paid over two years) will complement that strategy and add revenue of about $20 million per year. It also allows SMS to offer Indicium’s ‘Business Cloud’ infrastructure-as-a-service, meaning that the company can easily assist enterprises that have not yet moved to cloud-based infrastructure.

The company has also recently announced the acquisition of The Birchman Group Asia Pacific, for $25 million, half of which will be paid upfront. The acquired company has a strong presence in Western Australia. The acquisition will add further annuity-style contracts to the books, and annual revenue of about $32 million.

Foolish takeaway

Cabcharge and SMS face different challenges. SMS has arguably been slow to capitalise on the move towards managed services. Thanks to its strong cash balance and steady cash flow SMS is in the process of adaptation. Cabcharge faces an assault on its margins arising from regulatory change, and seems less likely to adapt well to the new circumstances. Investors should always remember that most turnarounds don’t turn, so this kind of investing can be quite risky.

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