Any good investor will tell you to have a checklist of things to look for in companies before you invest. Checklists are a good idea and can help prevent some basic mistakes and oversight on our part. Checklists also help to enforce a discipline in your investing process.
I use my checklist for two purposes.
1) Which companies are worth considering an investment.
2) Which companies are NOT worth investing in ?
My negative checklist reads:
1) Avoid companies that are highly leveraged
2) Avoid companies that do not generate FCF consistently
3) Avoid companies that have high fixed capex requirements ( especially if their FCF is weak)
4) Avoid companies where interest coverage is low.
5) Avoid companies that have poor Altman Z score that predicts likely bankruptcy.
Now, lets take a look at Tenet Healthcare Corp (THC).
"Tenet Healthcare Corporation, an investor-owned health care services company, operates general hospitals and related health care facilities. As of December 31, 2008, Tenet Healthcare Corporation operated 49 general
hospitals; and a critical access hospital with a combined total of 14,352 licensed beds serving urban and rural communities."
Tenet Healthcare has a market Cap $2.12 billion with an enterprise value : $5.69 billion.
Value investors often start by looking at the balance sheet. I look at the March 31, 2010 statement.
Cash And Cash Equivalents $589 million
Long Term Debt $4,271 million
Total stockholder equity $739 million.
The first thing that strikes out is that there is $4.2 Billion in long term debt v/s cash of about $600 million.
1) Debt / Shareholder Equity : 4271 / 739 = 5.8 ( Graham said to avoid companies that owe more than twice of what they own. So, If Debt / Equity > 2, avoid the company.
Avoid companies that are highly leveraged : Check
I could stop looking at THC right here but lets run down the list to see what else we find
2) In 2009, THC has Operating cash flows (OCF) of $425 million. However, Capital expenditures were $456 million. Now, I do not want to get into maintenance capex versus growth capex here. For me, Free Cash Flow (FCF) = OCF - Capex = -31 million.
Avoid companies that do not generate FCF consistently: Check
3) Look at the Capex over the last 3 years and you will see high consistent capex. Even though capex has been coming down from $743 million in 2007 to $456 million in 2009, it shows me that capex requirements are quite high in this company and industry in general.
Avoid companies that have high fixed capex requirements: Check
4) Next I look at the 2009 annual income statement and find EBIT = $650 million. On the next line I find interest expense = $445 million. Wow. You do not need a calculator to know that interest coverage is quite low. Interest coverage is defined as EBIT / interest expense. = 1.46. This means that interest payments could be at risk if operating income dropped and also the fact that there is not much for error here. Finally, not a lot remains for the shareholders after paying this interest expense.
You can also do simple math to find out the interest rate. We saw that LT Debt was $4271 million and THC paid $445 million in interest expenses. My rough calculation is that interest rate on the debt is just a shade under 10%.
Avoid companies where interest coverage is low : Check
5) Altman Z score The Z-score formula may be used to predict the probability that a firm will go into bankruptcy within two years. Here you can find a free spreadsheet to compute the Z score. A score less than 1.8 means that the company is in the distress zone. THC's Z score came out to 1.35.
Avoid companies that have poor Altman Z score : Check
At this point, I have not even gone into the details of the business, its history of profitability ( or lack there of), its management and its competitors.
The checklist has helped me decide that this company is NOT one I would like to invest in.
Other investors may think of THC as a potential turnaround candidate or an asset play or a LBO candidate. I do not have the expertise to value the assets of this company or speculate about a potential LBO.
Hope you found this exercise worthwhile. If you take anything away from this article and checklist, take the first point. Avoid companies where D/E is more than 2.