Does the stock market differentiate winners from losers? The case of one- vs. two-time bankruptcy filers.

This article analyzes the investment characteristics associated with firms emerging from bankruptcy. Specifically, it asks whether the stock market differentiates between those companies emerging successfully from bankruptcy and those emerging but then filing a second time for bankruptcy. The results indicate that the market differentiates early and significantly between one- and two-time fliers. Immediately following the initial bankruptcy, one-time fliers are already generating positive median market returns, while two-time fliers are seeing negative median returns. Over time, the differences increase dramatically. It does seem paradoxical that the median single-filer returns remain positive during the investigation period, given the poor operating results associated with those firms.

I. INTRODUCTION

Financial analysts and portfolio managers have increasingly focused their attention on distressed firm investing, despite few tools to assist them in making portfolio decisions. Nor is there much evidence that describes the returns and volatility associated with investing in distressed companies.

We analyze the investment characteristics of firms emerging from bankruptcy. Specifically, we ask whether the stock market differentiates between the companies emerging successfully from bankruptcy and the companies emerging and then filing a second Chapter 11 (commonly referred to as a Chapter 22).

Firms emerging from bankruptcy are required to file projections with the Bankruptcy Court as part of a reorganization plan. We analyze the relationship between stock market performance and the divergence of actual results from those projected as firms emerge from Chapter 11.

II. TWO BANKRUPTCIES

We use as examples Tracor and Harvard Industries. Both underwent leveraged buyouts in the late 1980s, and both filed for bankruptcy in 1991. Tracor emerged from bankruptcy in about six months, while Harvard took about a year to reorganize.

Both companies emerged in highly competitive industries. Tracor, a defense contractor, probably faced tougher industry conditions with the reduction of defense spending during the early 1990s. Yet Tracor flourished after emerging from bankruptcy, while Harvard floundered. Tracor grew greatly during the 1990s and Harvard filed for bankruptcy a second time. Tracor simply engineered a more sensible reorganization and executed a superior business plan.

A. Tracor, Inc.

As a defense contractor, Tracor designed, engineered, and manufactured a wide variety of sophisticated electronic and other military technology products such as unmanned drone aircraft, flight testing services, and sonar and electronic communications systems. It underwent a leveraged buyout in 1987, with the intention to grow the private mid-sized defense contractor by acquisition. However, in a declining market for defense products in the late 1980s, Tracor's strategy faltered. It attempted to sell off assets, but the efforts were insufficient, and Tracor filed for bankruptcy on February 15, 1991. It was confirmed out of bankruptcy on December 6, 1991 and emerged on December 27, 1991.

Immediately after bankruptcy, Tracor was smaller with about 3,400 employees compared to about 6,500 employees in 1988. Sales for 1992 were $262 million, compared to $642 million in 1988. Total assets were about $130 million as of March 31, 1992, compared to $978 million as of December 31, 1988.

Tracor's pre-bankruptcy debt of about $526 million was wiped out in the reorganization. The outstanding debt for the new Tracor consisted of a $60 million credit agreement. Bondholders became stockholders in the new company. Tracor's reorganization was described by the company as "preplanned," as it relied on a pre-existing agreement with the company's lenders which was entered into prior to filing for bankruptcy.

Both historically and at the time of emergence, Tracor sold approximately 75% of its products to the U.S. government, primarily the Department of Defense. It attempted to diversify to both non-government and foreign work. Through the 1990s, though, the 75% ratio remained relatively constant. Nonetheless, despite decreases in U.S. defense spending, Tracor was able to secure sufficient contracts. Tracor's work was described by the company as low markup, but steady.

Tracor's turnaround also involved dedicated management and cost cutting. CEO and President James Skaggs, who was appointed in 1990, had prior turnaround experience with two other government contractors. Tracor was diligent in shutting down and selling losing operations and cutting costs. An example of Tracor's dedication to cost cutting was the elimination of free coffee for employees, saving $300,000 per year.

Beginning in August 1993 with the acquisition of Vitro Corp., Tracor commenced a series of substantial acquisitions (12 from August 1993 through December 1997). Tracor's sales went from $262 million in 1992 to $1.2 billion in 1997. By carefully managing its acquisitions, Tracor's operating income went from $11 million in 1992 to $102 million in 1997. As of December 31, 1997, Tracor had 10,740 employees, 65% more than employed prior to entering Chapter 11.

Relatively soon after its emergence from bankruptcy, the stock market recognized Tracor's superior performance. It achieved a 506% gain in the first four years following its emergence from bankruptcy.

B. Harvard Industries, Inc.

Harvard Industries, Inc., historically was a holding company. During the 1980s, Harvard focused on automotive and related products by acquiring companies such as Harman Automotive (rearview mirrors), Anchor Swan Corp. (hoses), Elastic Stop Nut (fasteners), Trim Trends (decorative metal products for cars), Hayes-Albion Corp. (metal products), and Kingston-Warren Corp. (window channels and weather sealant). Harvard's main customers were the big three U.S. automakers.

In 1988, Harvard underwent a leveraged buyout engineered by Harvard's chief executive, William Hurley. The LBO resulted in $320 million in indebtedness. Following the LBO, Harvard attempted to expand and develop new products. However, due to weakness in the automobile parts market, it was unable to manage its debt. Beginning in 1990, Harvard sold units such as Anchor Swan, but was still unable to make interest payments on its debt. Eventually, on May 2, 1991, it filed for bankruptcy. Harvard was confirmed out of bankruptcy on August 10, 1992, and emerged on August 30, 1992.

After its first bankruptcy, Harvard was a slightly smaller company. Sales for the fiscal year ended September 30, 1993, were $583 million compared to $680 million for the year ended September 30, 1988. Total assets were about $365 million as of September 30, 1993, and $345 million as of September 30, 1988.

By terms of the bankruptcy, debt was restructured so that Harvard had approximately $117 million in post-emergence debt. For the year ended September 30, 1993, its net loss was $131 million compared to a profit of $14 million in 1988.

Sales increased gradually, and Harvard made small profits of $8 million and $7 million for the years ended September 30, 1994 and September 30, 1995, respectively. The stock market was hopeful about Harvard's prospects; its cumulative return reached 255% 24 months following emergence from this first Chapter 11. Yet prospects soured quickly. In July 1995, Harvard acquired Doehler-Jarvis, a maker of aluminum castings. To fund the acquisition, Harvard made cash payments of $104 million and assumed debt of $114 million. Harvard again restructured its debt, and debt totaled about $361 million. With the acquisition, sales increased by to $824 million by September 30, 1996, but at a net loss of $69 million.

While Tracor was able to finance and manage its dozen acquisitions, Harvard reentered Chapter 11 when it was unable to finance its growth strategy and major acquisition. Large losses continued, and Harvard filed for bankruptcy a second time on May 8, 1997. It would stay in its second bankruptcy for over a year, emerging in November 1998.

III. BANKRUPTCY LITERATURE

Bankruptcy is extensively discussed in the literature. The earliest classic work by Altman (1968) was followed by numerous articles including Altman (1984), Altman and Kishore (1996), Beranek, Boehmer, and Smith (1996), Betker (1995 and 1997), Branch (1998), Chatterjee, Dhillon, and Ramirez (1996), Cheng and McDonald (1996), Eberhart and Senbet (1993), Franks and Torous (1994), Logue (1990), and Opler and Titman (1994). Little has been written about firms' post-bankruptcy market performance, however.

Alderson and Betker (1999) analyze the rate of return earned by investors who own all the debt and equity claims on a firm as it emerges from bankruptcy. More than half of their sample firms generate returns in excess of returns available on benchmark portfolios. On average, the returns match benchmark portfolios during the five years following emergence from bankruptcy. They also find that firms that avoid a second restructuring show significantly better performance than firms entering a second Chapter 11, but they do not track the performance of one-time vs. two-time fliers over time or relate post-bankruptcy stock market performance to operating performance.

Eberhart, Altman, and Aggarwal (1999) find evidence of large positive excess returns in the 200 days following a firm's emergence from bankruptcy. They suggest that the results are due to the market's expectational errors rather than mismeasurement of risk, but they too do not differentiate between one-time fliers and two-time fliers.

These results and those of Alderson and Betker are particularly interesting, given the documentation of poor post-emergence operating performance by Gibson (1997), Hotchkiss (1995), Hotchkiss and Mooradian (1997), and Michel, Shaked, and McHugh (1998, 1999). Hotchkiss (1995) documents the large number of firms emerging from bankruptcy that are either not viable or operating so poorly they require restructuring. Both Hotchkiss (1995) and Hotchkiss and Mooradian (1997) find that the typical reorganized firm's operating margins fall below the industry median following reorganization. Gilson (1997) finds that 80% of firms in his sample have debt ratios greater than industry medians.

Michel, Shaked, and McHugh (1998) conclude that operating results are worse than projections made at the time of emergence from bankruptcy, and that actual results deteriorate markedly over time. Michel, Shaked, and McHugh (1999) find that projections provided to the Bankruptcy Court for two-time fliers prior to the emergence from their first Chapter 11 are typically overstated, with divergence from projections more pronounced than for single fliers. Moreover, the overstatements increase dramatically over time.

None of this research on …