I’d like to apologize right up front. This is an article that is heavy on numbers, focused on some mundane issues, and is really an academic exercise in how to analyze a turnaround. The good news: the company I am focusing on may be able to deliver 200% to 300% returns for the patient investor.

I am talking about Exide Technologies (Nasdaq: XIDE), one of the world’s leading battery manufacturers. I added this stock, albeit prematurely, to my $100,000 Real-Money Portfolio in late January (which you can read about here.)

I expected management’s actions to help set the stage for a steady turnaround, which I presumed the suddenly resurgent stock price was indicating. That was a false dawn, as Exide subsequently released fiscal third-quarter results that were still weak. In fact, the company was bleeding cash, which is never a good sign for a company with roughly $600 million in net debt.

A foundation in place
Exide went off the radar since then, and more than four months passed until the company released fiscal-fourth quarter results on Thursday, June 7. Shares posted a solid double-digit, one-day rebound on the news on Friday, moving back up above $2.60 for the first time in a month.

#-ad_banner-#More to the point, after digging more deeply into management’s comments on the conference call, I am now completely convinced that Exide could turn into a home-run stock pick. Much work needs to be done, but the foundation appears in place for improved results in the coming years. I realize that’s a long time-frame for many investors, but it is the only way you can approach this stock.

The balance sheet fears erode
The most important takeaway from fourth-quarter results: Exide generated $55 million in free cash flow. Much of that is attributable to better management of working capital and won’t be sustained over the next few quarters. But it does tell you that Exide is no longer at risk of tumbling toward bankruptcy — as the ever-sinking stock price may have implied. Exide finished the quarter with $155 million in cash, $153 million still available on its credit line, and expects proceeds of $45 million from the imminent sale of a building and land in Frisco, Texas. 

To be sure, Exide’s still-hefty debt load means the company paid out $71 million in interest expense in fiscal (March) 2012. This works out to nearly $1 a share. The key for management is to improve operating cash flow, pay down debt, reduce interest expense, and let that drag on earnings per share (EPS) diminish. And this is precisely the plan that is now in place.

On the conference call, Exide’s management talked through all of the tough decisions being made. The company is selling excess capacity, exiting unprofitable markets, pushing through price increases, streamlining its raw material procurement process and eliminating roughly 5% of corporate overhead. None of this is sexy stuff, but taken together, it can start to help bolster the company’s operating metrics that it has seen in years past.

Let’s run through the potential effects. Exide generated roughly $90 million in operating income in 2012 (excluding charges), and paid out most of that in interest expense. The steps outlined by management should yield savings on the $20-40 million annual range. Using that mid-point, it means Exide may exit fiscal 2013 at a run rate of $120 million in operating income, leaving $40 million after interest expense has been paid out.

Meanwhile, the economics of the battery industry are at a low point, thanks to weak global economic activity and recently mild weather that extends battery life. Management says that during the next few years, the announced cost cuts and a return to historical industry pricing and cost trends should enable the company to boost operating margins to 10%, right in line with the industry’s top players. For a company that has $3 billion in annual sales, this translates to $300 million in operating income.

I think it will be several years before that happens — if at all, so it is more prudent to anticipate $200 million in operating income. As a point of reference, this is right in line with Exide’s market value. The company’s enterprise value, thanks to the $600 million in net debt, is closer to $800 million.

Now, suppose Exide is able to pare debt by $100 million in the next two years through its cash flow. And let’s also assume that the smaller debt load will enable Exide to replace current high-cost debt (much of which is above 10% interest) with debt that carries interest rates of around 8%. This means annual interest expense would be reduced to around $40 million ($500 million x 8%). If operating income moves up to $200 million, then we’re talking about $160 million in pre-tax income and perhaps $120 million in net income. Again, we’re talking about a company currently worth just $200 million on the stock market. 

Risks to Consider: Even deeper economic weakness in Europe and elsewhere would pressure battery sales volumes and bring a fresh spotlight to Exide’s debt load. 

Action to Take –> This whole scenario is predicated on management’s  recently0-articulated plan. It will take a number of quarters to take shape, but a picture has begun to emerge of company getting healthier. Even if Exide traded up to just four times operating income (of $160 million), then the company’s market value would rise to more than $600 million. That’s why I still think this stock can double or even triple if the cards fall into place. Do you think this is an aggressive prediction? Consider that this implies a move up to $5 or $7.50, still well below the $12 share price seen just 15 months ago.

This has been a portfolio laggard for me, and it’s always important to ask “Would I buy this stock right now if I didn’t already own it?” For me, the answer is a resounding “yes.”

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