Thursday, May 21, 2015

Are declining businesses good shorts?

As the post title suggests, I was curious to see if declining businesses are good shorts. "Declining business" doesn't have a universal definition, so here's how i define it: it's any company that faces a big risk of obsolescence, either in the products and services it sells or the way it sells them. Sometimes declining businesses go from being the industry standard to filling a market niche, but usually they disappear completely.

I found twenty-eight publicly-traded companies that have been described as declining businesses. I've probably missed a few, but I think this is a representative list:

Abitibi-Bowater (newsprint)
Barnes & Noble (book retailing)
Best Buy (electronics/media retailing)
Blockbuster (video rental)
Borders (book retailing)
Cinram (DVD manufacturing)
Eastman Kodak (photography)
Fairfax Media (newspapers)
GameStop (video-game retailing)
Gatehouse Media (newspapers)
Hollywood Video (video rental)
Idearc (yellow pages)
Knight-Ridder (newspapers)
LaBranche (market making)
Lee Enterprises (newspapers)
McClatchy (newspapers)
Movie Gallery (video rental)
Nidec (disk drives)
Outerwall (video rental)
RadioShack (electronics retailing)
R.H. Donnelley (yellow pages)
Seagate (disk drives)
Solocal (yellow pages)
Spok Holdings (pagers)
Valassis (junk mail)
Van Der Moolen (market making)
Western Digital (disk drives)
Western Union (money transfer)

To avoid hindsight bias, I've included any company that was widely expected to decline, even if it subsequently defied these expectations. The disk-drive manufacturers are examples of this. A VIC writeup from 2010 begins, "We believe that a great migration from HDDs to flash-based / SSD-based devices has begun," and Jim Chanos made a similar argument for shorting Seagate in 2013. Yet the disk-drive industry has prospered over the past five years despite flat computer sales and the growing use of solid-state drives.

I've excluded companies that own both declining and growing businesses. For example, Gannett owns both newspapers (in terminal decline) and television stations (not declining yet), so it's not on the list, although several pure-play newspaper publishers are.

I've also excluded companies that are declining for company-specific reasons. Blackberry has imploded over the past five years, but that's because of strategic mistakes it made, not because its product category (smartphones) is becoming obsolete.

Of the twenty-eight companies listed above, thirteen have gone bankrupt or fallen 90%+ in the stock market. But a surprisingly large number have held their ground, and some have actually seen their stock prices rise. My conclusion is that declining businesses aren't great shorts, but that comes with the caveat that this is an anecdotal survey.


Risks to shorting declining businesses

Many investors believe that identifying a technological revolution's losers is easier than identifying its winners. Warren Buffett expressed this sentiment when he wrote that, "You could have grasped the importance of the auto when it came along but still found it hard to pick companies that would make you money. But there was one obvious decision you could have made back then... and that was to short horses."

The future isn't always so obvious. Horses actually survived technological change better than one might have expected them to. In the 1840s, Britain underwent an enormous railroad-building boom. Observers widely expected this to reduce demand for horses, but the opposite happened:

[R]ailways created an increased demand for horses. The rails provided efficient transport once one got to them, but the “first-mile problem” of getting to the rails... as well as the general stimulus given to the economy by the new technology, called for more horses. In fact, railways themselves used horses extensively, not only for local deliveries of goods they handled as carriers, but also within rail yards, to move wagons around.

More recently, some businesses that were expected to decline have proven resilient, including Gamestop, Outerwall, Valassis, and Western Union. Best Buy has withstood the showroom effect better than I thought it would.

Industry consolidation has allowed the disk-drive makers to earn record profits despite weak end-markets and a technological threat from flash memory. Seagate's market cap was $5 billion at its 2011 lows, and the company earned $5 billion in the following 24 months. The stock is up 400% since 2011 and 40% since Chanos panned it. One or two gainers like Seagate will offset the profits from shorting a lot of companies that actually declined.


I'd assumed that declining businesses would decline independent of economic environment, giving short-sellers both profits and diversification. I'm no longer sure that's the case. A few examples of declining businesses reflecting broader economic conditions:

• McClatchy's newspaper business experienced its earliest and most severe circulation declines in the states that had the biggest housing bubbles. The company's California papers declined 1-2 years before its other papers, and the Miami paper it acquired when it bought Knight-Ridder declined fastest of all.

• Kodak's stock was flat from 2001-07 as its business weakened and didn't collapse until the 2008 recession began.

• R.H. Donnelley may be the most spectacular blowups on my list, falling ~95% from mid-2007 to early 2008. It peaked at the same time the market peaked in 2007, and its collapse coincided with the beginning of the biggest recession since the 1930s. (To be fair, the yellow-pages sector collapsed so quickly and completely that Donnelley probably would have suffered even without a recession.)


Most declining businesses were previously cash cows, and some of them pay large dividends as a legacy of that. Kodak declared large dividends for years as its cashflow deteriorated. Solocal, a French yellow-pages publisher, paid a huge special dividend in 2006 and paid large regular dividends for years thereafter. Both Kodak and Solocal subsequently suspended their dividends, and their stock prices collapsed, but having to pay dividends for years before realizing a profit is an IRR killer.


Some declining businesses manage to sell themselves to dumb competitors once the decline has begun, e.g. Hollywood Video and Knight-Ridder.


Shorting declining businesses involves all the usual hassles of shorting: volatility, negative rebates, the risk of being bought in, etc. Labranche traded at $12 in 2000 and ultimately sold itself for less than $5 in 2011, but it spiked up to $50 at one point in the meantime.


Possible exceptions

Although I think that declining business are generally mediocre shorts, there are a couple situations in which they may have better odds.

The first is a declining business making a big debt-financed acquisition after the decline has already begun. The benefits of this are twofold: the debt amplifies the decline's effects, and it makes paying dividends less feasible. McClatchy took on a lot of debt to acquire Knight-Ridder in 2006, after newspaper circulation had started falling. McClatchy traded at $53 before announcing the acquisition, and by 2009 its stock was under a dollar.

The second is when there's a precedent for the decline. Fairfax Media is an Australian newspaper publisher. By late 2009 most American newspapers had imploded, but Fairfax still had robust margins and traded at 10x EBITDA. The company's stock is down 40% since then, and at one point it was down much more. I don't think there was anything unique in the Australian market that would have prevented it from following America's footsteps.

Similarly, Solocal, the French yellow-pages company, traded at a high EBITDA multiple in 2009-10 even though American yellow-pages companies had already gone bankrupt. Solocal's stock closely tracked France's CAC40 index in 2008 and 2009, so investors weren't pricing in the risk of secular decline that had already happened in another big market.

Tuesday, May 19, 2015

Twenty-five spinoffs that blew up

Consolidated Freightways (1996) - The unionized division of a large trucking company. Its financial condition steadily deteriorated after the spinoff, and it finally went bankrupt in 2002 when couldn't obtain a surety bond it needed to operate.

Reliance Acceptance (1997) - A subprime auto lender that spun out of a regional bank named Cole Taylor Financial, Reliance went bankrupt a little more than a year after its spinoff. David Einhorn was a shareholder and mentions in Fooling Some of the People All of the Time that Reliance had a lot of defaulted loans for which it couldn't locate and repossess the collateral.

Solutia (1997) - A chemical-manufacturing spinoff from Monsanto that went bankrupt in 2003. Environmental liabilities played a starring role in the company's collapse.

Vlasic Foods (1998) - Campbell's Soup spun this off as a way to jettison several of its secondary brands, including Vlasic pickles and Swanson frozen foods. It also used the spinoff to jettison $500mm of debt. The company went bankrupt within three years.

Azurix (1999) - This was Enron's water unit. It had negative cashflow and problems with big projects in India and Argentina. According to Wikipedia, "The company was formed with an IPO of $800 million and an opening stock price of $22.00, which fell to $2.00 within two years."

Avaya (2000) - A spinoff from Lucent, it lost 95% of its value in the following two years. The stock subsequently recovered, but total return from the the spinoff until Avaya's leveraged buyout in 2007 was still negative.

Huttig Building Products (2000) - A spinoff from Crane Corp. Management at the time of the spinoff was incompetent and nearly ran the company into the ground. They were replaced with better operators, but then the company suffered during the housing bust. Huttig has survived two near-death experiences, but the stock is still below where it was on the date of the spinoff.

Synavant (2000) - Synavant began life as a unit of IMS Health that offered marketing software to drug companies. The company lost a few big contracts post-spinoff, and the stock went to zero.

Visteon (2000) - After Ford spun Visteon off, it looked very cheap on projected earnings, but the earnings never materialized. The company limped along until 2009, when it filed for bankruptcy.

MCI (2001) - Worldcom issued an MCI tracking stock in 2001 as a way to separate its declining long-distance business from the rest of the company. While this wasn't a true spinoff, it served the same purpose as many spinoffs. MCI was saddled with a lot of debt and a big inter-company payable. The tracking stock became worthless after the Worldcom accounting fraud was revealed, but it had already lost most of its value by then.

Agere (2002) - Another spinoff from Lucent. Like Avaya, this one plunged right after the spinoff, partially recovered, but still gave investors negative long-term returns.

Constar (2002) - The plastic-packaging division of Crown Cork & Seal. It had less pricing power than Crown's can business and a large debt load. It's filed for bankruptcy three times since the spinoff.

Blockbuster (2004) - Separated from parent Viacom in 2004 and paid a large special dividend in the process. The debt it took on to pay the dividend, along with the innovator's dilemma, prevented it from competing effectively with Netflix.

ACCO Brands (2005) - This office-products company was a spinoff from Fortune Brands and MeadWestvaco. I'm not familiar with the company, but a Value Investors Club writeup argues that sales of office products have fallen since 2007 and are in secular decline. Acco's stock is down 70% since the spinoff.

Tronox (2005) - Like Solutia, Tronox went bankrupt because of environmental liabilities and a recessionary economy. Spun off from Kerr-McGee in what was later ruled to have been fraudulent conveyance.

Idearc (2006) - Verizon shrewdly spun off this yellow-pages publisher before yellow pages became obsolete. Burdened with billions of debt, Idearc quickly went bankrupt. Unlike Kerr-McGee, Verizon managed to beat a fraudulent-conveyance rap.

Seahawk Drilling (2009) - A spinoff from Pride International that served drillers in the Gulf of Mexico, Seahawk was saddled with a big tax liability and aging assets, its largest contact was set to expire, it served a high-cost basin, and business suffered after the Macondo disaster. Bankrupt within two years.

Lone Pine Resources (2011) - Spun out of Forest Oil. I'm not familiar with Lone Pine, but the stock went straight down after the spinoff, and the company filed for bankruptcy in 2013.

NovaCopper (2012) - A copper-themed exploration spinoff from NovaGold. This has lost nearly 90% of its value in an extended bear market for exploration stocks.

Orchard Supply (2012) - A regional chain of hardware stores spun off from Sears. High debt, high prices, and competition proved a fatal combination for the company.

Sears Hometown and Outlet (2012) - Another dud from Sears. The spinoff was supposed to carve out a niche in towns and smaller cities where competition would be less intense. The stock has tanked and many Sears Hometown franchisees feel that the company has given them a raw deal.

Civeo (2014) - Hedge funds pressured Oil States International to spin off Civeo, its roughneck hotel unit. It's probably glad they did, because Civeo is down 80% since the spinoff.

Paragon Offshore (2014) - Noble Corp. spun this off with aging assets and a lot of debt right before oil prices plunged.

Rayonier Advanced Materials (2014) -- I haven't followed this one, but Rayonier spun it off last year. Down 60% since then.

Seventy-Seven Energy (2014) - Formerly the captive services division of Chesapeake Energy, this has fallen 80% in its eleven months as a public company.



Some general opinions

Many companies use spinoffs as "garbage barges" that separate problematic business units from the rest of the company. This all but guarantees that spinoffs' returns will vary a lot-- they may outperform the market on average because they tend to undervalued at the time of the spinoff, but some of them have structural flaws that will sink them even if they're priced cheaply.

I don't think spinoffs, on average, are undervalued any longer. They were historically undervalued because investors overlooked them, but the growth of the hedge-fund industry has changed that. By now everyone has read Joel Greenblatt's book and knows his techniques for finding special situations, and some of Greenblatt's disciples are managing large funds.

Glenn Chan writes that spinoffs "[A]re gimmicky. Most of the time they lower the intrinsic value of the business due to legal and accounting fees." I agree, especially with regard to some of the recent spinoffs that activist shareholders have pushed through. Spinoffs that are intended to garner higher stock-market valuations can actually destroy value through transaction costs, increased public-company costs, and in some cases loss of focus.

Articles of interest

Apple

Scott Fearon offers a skeptical opinion of Apple's prospects:

Apple is a consumer product company. That’s an extremely volatile business, especially when–like Apple–you’re a consumer product company with exactly one hot-selling consumer product... As others have pointed out, Apple is now a cellular phone company that happens to make a few other products on the side. Yes, that cellular phone is fabulously popular right now. It’s shattering sales records left and right. But, like all consumer products, the iPhone is still subject to the fickle whims of consumer tastes.


Buffett

Warren Buffett was in the news recently saying that "If I had an easy way, and a non-risk way, of shorting a whole lot of 20- or 30-year bonds, I’d do it." Stagflationary Mark points out that Buffett has a poor record of predicting interest-rate moves.


China

GaveKal writes that "2014 marked the 10th consecutive annual increase in aggregate leverage as measured by total liabilities as a percent of equity. Meanwhile profit margins are down by more than half over the same period." Much of last year's leverage increase took the form of rising inventories and accounts receivable rather than rising debt.


Independent power producers

A doctoral candidate at NYU provides an overview of the 2002 merchant energy crisis, focusing on the experiences of AES, Calpine, and NRG. Particularly interesting is his discussion of AES, which extensively used non-recourse project financing and avoided bankruptcy when many of its peers had to file.


Lumber Liquidators

After previously defending Lumber Liquidators from some of Whitney Tilson's more hysterical accusations, "Max Vision" writes that the company's situation is getting worse. By pulling Chinese laminate from its stores after previously insisting it was safe, Lumber Liquidators has opened itself to inventory writeoffs, lawsuits, and bad publicity.


Oligopolies

Fortune reports that Christie's and Sotheby's, despite having an effective duopoly, are unable to earn oligopolistic profits.

Discussing Micron, Russ Fischer writes that "Oligopolies do not have a license to steal" and that "What isn't discussed so much is that, while an oligopoly can stabilize prices, it has no effect on costs."

On the other hand, Reihan Salam writes that industry consolidation has allowed hospitals to charge exorbitant prices. Salam also argues that hospitals, since they're often the largest employers in their Congressional districts, have enough political power to thwart efforts to rein them in.


Posco

Korea JoongAng Daily discusses Posco's origins as a state-owned company and the Korean government's continued interference in the company's operations since its privatization in 2000.


Profit margins

In "The Profit Parfait," Deloitte researchers analyze the different methods companies can use to earn sustainably high profit margins. Among other interesting anecdotes, the article mentions that Weis Markets earned high margins by pioneering the use of store brands but that its margins fell when competitors caught up. My impression is that Tesco has had the same experience in Britain, pioneering things like store brands and loyalty cards that have since been widely adopted.


Subprime

A 1998 Fortune article profiles FirstPlus, a subprime lender that offered 125% loan-to-value mortgages in the 1990s. Borrowers typically took loans from the company to pay off other, higher-interest loans (e.g. credit-card debt). According to the article, "FirstPlus usually doesn't bother with appraisals anymore--it mostly takes the borrower's word as to a home's value. And competing lenders are offering 135%, 150%, even 200% second mortgages."

FirstPlus depended on securitizations to finance itself. The securitization market shut down a few months after the article was published, and the company went bankrupt in early 1999.


Turkey

Dani Rodrik argues that Turkey's economic problems are large and growing and that, contrary to popular belief, they began before the country's political problems. Rodrik also writes that "Turkey (and other similar countries) benefited from an unusually favorable external environment. In particular, financial globalization and the availability of cheap foreign capital seems to have played a critical role."