Dead Companies Walking: An Interesting Book on Short Selling

I recently started a routine of writing summaries on books I have read. The goal is to further my understanding as well as to improve retention rate.

There have been discussions in terms of the best way to summarize a book – by chapter, by ideas, by index, etc. In summarizing "Dead Companies Walking" by Scott Fearon, I used the big ideas plus case studies approach supplemented by interesting ideas and stories. Below are my summary notes (please bear with the format as I couldn't fix the formatting issues somehow).

I'd be interested to hear readers' thoughts, especially suggestions on how to do a better job. Please also leave a comment if you want to share your experiences and insights with regards to book summaries or improving retention, or reading in general.

'Dead Companies Walking'

Six common mistakes committed by leaders of failing companies

1. They learned only from the recent past.
2. They relied too heavily on a formula for success.
3. They misread or alienated their customers. They forced their personal preferences on customers.
4. They fell victim to a mania.
5. They failed to adapt to tectonic shifts in their industries.
6. They were physically or emotionally removed from their companies’ operations.

Deadly combo – declining revenue + rising debt

Classic examples

1. Cal Coastal – California Coastal Communities. Had $200 million debt and revenue more than halved from the peak of $90 million in 2006.

Trouble signs + red flags

1. Declining revenue.
2. Revenue deceleration.
3. Declining margin.
4. Management wanted to double store counts or revenue growth in a short period of time.
5. Super competitive management team.
6. Blamed macro or external factors for internal failures.
7. Management uses all types of excuses to justify deteriorating fundamentals.
8. Intense management style that creates incentive and pressure to make the numbers.
9. Management that cares about its stock price more than the business fundamentals.

Case studies

1. Global Marine.

• Learned only from the recent past – only looked at utilization data of the recent past, ignored the possibility of a super cycle.
• Relied too heavily on a formula for success – stick to 70%.
• Fell victim to a mania – oil boom.

Offshore drilling rigs and ships leasing company that got rich during the oil boom. Stock traded at $5 in 1984 with book value $10 per share. CFO pulled out a chart and claimed any time the utilization rate reaches 70% it’s the sign of the bottom. Utilization ended up dropping from 70% to 25%. Global Marine filed for bankruptcy in January 1986.

2. TXU Electric Delivery – Warren Buffett (Trades, Portfolio)’s major unforced error.

• Historic myopia – enormous amount of free cash flow due to high electricity prices and demand. Management planned to build a dozen additional coal-fired plants.
• Failed to adapt to tectonic shifts – Coal-fired plants are dirty. Massive new natural gas deposits were being discovered all over North America.

3. Value Merchants.

• Milwaukee-based dollar stores. New CEO pledged to double the number of locations every single year.
• Even though all new stores had boosted revenue growth, margins were down.
• Fearon's store visits provided extremely useful insight – inventory Ponzi scheme. Value Merchants sourced junk merchandise and relayed these unsold inventories from store to store.

Fearon: “How do you decide what items you sell here?”

Store manager: “I don’t decide anything. Every week a truck backs up behind the stores and we offloaded boxes of merchandise. Then we take all the things that haven’t sold in the past week, and we put them in the same boxes and they go back to the truck. The truck then goes to the next store.”

4. Advanced Marketing Services.

• San Diego book distributor was growing both revenue and earnings rapidly and share price lagged fundamental growth.
• The reflection point and first red flag – growing revenue but declining margins.
• Second red flag – management took measures and assured investors it would bring the profit margin up – it was improving inventory software, cutting overhead and streamlining its distribution centers. But none of them brought the margin back up.

5. JCPenney.

• Alienated its customers – got rid of coupons, removed cash registers, stocked prohibitively expensive brands.
• CEO Ron Johnson refused to move to Plano, Texas. He used Penney’s (JCP, Financial) corporate jet and charged Penney for Ritz Carlton.

6. PlanetRX, Chemtrak, Webvan, Fresh Choice – fail to understand human behavior.

• The very consumers the company planned to serve had absolutely no interest in what it was offering. The founders confused their own preferences with the tastes of their target market.
• Chemtrak’s only product was an OTC bloodtest for cholesterol levels. (Fearon sent a gofer to 20 drug stores and put a small nick on the packaging of the first five Chemtrak tests on the shelf of every location. The gofer went back every other week for several months and at the end of the process, those first five tests in all the stores still had nicks on them.
• PlanetRX’s website enabled people to order prescriptions and have them delivered straight to their doors. Their customers are mostly older people who are not very comfortable using the computer to shop, and it takes longer to use PlanetRX (two to three days) than going to pick it up from a local pharmacy.
• Fresh Choice was a cafeteria-style, all-you-can-eat restaurant with a focus on healthy food, cleanliness, friendliness and family appeal. Most Fresh Choice restaurants are in the Bay Area. By and large in that market, and in other big markets like Los Angeles and New York, the people who care about eating quality food are not going to a place that looks like a cafeteria. They are willing to pay extra to be waited on. On the other hand, most people who go for buffet style aren’t interested in how nutritious the food is or how immaculate the countertops are. They want filling, cheap and meatloaf and chicken-fried steaks.

7. Blockbuster, PageNet, Yellow Page – failed to adapt to tectonic shifts in their industries.

• Blockbuster was saddled with over 9,000 brick-and-mortar store locations and tens of thousands of employees when Netflix (NFLX, Financial) started this new web-based, light overhead business model. Blockbuster reacted by adding more kids and video games and selling popcorn, candy, movie posters, etc. Blockbuster was pushing for the company to focus more on the Internet, then Carl Icahn (Trades, Portfolio) got involved and terminated the Internet plan. Blockbuster also acquired Hollywood Video, its biggest competitor who was also suffering. Blockbuster declared bankruptcy.
• PageNet was a pager company before cellphones and smartphones came along. Senior management thought consumers could carry both a pager and a cellphone for “added convenience.”

8. MiniScribe – disk drive maker dropped by a major customer.

• Disk drive was a sunset technology.
• Q.T. Wiles was hired by Bill Hambrecht, a revered figure in investing, to fix the business. Wiles didn’t want to leave Los Angeles so he traveled to the company’s headquarters in Longmont, Colorado, once every month.
• Wiles had an intense leadership style that created so much pressure that executives began to falsify their accounting records to meet his aggressive revenue goals. Same as Mike Pearson of Valeant (VRX, Financial).

9. Consilium, a major tech company, 50-Off.

• In 2013, a major tech company was blaming Chinese government’s anti-spy initiative for its offshore revenue dip. However, Huawei (SZSE:002502, Financial) had been taking shares from Cisco long before the news of the spying scandal broke.
• A software company called Consilium blamed M-1, the aggregate money supply, for its soft sales.
• 50-off used the same weather excuses for two straight years.

10. Cost Plus World Market.

• CPWM was the first major treasure hunt retailer with origination in Fisherman’s Wharf.
• CPWM had a viable business model, but management started to falter on several fronts.
  • It got caught up in the housing mania and got into high-end furniture.
  • It alienated the customers by offering more expensive and slow-selling furniture and fine Napa and French wines.
  • It followed the hypergrowth formula and opened too many stores too quickly.
  • When it was confronted with the clear evidence of the negative consequences of these strategies, it blamed external factors including the economy and the big dominant wholesaler effect.
• CPWM’s new management admitted that it screwed up and got back to the old core strategy.

11. Zale Corporation: America’s diamond store.

• Zale (ZLC, Financial) earned the majority of its revenue on bridal jewelry like diamond engagement rings before it shifted strategy to include more lower-end trinkets such as Hello Kitty branded iphone cases.
• A new management team closed unprofitable stores, got rid of the low-end trinkets and committed to finding new ways to boost its profit margin such as an exclusive Vera Wang’s agreement.
• Signs of recovery – comp store gains, Vera Wang and Collection responsible for more than 15% of revenue and growing, paid down debt, in-sourced credit card (saved 2% it had to pay Citi [C]).

12. International Game Technology

• On the brink of bankruptcy in 1986, the competition was eating up market share. The Supreme Court said that Native Americans could run casinos on their reservations.
• International Game Technology (IGT, Financial) spent 5x more on research and development than competitors.
• Came up with progressive jackpot – slot machines used to be isolated, IGT linked up them electronics so the payout can be much larger.
• They also stopped the selling unit model and went to a leasing model where they take a healthy cut of every coin that goes into the slot machines.
• Then gambling was legalized. Riverboat gambling was growing, and cities like Detroit were preparing to legalize gambling outright. At the same time, slot machines were becoming most of casinos’ revenues.
• IGT’s competitors, Williams Gaming and Bally Technologies (BYI, Financial), had much lower valuations in the early 1990s, but they wound up not being lucrative investments.

Interesting Ideas

1. The fallacy of elite infallibility – Page 29. Robert Jaedicke was an accounting professor at Stanford and then became the dean of the business school. He then became the chairman of the audit committee of Enron. Bernie Madoff was the former chairman of NASDAQ.

2. Short strategy – Page 59. Fearon generally holds off until a failing company’s stock has lost at least half the value of its 52-week high before he initiates a short because he wants to have enough downward velocity that there’s little chance it will stop before it hits the bottom. You can short a stock when it seems expensive, but you may sweat for weeks or months or even years because investors are irrational.

• Idearc (later emerged from bankruptcy as Supermedia) was a Yellow Page company that produced a hopelessly obsolete product. In 2010, Supermedia looked cheap at 5-6x EBITDA. Goldman Sachs, Merrill Lynch, JPMorgan (JPM), Fidelity all have buy ratings. Supermedia went to $45 before it went bankrupt in 2013 and merged with Dex Media.

3. If a company blames external factors for bad results, check whether its competitors have been taking shares from it before the external factors. And see whether the same excuse was used over and over again. Also see if the competitors have disconfirming evidences – i.e., despite challenging macro, they are growing the business. For instance, a major tech company was blaming Chinese government’s anti-spy initiative for its offshore revenue dip. However, Huawei had been taking shares from this company long before the news of the spying scandal broke.

4. “Rested and vested.” Employees of the acquired company, if felt alienated by the new corporate culture, would wait until the stock options of the newly merged company to vest before they quit. They’ll do the bare minimum to keep from getting fired.

5. Short selling not as profitable as before for four reasons.

• Fewer IPOs and continued trend of privatization – fewer stocks over $1 per share.
• SOX reduced number of companies with aggressive accounting.
• Borrowing cost shot up.
• More competition and better short sellers.

Interesting story

Starbucks (SBUX, Financial) did surveys of its customers as they were leaving Starbucks stores. The customers were asked how much did they pay for their coffee. The majority couldn’t remember – Starbucks can easily pass along cost inflation and raise prices. Small luxury items like Starbucks coffee and See’s Candy have enormous pricing power.

Disclosure:Â No position in any of the stocks mentioned in the article.

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