Variant Perceptions

Category: retail

Buffett on the imperfect turnaround

Can you think of an example of a retailer that was successfully turned around?

Broadcasting is easy; retailing is the other extreme. If you had a network television station 50 years ago, you didn’t really have to invent or being a good salesman. The network paid you; car dealers paid you, and you made money.

But in retail you have to be smarter than Wal-Mart. Every day retailers are constantly thinking about ways to get ahead of what they were doing the previous day.

We would rather look for easier things to do. The Buffett grocery stores started in Omaha in 1869 and lasted for 100 years. There were two competitors. In 1950, one competitor went out of business. In 1960 the other closed. We had the whole town to ourselves and still didn’t make any money.

How many retailers have really sunk, and then come back? Not many. I can’t think of any. Don’t bet against the best. Costco is working on a 10-11% gross margin that is better than the Wal-Mart’s and Sams’. In comparison, department stores have 35% gross margins.

It’s tough to compete against the best deal for customers. Department stores will keep their old customers that have a habit of shopping there, but they won’t pick up new ones. Wal-Mart is also a tough competitor because others can’t compete at their margins. It’s very efficient.

Warren Buffett, student visit 2005

Another addition to the turnaround toolbox so that I don’t forget the obvious and known even in tempting circumstances.

And these are tempting circumstances. There are two retailers that I like their owner operators and I like their prices. Is there a need to mention their names?

Running the risk of being repetitive, my opinion is that in comeback stories the balance sheet is better used to estimate the runway of a business rather than its value. Both of these retailers have decent runways but the problem is that neither is turning.

These were some thoughts from an old previous post on players facing external threats.

The prospects do not look so bright when you consider that for most of these companies, failure means their core business declines into oblivion. Also many of them may not have clients, hidden capabilities, or platforms to leverage.

A good financial position, like Dell’s or Yahoo’s,  can give them time to experiment and look for alternatives. But from the point of view of an investor even if the plan is successful the company will probably be a follower in the new industry, product, segment, business model: a shadow of its former self.

So the downside is not that well protected, the probabilities of success are not that good, and the upside will probably be limited: does not look like the recipe for successful investing. This is an area where I think value investors have to be careful.

I’m still curious about Dell and Yahoo. I’m still curious about these two retailers. Actually, at the moment there are dozens of interesting situations. However, my preferred style is to jump on businesses that are turning or have already turned at the risk of missing some… and there are some good ones out there.

Now, if they decide to liquidate abruptly or in willful steps … well, that’s not a turnaround.

Position: none.

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A friend suggests me to read Mauboussin’s More Than You Know, Chapter 21 and I do. Retail and technology are not the best sectors to look for comebacks.

Exhibit 21.2 shows what happens to companies that realize a downturn. The sample includes almost 1,200 companies from the technology and retail sectors.

The data for the two industries are strikingly similar, and not particularly encouraging: Only about 30 percent of the sample companies were able to engineer a sustained recovery. (Credit Suisse defined a sustained recovery as three years of above-average returns following two years of below-cost-of- capital results.) Roughly one-quarter of the companies produced a nonsustained recovery. The balance—just under half the population—either saw no turnaround or disappeared. Companies can disappear gracefully (get acquired) or disgracefully (go bankrupt).

This analysis also shows how long companies experienced downturns. For both retailers and technology companies, roughly 27 percent of downturns lasted only two years, and for both sectors over 60 percent of downturns lasted for less than five years. In other words, the destiny of most firms that live through a downturn is determined rather quickly.

These mean-reversion and turnaround data underscore how strong and consistent competitive forces are. Most stocks that are cheap are cheap for a reason, and the likelihood that a business earning poor returns resumes a long-term, above-cost-of-capital profile is slim.

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Charting Banking XX: short history of the last 25 years

US Bancorp is a great bank, did a great job navigating the crisis and is a Buffett stock. I just wish it was cheaper.

This March 2007 presentation on the business of banking was first shared by Noise Free Investing and I was reminded of it while looking for some info for the Charting Banking series. Some of the interesting points are:

  • Importance of fee income
  • Sector consolidation after the 1987-88 crisis
  • Branches are still a key asset
  • Non bank competition / shadow banks share (the info I needed)
  • New risks in modern banking
  • Regulation as a friend and a barrier to entry (Walmart?)
  • Customer loyalty and how to measure it
  • Supermarket banking shortcomings

Dean Foods: this is not good

Strange things happening in the milk category,

Yes, I’ll give you what is an anecdote. But it is one of the things frankly, that I am somewhat worried about. And that is if you go back and you look at our fluid milk volumes several quarters ago, and you track them on a weekly basis, we used to see, as you would expect, was a truly stable category with complete household penetration. You used to see very flat volumes week to week, right? So very little change in average daily sales.

We’re now seeing a different pattern. And that pattern is at the beginning of the month, we’re seeing sales rise above the trend line. And by the time that you get to the end of the month, sales are down in what are meaningful percentages for a category like this, that’s flat, it has been for 30 years. So you’re seeing inter-month volume volatility, or a volume pattern emerging. And the only conclusion, I think, you can draw from that is there are people who are big consumers in this category, they’re just running out of money, starting at the end of the month.

And you’ll recall, during the month of June and in part of July, the Congress stalemated over extending unemployment benefits for a large number of people. We saw that in our business in soft volumes. So that’s really my concern about the category is that there are still a very large number of households in the U.S. who are very constrained in terms of disposable income, and they’re cutting back wherever they can. And they’re not cutting back just one category, they’re trimming around the edges everywhere. And we see soft category volumes. – CEO Gregg Engles

Conference Call 2nd Quarter 2010

This strange pattern in a basic good that only just recently started being deeply discounted by retailers to drive traffic does not speak very well of the  consumer’s economic prospects. Consumers constrained, businesses hoarding cash, banks not lending yet, government tied up … The only glimmer of hope from this conference call:

And I think as Gregg mentioned in his prepared comments, we do see, to some degree, bifurcation of our categories. Our more premium categories are growing. Our more value-oriented categories seem to be flat. And so I think, we’re going to continue to see that as we move forward. I think the recession has affected different classes of folks in different waysCOO Joseph Scalzo

No Position

Turnaround Cases: Penn Traffic ($PTFC)

Let’s make a break with the Premier Exhibitions series. While doing some well deserved procrastination, I crossed paths with Penn Traffic Co a supermarket chain filling for chapter 11 a couple of days ago.

Retail is combat sport. Having worked for a very successful and admired retailer I learned to never start a retail business and to avoid investing in one. Why not?

Another big problem with retail is the transparency of the business. Sam Walton spent thousands of hours inside his competitors’ stores. It’s virtually impossible to have any trade secrets in retailing. Your competitors can walk into your stores and, in about 15 minutes, understand your entire business-model advantage and how to replicate it. There are very few industries that are as openly transparent, and that’s problematic for the long-term investor. – Pabrai

Large retailers are constantly trying to pick the next good location while running out of space to grow, with the competition right behind them, and paranoid of the possible appearance of a new demographic trend. “Location, location, location” and “retail is detail” does not seem too much of a competitive advantage. Because of this, retail is a low margin business with little margin for error.

It is also a business that heavily depends on the trust and credit of its suppliers. Suppliers do not want to be the last one standing with distressed receivables so in difficult times retailers can suffer the equivalent of a bank run and swiftly collapse. This makes turnarounds in retail particularly difficult.

After that nice intro you might wonder what intrigues me about Penn Traffic. Actually, it is a very good case study of what you want to avoid in a turnaround investment: a marginal business in a difficult industry. But it may also be, and may is the key word, a liquidation opportunity. To get up to speed you can find a couple of good VIC reports here and here. (subscription free)

Penn Traffic is what I call an unrepentant alcoholic with their third trip into chapter 11: not an unusual record in retail. The reasons for their problems are the two Ws: Wal Mart and Wegmans, two of the strongest retailers out there. Meanwhile, Penn Traffic has to compete with a unionized work force and small stores in suburban locations (approximately 35K ft per store).

During their previous chapter 11 they sold Big Bear their crown jewel: a bad sign. Asset divestments are common in turnarounds but you want the company to sell their marginal assets not their core. If they were forced to sell their core assets, it is very probable that their marginal assets were un-sellable.

I would say that at its current stage, Penn Traffic could still be interesting as a liquidation play and as a potential case study on the margin of safety provided by real estate assets. It still owns 17 stores and 2 shopping centers whose value is not reflected in the books, with a market value probably north of $50 million.

However, we have also to take into account the long term leases. These can be undone or renegotiated in Chapter 11 but I would be much more comfortable if the company manages to sell those stores. In the case of Penn Traffic:


I have not done the heavy lifting yet. However with the leased stores shopped around, hidden assets potentially way north of $ 50 million and still reporting $15 million of book value there might be something there for a company valued at $15 million $1.5 million. Buyer beware, bankruptcy is a highly uncertain process and I am definitely no expert.

Would love to discuss this idea with readers more informed in liquidation plays.

No position

Turnaround Lessons: When the tough gets going

I don’t look to jump over 7-foot bars: I look around for 1-foot bars that I can step over – Warren Buffett

Eastman Kodak should be an eye opener. Some turnarounds are just too tough.

So I decided to go over my watch list and highlight the ones that look difficult and not ready for the prime list. They are guilty until proven innocent: they have to show that things are improving, according to plan not from a stroke of luck, before considering them again. I then went through the list and classified the reasons why I disliked them:

  • End of a Demographic Trend (Gap)
  • Technological Disruption (Kodak)
  • Power Shift in the Value Chain (Newell Rubbermaid)
  • Deteriorating Industry (Mesa Airlines)
  • Threat of New Business Models (Dell)
  • Second in a Winner Takes All (Yahoo)
  • Quantity, Quality and/or Structure of Debt (Anthracite Capital)
  • Marginal Player (too many to mention)

Let’s leave the point of quantity, quality and structure of debt for a future post since it merits its own discussion. The commonality among the rest is an external threat to the core long term profitability. That makes them tough:

  • Success is not entirely dependent on the company
  • Even good management performing at its best could fail

To enter new industries, launch new products, develop new capabilities, change business models is risky revolutionary change. Here are some Bain & Co estimates on the probability of success of different radical solutions to a deteriorating core business

Core

The prospects do not look so bright when you consider that for most of these companies, failure means their core business declines into oblivion. Also many of them may not have clients, hidden capabilities, or platforms to leverage.

A good financial position, like Dell’s or Yahoo’s,  can give them time to experiment and look for alternatives. But from the point of view of an investor even if the plan is successful the company will probably be a follower in the new industry, product, segment, business model: a shadow of its former self.

So the downside is not that well protected, the probabilities of success are not that good, and the upside will probably be limited: does not look like the recipe for successful investing. This is an area where I think value investors have to be careful.

The first time I heard the term value trap I could not understand what it meant. Why not simply call it a mistake?

I think I can now define one specific situation for a value trap: a good company, facing deteriorating profits forced by external forces, with a good management team, hoping  to save the business, but that is taking too much of a gamble on a low probability plan.

Maybe this framework could be the start for a checklist on recognizing potential value traps, and put them at the level of others potential mistakes that need an extra margin of safety.

Did I depress you enough? Over the next posts I hope to brighten the spirits.