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.

4 comments:

  1. +weight watchers (high debt, decline due to internet, but could also be mismanagement)

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  2. Declining businesses are good shorts before everyone else knows they are declining

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  3. PBI is another one which keeps hanging around.

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