Dead Companies Walking
Page 2
I never got the chance to buy GLM on the way up, because it never went up. Like every other company in the Texas oil patch after the price of crude collapsed, Global Marine’s stock sank faster than a drilling bit in soft bayou mud. And Jerry’s “magic” utilization rate number? It went right down with it. As the oil services industry unraveled, utilization dropped from 70 percent to 25 percent. I don’t think the trend line in the chart Jerry showed me in his office even went that low. A share of Global Marine’s stock was trading under $1 by mid-1985. In January 1986, less than eighteen months after Jerry urged me to “buy, buy, buy,” Global Marine filed for bankruptcy.
I do not believe Jerry was stupid for thinking Global Marine would rebound from its slump. For one thing, he was far from alone. If I gave you a nickel for every person in the energy business in 1984 who believed a big, successful company like Global Marine would go bankrupt within two years, you wouldn’t have had enough to afford a gumball. No one, and I mean no one, thought things would get as bad as they did.
Nowadays, Dubai is the poster child for petrodollar extravagance, with oil-rich sheiks spending billions on crazy projects like man-made islands and indoor ski resorts in the middle of the Arabian Desert. But trust me, Dubai has nothing on Houston in the early 1980s.† On my first morning living there, I woke up to a loud, hive-like buzz above my apartment near Buffalo Bayou. Half asleep, I walked out onto my balcony and watched dozens of helicopters whirring above the choked freeways of the city. A coworker later told me that a quarter of all privately owned copters in the United States flew over the greater Houston metropolitan area at the time. They were there in such numbers because the city’s oilmen all wanted to live like James Dean in the movie Giant. They built custom mansions on ranches the size of small nations and rode thirty, forty, even a hundred miles into town every morning by air.
I’ll discuss the dangers of getting caught up in manias like the 1980s oil boom later. For now, let’s return to Jerry’s misguided, but highly instructive, confidence in his magic rig utilization rate number. It’s an example of a common mistake I’ve seen plenty of times over the years.
There is a good reason that Jerry’s utilization graph didn’t go all the way down to 25 percent—quite simply, it had “never” happened before. I put the word never in quotes because I don’t mean it literally. And that’s the root of the mistake I’m talking about.
Everybody always stresses the importance of learning from history: “Those who don’t learn from the mistakes of the past are doomed to repeat them,” the saying goes. In my experience, most people heed this advice, but only up to a point. They study the past quite closely and glean as many lessons from it as they can. But they almost never look back far enough. They confine themselves to the history of the previous few years, or perhaps a decade or two. In other words, it’s not that people don’t learn from the past. They do—but only the recent past. And that can be a deadly error.
I can’t remember exactly how far back Jerry’s rig utilization chart stretched in time, but it wasn’t more than twenty years. Over that time span, Jerry was perfectly right: Global Marine’s utilization rate had never stayed below 70 percent for more than a quarter or two. But Jerry assumed that just because the trend had persisted for as long as he could remember, or even a good deal longer, things had always been like that. Of course, that was not the case. Looking over a longer period of time, the oil business has suffered numerous catastrophic meltdowns. But because he had never lived through one himself, Jerry—along with everyone else in Houston—didn’t even entertain the possibility that the time was ripe for another one.
It’s a classic mistake in business and in life. Call it historical myopia. We assume the recent past is the most accurate predictor of the future and that the more distant past is less important or less relevant. Yes, as Jerry pointed out to me, business moves in cycles. The energy sector in particular goes up and down all the time. But those cycles are both large and small. Most cycles run their course over the span of months or years. Others take longer to play out—sometimes much, much longer. But that doesn’t mean that those larger, less frequent supercycles, as the academics call them, aren’t just as regular as the shorter ones. They are. Forgetting that fact has gotten a lot of businesspeople, and investors, in deep trouble. In 2011, scores of textile and apparel companies were crushed when cotton prices suddenly shot up. Nobody in the industry hedged against this kind of supercycle event because, as with the equally steep decline in Global Marine’s rig utilization percentage, it had “never” happened before. Of course, in reality, cotton (like oil and steel and every other commodity) has seen numerous large spikes and crashes in the past—just not in the recent past. People didn’t look back far enough, and it cost them dearly.
Investors also frequently fail to look beyond the recent past and not just by trusting shortsighted corporate executives like Jerry. When I started out at Texas Commerce Bank, I practiced Geoff Raymond’s method for picking stocks, called value investing—that is, measuring a company’s stock price against its assets, cash flows, dividend yields, and other fundamentals. As I said, that’s how I discovered Global Marine as a potential investment. But as my career progressed, I started prioritizing a company’s growth outlook over its current value. The reason I began to shy away from value investing was because I noticed that even its most accomplished practitioners often fall victim to historical myopia. They fixate on a company’s recent performance or financials while ignoring larger cycles, trends, and secular changes.
Lunch with Ken
One day early in my stay in Houston, I drove across town to a lunch meeting in the Transco Tower. Transco was a pipeline company, and the lunch speaker was the relatively unknown CEO of a company known at the time as Houston Natural Gas. I glanced at the program and nudged the person next to me. “What do you know about this guy, Ken Lay?” I asked him. He shrugged and went back to sawing at his skirt steak.
A short while later, the familiar whoop-whoop-whoop of an approaching copter shook the room. We all looked up from our plates in time to see the bird touch down on the helipad next door to the building’s conference room. A studious-looking man held his Stetson in place as he deplaned. He made his way into the room and gave an incredibly boring lecture wherein he predicted that energy markets would soon be entirely deregulated. He said that his company, which would be renamed Enron just a short while after this meeting, would one day rival behemoths like IBM and Exxon in revenues.
The guy next to me finished his lunch and immediately nodded off. I desperately wanted to join him, but I fought to keep my eyes open. Lay’s soft-spoken delivery didn’t come close to matching the grandeur of his predictions. He talked more like a librarian than a budding tycoon. But the rhetoric was not surprising. Before the price of oil collapsed, people were making big, bold—dare I say Texas-sized?—predictions like that all over town. Anything and everything seemed possible.
In 2007, a powerhouse private equity consortium backed in part by none other than the great Warren Buffett took on a staggering amount of debt to acquire Texas’s largest regulated utility, TXU Electric Delivery. At a cool $45 billion, it was the biggest leveraged buyout in history. Thanks to historical myopia, it will probably go down as one of the worst investments ever, too.
TXU—renamed Energy Future Holdings Corporation after the deal was consummated—derived a great deal of its revenues by operating coal-fired electricity plants, which it used to supply power to customers in the Dallas metro area. For years leading up to the deal, high electricity prices brought in enormous amounts of free cash flow for TXU, and the company’s management planned to build a dozen additional coal-fired plants to generate even more cash. With demand for power rising every year, and electricity prices following suit, TXU appeared to be a value investment gold mine to Buffett and the company’s private equity buyers. But by focusing on backward-looking metrics like cash flow and elect
ricity prices, they turned deaf ears to two very loud alarm bells.
First, despite the lobbying efforts of the coal industry (and its oxymoronic promise to create “clean coal” technologies), burning coal is still the dirtiest way to generate power, and the political and social climate is not exactly welcoming to new coal-based electric projects. Even in business-friendly Texas, TXU’s plans were quite controversial—and before the acquisition was even finished, the buyout group bowed to pressure from environmental groups and agreed not to build most of the new plants.‡ But that wasn’t the worst thing that happened to the company’s new owners. They were so busy salivating over TXU’s cash flows that they forgot the lesson Jerry and the rest of the executives at Global Marine had learned several decades earlier—the energy industry is as volatile as a live wire, and expecting short-term results to continue into the future is almost never a safe bet.
Even as the ink was still drying on the buyout deal, massive new natural gas deposits were being discovered all over North America. As that huge supply of cheaper, cleaner-burning gas came onto the market, electricity prices dropped drastically; TXU’s cash flows shrank with them. The only thing that did not shrink was the company’s debt load. By 2013, the giant utility was hiring lawyers to handle its impending reorganization.§ In 2014, the inevitable finally occurred. The company declared bankruptcy. As for Buffett, he was his usual honest and humble self. He called his decision to purchase $2 billion worth of bonds in Energy Future Holdings’ “a major unforced error.”¶
TXU’s implosion was record breaking, but it was hardly unprecedented. When I was still in Texas visiting companies like Global Marine, so-called fern bar chains like TGI Fridays and Bennigan’s were all the rage. TGI Fridays even went public in 1983. Its stock sustained a long rally after its initial public offering, mainly because, like TXU, the company generated a tremendous amount of free cash flow. Selling high-margin products always brings in a lot of cash, and there aren’t many products with higher margins than cocktails. Value investors got so drunk on those cash flow figures that many of them missed a sobering reality—the company’s growth was slowing. For a good while, its stock sold at a small multiple of its cash flow, which meant, by value standards, it was still cheap. But one thing I’ve learned in this business is that cheap can be very expensive, and as the fern bar craze waned, those cash flows went as flat as a bad wine spritzer.
The history of the restaurant industry shows that even popular establishments have to update their menus and decors to survive. Casual fine dining businesses almost always fail if they don’t tweak their concepts over time. Even loyal customers get tired of the same old thing, and that was a major problem for fern bars. They were locked into being . . . fern bars. That singular concept was their entire raison d’être, and it was bound to get stale at some point. People who paid attention to TGI Fridays’ growth numbers caught the inflection point when the fern bar fad began to subside. The ones who continued to base their decisions on value metrics like multiples of cash flow waited too long to leave the party and got hammered because of it.
TGI Fridays taught me the importance of growth over value investing. It was also the very first stock I shorted. I was studying the company’s numbers in my cubicle at Texas Commerce Bank, and I noticed that its revenue growth had begun to shrink over the previous few quarters. It was still making a handsome profit, and it was still trading for a low multiple of its cash flow, but it was opening fewer new bars and earnings growth at its existing locations was tapering off. The end of another quarter was approaching, and on a lark, I opened a personal brokerage account so I could short its stock. Sure enough, its revenues missed expectations and TGI Fridays’ share price dropped.
These examples show the danger of learning from only the recent past instead of paying attention to larger, less frequent cyclical patterns. But they’re tiny compared to the most disastrous case of historical myopia this country, and maybe the world, has ever seen. The 1980s oil bust, as bad as it was, was largely contained to a single region. The late 2000s real estate crash almost brought down the entire global economy. And it, too, happened because everybody forgot to learn from all of history, not just the history they could remember.
Rear-Ended
Fast-forward exactly twenty-four years to 2008, in Orange County, California.
I flew into John Wayne Airport and picked up a rental car from the agent at the terminal. It was the middle of January on a beautiful Southern California morning—mid-seventies, clear, and sunny. A pleasant offshore breeze had blown the smog out to sea, leaving the air fresh and clean. To the east, the snowcapped Santa Ana Mountains sparkled in the distance. I climbed into my rented SUV and guided it out of the airport and onto MacArthur Boulevard toward the San Diego Freeway. I checked my watch. I was due to meet executives of a real estate development company called California Coastal Communities (stock symbol: CALC) in a half hour. If there wasn’t too much traffic, I would be right on time.
A week earlier, I had targeted Cal Coastal as a potential short investment. It suffered from the two best indicators of a company on its way to bankruptcy—rapidly shrinking revenues and a quickly rising debt load. It’s simple economic physics. As revenues go down, debt obligations go up, because companies that are losing money have to take on more debt to pay for things like rent, raw materials, and other overhead expenses. Pretty soon, if they keep losing money, they can’t make interest or principal payments to their creditors and they’re forced to go into Chapter 11. Many people, even seasoned investors, misunderstand what bankruptcy actually means. They assume that a company shuts its doors forever the day it files and most employees lose their jobs. But that is often not the case. Bankruptcy is fundamentally about reorganizing a firm’s capital structure, as bondholders and other creditors often agree to ownership stakes in the new incarnation of the company. A lot of businesses emerge from Chapter 11 in better financial shape. (I’ll talk later about former Continental Airlines CEO Frank Lorenzo, who actually used bankruptcy as a management tool.) But one thing never survives the process: the stock price. It goes to zero as a company’s former equity holders are wiped out and its creditors take control. That means contrarian investors like me don’t have to cover our short positions. We make 100 percent on our investment.
Cal Coastal had all the hallmarks of a dead company walking. It was choking on almost $200 million in long-term debt, and its revenues had fallen from a peak of $96 million in 2006 to less than half that in 2007. Meanwhile, sales on its only pending development project—a 110-acre planned community called Brightwater on the Bolsa Chica Mesa near Huntington Beach—were sluggish, to put it mildly. Cal Coastal was planning to put up more than three hundred houses, but so far it had moved a grand total of forty. There was also the minor problem of a Native American burial ground on the property that had sparked some protests and negative media coverage. This was no remake of the movie Poltergeist. This was real.
Despite all of its troubles, shorting Cal Coastal was far from a sure thing. The stock was selling near its book value on the morning I flew in to John Wayne Airport. On top of that, almost everyone in the US real estate and financial industries was optimistically predicting that the housing market would rebound following the enormous rise in foreclosures that began in 2006. I was skeptical of this consensus, but I wasn’t ready to short Cal Coastal quite yet. A quarter century after my first corporate meeting at Global Marine, I was still following Geoff Raymond’s formula: crunch the numbers all you can, but then go see the real people involved before you act. That’s why I found myself in Orange County on that beautiful Southern California morning. I was going to give the company’s management one last chance to convince me that Cal Coastal wasn’t about to collapse.
I pulled my rental car up to a red light and started flipping around the radio for a news station. The light turned green. I lifted my foot off the brake, and just as I started to come down on the gas peda
l, an elderly man in a Coupe de Ville slammed into me from behind.
So much for being on time to that meeting.
The accident was no big deal. Nobody was hurt. The cars were barely dented, and the guy in the Cadillac was very apologetic. Once we had exchanged information, I called the rental company, which sent a new car out to me. But the delay had blown my schedule to hell. The Cal Coastal guys were jammed up the rest of the day. I had no other meetings scheduled, and I was due back in the San Francisco Bay Area that evening for dinner. I was torn. Half of me wanted to just head back to the airport and fly standby on the next departure. The other half was telling me to do something completely different—drive out to Bolsa Chica Mesa and take a look at Brightwater for myself.
There’s a famous, perhaps apocryphal, story from the late 1920s, of Joseph Kennedy listening in horror as the guy shining his shoes offered him stock picks. According to the story, Kennedy knew right then and there that the market was about to tank. I had a similar moment of clarity looking out at the denuded hills and half-finished homes of the Brightwater development. The place was an unmitigated disaster. The company was slapping up chintzy McMansions cheek-by-jowl and charging $800,000 for the smallest, cheapest units. I went into one of the few completed model homes and sat down at the mock kitchen table. Through a nearby window, I could see the house next door a few yards away. I imagined some poor homeowner trying to relax in her kitchen while the drone of her neighbor’s dishwasher came drifting through the window. As for the development’s name, some of the more expensive homes—priced well north of a million dollars—had peekaboo views of the Pacific Ocean off in the distance, but “Brightwater” seemed like a major stretch. Dimwater might have been more appropriate, because you had to squint to make it out.
Up to that point, I had had a pretty strong hunch that the housing market wasn’t going to recover anytime soon. I’d lived long enough to see real estate implode twice before, first in Houston during the oil bust of the 1980s, then in California in the early 1990s. But it wasn’t until I physically set foot on the pale red soil of Bolsa Chica Mesa and saw the debacle-in-progress that I fully understood the magnitude of the downturn we were facing.