Everyone loves a comeback – but why?

“Everyone loves a comeback” – you’ve probably heard that phrase applied many times to down-on-their-luck movie stars or sportsmen trying to mount a career resurgence. But the public fascination with comebacks applies equally to the capital markets. In fact, turnaround stories are a necessary product of how the market works every day: the very nature of the capitalist system pushes the winners to expand and gain share, and the losers to shrink, regroup, and try again (as long as they’re still in business). While of course every situation is a bit different, in general turnarounds can be great opportunities for investors, as whenever a company is radically changing the composition of its business there is a higher degree of uncertainty as to what that company’s future will look like – and hence there can exist considerably divergent views on the future value of a given stock (which allows you to make $$ if you get it right).

Where I differ from most, I suppose, is that instead of looking at restructuring companies as an opportunity to buy businesses on the dip, I instead try to identify situations where the turnaround is either doomed to failure, or will take a lot longer (and be more painful) than the market is expecting. Perhaps I am pessimistic by nature, but I have noticed that investors in general – and the sell-side community in particular – perennially over-estimate the likelihood of a comeback business regaining its former glory. I am not sure if this speaks to the poor quality of sell-side analysts (perhaps), who tend to believe a given company’s managers when they promise a successful turnaround; or perhaps it is to do with the eternal optimism of human nature as it pertains to the stock market (since, of course, over the long-term economies grow and stocks invariably rise). But in any case, as these overly-optimistic expectations are disappointed, the companies’ stocks tend to underperform, and as a result you can make money betting against these nascent comebacks either not getting off the ground, or taking a whole lot longer to get going.

Perhaps a few examples will help demonstrate this idea in practice. One of my largest investments on the short side over the last year has been Elizabeth Arden (RDEN), a beauty company that over-expanded into celebrity/designer fragrances, under-invested in their core brand, and as a result announced in the third quarter last year a fairly intensive restructuring plan to try to clean up the mess. Despite fairly clear signposting from management that turning the business would be long and painful (accompanied by a number of disastrous quarterly reports), sell-side analysts as recently as April this year maintained the same level of expected profitability (ie, EBITDA) for 2016 as they had in September/October 2014 (ie, when the restructuring plan was announced). It was only in recent days – once again, after another horrid earnings report – that the numbers started to come down meaningfully (though I still feel they are too high). I am no longer short RDEN (the stock has fallen ~50% in the last year), but the sell-side’s misreading of the depth of the company’s trough in performance is instructive, and, I think, related to excessive optimism that the business could be resuscitated easily.

There are numerous other examples, many of them in the consumer space. Aeropostale (ARO), the teen retailer, and Quicksilver (ZQK), the surf/skate retailer, have seen EBITDA contract for the last four years in a row – yet looking at sell-side consensus numbers, analysts predict profitability will improve sequentially in each of the next three. This is effectively calling the current year’s earnings the trough – the only problem being that if you look back at historical estimates a year, or two years ago, sell-side consensus similarly called a bottom in the then-current year and of course extrapolated similar, multi-year improvement…only to be disappointed time and time again.

Now, I am not short ARO currently, but it has been trying to restructure its business in the face of seemingly endemic structural challenges (the decline of mall traffic, the rise of fast fashion, a collapse in teen demand for logo product, a move away from denim, etc), and has been closing some stores and restructuring others for years. The story is similar, though a bit more complex, at ZQK (where I am still short as I think it ends in bankruptcy rather soon). I suppose you could argue after years of losses these businesses are bound to turn, but in my experience, capitalism doesn’t generally work that way – both negative and positive trends take a lot of breaking (that is, the winners tend to keep winning: look at Facebook and Twitter for a current example par excellence). As mentioned above, the sell-side consensus was consistently wrong in calling the bottom in both names, even though to even mildly-informed observers the odds of a successful comeback in both appeared significantly lower than their continued deterioration at most all points over the last few years. Why, then, do analysts (and thus the investors subject to their opinions) continue to make life so difficult for themselves and try to call the trough?

The answer is mostly related to incentives and roles in the market. I don’t mean to jump on sell-side analysts too much, but in general their job is to pick stocks to buy, which by necessity involves the hazardous exercise of trying to pick bottoms in restructuring stories like RDEN, ARO, and ZQK. As per the above, this is almost an exercise in futility. To me, it is far easier – and more profitable – to identify which turnarounds are likely to continue ad infinitum or end in tears than to call an inflection point on a struggling or perhaps structurally-impaired business.

There is one main reason why this is the case: often, management will signpost – either implictly or explicitly – that a turnaround will take a while or be quite painful. The example of Sodastream (SODA), the Israeli purveyor of homemade soda, is a case in point. In response to plummeting sales of their home soda-makers in the US, they announced a large restructuring and rebranding of their entire product line – away from soda and towards flavored water – in mid-2014. Such a large transition obviously carried significant risks: the water market is more competitive, has lower price-points (in general), and the company risked alienating its core of home soda enthusiasts in Europe. Furthermore the company would be transitioning from an older production facility in a controversial location (the West Bank) to a newer, more costly one in Israel proper.

To be fair to management, the company was fairly realistic in depicting a many-quarter turnaround, and stopped giving annual guidance (always a sign that the future outlook is probably bleaker than you think). They did not over-promise and under-deliver; but it should have been quite obvious to even casual observers that this was a major company-wide brand relaunch – a complete product overhaul whose success was anything but guaranteed. And yet, the sell-side consensus as of Dec’14 (about 4 months after the restructuring was formally announced) still pegged 2015 earnings (EBITDA) at 2014 levels ($60mm) – basically the all-time earnings peak for the company, and DOUBLE reported FY13 earnings ($32mm).

Fast forward a few more quarters, and predictably, the transition is taking longer, and costing much more in lost profits, than the analysts (but not the company, to be fair) expected. The street now expects FY15 earnings to come in at $39mm (and that number is heading lower), and the stock has fallen another 25% since announcing the initial restructuring. And yet, once again, the inability to execute on the turnaround plan dulls not the belief in its viability (as perhaps it logically should) but merely pushes back to next year (FY16) the sanguine forecasts for recovery (consensus FY16 EBITDA is $51mm at the moment).

Now, I have no stake in the Sodastream story either way at the moment (though I have shorted it in the past) – but it clearly encapsulates Wall Street’s almost religious adherence to the doctrine of the successful comeback, no matter the circumstances. Whether a function of the street’s role as a corporate cheerleader, or the natural optimism of most all market players, this is an opportunity for those willing to weigh the case for a comeback not on the basis of “once it bottoms, how much could it bounce?” but instead, “will it actually bottom or is there more pain to come?” And while still difficult, in my experience the latter question is much more solvable – and more profitable – than the former.

Disclosure: short ZQK, no position in SODA, ARO, or RDEN

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