6 Warning Signs a Company Is Quietly Dying (Part 2)

0:00So last episode, we were diving into like this type of business autopsy type thing, just suggestions that Andrew and I have for how you can look at businesses from the past and try to learn how to decipher the companies you're holding if they are going to end up dying on you. The last episode we talked about things, is management trying to make really pretty optics? Are they sounding super political? We talked about things like, is discounting becoming the normal for the business? Are they discounting everything all the time to try to make up profit margins? And so we are going to continue this conversation today.

0:40So I hope you're excited about it. I am. Buckle up. Here we go.

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2:50Stephen:You're tuned in to the Investing for Beginners podcast. Investing for Beginners podcast. The show for the long-term investor. We cut through the noise to focus on what works. Compounding, discipline, and the conviction to buy wonderful businesses and stick with them. Your path to financial freedom. Start now. And welcome back to Investing for Beginners podcast. My name is Stephen Morris, and he is the doctor, Andrew Saylor. He's not really a doctor. I don't know. Are you? No, you're not. You're just an engineer. Anyway, we got Andrew Saylor with us, and we are going to continue our conversation on business autopsies.

3:37and Andrew brought up a point last episode and again if you haven't listened to that go back and listen to that first so you so you're not lost in the sauce but Andrew brought up a really good point in that episode that autopsies are really something we don't do as a norm even in like our as after he said that I got to thinking about it even in like my own personal life it's rare that i'll sit back and look at something and try to figure you know whether it's just a mundane task like cooking dinner like how did i do how can i get better at it a lot of times it's just it is what it is and you move on with your day and i am not suggesting by any stretch of imagination that this becomes something that you do for every single thing you do but i think when it comes to our investments, our portfolio, this is a super important thing to understand and make sure that you are in fact buying businesses that are healthy.

4:38Stephen:So you ready to go, Andrew? I am ready. Fascinating topic, depending on who you are. Everybody wants to learn how to make money. Nobody wants to learn about how things can go wrong, but that's what we're here for. So let's do it i mean that's a good point talking about things that can go wrong like that that's to me it's foolish not to because it is reality and you know what is he called um murphy's law when you don't prepare for it it can and will hit you so um what is murphy what can happen will happen or something like that yeah so i mean the best way to to hedge your bet i guess for me anyway is to talk about these things understand them and so jumping into the next symptom that we want to talk about uh straight into it is a debt and dilution um You know, there have been companies in the past, and we have a couple examples today of that, where debt became their strategy.

5:53And, you know, I'm sure you guys have heard me use the term using a credit card to pay off a credit card. I don't know if you've ever tried that in your personal finance. It doesn't work. Spoiler alert. It's never going to work. And I mean, there are companies where, unfortunately, this becomes their strategy. And then, you know, eventually that debt starts to get into the high interest debt. And then the next thing you know, the company's just burning cash, trying to get out of that situation. But as their debt rises, their margins start to fall. and Andrew we know that when margins start to go away it's never looking good for that company.

6:45Stephen:Yeah this D &D you mentioned like the debt and the dilution these are the sneaky ones that is not going to show up on the nerding's call it's not going to probably even show up on the headlines or anything like that it's usually after the fact you kind of look back and you realize oh wow there's some scorched earth there there are some serious things that have happened. And both of those are very serious. Dilution is one of those things that the company can still be fine. And it's only the shareholders who are feeling the magnitude of that. And then to your point about the debt situation, markets can be very liquid for a long time.

7:27Stephen:You can issue bonds for a long time, but every once in a while that market seizes and it freezes up. And one of the examples I like to talk about, and I don't think I mentioned them in a while, but if you look at Washington Mutual, when that bank, was it? Yeah. WAMU. Do you recall that? No, I do not. Okay. Yeah. So Washington Mutual, I think they were based out of California, but if you look at their financial history, yeah, their bank, they had a lot of debt, but they had a big waterfall, big balloon. That's what it's called. The finance term is balloon, but they had a big balloon payment come up.

8:09Stephen:Couldn't pay it. Coincided with the great financial crisis. Perfect time to be owing a ballooned amount of debt. And sure enough, they got wiped out. So again, it's smooth sailing, but when things get tough, debt is not the thing that you want a company to have too much of. absolutely i one of the good examples uh that i have that i know of is toys r us and again this is another company um i think you're old enough to remember do you remember toys r us are you old enough oh yeah so i mean i remember when i was a kid man like toys r us was the place and you know i was super mad my mom and dad if they didn't buy my christmas presents at toys rs like for some reason that mattered and um because gi joes are different at toys rs than they were at walmart um but toys rs is a great example of that they got into they got over leveraged.

9:14And then when things like Walmart really started to take hold in society, and then the ever invasive internet started to creep in, they were so over leveraged on the debt end, they couldn't invest in the e commerce. And they couldn't invest to compete with Walmart and target and you know the such so i mean that that's just one way of not staying uh like we talked about earlier not staying liquid that's just another way that that can absolutely wreck your business and with toys r us i could be wrong but if i remember correctly it happened fairly quickly um one minute they seemed fine and like you said it was kind of a blindsided shock for for most people because we didn't see it coming uh uh what was it kmart is that the one the discount retailer that died i think it was kmart yeah kmart like we all kind of saw that coming um you know over the years just getting worse and worse and uh stores started disappearing um even in in some of like you know the fast food chains we we hear about you know they're cutting x amount of stores or whatever so i mean we can kind of see those signs the the their death may be imminent but with toys r us i don't think that it was that that was the case Now, it's hard to remember.

10:54It was a long time ago. But I mean, like I said in the beginning of this, it's one of those those chains that's like, man, it's Toys R Us. They're a giant. They're not going anywhere. And then sure enough, bye bye Toys R Us. And it sucks too, Andrew, because our kids now miss the amazing experience that was going into a Toys R Us. so did they have commercials like how did they brainwash child steven oh definitely the commercials with the giraffe i can't remember his name oh okay yeah yeah well uh what was his name i gotta keep talking i gotta google it and figure out what his name was

11:41it was jeffrey the giraffe how did i forget that but uh yeah oh definitely the the giant giraffe playing with the toys the new toys with the kids heck yeah the commercials got me man

11:55Stephen:that's funny when ronald ronald mcdonald and jeffrey the giraffe were fighting for market share all right so i mean but that's definitely a classic case of getting over leveraged letting the dead destroy you and i think the the key here is they didn't see the the at least they They may have saw the e-commerce coming, but by the time they saw it coming, it was too late. And, you know, that's how a company can just get so far behind the eight ball. And once that's happened, you know, like Warren Buffett said, turnarounds, never bet on a turnaround. They very, very rarely turn. Yeah, I mean, some situations is like the debt comes after the struggle.

12:43Stephen:And in others, it was the debt that kind of toppled something over. So you do have to be careful. One of the benefits to buying a company that's bigger is they have that access and that can be an advantage, especially if they buy them a couple of years to catch up with the competition, make an acquisition or things like that. But if management's asleep at the wheel or if they just, for whatever reason, lose that fight, to your point, e-commerce, it's just one of those situations. So just because a company is big and just because you buy it and it's as popular as Jeffrey the Giraffe does not make it a good investment, you have to also, I think, as investors, we can learn to also analyze the competitive landscape and try to figure out which competitors really have the strongest most, the strongest competitive advantages, and which ones maybe don't have them as strong and might see further.

13:43Stephen:market share decline. Yeah, that's a great point. I love that you brought that up because that is a prime example of why moat is so important because you could have definitely seen like as you're looking at Toys R Us's moat, you could have definitely seen the creep of Walmart and Amazon as those things started to take hold in society. And I'm sorry, like, I don't care how awesome you are you you can't compete with drastically discounted prices eventually that's going to catch up to you and so i mean yeah that's a great point are there was there any other company that comes to your mind uh that just got over leveraged and ultimately ended up crushing them i mean i i think we can find a bunch of them um there's not one that screams out at me at the moment, but I do double down on what you said.

14:46Stephen:One of the things I think value investors particularly can get caught up in is if you're so focused on balance sheet, cash flow statement, income statement, and you look, oh, this company looks so cheap. If you're too focused on that company and you're not looking at who's emerging, even if their growth sucks like a Walmart, you still need to do the work to analyze those to see if they might take share from somebody like a Toys R Us. So that was one of the things I know I fell into early on, and I'm trying not to make that mistake again. And it's also more fun to analyze gross stocks. I don't know.

15:23Stephen:It's more fun. Definitely. What about Krispy Kreme? You go using high interest to buy out their, what's the word, franchise? Their franchisors? Yeah, yeah, yeah. What if you could get a 25 % match on every dividend you earn? Well, now you can. When you earn dividends on the Plink app, you'll receive a 25 % cash boost up to$250 bonus per year. That means if you earn$1 ,000 in dividends, that's$250 more in your pocket. Your bonus can be taken as cash or reinvested, giving you potential to grow your earnings. No opt-in, no extra steps. As long as you own eligible dividend-paying stocks, ETFs, or funds on the Plink app, your dividends are automatically boosted each month.

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17:40Stephen:I use this and you should too. Check your health the way I do. Function provides 160 plus lab tests for a dollar a day and member pricing on MRI and CT scans. Join at functionhealth.com slash beginners or use gift code beginners25 for a$25 credit toward your membership. What's the best way to get started in the market? download my ebook for free at stockmarketpdf.com. Yeah, we should talk about that one. So I did do a blog post on Krispy Kreme a while ago. They did a couple things that really caused their stock to drop. But essentially what they did is they had a franchise model. If you're familiar with the franchise model, it's supposed to be capital light.

18:21Stephen:So basically, if you take a Domino's pizza, the stock you buy, the Domino's stock, They just really own the brand and some of the marketing and the people who actually are running the restaurants, the operators, they own that restaurant unit. And then they send a royalty up to the parent company in exchange for being able to use the Domino's trademark. And so Krispy Kreme IPO with that same business model. And then they do an abrupt U-turn and they start burning cash, lighting capital on fire. They end up doing this massive, I don't know if you want to call it buyback. The way they wrote it in the cash flow statement was acquisition of franchise markets.

19:06Stephen:But they basically took the franchisees under their brand and bought them out and said, okay, no longer are you going to stay independent operators. We're going to put you into the fold so we can get more of the profits. But that comes with much higher capital intensity needed. So the way that they did it specifically, which is common for smaller businesses, but still, I think if you look at the scale of it, it was not a good decision. Obviously, in hindsight, the stock absolutely crashed, but they did a revolving line of credit to fund these big acquisitions. And so they did something like 10 years worth of free cashflow and they didn't have much free cashflow because they were, they had a really high CapEx compared to their cash.

19:54Stephen:And so did a huge proportion to that. And you wonder, was it the capital that was burned or was it just wall street, not liking the idea that you're going from a capital light business model to a capital intensive business model, regardless of what it was, I think in hindsight, you can look and say that was a pretty bad decision. And so if you're paying attention to debt, for example, if you're reading the 10K and you see, oh, what is this$122 million in debt that they just added? And then you can start to connect the dots to some of the other things that they're doing in the cash flow statement and that will include you in.

20:38Stephen:So I think that's always a good thing to look at. I think it can help you tell the story very well of where a company's heads at, where the management is going, what they're thinking and what they're doing with the capital that ultimately, whether it comes back to you or not, will likely determine what kind of return you get as an investor. interesting why did did they give a reason why they were doing that why they were buying the franchises i don't know um i did a little bit of a my style of whether we call this autopsy is um more of a forensic guy i'm just looking solely at the hard evidence so i just i pull up like their financial statements i didn't actually i wasn't a good analyst i didn't go and listen in the earnings calls or anything.

21:26Stephen:I apologize. I'm an investigator, not an analyst. No, I was just curious because that does seem, if I had been an investor, that would have definitely caused serious concern for me because like you said, they're going from a very capital light business to a capital heavy business, especially being in the donut space that they're in. And like that's a lot of upfront costs, not to mention you're looking at, you know, having to minimize waste, all that stuff, which I think definitely would be easier to do on a store by store basis than as a as a giant company. And, you know, talking about franchises, we should do an episode on Subway.

22:20Have you ever done a deep dive into their franchises? I'm not. Worst franchise model in the history of franchise models, man. Like, it makes me not want, I love Subway, but every time I like look at how their business is built and ran, it upsets me. But anyway, I digress. No, that's good stuff. So moving on to probably, I think, one of the most important things to identify, but also one of the hardest things to identify when we're doing these autopsies is irrelevance. Is the company becoming irrelevant? And the reason it's hard is because in the moment, like we can look at Blockbuster and say, oh, yeah, they became irrelevant really quickly.

23:13But in the moment, was that, was it that obvious? And I don't think it was because at the time Redbox, you know, was kind of the thing. Netflix was still mailing DVDs to people just getting into the streaming business. And so, I mean, man, I don't know how easy it was to predict. is streaming going to be the new normal and i don't i don't really remember when netflix became a thing um i don't even i don't it's hard for me to even remember red box like i don't even remember those um oddly enough though uh my local kruger still has a red box in it um yeah Yeah, I've never seen anyone use it, though.

24:12Right. But I don't really remember those things taking hold, but I definitely remember watching the blockbusters get boarded up store after store after store. And, you know, the world moves on without them. The consumers move on to the next best thing. And, you know, the new hotness, as we used to say, and the company ends up becoming just that value trap. And eventually they completely disappear as Blockbuster did. And I honestly, in prepping for this episode, I tried to think of ways, good ways we can try to identify this. But like I said, it's really hard.

25:04um i really i really have nothing like solid idea of how you identify this you just have to pay attention that's all i can say well i know that's helpful but i i don't know i actually think

25:20Stephen:it's a good example of some of the simplest things that we say and we teach can be also some of the most profound. So who is somebody that we always quote other than Benjamin Graham, who would be like the second person we quote in your opinion? Warren Buffett. Other than Warren Buffett. Charlie Munger. Peter Lynch. Oh, Peter Lynch. Okay. Yeah. I mean, yeah, those are all, so I guess top four, but what does Peter Lynch always say? He says, know what you buy, right? Like know that company really, really well. And so I remember hearing Professor Domodorn talk about when he needed to learn about Uber, because at the time he was teaching his finance class for students and he needed to do evaluation for it.

26:07Stephen:So what's the first thing he does? He gets his son to help him download the app and order an Uber. And that's such a simple and then he ends up you know like talking to the uber driver and things like that about do you like being an uber driver you know how's the model work but those are the type of things that can oftentimes tell you sometimes it is obvious like uh sometimes it is obvious that using netflix is better than blockbuster for example um to the the consumers that are really feeling that like I look at I don't know how long it took you Steven to move to Spotify but I feel like with how much you're into music you would have been you would have seen why Spotify is a better music platform sooner than other people and that can be in the edge in different stocks when people can see that in different places yeah so when it came to music streaming i started with pandora because pandora was first obviously um and then spotify came out maybe a year or so later and i just like the user interface of it and i like because at the time with pandora and pandora may still be like this i have no idea but pandora was just like a radio station that you got to select the type of music spotify like you could you could download entire albums and make a playlist of albums and so in like they had a better interface like you could actually select the music you wanted to listen to so instantly shifted over to spotify no questions asked and funny enough when I started investing in the stock market, Spotify, and to this day, I still own them.

28:07Spotify was one of the first stocks I ever actually bought. For that reason, I freaking love Spotify. There isn't like, we're recording a podcast. It's like literally the only time in my day that Spotify isn't playing. I would share my rap with you, but it's embarrassing how much I listen to it. Like, so, I mean, it's, you know, like you said, it's what, you know, and even without, you know, cause I hadn't met you, you guys yet hadn't started working with you guys yet. And even before then I was very comfortable buying stock in Spotify. Like you said, simply because I know their business so well.

29:00because I've been with them since day one. And I even have a badge on my account. It's a legacy badge. I don't know how to use it, but I have it. But I was one of like the first X amount of subscribers they had.

29:17Stephen:That's cool. That's really awesome. So if you were tempted, ever tempted to be an investor in whoever owns Pandora, I mean, that's sometimes what it takes. Again, going back to that lesson, don't just analyze the business you're looking at. Analyze who's its biggest competitors, who are the biggest threats, who are the biggest disruptors, and then take an honest look at whether that moat really is strong or if there's simply a better option out there. That's a great example of Pandora compared to Spotify because I just recently found out Pandora is still around. I thought they had completely gone out of business, but they're definitely not as big as they used to be because Spotify, Apple, some of the others definitely took their market share away from them.

30:14And so, I mean, how could you have predicted that Spotify would do that? and like we've already discussed, it was pretty obvious just simply by my reaction. The interface is better. How you listen to music is better. If I feel that way, chances are a lot of other consumers are going to feel that way as well. So then the trick just becomes of figuring out how many of the consumers you believe that's going to be the case. so that's a great autopsy question I guess that you could ask yourself as you're going through it yeah totally agree I like that another another version of just irrelevance that I think really speaks volumes is Bed Bath & Beyond and I never I wouldn't I never liked Bed Bath & Beyond I guess because I'm a guy.