About this time last year, GT Advanced Technologies announced its surprise bankruptcy filing. The company was known for its enthusiastic shareholders that had the zeal of the St. Louis Cardinals fan base, and stood to make shareholders a lot of money by manufacturing the sapphire glass that would be used in iPhones and Apple watches across the world. When GT Advanced missed a production deadline, Apple switched suppliers and simultaneously demanded debt payments from GT Advanced. The sapphire glass manufacturer created the Bill Buckner mistake of going deep into debt against the company that also had full control of its earnings.
In the aftermath of the bankruptcy, I received quite a few e-mails from readers asking what kind of elements can signal a threat to a potential investment before the benefit of hindsight kicks in.
Aside from valuation concerns, a bad investment occurs when: (1) a company has bad management, (2) a company has a poorly leveraged balance sheet or something problematic in the capital structure, (3) some headwinds or a megatrend threatens the core business model, and/or (4) loss of market share due to self-destructive actions or rising competition.
Those four elements are how you can make an investment that goes bankrupt. Other things fold into those elements. Share dilution is the result of bad management and something problematic in the capital structure. Deteriorating profit margins can be the result of mismanagement, headwinds, or competition. And changing consumer preferences could be the result of headwinds, self-destructive actions, or rising competition.
Using those elements as our North Star, let’s take a look at a company that is destined to doom shareholders although the eventual moment of wipeout may be years or decades in the distance.
Let’s take a step by step look at Men’s Warehouse. At a superficial glance, it seems like a fair candidate for investment. It has existed in the present form for a quarter of a century. The Jos A. Bank and Men’s Warehouse brand, as well as that of Moore’s in Canada, seem to have decent brand awareness in the clothing industry. The company is profitable to the tune of $140 million per year, and has always generated positive cash flow per share. It has been an excellent investment, trouncing the overall market with 15% annual returns since 1992.
If you made decisions based solely on past and current conditions, you would conclude that Men’s Warehouse might be the kind of stock you’d want to buy and hold. It certainly doesn’t look like something that is going to cause shareholders pain.
But when you analyze Men’s Warehouse according to the Four Factor test, the company looks much less attractive as an investment.
The “Buy 1-Get 3 Free” sale popularized at Men’s Warehouse was not good for shareholders. It reduced profit margins from 15% to 10%, and the sales gains did not offset the lower margins. Men’s Warehouse made $2.73 in profits in 2007, and is only expected to make $2.90 this year.
Even worse, the management team has been candid in saying that it can’t sell formal wear and rent out tuxedos during recessions. The current 2007 through 2015 period, which measures Men’s Warehouse during periods of fair/good economic conditions, has not delivered impressive earnings results.
Things get much worse if your measuring period focuses on the performance of Men’s Warehouse during recessions. Profits of $2.73 in 2007 fell to $0.86 in 2009.
The reason why I care about recession performance is because the company’s balance sheet is incredibly highly leveraged, especially in light of the Jos A. Bank acquisition. It has $2.3 billion in long-term debt. That is absolutely unacceptable for a company that is only pumping out $140 million in annual profits.
And it’s actually worse than that:
Because Men’s Warehouse barely has an investment-grade rating, it has to pay high interest rates on its debt load. In the next five years, this $2.4 billion debt load will require a cumulative $650 million in interest payments. Between now and 2020, the company will have to pay about triple this year’s profits in interest payments alone.
And secondly, Men’s Warehouse is one of those company that has what is commonly called “off-balance sheet obligations.” This refers to money the company owes, but doesn’t report directly to shareholders when it releases its earnings figures.
Remember how I wrote in the past that McDonald’s is a great company because it owns all of its real estate company, and shareholders in McDonald’s essentially own giant annuity streams that collect percentage-of-revenue fees from franchises and rent payments from its locations?
Well, Men’s Warehouse is the opposite of that idyllic situation. It does not own any of its properties, and currently has $1.3 billion in contractual obligations for the property that it rents. This may not be reported on the balance sheet directly, but it costs shareholders real money.
The only way to learn this information is by reading page 45 of the Men’s Warehouse annual report. You will see that Men’s Warehouse also needs to come up with $262 million this year, $434 million between 2016 and 2018, $296 million in 2019-2020, and $361 million after 2020 to make its rent payments. These are very real obligations, and reinforce why it is important to read the company’s financial information before making an investment (though the $2.4 billion in regular debt on the balance sheet may have been enough to keep you away).
And then, there is the question of headwinds and megatrends that threaten the business model.
Men’s Warehouse has frequently expressed the concern that the American workplace and formal events like weddings aren’t quite as formal as it used to be. Even as recently as the 1990s, Men’s Warehouse would mention in its annual report that young boys and girls attending religious schools would get outfitted for the year because the school dress code frequently required coats and ties. The idea that a sixteen year old boy would get a full wardrobe at Men’s Warehouse is not part of the business model anymore.
The other megatrends affecting the company are the general declines in workplace formality and the decline in formal weddings that require tuxedos. Over the past twenty years, the percentage of Americans wearing a tie to the office has declined by 2.5% annually. Current estimates have that figure trending towards 3% annually. Traditional weddings that demanded tuxedo weddings led to a 10% decline in rentals during the past year, although the five-year figure only shows 1.5% annual declines in demand.
This reminds me of cigarette shipments where the core product seems in general decline, and advances in the population are not adequately making up for the percentage point drop. The only problem is that selling suits and renting tuxedos only generates about a third as much profit per dollar as selling cigarettes. I think it is entirely fair to wonder, “What exactly is the core market of Men’s Warehouse going to look like over the next fifteen years?”
And lastly, there is the element that includes rising competition. At least publicly, Men’s Warehouse has not acknowledged that online tuxedo rentals are posing a threat to its business models. The Black Tux and Menguin currently have 3% of the tuxedo market, and the trend towards online renting of tuxedos may be accelerating as George Zimmer launches zTailor to send tailors to your home and also provide online rental options. Zimmer was the ousted head at Men’s Warehouse, and seems hungry to re-establish relevance in the world of formal clothing.
These online tuxedo options will put a dent in the Men’s Warehouse business model. Procter & Gamble was slow to take seriously the threat of Dollar Shave Club and Harry’s, which now combine for a $1 billion valuation. Gillette was belatedly responded by launching the Gillette Shave Club. Hotels have been slow to recognize the threat of airbnb, which has limits on its rapid growth because many non-urban homes have covenants that prevent homeowners from taking on commercial weekend renters (though there are plenty of people willing to risk it and rent out part of their home’s on the down low).
The online tuxedo rental options seems to most closely resemble where the Dollar Shave Club was three years ago–it is in that stage where it is starting to take market share but does not have quite enough heft yet to be considered a significant player in the industry. But while the Gillette brand is strong enough to tolerate management fumbles, I am more skeptical that the Men’s Warehouse brand has the strength to ward off a more attractive online option.
Warren Buffett was correct when he stated that the investors of today do not profit from yesterday’s growth, and it is the future gains of the business that will be the primary determinant of investor returns. I picked on Men’s Warehouse because it is an example of a company that does not self-evidently appear to be a bad investment based on past history and current reporting figures, but the picture is much bleaker when you analyze the kind of factors that can eventually drive a company towards bankruptcy 10+ years down the line.
Men’s Warehouse does not have an effective sales strategy right now, nor does it have product offerings that create strong brand loyalty. The debt on the balance sheet is staggering, and is even worse when you consider the totality of its off balance-sheet burdens as well. This is not a company that performs well during periods of economic hardship. There is also a trend towards anti-formality in the workplace and for special events, and Men’s Warehouse faces the task of fighting this headwind/megatrend while also keeping at bay the rising threat of online tuxedo rentals.
Uninspiring management, super leveraged balance sheet, poor cash flow in bad times, industry deterioration, and competition offering better convenience are the risks facing Men’s Warehouse, and these are the elements that lead to terrible investing results when you find them in a company.
Originally posted 2015-09-15 11:43:31.
