My Due Diligence On Turnarounds

In this blog today, I’m going to be sharing some of my due diligence on turnaround companies. But first, what is a turnaround?

According to Investopedia:

“When a company that has experienced a period of poor performance moves into a period of a financial recovery, it's called a turnaround."

However, turnarounds are incredibly hard to execute, and there are only so many successful turnarounds in the world today. But I will go as far as to say that when a turnaround is executed well, it goes something like this:

Financially distressed (brink of bankruptcy) → Turnaround (Growing revenue + breakeven) → Growth company (accelerating revenue + profitability).

As I’m writing this today, these are companies like Celsius Holdings, XPEL Technologies, Ford, Fiat Chrysler, PAR Technology, and many others. If you haven’t checked out my previous article on Celsius, you might want to do it later on.

Some of these companies have turned out to generate superior returns for their shareholders. So what do these companies have in common? What contributed to their success?

Here’s what I’m going to be sharing. Let’s get right into it.

To Orchestrate A Turnaround, You Need A New Management Team

Most often than not, these companies are filled with poor capital allocators who do not know how to run the company, leading the company to the brink of bankruptcy. Knowing that something needs to change, they often had new CEOs come in to lead the turnaround:

Here are some CEOs that were brought in to lead the turnaround:

• Marvel: Peter Ceuno.

• Fiat Chrysler: Sergio Marchionne

• Celsius: Gerry David and John Fieldly

• Ford: Alan Mulally

• Middleby Corporation: Selim Bassou

• Par Technology: Savneet Singh

• Best Buy: Hubert Joly

• XPEL: Ryan Pape

But…these companies were left for dead

However, before these CEOs entered the company, the company and the stock were left dead. Investors and analysts did not believe they could survive.

• Fiat and Chrysler (before the merger) were on the brink of collapse. Few believed CEO Sergio could save them. Today, the company is worth 10 times compared to when he first took over.

• Before CEO Alan Mulally joined Ford, the business was deteriorating. They were losing money. Stocks plunged to a low of $1.08 in 2008 from as high as $17.34 in 2004. CEO Alan worked hard to raise money and kept the company alive, and this was done during the 2008 financial crisis.

• Article after article predicted that Best Buy would die. That they are unable to weather market changes and low-cost online competition (with Amazon).

• In the early days, Celsius was heavily mismanaged and fell out of the NASDAQ capital market in 2010. New management eventually came in and brought the company out of the woods, and got it uplisted on NASDAQ in 2017.

These CEOs have defied all odds when no one believed in them.

Not All CEOs Have Prior Industry Experience

We tend to assume that these CEOs have prior industry or management experience. But this isn’t the truth.

Here’s a quote by Ian Cassel of MicroCapClub:

“Many intelligent fanatic founder-CEO’s didn’t have previous industry experience. They weren’t taught what was impossible. Their minds weren’t fenced in by conventional norms. They were iconoclasts that intelligently attacked convention. They rose to dominance by trying new things, experimenting, taking calculated risks, and not giving in to the fear of failure.”

For examples:

• John Fieldly of Celsius was a Chief Financial Officer (“CFO”) when he joined Celsius. He eventually succeeded as the CEO of Celsius.

• Sergio Marchionne of Fiat Chrysler & Alan Mulally of Ford did not come from the automotive industry.

• CEO Jeff Bezos previously studied chemical engineering and computer science at University. He was also working in an investment firm before he quit and started Amazon.

• Hubert Joly of Best Buy had spent his career in technology, video games, travel, and consulting. He did not have prior retail experience.

• CEO Savneet Singh did not come from the restaurant industry.

And yet, all of them succeeded.

So while it is great to have CEOs who have prior track records or industry experiences, we can see that in most cases, they do not.

Break-Even

One of the few things that I see in companies during their turnaround phase is the aim to break even. In layman's terms, it is to first survive.

That usually involves companies cutting costs, while also growing their revenue organically. When you become self-sustainable, this leaves you with more options to pursue growth. You could come up with new products, do more marketing, and potentially, even raise capital to do strategic acquisitions.

For instances:

• CEO Sergio of Fiat Chrysler pared-back production levels to meet demand, and eliminated some slow-selling models.

• CEO Selim of Middleby Corp eliminated low-margin products and with no competitive advantage to focus on products that are selling fast.

• Former CEO of Marvel, Peter Cuneo also divested some loss-making businesses; reorganized the company around five operating units; and reduced operating costs.

• Gerry David & John Fieldly rebranded & repackaged Celsius as a premium functional drink instead of a calorie-burning drink (as it did not resonate well with consumers). They remove heavy discounting, reduce headcount, cut back on excessive marketing campaigns, and remove unprofitable products.

• Savneet Singh slowed down sales and focused on R&D and serving its customers instead. Its Brink POS was heavily under-monetized, and prices were raised over time which led to margin improvement.

• When Ryan Pape was brought in, the company was near bankruptcy. He had to reduce headcount, and they never make a single profit. Zero dollars were also spent on marketing, and there was no sales organization. He was so focused on every penny that it ensures XPEL could survive.

Skin-in-the-game

For these CEOs, certain sacrifices are made. From their actions, they tell us about their commitment to making this work and the purpose of running the company.

For investors who had their money on the line, their interests must be well-aligned. After all, there is a high possibility that it could fail.

Here are some examples of CEOs who have made certain sacrifices:

• Alan Mullaly of Ford pledged to take an annual salary of $1 and cut bonuses for management in the wake of a $14.6 billion company loss during the 2008 financial crisis.

• Ryan Pape of XPEL used his own money to pay off the company’s debt. He knew that he will eventually get paid back by the company.

• Savneet Singh had his family move near to the PAR office and had his kids sent to nearby schools.

• Selim Bassoul switched from a high-flying career at Premark to take a pay cut to join “an unknown, not well-run company” in Middleby. He sold the house he just built to buy a large stake in the business, making him the 2nd largest shareholder in the company. He simply can’t afford to lose.

You can see that in each instance, all of them had skin in the game in one way or another, not just in the form of stock ownership.

White Knights

White knights are essentially someone that comes to the rescue of another.

I thought this was important to bring up as I was researching the turnaround of Celsius Holdings.

During Celsius’s turnaround, they were incredibly fortunate to have Carl DeSantis, the largest shareholder and the pinnacle of Celsius's successful turnaround. Carl had an unwavering conviction in its products and had injected funds into the company, again and again, to keep it from the verge of bankruptcy. Being the largest shareholder, he forced the old management team out and leveraged his connection to bring in Gerry David and John Fieldly.

Just imagine the amount of pressure he got from holding onto Celsius while many others deemed the company as a failure. Just a reminder, Celsius got delisted from Nasdaq once.

You could argue that he may have been one of the biggest laughing stocks then, but he sat through the noises, and that was admirable to me. Since then, the company went on to deliver over 1,000% return.

Asset-Light & Scalable Business Model

There was always a misconception that non-tech companies aren’t scalable. However, this is not true at all.

For companies like XPEL, Celsius, and Monster Beverage, the reason they were able to grow and scale so quickly is that they outsourced their manufacturing to third parties. This makes them an asset-light and thus, highly scalable businesses.

The Key To Generational Returns

Some of these companies that successfully turnaround went on to deliver generational returns for their shareholders.

XPEL:

Celsius:

What enabled these returns?

Before that, we have to understand what drives share price, and that is earnings & price multiple.

Let’s take a look at the table below.

In scenarios A and B, you’ll see the difference that both earnings and price multiple play on the share price.

In scenario A, both the earnings and multiples grew by 100% Y/Y. This resulted in a share price return of 300%. However, in scenario B, despite the earnings growing only at 20% Y/Y, the price multiple grew by 300% Y/Y and that resulted in a share price return of 380%, more than scenario A despite growing its earnings much faster!

The purpose of this exercise is to show that price multiple expansion also plays a crucial role in the share price appreciation. And in an ideal investment, we want to have BOTH growing earnings + multiple expansions.

This also explains why a great company that is overvalued does not necessarily make a good investment. When multiples are high, chances are, lots of expectations have been priced in. This is why the great Warren Buffett insists on a margin of safety.

How these companies multiples have expanded (according to TIKR):

• Celsius Price-to-Sales (“P/S”) rose from 2.97x to 13.07x today (+340%)

• XPEL P/S rose from 0.64x to 5.48x (+756%)

• Ford’s P/S rose from 0.1x to 0.41x (+310%)

Conclusion

However, investing in turnarounds is incredibly tough.

This sort of investment requires a different temperament, unwavering conviction, and the ability to stay true to your investments knowing that this journey is incredibly lonely, and filled with constant doubts & uncertainties. Furthermore, the market will constantly remind you of how wrong and how stupid you are.

However, if your assessment is right, you have a chance to make what’s called a “hall-of-fame” return (This term was introduced to me by one of my friends).

Alright, let’s wrap it up here.

Here’s a recap of what I have covered so far:

• How turnarounds require new leadership

• These new CEOs do not necessarily have prior experiences

• These CEOs tend to have high skin-in-the-game

• The key to a turnaround is often to breakeven first

• Importance of white knights

• The misconception that non-tech companies are capital intensive and non-scalable

• Finally, price multiple expansion plays a key role in generating “hall-of-fame” returns.

Now, you may be wondering, what’s the point of me coming up with this blog?

It is to develop pattern recognition. And also by doing so, I can share my due diligence, hoping that it benefits you. I will be updating this list as I go, so be sure to check it out.

I will also appreciate it if you could subscribe and share this with the people around you. If you like to see more of my work, head to SeekingAlpha and follow me on Twitter. Till then, stay tuned!