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Posted on 29 Jan 2018 by Alvise Peggion

Why Declining Businesses are Hard to Stomach

Why Declining Businesses are Hard to Stomach

 

Forget pizza, bruschetta, risotto and pasta. What I most miss about Italy is mortadella, a pork sausage flavoured with spices and pistachios. It may not be fancy but it is loaded with flavour, and great childhood memories.

What, then, to make of Felsineo, the leading mortadella manufacturer, offering a vegan option – of a pork sausage, no less – sold under its traditional label?

The decision could be seen as either bold or stupid but Felsineo had little choice. As Italy’s population ages, demand for meat is falling. Younger Italians, meanwhile, are increasingly choosing a meat-free life. Eurispes, estimates that 7.6% of the population is either vegetarian or vegan. And meat-eating Italians are buying higher quality cuts. Sales of cured meats like mortadella fell 5% in 2016.

Felsineo is desperately trying to fight a slump in sales, which is proving more structural than cyclical. It’s a challenging task, although successfully investing in a shrinking business like Felsineo may be even harder.

Different strategies

Overcoming structural change is possible. Netflix (NASDAQ:NFLX), which once sent out DVDs in cardboard envelopes and now streams its own content across the Internet, proves it. But it’s a rarity. History shows that established firms struggle to reinvent themselves.

Changing what has worked for decades takes courage, especially if it causes sales to initially fall faster and costs to rise for years. Genuine innovation is more likely to come from newer and more agile firms with no preconceptions, no history.

An alternative path is to fight structural change through diversification. This, as in Felsineo’s case, involves expanding the product range to ‘adjacent’ categories and markets. It seldom works though, as all challenged firms end up doing the same thing, competing fiercely with each other.

A third path is to acquire businesses in unrelated industries, much like Fairfax (FXJ) bought Stayz, an online accommodation portal. This is risky. Successful acquisitions are generally opportunistic and not motivated by need.

None of these options are attractive. So, if a firm falls victim to structural change, why not just shrink?

For investors at least, this makes sense. The best managers are those that allocate capital most efficiently, not those that try to predict future trends. After reaching maturity, often sitting back and focusing on cashflow is the low risk option. In practice, though, it rarely happens.

Shrinking is preferable but hard

When sales are falling, fixed costs have a growing, adverse impact on profitability. And there is only so much that a firm can cut expenses. Again, Fairfax proves this point.

At the same time, directors and managers don’t want to oversee a contracting business, often because their fees and salaries are dependent on growth. Owner-managers, meanwhile, tend to take pride in the longevity of their companies to the point of even denying their businesses are in trouble. Gerry Harvey, the founder of white goods retailer Harvey Norman (HVN), comes to mind.

Declining businesses tend to first resist structural change. Then, when it’s too late, they try frantically to fix things up with ill-conceived new products or foolish, overpriced acquisitions.  Either way, shareholder value is destroyed. This is why declining business make for such difficult investments.

When we invest in such businesses we don’t expect them to turn around. We look for alternative sources of value unrelated to the core business that might be hidden within them.

The International Fund’s recent investment in set-top-box manufacturer Technicolor (ENXTPA:TCH) is a good example. The stock is discussed in detail in our December quarterly report. But if you can’t find a reason like this to invest in a declining business, best steer clear.

 

Why Declining Businesses are Hard to Stomach
Why Declining Businesses are Hard to Stomach  Why Declining Businesses are Hard to Stomach  Why Declining Businesses are Hard to Stomach  Why Declining Businesses are Hard to Stomach

5 thoughts on “Why Declining Businesses are Hard to Stomach

  1. Although it may not automatically come to mind given the current span of its operations Amazon is another example of a business that was able to able to pivot from a declining business (the sale of physical books) to a growth business (ebooks and of course everything else since). It takes a long term oriented and customer focused CEO like Bezos to tell your employees to come up with something that will effectively kill your most profitable line of business. Both those qualities are in short supply among Australian corporates.

    I would however respectfully disagree that shrinking is the best thing for shareholders. Taking the capital and investing it elsewhere successfully is best (think Berkshire using cash from the textile business to businesses in insurance, banking, consumer industries etc). Unfortunately, this too is an uncommon skillset.

  2. Thanks Alvise – insightful piece.

    Netflix was indeed an exception, but for good reason. From what I have read, Reed Hastings knew (or believed) the world was going to move to streaming as far back as the late 1990s when they were still ramping up their DVD mail-order business. So he always had a long term strategic plan to pivot to online when the time was right. This farsightedness is seldom the case with incumbent businesses, and probably helps explain why Netflix was one of the few companies that succeeded in doing so.

    In nature, if the environment changes, either previously incumbent species need to rapidly adapt & evolve their DNA to be better suited to the new environment, or alternative species that are ‘lucky’ and are already endowed with genes more adapted to the new environment thrive and grow and displace former incumbents. Nature suggests that the latter tends to succeed far more often than the former, and the same is true in business.

  3. Sensis is an example in this regard. 6 years ago I was chatting to a manager there whose attitude was, “Clearly we are a business there won’t be much left of in 10 years. But in the meantime our core Yellow Pages are cashflow positive. Lets maximise the cash we can pull from this before it dies.”

  4. Of course what they can do is get a “celebrity chef” to start serving Mortadella in their restaurant dishes and charging double the price. Market it as comfort food. The hipsters and foodies will follow;, as will sales and profits.

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