Underperformance - Part I

“It's early days. A few skeletons are bound to keep jumping out of the closet.”

Alan Moore, Watchmen

Overview

Joann, a craft retailer, recently announced that it would be filing for bankruptcy in order to effectuate a restructuring of the company. On the surface this is not a particularly noteworthy development. Retail as a sector has had more than its share of struggles. Many retailers, facing rising costs, lagging growth, the need to meet consumer omnichannel expectations, declining foot traffic, and unsustainable levels of debt, have pursued restructuring (both in and out of bankruptcy court) in recent years. The sector is troubled, and its challenges continue, with a large number of retailers considered to be at risk of bankruptcy in the near future.

In the case of Joann, however, the story is more complicated. The company had only recently emerged from a prior bankruptcy filing. On March 18, 2024, the company filed for chapter 11 bankruptcy, and it emerged with a confirmed plan of reorganization on April 25, 2024. In short, Joann lasted just over 300 days, from one bankruptcy filing to the next. This is abnormal.

Notwithstanding the morbid curiosity that attracts lurid interest in car crashes and other can’t look away incidents, it is fair to ask why the situation at Joann should matter for those fortunate enough not to be a party to this particular mess. The answer is that Joann’s struggles are illustrative of a tendency of financing underperformance to persist and for underperforming companies to be their own worst enemies, consistently defending an unsustainable status quo and rigorously pushing back on any initiative aimed at creating a new, and value accretive, equilibrium.

What is a useful way to think about underperformance? What tendencies keep companies stuck in a rut of chronic underperformance? How can leaders guide companies out of the rut of underperformance? Let’s dig in.

The Nature of Underperformance

Underperformance is not a prison sentence, doled out maliciously to otherwise virtuous companies and their leadership. Rather, it is more akin to the suffering of the penitent who has forgotten that the hand which brandishes the scourge is their own. It is foremost a mental prison, built brick-by-brick of critical assumptions which evidence whispers no longer apply but which fear insists still hold sway. 

Some key points on underperformance:

· It is often rooted in fear. The ambiguity of new paradigms haunts the underperforming company, with the comfort of the status quo and the uncertainty of change standing out as the imposing Scylla and Charybdis of this dynamic.

· It is prevalent. In a recent research paper Edward Altman (NYU), Rui Dai (Wharton Research Data Services), and Wei Wang (Queen's University) examined global “zombie firms”. The team utilized multiple criteria for defining a zombie firm, but the definition I favor considered a firm to be a zombie if the three-year moving average interest coverage ratio (EBITDA / interest) was less than one. Essentially, if profit is consistently insufficient to cover interest expense, the company is a zombie. By this definition, in 2020 19.5% of U.S. publicly traded companies qualified as zombie firms (see Exhibit A). As noteworthy as that finding is, back of the envelope math suggests that the number of zombie firms in the U.S. lower middle market could be staggeringly high (see Exhibits B and C).  

· It is a signal. Like pain in the human body, underperformance is a signal to a complex system that something is wrong, and that the status quo is unsustainable, perhaps even harmful.

· It works slowly. The Altman et al research paper found that 15.3% of U.S. zombie firms filed for bankruptcy eventually, with the average time to filing being nearly 4 years after the company achieved zombie status. This implies that on average, a publicly traded zombie could spend seven years or more limping along before eventually restructuring (for smaller, non-public companies it is not hard to imagine some sustaining themselves in this state for far longer).

· It is sustained by stubbornness. Underperformance can be understood as a value destructive equilibrium in which key decision makers are playing the wrong game and refuse to stop.

Exhibit A: Zombie Firms (Publicly traded)

 Exhibit B: Zombie Firms (Est. U.S. lower middle market)

Exhibit C: lower middle market estimation methodology