Dead Companies Walking

by Scott Fearon

  This is what happens in manias. People willfully forget inconvenient facts like arithmetic. Alan Greenspan famously called this phenomenon irrational exuberance, but that was a major understatement. Remember when I said that Costco’s multiple (the ratio of its share price to its earnings per share) scared me away from buying the stock? It was in the thirties. Dotcoms like Webvan and Women.com had infinitely higher multiples than that because they had no earnings. But investors were so hot to believe in these companies—and the great new internet age—that they started valuing them based on page views, or “eyeballs,” as they called it. No, I am not kidding.

  I still have a research report from the brokerage Credit Suisse First Boston on a company called Commerce One. “Conventional valuation measures,” the report says, “don’t capture a revenue stream where the real value is hidden in services yet to be introduced.”†

  That report is from late 1999. I’ve read it dozens of times since then, and I still don’t understand what they were saying. “Services yet to be introduced”? Huh? But this kind of gobbledygook was everywhere at the time. One analyst at Paine Webber tried to talk me out of shorting a money-losing dotcom by repeatedly predicting a price target based on something called its “future terminal multiple.” When I finally asked him what the hell that term even meant, it turned out he had made it up.

  These methods of hyping dubious investment (Commerce One filed for bankruptcy in 2004) were certainly “irrational.” But I wouldn’t say they were based on mere “exuberance.” Once you start making up new ways to value companies based on fantasy scenarios ten years down the road, you’re not just being exuberant. You might as well start measuring your head for a shiny new tinfoil hat, because you’ve officially crossed over into an alternate universe. And yet most people in the valley thought Bandel and I were the crazy ones for being skeptical of this nonsense.

  Sunk

  One month after my visit to Women.com, I parked my car on Brannan Street in the South of Market neighborhood of San Francisco and strolled into the corporate headquarters of a company called Quokka Sports (stock symbol: QKKA). Its CEO was a youthful, energetic Aussie named Alan. He had curly blond hair, brilliant white teeth, and an unusual idea for the next big thing in sports broadcasting.

  “Yacht racing!” he declared to me as I sat down in his office.

  “Yacht racing?” I asked. “You mean, like a bunch of rich guys sipping champagne on a sailboat? That kind of thing?”

  “No, mate!” he laughed. “I mean teams of highly skilled athletes competing in one of the most exciting sports in the world. Let me show you.”

  Alan fired up the iMac on his desk and logged on to Quokka’s website. It showed a sailboat lowering its jib. A couple of other sailboats were behind it. I surmised that they were in some kind of race. But it was hard to be sure. They were hundreds of feet from each other and they looked like they were going about three miles an hour.

  “Is this in slow motion?” I asked.

  “No,” Alan replied with a frown. “This is live. Check this out.”

  He clicked his mouse and the action—if you can call it that—switched over to a close-up of a crew member on one of the boats turning some kind of spinning handle. (I’m sure the thing has a special nautical name, but like most Americans, I don’t know a thing about sailing.) Alan clicked his mouse again, and the screen switched over in quick succession to the view at the top of the boat’s mast, then behind the helm, then alongside the hull, almost down at the waterline. The last camera angle Alan showed me was from a buoy. As the thing heaved up and down in the waves, the first sailboat passed close by and started to turn. I had to look away. I was getting seasick.

  “We call it immersive viewing,” Alan enthused. “You can choose which camera you want to watch at any given time. It puts you right in the action!”

  For the next few minutes, he explained that the America’s Cup race was about to start down in Australia and boasted that Quokka had secured the exclusive online rights to the broadcast. To be honest, I wasn’t paying very close attention at that point. I was still a little queasy. Then Alan said something that piqued my interest: “We expect a minimum of two million unique visitors to our site during the race.”

  “Two million visitors?” I asked. “You mean, worldwide?”

  “No, in America. Worldwide we expect double that amount.”

  “I don’t know about the rest of the world,” I said. “But do you really think Americans will get excited about sailboats?”

  “Absolutely!” Alan cried. “When they get to witness them up close like this, they will.”

  As a rule, I don’t get into debates with executives. That’s not why I go to these meetings. But this argument was so farfetched, I had to challenge it. “Alan, I’ll bet only one out of a thousand people in California has ever even been on a sailboat. And if you’re talking about the rest of the country, it’s probably more like one out of every fifty thousand, maybe even less. Why would they care about the America’s Cup?”

  “Because watching it online will change everything, Scott. They can see every angle! They can create their own experience!”

  As I said in the last chapter, I was extremely gun-shy when it came to shorting tech stocks during the dotcom boom. That caution kept me from shorting Women.com and PlanetRx. But not Quokka. Almost exactly one year after my meeting with Alan, the company filed for bankruptcy.

  I forgot to mention that during our meeting, Alan looked like he had just stepped off a yacht himself, right down to the Sperry Top-Siders he was wearing sans socks and the knit sweater he had cinched loosely around his neck. It turned out, he was an avid sailor. He had even worked for the Australian team in an earlier America’s Cup. In other words, his enthusiasm for yacht racing was a classic case of a businessman confusing his own tastes for the tastes of his target market, just like I did when I opened a Cajun restaurant in Marin County, California. But I didn’t include the story of Quokka Sports in that earlier chapter because, to my mind, it’s an even better example of what manias do to people’s brains.

  At their core, manias are about storytelling. People become enchanted with a story, and they convince themselves—and each other—that it just has to be true no matter what. During the dotcom era, people fell in love with a story about the internet: that it would magically transform human behavior. I can’t think of a stronger illustration of this than Alan’s predictions about yachting. He thought that just because Quokka planned to show the America’s Cup online, average Americans would suddenly give a damn about it. Think about that for a moment. He had so much faith in the internet’s power, he expected it to make a nation of NASCAR fans log on to watch a bunch of billionaires bobbing around in the middle of the ocean.

  The oil boom that I lived through in Houston was predicated on an equally fictitious story: that the price of crude would rise forever. The same was true for the real estate bubble of the mid-2000s. People invested everything, not just their money but their hopes and dreams, in what amounted to a very dangerous fairy tale: that their houses would always be worth more and more and more. In many ways, mania participants suffer from acute cases of historical myopia. They only look as far back as the first days of their particular bubble and assume that older ways of living or doing business have now been rendered permanently obsolete. This was especially true during the dotcom boom, when people who seemed perfectly reasonable would stop you on the street and tell you that the “new economy” of the internet had made investing metrics such as profit margins—or even actual revenues—relics of a bygone age.

  Sunk, Part II

  Manias don’t die easily, especially when they’re fueled by rich, powerful, and obsessive people. In 2013, fourteen years after Alan swore that “immersive viewing” would magically cause Americans to love sailing, Oracle founder Larry Ellison tried to bring yachting to the masses again w
hen he hosted the America’s Cup on San Francisco Bay.

  Ellison made many of the same claims the CEO of Quokka Sports had tried out on me more than a decade earlier—specifically, that people would suddenly care about a bunch of billionaires on sailboats if they could see the action up close. Promising that the races would attract huge influxes of visitors and over a billion dollars in economic benefits (three times as much as the Super Bowl!), he convinced San Francisco’s political leaders to spend millions in public money on waterfront facilities and viewing areas. Ellison even managed to get NBC Sports to broadcast the event. But, just like Quokka Sports, his efforts were a bust.

  Thanks to Ellison’s insistence on using cutting-edge, massively expensive catamarans, only four teams could afford to enter the competition. Because of the small number of challengers, several of the preliminary rounds featured the bizarre spectacle of one boat racing itself around the bay. Making matters worse, a crew member on one of those teams died tragically during a practice session, so organizers imposed strict limits on wind conditions, which caused frequent race cancellations.

  A fair number of people did turn out to watch some of the races, especially on weekends. I have to admit, those space-age catamarans were pretty cool looking, and I even drove down to the city one day to see them for myself. But more often than not, the stands along the shore of the bay were empty. Television ratings were surprisingly high for the opening day of the main event, but they quickly dipped close to the levels of another sport Americans have a history of ignoring: soccer.*

  *Richard Sandomir, “NBC Gets More Than It Expected,” New York Times, September 25, 2013.

  It’s easy to look back at manias in the past and spot the central flaws in peoples’ reasoning. But, trust me, manias happen all the time. There are probably several of them taking place as you read this. They might not be as big or historic as the ones I have discussed so far. They might even be limited to individual industries. Barely a decade after the dotcom crash, people in Silicon Valley and the Bay Area tech world as a whole started to party, to paraphrase Prince, like it was 1999 all over again. Even after the harsh lessons of the first bubble, venture capitalists and larger corporations began to throw huge piles of money at every start-up with a half-baked smartphone app. In 2013, the founders of Snapchat—an application mostly used by teenagers to send goofy photos to each other—turned down a $3 billion buyout offer from Facebook. I don’t know what’s more maniacal: that one company offered that kind of cash for the rights to an obscure product or that the other said no to it. Another sector that has behaved maniacally for years is renewable energy. Replacing dirty carbon-based fuels is a laudable and critically important goal. But too often, businesspeople, investors, and consumers buy into unrealistic technologies with little or no chance of making a short-term profit, let alone revolutionizing the world’s energy consumption. A few years ago, investors would rain money on any company that had anything to do with biofuels such as ethanol. The same thing happened with hydrogen fuel cells, then solar, wind, and other green sources. I’m not claiming that these technologies are worthless, just that the enthusiasm for them often seems awfully, well, exuberant.

  Manias can even take hold at individual companies. Managements—and investors—willfully believe all of the happy parts of a given narrative about their firms and ignore gaping flaws in their reasoning. I once visited the offices of a hot new chain of cafeteria-style, all-you-can-eat restaurants called Fresh Choice (stock symbol: SALD). It had just come public a few months earlier, and its stock had already almost doubled. Everyone who worked there was dressed straight out of a J.Crew catalog: below-the-knees skirts, tucked shirts, pressed trousers. And everyone—and I mean everyone—smiled and said hello to me as I walked by. It was the friendliest corporate environment I’ve ever been in. For a minute I thought I had woken up in the movie Pleasantville.

  The two executives I met, the company’s CEO and CFO, were as inviting and genial as their employees. They were young guys in their early forties, very clean-cut and well groomed, and they came striding out of their offices with giant grins on their faces. To hear them talk, they had good reason to be so happy. They were going to revolutionize their entire industry.

  “There’s no way a mother or a father would bring their children to most restaurants if they knew what they were serving,” the CEO said. “The kitchens are filthy, the food is old and frozen and barely warmed over. But we’re different. For a reasonable price, you can bring your family to Fresh Choice and know that they’re going to get nutritious food that was prepared the same day.”

  He then talked at length and in exhaustive detail about how clean Fresh Choice locations were—everything from how often the employees were required to scrub the kitchens and serving areas to how they maintained the refrigeration units beneath the salad bars to the special type of scraping tools they used to clean off the counters. I think he even described the types of muffins they served and how often they baked them. Most of all, he emphasized the importance of appealing to families. He must have said the word family fifty times in less than an hour. According to him, giving families a low-priced, high-quality option for eating out was going to make Fresh Choice the king of chain restaurants.

  I was so struck by his zeal for healthy, clean, and inexpensive dining that when I got home I did a little research on him. I discovered that he and most of the other executives in the company were Mormons. It all made sense to me then—the Donnie-and-Marie friendliness, the J.Crew wardrobes, and, most of all, the obsessive focus on creating a family atmosphere in their restaurants. Big families are the norm in Mormon culture. And even for the fairly well off, taking a big family out to eat can be prohibitively expensive. It was plain what the Fresh Choice guys were after: they were trying to give people like themselves a chance to enjoy a meal with their kids without having to dip into their college funds to afford it.

  Unlike my experience with my own restaurant, I quickly saw Fresh Choice’s fundamental error: the very customers they were trying to reach didn’t want what they wanted. Most Fresh Choice locations were in the Bay Area. By and large in that market, and in other big cities like Los Angeles and New York, the people who care about eating quality food are not going to go to a place that looks like a cafeteria—not even a sparkling clean cafeteria. Pushing a tray down a counter is just not their idea of a great dining experience. They’re willing to pay extra to be waited on. On the other hand, most of the people that do go for the all-you-can-eat concept aren’t interested in how nutritious the food is or how immaculate the countertops are. They want their fare cheap, filling, and plentiful—and they want meatloaf and chicken fried steak, not Greek salads and pasta primavera.

  Investors bought into Fresh Choice’s vision for spotlessly clean, cafeteria-style dining for a little while. Like I said, it only took a couple months for its stock to double after its initial public offering. The company rode that momentum and expanded rapidly, opening outlets on the East Coast and in the South. But the good times didn’t last. After a few years, Fresh Choice smelled pretty stale. Same-store sales fell, they started closing locations, and its stock slid down into single digits. Bankruptcy didn’t come for another several years, but it was only a matter of time.

  No matter their scale or their origins, the same dynamics are at play in all manias: people get so caught up in a compelling story, they convince themselves and each other that it is destined to come true. Like Marleen at Women.com or the founders of Fresh Choice, they think there is no way they can fail. That is a very dangerous mind-set, because believing that you can’t fail is one of the best ways to do just that.

  Sweating It Out

  One of the more maniacal industries in the last thirty years has been biotech. I’ve seen dozens of companies in that sector come public—and soar to huge valuations—on nothing more than a few promising results in the lab. The founders of a company down in Redwood
City called Cygnus Therapeutics (stock symbol: CYGN) had a particularly hopeful story. Way back in the early 1990s, they announced that they were going to manufacture a noninvasive method for monitoring glucose levels in the blood. They called their product the GlucoWatch. It was exactly what it sounds like—a wristwatch that gave regular readouts of its wearer’s blood sugar levels. Amazingly, Cygnus claimed its invention wouldn’t need to draw any blood to accomplish this. It would detect glucose in a person’s sweat.

  As you can imagine, the GlucoWatch promised to be a huge benefit for anyone with diabetes. Instead of having to draw their own blood, diabetics could simply glance at their wrists every so often. The watch even featured alarms that would alert users if their glucose levels reached a dangerous level. That’s not just an added convenience; that’s a potentially lifesaving technology. Needless to say, investors, including me, were very interested in Cygnus’s progress in developing the watch. With more and more Americans being diagnosed with diabetes every year, it had a chance to be a blockbuster, Prozac-level product.

  Cygnus’s offices were in a business park east of the 101 freeway between a granite quarry and a go-kart track. Interestingly, it shared a parking lot with NeXT Computer, the company Steve Jobs started after he was booted from Apple. I was at Cygnus a total of five times between 1994 and 2002. It’s rare that I visit a company that often if I don’t own its stock. But I was excited by Cygnus’s idea and I wanted to keep up with how it was faring.

  Every time I went down there, I got the same story from the various executives I met with: the watch was almost ready. The only thing that changed was the reasons for the delay. They were working through the last technical challenges, they were dealing with regulatory obstacles, they were finalizing testing procedures. There was never a doubt about the final chapter to the story, though: the watch was going to be a huge success. The brass at Cygnus was so confident, they sold the rights to other products they were developing so they could pour everything they had into bringing the watch to market.‡