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Case Study: A Short-Seller Crashes the Party

Geplaatst op okt 12, 2013 in News

When the well-known hedge fund manager and short-seller Jeremiah Hughes first put Terranola in the spotlight, issuing ominous warnings about unsold products, a looming patent expiration, and flawed growth projections, the considered judgment of the executive team was to do nothing.

“I refuse to dignify this attack with a response,” said Henry Guillart, the CEO, just hours after Hughes had given his initial negative presentation at an investor conference in New York. That decision turned out to have serious consequences. Terranola’s stock began tanking that afternoon, precipitating a slide that took the Seattle-based company’s reputation, employee morale, and ability to raise capital along with it.

A month later, when Hughes mounted a second attack, everyone expected Terranola to counter. But behind closed doors, its leaders were torn: They realized that responding this time might lead to even more trouble.

(Editor’s Note: This fictionalized case study will appear in a forthcoming issue of Harvard Business Review, along with commentary from experts and readers. If you’d like your comment to be considered for publication, please be sure to include your full name, company or university affiliation, and e-mail address.)

The Power of the Power Bar

Terranola is the company behind those granola bar machines you see on every kitchen counter nowadays. It’s hard to believe that little more than a decade ago people didn’t even think of making their own snack bars at home. That’s a testament to the speed and thoroughness with which Terranola has dominated the business sector it invented.

By now everyone has heard the story of how the company’s flagship product, the Express bar-making machine, came to be. Henry Guillart had been running an organic food distributor when he came across a sandal-wearing inventor in a Whole Foods store demonstrating what was then called the Power Bar Press. It was ugly, clumsy, and expensive, but Henry immediately saw its potential and bought the idea. He renamed his company and put a team of engineers to work solving the product’s mechanical, food safety, cost, and design flaws. When the Express finally emerged, it was a peach: simple, speedy, and elegant. Henry positioned it for several customer segments at once: gadget lovers, foodies, hikers, moms packing their kids’ lunches, and people with dietary restrictions, such as nut allergies.

The business model centers on the old razor blade strategy: Sell the machine at just above cost and make high margins on the system’s consumable element – patented plastic pods. These come in fill-it-yourself kits for consumers who like to exercise their creativity: If they’re tired of cinnamon-oat-raisin, they can make pistachio-millet-honey-blueberry. The pods are also available prepacked with nuts, grains, dried fruits, and flavorings for Express owners who simply like using their gadgets.

Half a dozen companies worldwide are licensed to manufacture the machines and pods and sell them to retailers and distributors, paying royalties to Terranola on each sale. So although the company makes almost no money on the machines, it earns a profit of about 15 cents on each pod, not to mention additional licensing fees from food brands, such as Kellogg’s and Nature’s Promise, that are keen to be associated with a wildly popular product.

Investors adored the Terranola story. When the Express launched, sales of food bars in the United States were already $2 billion annually and expanding by double digits. Europe and Asia were the next frontiers. Terranola’s first five years of sales were unprecedented for kitchen gadgets, and revenue soared to $1.1 billion. Competitive products came on the market, but none were as popular as the Express. Michelle Obama bought one for the White House, and the president gave one to David Cameron as a Christmas gift. Terranola’s market cap skyrocketed to $8.1 billion, and even then many analysts remained bullish, saying that household penetration of Express machines could increase threefold in the United States and Canada alone.

Yet the company also attracted a lot of short-sellers – investors who borrowed shares from a brokerage and sold them, hoping to buy them back later at a discount, return them, and pocket the difference. At the stock’s peak, nearly a third of shares were sold short. It seemed that many market players, notably Jeremiah Hughes, thought the Terranola story was too good to be true.

Doom and Gloom

Hughes was the founder of a hedge fund managing more than $6 billion in assets. He had become known for bringing down overvalued companies by shorting their stock and then publicly shaming them. The first thing he did in his 20-minute presentation at the Council of Value Investors was to show, on the basis of household income and food bar consumption data, that Terranola might conceivably be able to double its sales in the coming years, but it certainly couldn’t triple them. Then he made a few ominous comments about warehouses full of unsold pods and launched into an analysis of threats to the company’s intellectual property – specifically the looming expiration of a key patent on Terranola’s pods and the possibility that its own licensees would soon be able to make identical, lower-priced ones for use in the Express or copycat machines. He argued that the company’s current effort to get a patent extension was bound to be unsuccessful, because its so-called technical improvement consisted of a trivial change – making the pods fluted rather than smooth.

In a final flourish, Hughes recalculated Terranola’s likely earnings per share at just one-third the level that was being bandied about by the bulls. “Once the patent expires next year,” he told the crowd in the Waldorf Astoria ballroom, “this business model will crumble – just like an old, stale granola bar.”

A.J. Densmor, Terranola’s CFO, saw those words on Twitter about one minute after Hughes had uttered them. An agitated Henry burst into his office only a few seconds later. “Jeremiah Hughes is talking trash about us!” he nearly shouted.

“I know,” A.J. said.

They called in the company’s investor relations and PR chiefs and, after a long discussion, agreed to hunker down and watch how the situation played out. “Everyone knows that a short-seller is just trying to make money for himself by driving the stock down,” Henry insisted. “This will blow over.” A.J. wanted to believe him. But of course Hughes’s presentation was a tipping point. It irrevocably changed the way investors perceived Terranola.

A week later A.J. spoke up. “We have to rebut,” he told Henry. “We’ve got a legitimate chance for a patent extension. Investors need to know that.”

Henry shook his head. “What he’s doing is unethical and immoral, and I’m not going to get down in the mud with him. I know the investors will come around.” Confident words. But A.J. sensed a deep discomfort in the CEO, as if Henry was afraid to tangle publicly with Hughes.

As CFO, A.J. was painfully aware of the consequences of the stock slide, which now amounted to 20% from the peak, with no bottom in sight. Beyond the intangibles of poor publicity and anxious employees, a sinking share price wreaked havoc with the company’s compensation structure, which relied on stock options as incentives. Even more important from a strategic perspective, creditors would balk at further loans until the uncertainty was resolved, making it harder for the company to raise money.

The timing of all this was particularly bad. Terranola had been moving forward with A.J.’s plan to acquire all six of the licensees that made Express machines and pods. With the company’s share price sinking and its cost of capital rising, those deals might have to be put on hold. But if they didn’t go forward and the patent expired, the licensees might indeed become competitors, and Hughes’s prophecy would be self-fulfilling.

In subsequent weeks, as the stock sank to 30% below its peak, Terranola’s silence created an information vacuum into which all sorts of rumors and speculation rushed. One analyst pointed out that although the company’s earnings were spectacular, often beating forecasts by 40%, its sales were more modest, typically meeting forecasts or bettering them by just a little. “How is that possible?” she asked, implying that the books were somehow being cooked. Shareholders began contacting the company, demanding that it do something. Still Henry refused to respond.

But when his marketing chief got a tip that a global snack industry website was about to publish an interview with Hughes about Terranola, A.J. could tell that Henry was ready to reconsider. He suggested a meeting of the executive team to plan a response or even launch a preemptive attack, and the CEO agreed.

The discussion was heated. There were calls for a lawsuit against Hughes. Someone suggested that they advise the New York attorney general’s office to initiate a case against him for stock price manipulation. Terranola’s chief counsel floated a plan to ask shareholders to demand the physical certificates for their shares, preventing brokers from lending them to short-sellers and possibly forcing people like Hughes to cover their positions. A.J., for his part, said the company should launch an aggressive PR campaign, encouraging reporters to examine the company’s assumptions and forecasts in detail.

But everything changed when the Hughes interview appeared the next day.

A Veiled Threat

“What’s your reaction to Terranola’s silence about your analysis?” the interviewer had asked.

“I’m impressed by it, to be honest,” Hughes replied. “I would have thought they’d do what ExSolv did back in the 1990s. ExSolv claimed to have a technology for extracting oil from sand. Investors didn’t believe the hype, so they shorted it, and the company fought back tooth and nail. They told shareholders to request immediate delivery of their stock certificates. They hired private investigators to find out who was spreading misinformation. They even sued one fund manager. They damaged a lot of people’s reputations and cost a lot of people a lot of money. And lo and behold, the company turned out to be a fraud. That’s chutzpah!

“I’ve come to believe that the harder a company fights me, the more likely they are to be lying. So I’ve always got more ammunition in store. I always know a lot of things that I don’t say publicly. I wait and see how a company is going to react – I let them take the lead. If they come after me with lawsuits and investigations and accusations, I let them have it. And in the case of Terranola, believe me – well, enough said.”

A.J. went to Henry’s office after reading the interview. The two men were thinking about the same thing: Hughes’s cryptic reference at the Waldorf Astoria to warehouses full of unsold pods. For a long time Terranola had been buying machines and pods from its licensees to sell through its website and branded sections in department and big-box stores. As a result, it booked hefty royalty payments before the products were actually in consumers’ hands. That’s why the company’s earnings were so much better than its sales.

But A.J. knew perfectly well that much of this inventory was indeed being stored, and that the ingredients in the prepacked pods would have to be discarded if they sat around too long. He’d repeatedly told Henry that they should stop the practice or they’d risk being accused of self-dealing and juicing the company’s earnings. But he’d also figured that the problem would go away when Terranola acquired the licensees. Unfortunately, it seemed that Hughes had somehow found out. He probably didn’t have enough solid information to go public, but if pushed, he would undoubtedly dig around and get it. A.J. could only imagine how that would look to analysts and to Terranola’s shareholders. Would the share price – and, indeed, the company – ever recover?

Just then the chief marketing officer, Janet Washington, came in. She’d read the interview with Hughes too, but she didn’t know about the royalties practice, so she was puzzled by his comments.

“What was he talking about?” she asked.

Henry and A.J. were silent.

“I think we should go ahead and get aggressive with him,” Janet said. “Who is he to tell us what we can do? The sooner we get our side of the story out there, the better. When can we start?”

Question: How should Terranola respond to the short-seller’s accusations?

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