6
do your homework
DONALD RUMSFELD, who did two tours as secretary of defense under different presidents, once said the following: “There are known knowns; [these] are things we know we know. We also know there are known unknowns; that is to say, we know there are some things we do not know. But there are also unknown unknowns—the ones we do not know we do not know.” This may sound like gobbledygook, but if you analyze it, it actually makes sense. The bottom line of what he is saying is: Do your homework.
In today’s world, there is a massive amount of information available to everyone. Information is no longer difficult to obtain. All you need is a computer and a subscription to any database. It is what you do with this information that counts. We call it the “executive dilemma”: having to make decisions without knowing all the facts—or without knowing what you do not know you do not know. You never know all the facts. Therefore, the measure of your ability is the number of correct decisions you make with the least amount of information. In this age where nearly all the facts are available, the premium is on the speed with which you are able to comprehend the importance of the facts and put them in order of priority. This means that sometimes the cost of indecision is much greater than the cost of making a wrong decision. Many times this means questioning conventional methods and working through the “wrong ways” in order to find the “right way.”
How does this work in practice? Remember the vineyard? I researched the best way to use the asset, in this case the land, to produce a viable income stream. I had made the initial decision to proceed while I was in the process of doing my homework. An unforeseen problem then forced me to question the conventional methods of planting a vineyard, and the new process that resulted has now been accepted as the best way to plant a vineyard. By doing my homework to solve one problem, I came up with a better way to do something that I was not even considering initially.
making my kind of deal
My friend Herb Siegel conducts his business according to a theory based on a favorite expression of his father: “Well-bought is half sold.” Not only is Herb a great guy, he is a billionaire—two good reasons to take his advice.
Distress is very attractive to me in the sense that I am always trying to acquire assets for less than their perceived value. There is a certain mindset that supports this kind of thinking. Some people run from distressed properties because they see problems. What they see as problems, I see as opportunity.
I use the phrase “perceived value” to mean the value the free market has assigned to a property by valuing comparable assets. The more common term for this is “market value.” If the price of an asset is x, and all things comparable in size, location, structure, and so on are selling at a similar price, then the free market has determined its market value. If you can acquire that asset for much less than x, then you have made my kind of deal.
Of course, this begs the question of why the market gives certain value to certain assets, a question that is answered by the level of free cash flow that the asset is expected to produce over a measured period of time, inclusive of the risks to produce that level of return. If the market expects a return of 8 percent and the asset produces only 4 percent, then the asset’s value will be reduced. So it becomes a question of seeing potential value in a discounted asset where others only see the discounted asset.
In 2009, a couple of partners and I looked at a privately owned student-housing complex near Samford University in Birmingham, Alabama. The complex consisted of five two-story buildings with 175 units, ample parking, a gym, a pool, and basketball courts. The units were all three-bedroom, three-bathroom apartments. They were rented by the bed, much the way college dormitories are. Low occupancy had put the complex in the red. Because it was losing money, it was for sale at a distressed price.
Sounds great, but then came the homework. Because the units were rented by the bed, the complex was almost exclusively rented by students. This meant that families would not want to live there, nor would young working couples. The complex is located about two and a half miles from the university. Transportation being what it is, you would need a car to get around. That alone seemed to be a barrier to making the project work. In addition, a survey of university housing showed no real shortage; therefore, the use would need to be reconceived.
Our intent was to convert the complex into standard apartments for families. This would take more research, focused mainly on cost. The units had no master suite, so we would need to figure out how much per unit we would need to spend to create one. After doing our research, we concluded that the cost did not warrant the conversion, so we decided not to make an offer on the project. While the complex had all the appearance of a good opportunity, inspection and examination of the details revealed what had looked like a bargain carried too much risk.
not-so-convenient stores
On the surface, the convenience store business is not very complicated, particularly if you do your homework. It is mostly known knowns. First, convenience stores are not stores of destination. Wal-Mart is a destination store. You go to its location to get a specific product. This is not true of a convenience store. If it is not convenient, you do not stop there. You would be surprised at the number of people who are in that business who do not understand this basic concept. During the years that my partner, Clay Hamner, and I built up the Swifty Serve chain into the second largest private convenience store chain in the United States, with 547 stores in ten states, I went to marketing meetings and listened to people talk about esoteric things like “scale pricing” and “target marketing.” But the bottom line is that if the stores are not convenient, no one is going to shop there. Someone on his way home from work is not going to drive ten minutes out of his way for a pint of milk.
The items you are selling at convenience stores are by and large impulse buys. Eighty percent of what is sold is consumed within one hour of the time it is bought. Therefore, you must lay out the store strategically. For example, between the front door and the bathroom (using the facilities is a reason half of the people even enter the building) are all those items that you are impulse-selling, such as potato chips, donuts, and beef jerky. Items like peanut butter, of which you sell one jar a week, are on the far side of the store.
If you pay attention, this essentially requires no imagination. Because convenience stores are a business of pennies, you must sell the right items. How do you know which items will sell? You guessed it—by doing your homework. A trade paper called Convenience Store News publishes reams of statistics on every subject related to c-stores. You can find out how many donuts and cups of coffee are sold and consumed in any area of the United States. You can find out which geographic areas are home to people who prefer jelly-filled or chocolate-covered donuts. Through -out the year, this publication conducts research on a variety of topics, including category performance, industry overviews and forecasts, and new product information. All that is required is the ability to read.
Most convenience stores sell gasoline. In that sense, they have replaced the once-iconic gas station where fuel was the only item sold. The legacy of that era is the large signs noting the price by the gallon and the name of the brand being sold. A branded store is a store identified by a major oil company brand, such as Exxon or Chevron. Being branded means that a store has to follow an agreement dictating such things as image and the nature of the gasoline being sold. For example, every time our trucks went to a place called the “rack” at the Colonial Pipeline in Bainbridge, Georgia, they had to fill up with Chevron’s petrol. The rack is essentially a farm of tanks with spigots. On a given day, Chevron’s gas might be 8 cents a gallon higher than the Conoco Phillips tank right next to it. Why? Because the Chevron refinery was running jet fuel that week and was nearly out of automobile fuel, whereas Conoco Phillips was producing auto fuel that week, so it might have a large supply. However, as a Chevron distributor, we could not buy from Conoco because our branding agreement would not allow it.
To further complicate things, there are something like twenty-seven different kinds of fuel available in the United States. Further -more, every state has its own Environmental Protection Agency (EPA) standards, and meeting them costs money. It’s a nightmare. You’re going to get a spread at the distributor level as high as 15 cents a gallon because refineries are constantly switching over to different fuels.
The result is that the car owner claims the person who owns his gas station or convenience store is gouging him. But the person who owns the pump is a victim, not a crook. He is being squeezed by the refiner, the distributor, and the competition. He is just hoping to keep somewhere between 9 and 12 cents a gallon, which will pay his overhead and his taxes and leave him with a very modest profit. (Meanwhile, Exxon Mobil earned $11.7 billion in the fourth quarter of 2007, the most an American company has ever made in a three-month period.)
In a cash business, pennies are important. For example, people will drive past a gas station and go to another where gas is 2 cents cheaper per gallon. I drive a car approximately twenty thousand miles a year. If I get twenty miles to the gallon, I’ll use a thousand gallons, so a difference in price of 2 cents adds up to $20 a year. Few people make this calculation and therefore run all over town to save twenty bucks a year. To me, this doesn’t make any sense. Aside from the extra time involved, they also do not figure that if they drive one more mile to get gas, they might have an accident and raise the cost of their insurance.
Another drawback for independent dealers was that in 2008, the EPA mandated that all gas stations have their tanks upgraded to meet a certain standard, which included double walls and other protection from leaks. This wiped out a lot of independents because they did not have the money to comply, which is why you probably saw several stations in your area changing to Big Oil brand names. Big Oil was able to comply with the new regulations, while small dealers were left scrambling. This is another example of how government regulation makes things difficult for the entrepreneur. Once again, regulation is one of the rules of the road that you must understand. You can’t change it, but you have to understand it.
One of the attractions of the convenience store business is the underlying real estate. If you purchase a key corner, you are buying an asset, as well as a business. If there is an economic boom in the area, you can sell the land to a developer for another use. This is not unlike the principle that Sumner Redstone used to start his National Amusements theater business, which ultimately became the world’s largest media company, Viacom. He ran outdoor movie theaters to make use of the land for an extended period of time until development came to the area. When it did, he sold the land at a significant profit to developers who planned to build houses, malls, and office parks.
But, again, you must do your homework, because there are environmental issues involved in owning the real estate on which the store is built. Contamination from gasoline is one of those issues. If you have a spill, you have to file reams of paperwork with the state and with the EPA, and then you have to spend an undetermined amount to clean up the spill.
When you are exploring the purchase of a property, you have to order a Phase 1, a Phase 2, and sometimes a Phase 3 EPA inspection. Phase 1 is paperwork. It tells you who has owned the property and what structures may have been on it over time. The report might tell you that there was a car lot there for five years and prior to that a bakery for eighteen years. But research may also reveal that thirty years ago, there was a chemical company on the site. That’s a red flag. What did the company make? It made solvents! What kind? Xylene! Well, xylene is a clear and colorless liquid that can cause severe neurological problems. Its primary route to humans starts with leaky underground storage tanks.
Now you need to order a Phase 2. A qualified inspector will come out and drill down. Let us say he finds xylene at twelve feet. How do you remediate that? You either have to dig it all up, cook the dirt, and put it back or send the contaminated dirt to a landfill and truck in new dirt. If it turns out that the xylene has seeped in the ground water, it could cost millions of dollars to clean it up.
The person whose name was on the title at the time of contamination is in enormous trouble—provided he can be found. The inspectors will go back through all the records and search for each owner. Often, the past owners are bankrupt or cannot be located. If the owner of the chemical plant knew that chemicals were leaking into the ground, he probably did not leave a forwarding address. In that case, the current owner is stuck holding the bag. Had you bought the property without doing your homework, that would have been you.
Even if you do your homework, there is still a chance that the inspectors may miss something. I ran into this problem when I was selling several of the Stop-N-Save stores to Circle K, a large chain owned by a Canadian grocery store company. Two of the stores had a problem that had been there for many years. At some point in the past thirty or so years, there had been two fairly significant leaks that had not been disclosed to me. When I sold the stations to Circle K, I said that I wanted to be indemnified. They said they would not do that. I said, “Fine, no deal”—and then they came through with the indemnification.
I have seen cases where stations were built in locations many years before we had an active EPA and nobody reported the leaks over the years. Recently, I looked at buying such a station that was located in a heavy traffic area. I ordered a Phase 1, which revealed possible issues. The Phase 2 showed that a plume of chemicals from years ago had made its way underground from the site, across a major highway, and into someone else’s property. That meant that the buyer would be responsible for cleaning up the site and all of the surrounding land. Having done my homework, I would not be that buyer.
doing homework first can yield a big payoff
Homework can also provide foresight, too. Sometimes trial and error in a previous venture unknowingly turns into homework for a future venture. In late 1992, Lew Wolff and I had an idea for land across the street from a five-hundred-room Hilton that Lew owned and operated in Burbank, California, where the old Lockheed Martin plant was located near the Burbank Airport. Burbank is the home of the Warner Bros. studio, a huge part of the entertainment industry, and I had done numerous shows there. We thought the site was a great location for a sports arena because it was near a major freeway and had ample space for parking.
The homework—and legwork—began. We commissioned preliminary architectural studies and sketches depicting the kind of arena we wanted to build, including alternative capacity and multiple uses. We visited several new arenas around the country to see what was being constructed and why certain designs had been executed. All of this study was the preliminary part of the development process.
We met with Burbank city officials and reached an understanding that we could probably finance the stadium without using the city bonding authority. That was attractive to the city because it could then tell the taxpayers that the arena wouldn’t cost them anything. The city was going to put money into infrastructure improvements only, such as the necessary ancillary roadwork. Our plan was to finance the stadium by leasing the skyboxes on a longterm basis and creating other such income streams. We would then borrow against those contracts to raise the construction cash.
Before going ahead with the project, we needed a major tenant, a team to play there. We approached Bruce McNall, who owned the National Hockey League’s Los Angeles Kings, and Don Sterling, who owned the National Basketball Association’s Los Angeles Clippers. Both were interested in moving their teams to the new venue. Warner Bros. was also interested in getting involved because a stadium can be used for major music acts.
An arena summit meeting with all the interested parties was convened in the office of Terry Semel, the chairman of the Warner Bros. studio. Those in attendance included Lew, McNall, Sterling’s right-hand man, the music mogul Irving Azoff, who was interested in booking the arena for concerts, and me.
Terry opened the meeting talking about how the Walt Disney Company had just bought an NHL expansion team and synergistically named it the Mighty Ducks after one of its family movies. He said, “Disney has stores; Warner is going to have stores.” His message was this: If Disney has it, we will soon have it. In short, Disney had beaten Warner to the punch at many things, but the tide would soon shift—and this arena would be part of that. To me, this strategy seemed to be more about corporate ego than about business.
I was sitting next to Bruce McNall, a burly man with a booming voice. Though no one knew it at the time, Bruce was financially under water. He had made his money in the rare-coin business and then bought the hockey team. In the meeting, he started pontificating about all sorts of revenue streams and events the hockey team would provide. I sat, listened, and thought, “He must know something I don’t know.”
As a general rule of thumb, an arena has to be occupied two-hundred-plus days a year to make money. You have to account for the possibility that your team will make the playoffs, meaning that you cannot prebook other events during the playoffs even though those games may never be played.
That was where Irving Azoff came in. He said that he could book musical acts on relatively short notice to fill the holes in the schedule. It would be quick and profitable. To me, his remarks seemed to make the most sense.
The meeting ended, and soon so did the project. We could not make a deal with Don Sterling, and Warner lost interest in ancillary entertainment revenue when its Disney-like stores did not work. Bruce McNall went away. Literally. To prison. He defaulted on a $90 million bank loan and lost the hockey team in the process; he then pled guilty to bilking some $200 million from banks over a ten-year period and was sentenced to seventy months in jail.
In the end, this was a good experience for me. On the people side, I learned that one sure sign of someone who is about to go under is that he becomes more grandiose, like the proverbial star that shines brightest just before it expires. On the business side, it gave me an idea of how to do an arena—and when not to build one.
Cut to the present. One of the things on Lew Wolff’s plate as managing owner of the Oakland A’s is a new stadium. The team currently plays in the Oakland–Alameda County Coliseum, where the Oakland Raiders also play football. The situation is not ideal for reasons that are both financial (the A’s pay rent rather than collecting it from secondary events) and aesthetic (baseball played in a football stadium makes for less-than-desirable sight lines).
The team spent three years seeking a way to do a venue in the City of Oakland. Once it was proved that no option was available in Oakland, a location was found in the city of Freemont, near San Jose, that could have accommodated a stadium complex that included shopping, restaurants, and a hotel. This type of project seems to be the wave of the future. The New England Patriots, for one, have had great success with a similar venue located in Foxboro, Massachusetts, which is halfway between Boston and Providence, Rhode Island. We spent two years working on the design, actually acquired some of the land, and had options on other land. Eventually, though, too many lawsuits were filed under various environmental laws against different stakeholders, and we could not get everyone on the same side of the table and had to abandon our efforts. It became another case of regulation killing an entrepreneurial concept that would have contributed hundreds of jobs, ancillary businesses, and civic pride to the community.
If and when the A’s stadium is built, we will have done enough homework to earn a Ph.D. in stadiumology. Ultimately, that is probably not a bad thing, given the myriad issues and the cost involved.
a barrage of barges
Lew Wolff once said that I am a good buyer and a reluctant seller and that he is a reluctant buyer and a good seller. Both of those approaches rely on doing your homework. There is common ground to buying and selling. If you wait for the bottom as either a buyer or a seller, you will never find it. I found myself on both sides of this fence in the barge business.
In 1977, there were two good reasons to be in the barge business, both economic. On the positive side, the return on investment exceeded alternative investment returns by a wide margin. So, a group of partners and I formed the Delta Pacific Trans-portation Company. The math worked like this. We could build a barge for about $200,000. At the time, we could collect a trip rate of about $80 a day for roughly three hundred days a year, which comes to $24,000. Therefore, on a $200,000 investment in one barge, we would see a return of $24,000, or 12 percent. Multiply that by twenty barges, and it sounds like a profitable enterprise. However, shortly after I went into the business, the market collapsed very quickly, though not for any reason we could have foreseen or controlled.
In those days, individuals could get an investment tax credit for buying equipment. (Remember how I talked about studying tax law on my first real estate deal, if only for that transaction? Well, this became a business beholden to tax law.) Wall Street discovered railroad cars as a way to take advantage of this. It could buy a thousand rail cars, package them into syndicates, and sell those with the tax credits, thus recapturing much of their cost. Without the tax credits, the transaction did not make a lot of sense, because the underlying economics would not produce a profit. This was not unlike the artificial market that Wall Street invented for credit default swaps in the derivatives business: Selling a tax credit became the reason to produce rail cars.
All of a sudden, there were more rail cars than anybody needed, and the rail car business went belly up.
After Wall Street finished blowing up the rail car market, some bright kid wondered what other mode of transportation could be used to take advantage of this equipment tax credit. What about the barges that run up and down the Mississippi and compete with the rail cars? That is when the negative side of the deal made its appearance. Over the next three years, Wall Street demolished the barge business the same way it had blown up the rail car business—by packing them into syndicates and reselling them, purely for the purpose of gaming the tax law.
Now there was a barrage of barges. I remember being in Greenville, Mississippi, during this time and seeing so many barges that you could walk across the river by stepping from barge to barge. It gave new meaning to walking on water.
This was three years after I entered the business, and no amount of advance homework could have saved me. Nor was this like the vineyard, where I ended up with too many rootstocks and nowhere to plant them. What I desperately needed was a creative solution. There was no way to anticipate that the barge market would be taken over by investment bankers selling credits and leading the barge business into a period of disaster.
It was so bad you could not pay a pirate to steal the barges. Acquiring distressed assets has always been my métier, but I did not want to commit financial suicide. There were a lot of people who were more distressed than I and who were filing for bankruptcy. We were struggling, but we stayed afloat(!), and it was not long before I began to look for opportunities. I found one at Union Planters Bank in Memphis. The bank had foreclosed on $27 million worth of marine equipment, consisting of barges and lower-river boats. I bought the entire lot for $3 million!
Why would the bank sell the boats to me for $3 million? Because it had to pay port risk insurance and fleet all of this equipment, and that was costing a fortune. Not unlike the situation with the very first apartment building I bought, the bank wanted this equipment off its books and was willing to make almost any deal that gave it a chance to recoup some of its money. The key word was “chance.”
I did not actually give the bank $3 million. Enter creative financing once again. I gave it $300,000 down and a note for $2.7 million. So the bank had now gone from a note of $27 million to $300,000 in cash and another note that it secured for $2.7 million. Wellbought is half-sold, right? I thought I was in on the ground floor.
The next year, 1980–1981, I discovered there was a basement. I could not rent these boats for anything. I could not give them away.
Guess what? The following year, I discovered a subbasement. The market got even worse. Distress had turned the deal from opportunity to disaster.
Somebody suggested, “Why don’t you sink them all and collect the insurance?” I had heard that already. “Because the business is so bad,” I replied, “that the insurance adjusters are waiting in wet suits at the bottom of the Mississippi River to identify the boats as they come down so they can determine who’s sinking them.”
I was done. I dragged myself back to Union Planters Bank in Memphis to try to escape. I sat down in front of the head loan officer and pulled a full keychain from my pocket, placed it on his desk, and said, “Here you go.”
He asked, “What are those?”
“What do they look like?” I replied.
“Keys,” he said.
“Right answer,” I said, “and they’re yours. I am on a nonrecourse note. I’m taking my loss, and I’m giving it all back to you.”
The banker sat up in his chair. “No, you’re not,” he shot back. “I don’t want them.”
Back and forth we went, playing hot potato with thousands of pounds of steel barges. I explained that the insurance and fleeting was costing me $40,000 a month, and I had virtually no income. Finally, the banker offered to help. Bankers might work with you in those days because the regulators would try to understand all the factors affecting the loan rather than relying on an autocratic enforcement policy. This worked well for all parties: the lender, the borrower, and the regulator.
We negotiated a cooperative deal. The bank agreed to pay part of the operating costs, and I paid part. Little by little, we worked our way out. The cooperation of the bank was essential because it did not foreclose on me when loan payments were late. Eventually, the business slowly returned, and I was able to pay off the note in full. It was a case of all parties with the same good intentions prevailing over the onslaught of arbitrary enforcement.
It was a long slog, but I was beginning to look like a good buyer. Being in the business during tough times was my form of hands-on homework. Based on what I had learned, I made some changes after Wall Street left town.
I put together a company called Triangle Marine with two partners who understood the business and were owner-operators: Johnny Nichols, who owned a shipyard, and the aforementioned Peanut Hollinger, who operated barges. Triangle Marine was a boat-operating company that bought or leased boats from other entities and then rented them out to companies shipping goods on the river.
Shipping on the river is done in different ways. The primary method employed by major barge companies is through the free market, using a bid-and-ask auction of freight rates. Let’s say you’re going to ship coal from Pennsylvania down the Monon-gahela River to the Ohio River and then to the Mississippi and into New Orleans, where the coal is going to be loaded on a ship bound for Japan. There is a person asking so much to transport that coal. You go into the market and bid a rate at which you will move the coal. That trip is a bid trip. You may be a broker or a shipper. But if I am the person supplying the barges and the boats to move them, when the trip is over, my equipment is dormant, and so my business then depends on my booking another trip.
An alternative is a bare boat charter. Let’s say the grain company Archer Daniels Midland has a need for more barges than it currently has. ADM might come to me and lease ten barges for three years. Then I wouldn’t have to worry about bidding each trip. The boats are ADM’s for three years. ADM has to insure them and fleet them. If the grain market collapses and it doesn’t need the barges, it becomes ADM’s problem, not mine, and ADM still has to pay me every month.
When I first went into the business, my partners and I were bidding trips. We were taking risk—both the risk that we could make more money by bidding each trip and the risk we could end up with no business. But after Wall Street turned the market into a giant tax dodge and made that method of operating uneconomical, we moved to leasing. It was safer renting out the barges for a specific period.
As the market picked up, every time we had an opportunity and the right price, we sold off equipment that we had purchased from the bank, but we retained some twenty-five barges free and clear, which we operated profitably for many years.
Even though they are made of steel, barges suffer damage and real depreciation over time. The working life of a river barge is about twenty to twenty-five years. At the end of that time, they are sold for scrap, and the price of scrap steel at the time of this event determines their residual value. We had been offered an average of $15,000 per barge as a scrap price before the building boom of 2004–2005. Suddenly the market for steel went berserk.
My partner called me one day and said that a broker wanted to buy several of our barges and was offering $85,000 per barge. “Sell him everything!” I said. I wasn’t trying to time the market; like my friend Louis Marx, I had stayed around long enough to get lucky. As General George Patton said, “Success is how high you bounce when you hit bottom.” By that measure, our bounce was a rocket to the moon.
Yes, you can do your homework, and it can help make you successful in a business. When that business shifts, you can reexamine the situation and try to dig yourself out. But never stay at the craps tables too long. The odds are roughly 1.4 to 1 against the guy with the dice. There are too many external circumstances over which you have no control. You don’t change; the circumstances change. The second law of thermodynamics will work against you: In an open system, entropy will always increase.
In the barge business, I also learned that there are some things for which no amount of homework can prepare you. One day, we had an ordinary tow going down the river. My phone rang. A river officer was on the line. He explained that the tow had gotten away from one of our boats and had crashed into a railroad bridge crossing the river. Nobody was hurt, but the bridge had been wiped out. A bridge over the Mississippi River?! Are you kidding me?
This was a major catastrophe! A flash went off in my head: insurance nightmare. Yes, each trip was insured, but this would be particularly complicated. Would this fall under contract law or be a tort? River, state, and federal authorities were sure to be involved.
I said to the guy, “Excuse me, let me put you on hold.” I poured myself a stiff drink, chugged half of it, and then picked up the phone again. “Okay,” I said, “explain this to me slowly.” The homework was just beginning. I was about to enter the world of unknown unknowns.