Astronomers constantly scan the night sky for supernovas so that they can observe and study how stars die. It’s a fascinating process. Right now, a very large corporate supernova has begun and it is just as fascinating–and educational. Unfortunately, I was forced to cover my short position in the dying company because my prime broker now charges me an exorbitant “negative rebate” to short stocks. But I’m still watching from a distance.
In my career, I’ve shorted the stocks of over 200 companies that have eventually filed for bankruptcy, As I write about in my book (available for pre-order now!), there are a number of tell-tale signs I look for when I scout these terminally ill businesses. The two most common symptoms are falling revenues and mounting debts. A while back, the once high-flying biotech company Dendreon (DNDN) started suffering from these twin maladies in a big way.
Just over a year ago, I wrote about Dendreon for Seeking Alpha. Its prostate cancer treatment was being outsold by cheaper alternatives. Meanwhile, repayment on a massive $600 million bond issue was looming in 2016. Given its lackluster revenues and poor prospects for improving sales, I couldn’t see any way Dendreon would be able to make good on that debt and I couldn’t see any way they could refinance it at better terms either. That would leave it with one option: wiping out its shareholders and going into Chapter 11.
In the comments to my article, Dendreon backers came up with all sorts of hopeful alternative scenarios. Three were very familiar to me: overseas sales would offset the company’s domestic struggles, new uses for the treatment would lift revenues, and a competitor would swoop in and buy out the company. I’ve seen this trio of overly-optimistic predictions precede the bankruptcy of almost every dead company walking I’ve shorted. They’re like the three horsemen of corporate doom. When a troubled company’s boosters begin to hype foreign sales, alternative revenue sources and a potential buyout, failure is nigh.
Fast forward to last month and the all-too-predictable has occurred. Dendreon included a stark liquidity warning in its 10-Q:
Based on our currently anticipated operating results, however, and even assuming the realization of future expense reductions that we plan to make and product revenues that we forecast, there is a significant risk that, while we believe we have sufficient cash to meet our ordinary course obligations for at least the next twelve months, we will not be able to repay or refinance the 2016 Notes. Accordingly, we are currently considering alternatives to the repayment of the 2016 Notes in cash, including alternatives that could result in leaving our current stockholders with little or no financial ownership of Dendreon.
Don’t let the mushy “considering alternatives” language fool you. Companies don’t put out liquidity warnings because they might default. They only do so when default is likely, if not unavoidable. Dendreon’s stock quickly lost half its value after this announcement. That’s not surprising. When a business says it is considering “leaving [its] current shareholders with little or no financial ownership,” you would expect most–if not all–of those shareholders to head for the exits, stat. But what makes corporate supernovas like Dendreon so fascinating isn’t how quickly they explode, but how slowly.
There is no earthly reason for DNDN to be trading for anywhere above a penny or two right now. And yet it has held steady at about a buck-and-a-half since the liquidity warning. This happens time and time again with companies on the verge of bankruptcy. Managements all but scream from the rooftops that their stocks will go to zero in the very near future and yet people continue to buy. Incredibly, DNDN has even seen a number of small rallies in the past month. That means there are people out there–a lot of people, Dendreon has 150 million shares outstanding–still taking positions in the company. They might as well be betting on Ray Rice to win the rushing title in the NFL this season.
Too many investors, especially retail investors, simply do not understand capital structures. With bankruptcy all but inevitable, the people and institutions who own Dendreon’s debt have essentially taken control of the business already. They’re the ones who will wind up with equity in the company if it reemerges from bankruptcy, and if it doesn’t make it through Chapter 11, they will be the ones who make money on any sale of its assets. Anybody who owns stock in the company now will be excluded from those proceeds because their equity will have been wiped out. How do I know this? Because that’s how capital structures work. Not to mention, the company said so itself in its liquidity warning last month! Why anyone would be buying DNDN at this point is beyond my comprehension. Then again, so is astronomy.