In the latest of our editorial series, Link, AIQ brings members of Aviva Investors’ equity and credit teams to discuss how long capital markets will continue to fund unprofitable tech companies.

10 minute read

In November 2013, Aileen Lee, a US venture capitalist, wrote an article in which she tried to identify common denominators behind software start-ups that were less than ten years old and valued at $1 billion or more. Since these firms were extremely rare – less than 0.1 per cent of venture-backed start-ups fitted the description – Lee coined the phrase ‘unicorn companies’ with which to stamp them.1

In the six years since she penned her article, unicorns have become decidedly less rare. According to CB Insights, a provider of data on private businesses, as of January 2020 there were 449 such companies around the world with a combined value of $1.35 trillion.2 Although the majority have yet to make a profit, that has not deterred investors. With financial markets awash with cheap finance, they have been only too eager to try to unearth the next Google or Amazon – the 1990’s original unicorns; at least until now.

The proportion of US companies reporting losses before going public is at its highest level since 2000

However, with the proportion of US companies reporting losses before going public at its highest level since 2000,3 and growing numbers of commentators drawing parallels with the bubble of two decades ago, there are signs public, if not private, markets may be growing more cautious. According to Renaissance Capital, the number of new listings in the US fell 17 per cent in 2019, with initial public offerings (IPO) in the technology sector down 19 per cent.4

Sentiment has not been helped by a number of high-profile casualties. They include Uber, the ride-hailing-to-food-delivery group which was the biggest unicorn to list in 2019. Having floated in May at $45, within six months its shares had lost more than 40 per cent of their value. Although they have since staged a partial recovery, the company is now worth barely half the $120 billion once being touted around by investment bankers. Rideshare rival Lyft, which floated two months earlier, has fared even worse, while WeWork was forced to pull its flotation altogether in September forcing its biggest investor, Softbank, into rescuing it.5

Amazon became the world’s second trillion-dollar company just 21 years after floating

With no end in sight to the flow of cheap finance and given the premium placed on companies capable of growing quickly, tales such as these are unlikely to completely deter investors from continuing to plough money into unprofitable businesses, especially in the technology sector. The prize on offer is clear. Amazon raised $2.1bn in debt before just about breaking even in 20016. In 2018, just 21 years after floating, it became the world’s second trillion-dollar company.

The AIQ editorial team brought together Mikhail Zverev (MZ) and Alistair Way (AW), heads of global and emerging market equities respectively, and US credit analyst Scott Freundlich (SF), to discuss the danger signs to look out for when investing in unprofitable companies and where they see value in the technology sector.

AIQ: Are there any similarities with the bubble in terms of the valuations being ascribed to some companies today?

MZ: It is important to distinguish between what is going on in the private and public markets. What is going on in the former is very concerning. There are at least five competitors to Uber. But none of them is making money and nobody seems to be asking how many ride-hailing apps does anyone need? In some cases, what we are seeing now is very reminiscent of the bubble. It is possible to stay private for longer and achieve unicorn status, which wasn’t really happening in 2000. Capital has been flooding in and private markets have been very exuberant in places.

You could argue the stock market is turning a blind eye to the risks

The situation in public markets is slightly different. It is true there are some examples of companies where you could argue the stock market is turning a blind eye to the risks. For example, the market seems oblivious to the fact Netflix is a cash-negative, indebted company, and it’s the same with Tesla, with only a couple of quarters of profitability.

You can see why that is happening, as the winning formula over recent years was to imagine a picture of what life might be like in 20 years’ time, keep funding it through years and years of negative cash generation, in the belief you’d end up owning the next Amazon. For both companies, you can paint a scenario where it is all going to turn out great. But all the same, it is questionable whether the risks are being fully priced in given neither company has yet to prove they can generate cash sustainably. However, I don’t think this applies to the technology sector as a whole. People are well aware there are only so many potential Amazons out there.

Recent lacklustre IPOs will take some of the froth out of new listings

Perhaps some of the recent lacklustre IPOs will take some of the froth out of new listings. Investors are going to be warier and will want the dust to settle in private markets before considering more deals. 

AW: I can’t really say in aggregate whether loss-making tech companies are overvalued. It sounds like in the US or in developed markets as a whole maybe you can, but I think valuations in emerging markets look more reasonable. It is true there are lots of loss-making technology companies across emerging equities and, in some cases, you could argue the market is far too optimistic about their ability to generate cash. But in plenty of others I think it is quite right to be giving them the benefit of the doubt and helping to fund them. We know there are huge rewards for being a dominant E-commerce player in an under-penetrated market like Brazil, for example. It can pay to be patient.

One only has to consider the case of MercadoLibre, an Argentinian E-commerce company often referred to as the eBay of Latin America. It went through a tough period after margins fell. But that was because it was concentrating on investing into the business to drive top-line growth. Its shares are trading on several hundred times earnings, because the market is prepared to look beyond a period of poor returns and focus instead on the long-term potential. That isn’t an irrational thing to do, so long as management is articulating a clear message and delivering a consistent strategy.

SF: We are arguably seeing it in selective cases, but generally, in terms of valuations, the volume of bad deals being done, and the number of new companies coming to the market, it is hard to compare today’s situation with the era.

Growth companies in a world where growth is hard to come by due to demographics, pension shortfalls and so forth

A lot of this comes down to a search for yield. We are talking about growth companies in a world where growth is hard to come by due to demographics, pension shortfalls and so forth. Nevertheless, it is valid to wonder how long the bond markets will continue to fund loss-making companies such as Netflix, one of the firms I cover. It generated negative $3.2 billion of free cash-flow in 2019; it also generated negative $2.9 billion in 2018. You have to wonder if it will ever stop burning cash in the intermediate time frame as management is focused on growth in every sizable international market, and content costs rise.

The continual development of content is eating up significant amounts of money, and yet with the rate of change in new subscribers slowing, it is far from clear it will be able to create a positive return on investment. The same applies to a host of other companies such as Uber and Lyft to name but two.

MZ: I agree on Netflix. On headline numbers its net debt to EBITDA is over 3.0, which is already pretty punchy for a barely profitable company that doesn’t generate cash. But the real number is closer to ten when you add in commitments it has made to people to create proprietary content for it and to third-party content providers, which are financial obligations like any other.

So, it is not going to generate cash for several years, and all the time the competitive environment is getting tougher. Amazon Prime is investing a billion dollars in the TV series based on Lord of the Rings alone, Apple is putting a couple of billion in Apple TV Plus just for starters and there is also HBO Max and Disney Plus.

SF: The fact Netflix only owns a limited amount of content leads me to question how much of a first-mover advantage – something that usually conveys massive benefits as it is so hard to disrupt – it really has. It has created amazing scale and it may be the global aggregator at the end of the day, but in media, owned content is critical and Netflix is playing catch up. Netflix’s direct-to-consumer efforts began by simply re-bundling third-party video content differently. Now the company is more focused on original content creation as it sees competitors leverage their own library of content. This is not Amazon. Amazon web services, and cloud computing infrastructure, that is innovative, that is a first-mover advantage.

AIQ: When valuing a company like Netflix, where do you begin?

AW: For this type of investment, it makes sense to try to work out some sort of endgame. If things turn out reasonably well, what might a steady-state market environment look like, in terms of market share, growth, and the market structure you might expect to get? And then maybe discount it back, with a reasonably sceptical view about whether all these things will fall into place so easily. That is the correct way to do it from an investment perspective: try to take a long-term, best-case scenario, then try to work out how likely it is in terms of the upside of a successful business model. But in practice, it is not always easy to do.

SF: I think you’ve got to look at these companies from a long-term perspective. You look at the total available market and how penetrated that market can be. The problem in the case of Netflix is that it competes against a host of well-funded companies launching new services. You need to have deep pockets to protect yourself. Arguably capital markets are looking at Netflix’s size today and not discounting the competition as heavily as they should be.

MZ: The other problem is this is an industry that might get badly disrupted. When the music industry shifted from CDs to downloads and eventually streaming, it deflated the value of the market very significantly, to the point where recording artists don’t make money from streaming.

Margins are tumbling before the bloodbath has even started

When you have one disruptor like Netflix going at this multi-billion-dollar market it is tempting to think that is the amount of money available for it to get. But now you have got multiple, credible players divvying up the legacy profit pool while at the same time deflating it. To put it crudely, margins are tumbling before the bloodbath has even started.

AIQ Given these concerns, do you see any value in the technology sector?

MZ: Yes, in fact our global equity funds are currently overweight the sector. But where we own high value, high growth, high multiple stocks it tends to be in emerging markets given the comparatively low rates of market penetration.

Apart from wanting to avoid the growing risks accumulating in Pay TV streaming wars, I am wary of owning some software-as-a-service (SAAS) companies that not only tend to be overly competitive with one another but are, in many cases, competing against Microsoft, which bundles similar functionality as part of your Office365 subscription for free.

In developed markets we prefer established, profitable companies

In developed markets we prefer established, profitable companies like Microsoft and some semiconductor makers. They may not be as fashionable as some of the SAAS companies, as they may not offer the same growth potential, but they are still capable of growing strongly and are much more reasonably valued.

AW: Our strategy is quite conservative. Like Mikhail’s global perspective, we prefer firms with tried-and-tested business models and with a road map rather than something that looks potentially exciting. We are invested in companies such as chip makers with good pricing power that are likely to benefit from growth in artificial intelligence and the huge rollout of 5G mobile networks. That said, in emerging markets you are not seeing the signs of speculative excess that is so prevalent in the US. As a result, I also see selective opportunities in E-commerce and gaming companies where market penetration is low.

SF: It seems likely that data centre and public cloud usage is only going to increase, and the level of penetration globally is still pretty small. I think these are on multi-year, if not multi-decade, growth trajectories.

AIQ: Alistair, can you talk us through how protectionism is impacting companies in emerging markets?

AW: We are seeing a massive relocation of supply chains towards Asia. It is quite striking how well Asian tech has performed compared to US tech. Clearly Huawei has been badly affected by sanctions, but it is now trying to reinvent its business model to make it independent of US tech, which is hugely beneficial for any local chip maker or design company.

Korean companies are looking to domestic companies to supply them with machines that make chips, chemicals and other inputs

Elsewhere, a spat between South Korea and Japan has led to big Korean companies such as Samsung and Hynix looking to domestic companies to supply them with machines that make chips, chemicals and other inputs. It is leading to quite profound changes in the way that things are made and who makes money out of making them. 

AIQ: How serious is the threat regulators will reduce the monopoly powers of some of these tech giants?

SF: Calls for some of these companies to be reined in by divesting certain assets or protecting data is only likely to grow louder. We are seeing speculation that Facebook could be forced to divest Instagram, while some countries have demanded users need to opt in to share their personal data with social media platforms before that same data can be leveraged for advertising. As these tech companies play an ever-bigger part in people’s lives, it is inevitable we’ll see more government intervention.

MZ: I think it’s telling that (Democratic presidential candidate) Elizabeth Warren publicised her intentions to redesign monopoly regulations to consider not only consumer welfare but also innovation competitiveness. The big risk to my mind is that Alphabet (Google’s parent company) is broken up. That would be massive. As for Facebook, the shares are only trading on 18x next year’s earnings. Even if it were forced to stop accepting political ads, a lot of the danger of regulatory intervention seems to already be in the price.

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