Saturday, October 13, 2018

My Last Memo On The VC Bubble -- Now Is The Time To Get Out

“No one is satisfied with even exorbitant gains, but every one thirsts for more, and all this is founded upon the machine of paper credit supported only by imagination.” – Edward Harley

This is the last letter I will write about the excesses (read bubble) brewing in the venture capital (VC) industry and in some technology stocks in the public market which have ‘venture appeal’.
Why is this the last memo? First, I have spoken and written about this topic often. There’s little new left to say. Second, I do not like to repeat myself endlessly. It enhances what psychologists call commitment bias. This bias has led many to become ‘perma-bears’, i.e. those who always think the world is coming to an end. I’m not in that camp and do not want inhabit it. I’m simply pointing out that prices in VC and some technology stocks have reached truly manic levels. Purchases at these prices represent a speculation instead of an investment. Further, a bursting of this bubble will present a melancholy prospect for those investors who stay last. These are, in many cases, pensions, universities, endowments, and also mutual funds. It will also hurt employees of the venture-backed companies.

What has happened?

1.       Investors developed a strong preference for private assets

Heading into the Great Financial Crisis (GFC), hedge funds had been the vehicle of choice for wealthy investors and institutions. Most hedge funds mark their positions to market and their values fluctuate on every trading day and are reported to investors on a regular basis. During the (GFC), many investors saw the values of their investments drop as stocks and bonds fell. As these valuations sank, so did investors’ confidence.

Private equity, venture capital, private debt, infrastructure, and such other ‘private assets’ appeared to do much better. The word ‘appeared’ is important. The common theme uniting private assets is that these are marked to market based on underlying performance of the companies, which moves much less than the public markets for securities. Minor setbacks, political news, and fear do not lead to dramatic revaluations of assets downwards. Additionally, the valuations are provided by the fund managers themselves (or their hired consultants), creating a conflict of interest. As a result, even though the performance of the public and private market is often equivalent over long periods of time (adjusting for leverage), private assets give the appearance of smooth, high returns. Investors, having burned their fingers in the public markets, fell into the embrace of the private market.

In reality, investors are trading in very valuable liquidity in exchange for higher leverage, lower liquidity, and higher fees with a view to apparently smooth returns. Buying in the public market and closing one’s eyes to the daily fluctuations would arguably achieve the goals of private asset investing while maintaining liquidity.

2.       Investors developed a strong preference for ‘growth companies’, particularly in technology.

The ‘cure’ for the Great Financial Crisis required global central banks to drive interest rates to very low levels. Some sovereign bonds even traded at negative yields. When rates are that low, generating coupon income becomes nearly impossible and drives investors (whether individuals or institutions) to rely on capital gains to provide targeted returns. This was evident in rising bond prices, rising stocks, etc. which rose for two reasons. First, lower rates cause all assets to reprice upwards. Assets (whether homes, farms, or stocks) are worth more when interest rates are lower. Second, as investors piled supply-demand dynamics caused prices to go up.

Once prices are on the move that alone creates excitement separate from the fundamentals. Equities (whether publicly traded or ‘private’, such as venture capital and private equity) have an added element that makes them ideal devices for speculation. This is because, in addition to dividend payments (like bonds coupon), equities have a future element of ‘what could be’. A 7% coupon bond pays 7% no matter what. But a pharma company can invent a new drug and enhance the fortunes of its shareholders through increased dividends and earnings. A tech company many design new hardware or software. This potential of positive future developments makes equities especially susceptible to excessive and unwarranted optimism.

3.       New technologies developed concurrently

Investors’ receptivity and hope collided with a development that often ignites the fire of speculative excess, i.e. bubbles. That development was the emergence of a host of new technologies, such as smartphones, self-driving cars, drones, e-commerce, apps to do almost anything, ‘big data’, Artificial Intelligence, virtual reality, cloud computing, SAAS, etc. in the period between the 2009 and today. Hopes and dreams of grand returns lead investors to march into the abyss of speculative ventures, money in hand. They imagine a new world where everything will be different; say, robotic chefs, self-flying planes, mind-reading speakers, etc. The visions are sold to them by experts who take on different names in each speculative cycle but retain the same character – disruptor, ‘technologist’, founder, venture capitalist, or the plain old ‘visionary’. Not to say there aren’t true visionaries out there. But we should expect to get one Steve Jobs in a life time rather than one every Wednesday. 

Needless to say, some of these visions may actually come to pass. But the timing and profitability is greatly exaggerated by those promoting these ventures. Such promoters are sometimes fooling investors but, many times, are fooling themselves as well. One has to go back only to 1999 to see that many of the things envisioned at then came true, but not in 2000 or even 2002. They came true in 2016-2017. With the exception of Amazon, the imaginations of 1999 were accomplished not by companies who dreamed them (as most of those died in the subsequent crash) but by others who came after.

How do we know it’s a bubble?

These are many elements present today that were historically present in other bubbles (whether tulips, canals, gold, real estate, rail roads, government bonds, technology stocks, or countless others). These are briefly discussed below.

1.       ‘Something new’: Something new that engages the fancy of the investing public is usually the genesis of a bubble. As noted above, the period from 2009 to today has been especially productive in this regard. Exhibits include, smartphones, self-driving cars, drones, e-commerce, apps to do almost anything, ‘big data’, Artificial Intelligence, virtual reality, cloud computing, SAAS, etc.

2.       Prosperity: Speculative excess almost always occurs during times of prosperity. It’s difficult to get a bubble in the middle of 2008, 1974, or 1929. With unemployment at 3.7 % and stock market at an all-time high, we’re certainly feeling prosperous.

3.       Proliferation of promoters: As honey is to bees, money is to enterprising capitalists. Having seen money, fame, and success accrue to those who were early to start and  fund successful companies, a legion of ‘founders’, venture funds, investment bankers, consultants, and employees have descended upon the venture scene. An elaborate machine is at work to make all of the parties wealthy at the expense of investors. It works like this:

A ‘founder’ or a group of founders dream up an idea. A working product is quickly created, presented to venture funds and early stage investors, and is able to get funded. Goals are set for number of users and other such metrics, but not profitability. Accordingly, money is spent in promotions and sales/marketing to sign up as many users as possible (even though many might leave when the promotion period expires). The growth in users is relied upon to increase the valuation for the subsequent ‘round’ of funding, which is, of course, required to spend more to gather new customers. The business doesn’t generate enough cash flow or earnings to fulfil this very basic task of acquiring new customers. However, that is deemed to be okay because “old rules do not apply to the ‘Web 2.0 economy’, to ‘scaled businesses’, to ‘winner take all businesses’, to ‘flywheels’, or to ‘hyper-scale platforms’, etc.”, notwithstanding the fact that the proven large scale businesses (cable, telephone), platforms (credit card networks), and winner take all (rating agencies) businesses, and hyper scale platforms (search engines) were all profitable from the very beginning.

The higher valuation at a new funding round allows the earlier investors to ‘mark-up’ their valuations and show good returns on their investments though these, of course, are on paper only. These paper gains prove very useful in raising new funds. For e.g. SoftBank’s $100 billion Vision Fund apparently showed a 20% gain in just 5 months (even though it’s not fully deployed) which has allowed SoftBank to start working on raising a second $100 billion fund. The owners and managers of the venture funds take fees from these pools of investor capital and also take equity in the funded companies. The founders take more-than-decent salaries and also equity compensation (which is accordingly marked up at each funding). Same goes for the employees of the ventures who, though not perpetrators of the bubble, nevertheless temporarily benefit from it (on paper). The ‘eventual investors’, the endowments, pensions, universities, mutual funds, etc., see their capital accounts marked up and are quite happy with that. However, they do not have a ready exit, i.e. they cannot cash out their gains. That will have to wait for an IPO or a sale, if there is one. For now, of course, they don’t dream of ever wanting to get out of these investments (which have a rapidly upward sloping curve), a thought process similar that which led to them signing up for long “lock ups” to the hedge fund investments made in 2002-2006 (having tired of the tech bubble losses of 1999).

In the recent cycle investors have preferred to provide private capital. Conversely, companies have also preferred to stay private to avoid the scrutiny of the public markets. The focus on quarterly earnings (and, thus, short term focus) of public companies is blamed for this desire. There is some limited truth to this; limited by the fact that with dual-voting structures common in recent venture/tech IPOs, management is not necessarily beholden to Wall Street’s caprices. However, by staying private longer, the companies and their venture backers are also very happy to avoid facing the realities of life when they can’t decide their own valuations. As long as new investors can be lined up to pump new money in, venture companies can stay private and delay the day of reckoning.

Fundraising for venture has surpassed all limits. The Softbank Vision fund raised almost $100 billion to invest in venture companies. This one fund is larger than the entirety of the venture capital deployed in the United States in the year 2015. That would be incredible on its own if not for the fact that SoftBank is engaged in raising a second such fund! There’s no possible way to deploy this amount of money in venture companies. It’s indicative not of the need for venture funding, but solely that of the aforementioned incentives of promoters to raise funds on which fees can be charged, on which investment bankers may earn commissions, on which consultants and attorneys may levy their fees, and so on. The same funds, then invested at higher valuations allows funds to show more paper gains allowing for further fund raising. This cast of characters feast upon the infinite fund of naivety that exists during speculative episodes. Investors are most credulous near the peak.

4.       Rapidly rising prices: A rapid increase in prices is a characteristic of speculative bubbles. Due to the private nature of venture capital, this is not as obvious today as it would be in public markets. However, it’s very much present. A few examples, include the recent doubling of valuations of scooter companies, whose product has been limited/banned by many cities, is unsafe to use in rain, and whose target customers are engaged in defacing the product. Peloton tripled in 16 months. Snowflake and Stripe more than doubled in 18 months. Go-Jek and Meicai did even better doubling in 8 months. And SmileDirectClub bested everybody when its valuation went up 11 fold over 2 years to $3.2 billion. The common theme in all of these companies? A lack of profit to finance their own operations. Of course elaborate and reasonable sounding explanations are given as to why profits can wait four or five more years while the work of transforming mankind is carried out. But one plus one, by any rules of perverse mathematics, will never equal three and a quarter.

The abovementioned promoters of private venture companies have also resorted to using old tricks to beguile investors. When a private company goes public, it’s often beneficial to generate a ‘buzz’ around the IPO. This buzz allows for the price to rise rapidly, allowing the venture firms to show good quick profits on their investments. It also allows for insiders to offload stock at high prices and to attract employees. One way promoters do this is to IPO only a small portion of the total shares outstanding. Given the current euphoria in the market, demand easily overwhelms the number of shares available causing prices to skyrocket and attracting more buyers. The popular IPOs of StitchFix, Roku, Docusign, and Dropbox, among others, all IPOed less than 15% of their shares outstanding. By comparison, non-venture IPOs routinely sell between 30% to 60% of the float.

But how do the promoters get rid of the rest of their stock? Clearly, if it’s forced upon the market, prices will collapse. So they simply transfer it to the underlying investors in the venture funds at prevailing prices and show large gains. The problem of selling large positions in thus discreetly transferred to the investors.

The startup Brex exemplifies many elements of the bubble. Its business is extending credit cards to other startups who could not previously access such credit without a personal guarantee from the owners. Brex figured out that, without requiring a personal guarantee, the market for its cards would be very large! Brex extends credit based on the amount of money startups have in their bank accounts. Founded less than two years ago, with the product launched only four months ago, one co-founder said the company is on its way to “disrupting American Express.” Further, “if the company grows as much as we expect it to grow, it’s a $100 billion business.” How will it grow to be so large? “We don’t require a personal guarantee… and we can give people a credit limit that’s as much as 10 times higher…in literally five minutes”. And why should it succeed? “…because Silicon Valley companies are very good at spending money but making money is harder”, said the co-founder. In other words, given the large ‘addressable market’ of unprofitable venture companies looking for credit cards without personal guarantees, Brex has a bright future. It’s valuation promptly rose to a billion dollars valuation four months after its product launched!

On the public side, many unprofitable recent tech stocks have seen their prices double or more within the last 18 months. Examples include Okta, HubSpot, MongoDB, Alteryx, etc. Their businesses might be decent and may even do well over time. But the prices of these stocks are so high as to almost certainly give a bad result for the group as a whole.

5.       Weak protections, structures, and securities: In addition to actual fraud, plenty of moral fraud has been perpetrated upon investors. This often comes in the form of weak corporate and capital structures, voting, and remediation rights. In many cases, later venture investors demand rights superior to prior investors and can also sometimes block an IPO from happening.

In the public market, no one demonstrates the corruption of investor protections better than Snapchat. SNAP shares are divided into two classes, with the CEO/Founder owning one class and the public investors owning the other class. The public shareholder class has no voting rights whatsoever. The company which debuted at $17 and traded up to $27 on its first day 18 months ago, is now trading at $7 and barreling towards a liquidity crunch. Were it still private, more capital from uncritical investors might be pumped in (and perhaps the valuation raised on one account or another). But without the ability to change CEOs or, for that matter, vote on anything, no such bail-out has presented itself on the public markets. Unfortunately, SNAP is not an isolated case and examples of abuse of investor protections are not rare.

Of the popular IPOs referenced above, StitchFix, Dropbox, Docusign, Roku, all except Docusign debuted with multi-class structures where promoters will retain an outsized voting power even after selling much of their economic stake.

For an example of weak security, consider the case of self-driving car company, Nio. With a loss of $505 million in just the first half of 2018, a loss of $750 million in all of 2017, and revenue of just $7 million in the first half of 2018 and that of $0 in 2017, the Chinese startup went public in the US market at a valuation of $6.5 billion.

6.       Speculative Contagion: Speculative excess is a state of mind. As such, it is contagious like any human emotion. Consequently, speculative bubbles in history have occurred across many assets at once. Currently, in addition to venture capital, we are seeing speculative excess in crypto currencies, marijuana stocks, etc. All strata levels of society are involved. Even though venture funds are directly available only to wealthy individuals and institutions, crypto currencies and marijuana stocks have not exercised segregation based on economic class.

7.       Fraud: When investors get carried away and let their guard down, cons find it very easy to exploit their gullibility. We’ve seen this with high profile cases like the Theranos debacle but also in other small ways such as the recent Sequoia Capital ‘capital call fraud’. However, most fraud generally is exposed after a bubble bursts. So we should expect more news on this front in the future.

In the crypto currency space, which is also experiencing a bubble, fraud has been the rule rather than the exception. Even where there’s no outright fraud, we’re seeing exaggerated and misleading accounting practices, which are accepted by investors without asking very many questions (e.g. Tesla, WeWork, etc.). In the public markets, many companies are engaged in making almost comical ‘adjustments’ to their earnings to present a picture better than reality.

8.       Low interest rate: In the past four centuries, speculative bubbles have tended to build when interest rates are low. This factor is present today. The connection between rates and the desire/need to speculate was described above in the section, “What has happened?”

9.       A mass rush to become involved: The graduating classes of undergraduates as well as MBAs are shunning traditional post-graduation jobs to join the legions of startups and venture funds cropping up daily. Even established professionals have quit their industries to join startups. In the beginning investment bankers left to become tech executives. Most recently, Gary Cohn (ex-COO of GS and White House Economic Adviser) joined a block chain startup, Spring Labs. Further, in addition to large investors, mutual funds (Fidelity, T. Rowe Price, Wellington) have also invested in late-stage venture companies. Those owning these mutual funds have thus become involved, whether they know it or not.

On the other hand, to be fair, there are two elements of speculative excess which are not widely present to my knowledge.

1.       Credit: Buying and selling on credit is generally seen in bubbles. While we are not seeing this with venture capital, it’s not totally absent either. First, when the partners of a venture fund invest on behalf of their limited partners, they are not using debt. However, it has much the same effect as using other people’s money, which is what debt is. The venture partners are entitled to the upside in betting client funds but not the downside.

Further, SoftBank’s Vision Fund does employ leverage in the form of preferred shares. These were required to be purchased by the LPs as part of their equity investment, whereas SoftBank only bought the equity for itself. Thus LP’s provided leverage for their own returns and for SoftBank’s returns! Of course, SoftBank also has fees and carry on invested capital, which again is a leveraged payout as described above.

2.       Flipping: Buying assets solely with a view to selling them to the next person is a common characteristic of bubbles (such as crypto, tulips, canal scrip, consols, and marijuana stocks). However, we have not seen this in venture. That may be due to the difficulty associated with flipping venture investments, where the partners of the venture firms are expected to work with the investee long term on building the business.

How will it burst?

This is always tough to know. But to ignore the possibility is to shut our eyes to all prior history. Sometimes there’s a particular reason (such as mortgage rate resets in 2007) at other times there’s an external shock to the system which collapses the scheme (antitrust case against Microsoft in the year 2000). Yet other times, the bubbles simply collapse under their own weight. How it will end is not as important as it may seem. If we know there’s a fire in the movie theatre, knowing who will yell ‘fire’ is not as crucial as leaving as soon as we are able.

Yet, if I can make one observation on this topic, it is this. Bubbles only grow because risks are ignored. As a result, internal risk factors are not able to prick the balloon. Whatever kills the bubble will have to be an external shock as the market participants have already ignored almost all internal risks: competition, data breaches, regulation, expense growth, cap-ex growth, expanding losses. What will cause VC funds to stop funding? Only a lack of LP interest. What will cause that? Possibly something external. Once the external trigger is pulled, it’s the internal risks (heretofore ignored) that move to the forefront to finish the job.

There’s one additional peculiarity to the VC bubble. There’s no liquidity! Given that there’s very limited secondary trading, it’ll be very difficult for investors to get out of their investments as they watch them sink in value. However, the funds will try their best to not allow this sinking to happen too fast, seeing as the valuations are within their control (i.e. done by them). However, the pain, though delayed, must eventually come. Owing to low liquidity and control over valuations exerted by VC firms, the pace of decline is likely to follow the same trajectory as that described in Hemingway’s book, ‘The Sun Also Rises’. When asked, “How did you go bankrupt?” the Mike Campbell responds, “Two ways. Gradually and then suddenly.”

Who will be affected?

1.       Investors: One set of obvious victims is the investors. Unfortunately, this includes universities, pensions, not for profit endowments, foundations, etc. It also includes those who have purchased interests in special purpose vehicles or mutual funds that have invested in venture capital funds or directly in the underlying companies.

2.       Employees: Venture funded companies have attracted talent by the promise of equity awards, whether stocks or stock options. These employees are under the illusion that their equity awards have multiplied in value based on baseless valuations placed upon their employers by the venture funds. Each round of funding has diluted their equity interests. Should these companies collapse, the employees will find themselves without work, with equity they find out is worth much less than they imagined, and competing with the other freshly unemployed for a few job openings that remain.

What should you do?

1.       Investors: It’s easier to call attention to the difficulty than it is to propose a remedy. It’s not easy to get out of venture commitments. The best course is to find a secondary buyer if possible as an ounce of prevention should prove to be worth a pound of cure. Even a haircut of 10-15% to a current valuation (at which the investors will still likely realize gains if they sell now) will seem very modest compared to what they’ll get down the road. Further commitments to venture capital funds are to be avoided. Those owning mutual funds or special purpose vehicles, should consider selling. They should not think that they can identify ‘the top’. End of speculative bubbles come swiftly and even those aware of the bubble and waiting to get out can get caught. The other side of the coin is that investors will find opportunity in the washout, when the prices are right and the cream is separated from the crap. For e.g., if WeWork collapses, it might create real-estate opportunities in NYC and other cities.

2.       Employees: Employees are best served by taking advantage of this job market to find work with profitable, well-established firms, even if they have to leave some equity awards and bragging rights on the table as the cost of leaving their employer. At the very least, they should try to sell their employee equity on the secondary market that has emerged for such purposes.

“…the sudden Fall of our Stocks, without visible reason, is the Surprize of the world” – Applebees’ Journal, 1720


Under no circumstances should this communication be construed as investment advice or a recommendation to buy or sell any security, whether expressed or implied. Factual statements are believed to be truthful and reliable, but are not warranted against errors or omissions. Please do your own due diligence prior to investing.

Wednesday, September 12, 2018

Why I passed on Honeywell's spin-off GTX

Since Joel Greenblatt popular book came out, investors have been turning over every spin-off in search of profits. Lately the activity has turned into a fever to invest in every spinoff, replete with (totally expected) launch of ETFs that will allow one to do just that. Studies that show spin-offs outperform the indices have been used to push these ETFs. Yet, those studies have not looked at what happens when everyone chases spin-offs. I suspect the future results from blindly buying spin-off may not be as good as past results, though they can be decent. This is all simply a long way of saying that investors must study each spinoff thoroughly to determine whether it’s likely to succeed (or even survive) on its own merits.

Investors in Garrett (GTX) the coming spinoff from Honeywell (HON) might benefit from doing the same. Suppliers to ICE autos have recently traded at low multiples due to fears of EVs, automation, peak auto cycle, etc. I am not an expert in this industry so I am unable to comment as to its future. There are many views on the issue (EV’s will not happen, they will happen slowly, automation will happen next year, or it will never happen, etc.) and I don’t know which one is correct. But Buffett, did once say that you don’t have to know exactly how much a man weighs to know if he is fat. In that vein of thought, one thing stood out to me from the GTX Form 10 and their investor day presentation.

The leverage, as presented in the investor day presentation (as well as the form 10), is not appropriate for use by equity investors and understates valuation.

The Form 10 Adjusted EBITDA adds back the legacy asbestos liability payment to Honeywell (related to Bendix). Presumably this document is directed to equity holders. On the other hand, in the credit agreement Adjusted EBITDA, this payment is not added back. Correspondingly, the credit agreement numerator does not include the present value of that liability. This indicates debt holders think of the asbestos cash outflows as not available for principal and interest payments (i.e. coverage has to be provided by after-asbestos cash flows). Thus, leverage is calculated off the lower EBITDA and the lower numerator. While this may be okay for the creditors, it’s certainly misplaced in the equity roadshow (investor day presentation).

To the extent Adjusted EBIDTA provided in the Form 10 adds back the asbestos payments, equity holders ought to recalculate the leverage ratio including the present value of such payments ($1.4 billion) in the numerator. All of these payments are ahead of equity holders. In fact, the asbestos liability, with a maximum annual payment of $175mm on a PV of $1364mm, is perhaps the most expensive of GTX’s ‘debt’. The recalculated leverage would be 4.8x v/s 3.25x presented on investor day.

Many of GTX's peers trade at a total EV/EBITDA multiples close to GTX’s leverage level alone (including the asbestos liability as noted above). This means Honeywell is getting paid full value of the business (through the dividend now and the continuing asbestos payments) in cash, leaving behind a highly leveraged business. With reference to the Buffett quote above, this man does not look fat! While that alone is not a sufficient reason against investing in GTX, it certainly was a quick way for me to move on to something else (given lack of industry specific knowledge). It appears the spin-off is designed more to benefit Honeywell by providing earnings boost to the parent by pick-pocketing the child. This history of these types of spin-offs has not been good.

Why make a post about something where I passed on investing? First, one of this blog’s purposes is to serve as a store of my thought processes which I can go back to later to see if I was right or wrong and to learn what could have been done differently. Second, this blog has very few other readers (to my knowledge) so I tend not to write with a particular audience in mind who might like to hear about this or that investment idea. I simply write my thoughts which does some include investment ideas but also includes other items I find interesting.


Under no circumstances should this communication be construed as investment advice or a recommendation to buy or sell any security, whether expressed or implied. Factual statements are believed to be truthful and reliable, but are not warranted against errors or omissions. Please do your own due diligence prior to investing.

Tuesday, September 11, 2018

Tom Rutledge's (CHTR) Widely Reported Equity Award Quantified

In the last two years, any discussion of Charter (CHTR) has not been without reference to the equity incentive package issued to the senior management team of the company in 2016. Greg Maffei has spoken about it to anybody who will listen (which is a lot of people because Maffei has a good track record as an investor). Seeking Alpha/VIC/COBF/etc. posts have also referenced it. But I had yet to see it quantified. Of course, there’s the headline figure of $99 million for Tom Rutledge (CEO) from the 2016 proxy statement. But serious investors know that the Summary Compensation Table in the proxy statements tells us almost nothing about the reality of compensation plans.

To really understand things, I’ve tried to make sense of that particularly large equity package granted to the management team by quantifying the pay-outs to the CEO in the event of the stock price reaching various thresholds. The results are in the following table:


I have calculated the payout at each threshold assuming Rutledge exercised all of his options at that threshold. So, for example, the 364.97 threshold assumes that options vested at 289.76 are also held and exercised (or exercised and stock held) at 364.97 per share.

It could, just as easily, be argued that the decision to hold from 289.76 to 364.97 is Rutledge’s own investment decision unrelated to any equity incentive envisioned by the BOD. However, it could also be argued that, if he believed in these targets, there is no reason he wouldn’t hold as many options as he could as long as he could. In that case, to see the maximum upside to Rutledge, we must assume that he does hold these options.

In reality, he likely does not have the type of additional liquid funds required to exercise the options, hold the underlying stock, and to pay taxes thereon. So readers can make their own changes to the calculation as needed. There are too many permutations and combinations for me to address them all here. The conclusion remains that this award package should serve to incentivize Rutledge rather well. Perhaps, more than well.

There are also further small equity awards/grants, but I have only attempted to quantify the large award from 2016 which is the largest portion of Rutledge's compensation 2016 onwards.


I own shares of CHTR (through LBRDK). Under no circumstances should this communication be construed as investment advice or a recommendation to buy or sell any security, whether expressed or implied. Factual statements are believed to be truthful and reliable, but are not warranted against errors or omissions. Please do your own due diligence prior to investing.

Thursday, August 9, 2018

Luxury Purchases Masquerading As Recurring Revenue: Is No Price Too High For Subscription Businesses?

Venture capitalists have added a new dimension to that well known Sherwin Williams slogan by covering the earth in subscription businesses. Having a ‘subscription’-based revenue stream today makes a business worthy of investor affection, even adoration. Even established businesses are contorting themselves into subscription services. Subscription revenue (and its cousin recurring revenue) is the elixir that makes fund raising and rising valuations possible. Startups and established businesses want you to buy mobility, ‘subscription boxes’, clothing boxes, shaving razors subscriptions, meal kits, computing power, online storage solutions, etc. all on a subscription basis; or better yet, ‘as a service’. In the view of this, let’s consider two thought experiments.

If you sell a widget, is your business worth more if you sell it as a subscription than if you sell it on a traditional ‘as needed’ basis? I believe the answer is no. All told, the consumer sees the same value in the product. Take meal kits. A consumer might be willing to value a meal at $10. That won’t change just because they ‘subscribed’ to a weekly delivery. Further, food consumers, in aggregate, will not rapidly increase their consumption (they can only eat so much, subscription or not) by more than say, 1-2% a year. That is just the nature of food consumption growth. One meal-kit company might divert a little business from a restaurant to grow faster using promotions. The same could be said of clothing boxes, etc. But when the whole industry doesn’t grow, the value proposition has to be undisputable. It’s true that where a subscription is priced lower than the traditional delivery mechanism (e.g. dollar shave club), there’ll be large consumer uptake (by drawing business away from incumbents even in a low-growth market like razors). But that is not a new paradigm; it’s simply proving an old paradigm that consumers gravitate to lower prices for equivalent value. So if every business in the country/world became a subscription business would they all be worth more? Certainly not. For one, most of these industries aren’t growing as a whole (food consumption example noted above). Second, aggregate revenues (based on what the consumer is willing to pay) don’t change and aggregate expenses probably go up because of the logistics involved, which means margins are lower. Third, there exists a mass of well-funded venture-backed competitors willing to lose money. Can this set the stage for increased valuations? In my view, no.

Yet, today companies are twisting themselves to fit a subscription model. Why? Because a sound idea (this time taken from software businesses) has come to dominate thinking in spaces where it just doesn’t apply. Subscriptions are used to tout customer “LTV”. Then LTVs are used to justify the need to invest NOW (before competitors invest) with venture raised funds rather than reinvesting capital generated by the business. But why the hurry? Why not prove the concept and then re-invest profits to grow the business? The thinking goes, “We cannot wait. E-commerce is a winner take all market. We better dominate before our competitor does”. In reality, there are very few winner-take-all markets. Internet Search is one of them. The credit card networks are another example. Meal kits are certainly not winner-take-all markets, though that didn’t stop HelloFresh from claiming that it was. There is no need for all consumers to order from the same provider. Same can be said for the growing list of clothing boxes, online storage companies, and market places. But consider how easy it is to sound like you have a network business… “Well, we will lose money to acquire a mass of customers. When we have a lot of customers, we can afford to have a lot more widgets (whether clothing options, meal recipes, data storage, or any other item), which means we can have yet more customers attracted to the growing choices now available. And no one will be able to steal customers from us, due to our scale. This means customers will not leave us…which means our LTV is large, which means we better lose money now to acquire customers.” This type of a sales pitch is happening daily in the VC/incubator/angel world. What are essentially luxury purchases afforded by the few are marketed to many in the upper reaches of an economic boom by the use of promotion subsidies (funded by VCs). The reality of Blue Apron, BirchBox, Chef’d, etc. would make one think the backyards of VC firms seem should be knee deep in dead subscription/network businesses. That reality has not been reflected in investment decision making.

The second thought experiment is comparing subscriptions to leases. When calling something a subscription business, it’s helpful to compare it to a lease. Leasing companies do not generally trade at the kinds of generous valuations afforded to ‘subscription’, ‘marketplace’, or ‘recurring revenue’ companies. Why? Because they are financing companies, subject to the vicissitudes of the economy, credit quality, unemployment, defaults, etc.

One thing a lease shares in common with a subscription is recurring payments. But there’s a big difference. While a lease is a legal contract requiring payments, a subscription is ‘at-will’ and cancellable with little notice. Leases also generally finance ‘expensive objects’ which are sold once and paid-for over time. But in services (meal kits, delivery, or mobility), there is no object; the service is continuously provided. This seems like a big difference and is the reason why financing components of, say, John Deere are easily separated for analysis. However, I believe the second difference is only cosmetic. The company is agreeing to keep providing the service (which means they must keep incurring related expenses) and the subscriber is agreeing to buy it, until they stop buying it. What makes some subscription businesses better than others is that the nature of the product keeps the customer from cancelling. For e.g., ERP software. This makes is kind of like a lease (but even better), an almost-certain stream of payments from the consumer that is unlikely to get cancelled baring the unthinkable. This is why the concept of LTVs made a lot of sense is some types of software. However, that is certainly not the case with a meal kit, a Netflix subscription, or even in-app purchases. At the first hint of trouble to the consumer, the meal kit, the clothing box, and other ‘subscriptions’ are as likely to be shown the door as a meal out at a restaurant and a shopping trip to Nordstrom. Leases will fare much better as they did during the GFC because of their contractual nature. And if we value lease companies with the fear of credit quality, economic fluctuations, and default, then these should be considerations for ‘subscription’ businesses also, which are already structurally weaker as noted above.

This extends even to established platforms like Apple. While services revenue is growing at a nice clip, will it be too difficult for end users to switch to free Google Photos (or other storage) from iCloud in the event of a little belt tightening? This line of thinking applies to even phone sales which, having stagnated, are now reliant on price increases. Many customers finance their phones (a true lease, not ‘communications subscription’) as you would a big ticket appliance (the phone almost replaces the ‘home computer’ of yesteryear). As a result, in a less forgiving economic environment we should expect the sales of high-end phones to show the similar (though less severe) character as sales of homes or cars, i.e. consumers make the old ones last longer are loathe to take on (and do not qualify for) new financing. I’m simply using Apple as an example. I don’t think this factor should have a big bearing on Apple’s valuation because Apple’s valuation is quite reasonable and some of this appears priced in unlike in the subscription unicorns of the world.

The latest example of the luxury good masquerading as a subscription service is, of course, Peloton. The company raised $550 million just a few days ago at a valuation of $4.15 billion. Just 16 months ago, this valuation was $1.25 billion. According to Fortune, “Peloton will use the money to expand internationally, bring a treadmill to market and establish itself as the premier source of fitness-related content. The company will open in Canada and launch five retail locations in the U.K. this fall, its first moves beyond the U.S.”

The proposition goes like this: you buy a $2000 stationary bike. This can be financed in a ‘true lease’. Then you pay an additional $39 per month ‘subscription’ to access their library of training videos. “The Peloton Monitor only shows Peloton content. Without the subscription, the bike will have 3 pre-selected classes and will show the metrics while riding, but will not track them to your profile”, according to the company. In other words, the Peloton bike is useless without the subscription. Even at a 0% APR, the cheapest package costs $58 per month for the bike (for 3 years!) and another $39 for the subscription, for a total of $97 a month before taxes. (The newly coming treadmills will sell for $4000, so the cost will be almost double for runners). Now this total of $97 is more than the monthly cost of many gym memberships, which come with live classes. If gym memberships didn’t have great persistence when consumers suffered last time, what gives confidence that Peloton costing many times as much will? The company wishes to establish a ‘platform’ by signing up fitness content (like Netflix) to be transmitted through the Peloton monitor. Needless to say, with normal stationary bikes retailing on Amazon for $200 and free availability of YouTube classes, the value proposition is seriously in question.

Also not to be ignored by investors are the omni-present competitors in a capitalist economy such as Flywheel, NordicTrack, and Echelon. Part of the recent capital raise will be used to fight these competitors, which is generally not a positive-return activity. However, this is a season where no price is too high. Accordingly, the company is looking to go public in 2019, notwithstanding the fate of Soul Cycle whose IPO was cancelled last May due to ‘market conditions’.
The CEO has said the company is profitable, though it’s not known on what basis…GAAP, non-GAAP, EBITDA, Adj. EBITDA, or EBITDA before customer/marketing expenses (seriously, this exists). Certainly, Peloton isn’t profitable enough to fund $400 mm on its own or in the debt market. But, when a $4.15 billion valuation is placed on a company with $700mm in revenues, unreliable profitability, a small target market that solely resides in large cities with high incomes and small dwelling, it seems ‘subscription’ based ‘platforms’ are a better sales pitch to investors than $4000 treadmills might be to consumers. Investor enthusiasm at this price, which has already tripled in 16 months was best captured in a NY Times article,

Jay Hoag, general partner of TCV, compared the business model to Apple’s iPhone and App Store. And he said Peloton’s repeat revenue from subscriptions reminded him of Netflix, where he’s a board director, and of Spotify, a TCV portfolio company. “They have a similar-sized opportunity to reshape fitness,” he said.

Sunday, July 29, 2018

An example of bubble valuation, Netflix

Continuing the theme of the previous post…

Let’s take the example of Netflix (NFLX), a company known to most readers which also happens to be currently popular with the investing public. I think Netflix is a great product, possibly even a good business when stabilized, but it is likely to be a disaster as an investment given the current price of $420 (i.e. a market cap of $175 billion) supported by earnings of $0.6 billion last year and no free cash flow. It is argued that scripted programming streaming services are a “winner take most” market and, thus, it makes sense for NFLX to lose a copious sums of money to “land grab”. Profits are expected to come when the company doesn’t need to invest as much in programming as it does today, presumably after all of the land has been grabbed. Price increases are also expected to increase earnings.

Here are a few reasons why the investment is not likely to work out. Before I list the reasons I would like to restate a simple fact that is sometimes overlooked in the jargon-filled investment frenzy that is the current VC/tech environment. To be valuable, a company needs earnings in the foreseeable future. And for a company to have earnings (or to create them if it doesn’t), revenues need to exceed expenses.

With this simple framework, let’s compare Netflix with the traditional cable networks. The traditional networks routines report EBITDA margins of around 40%. This is achieved with 90-100mm subscribers paying from $0.5 to $7 per subscriber per month. The range is wide because of outliers; most networks seem to command between $1 and $3. Traditional network metrics suffer from the distortions of bundling. Not all of those 90-100mm subscribers necessarily watch each channel. They receive it as part of their ‘video bundle’, that great Achilles heel of traditional video model. So, for example, if 1/3rd of the ‘customers’ actually watched a given network, the economics would stay the same if the network charged 3 times as much, so $3 to $9. This would be the appropriate comparison to Netflix. The rub is that no one really knows (though there are guesstimates) what the actual ‘true penetration’ of a given cable network is. There’s another way to think about the issue.

Netflix has 55 million subscribers in the US. Let’s say it gets to 100 million subscribers, i.e. every household that once watched linear TV now subscribes to Netflix. This is envisioned in some bull cases. This would necessitate Netflix replicate all of the varying tastes and preferences of all of its customers currently provided by the cable bundle. Let’s assume that such tastes and preferences are captured in the top 20 cable networks and scripted programming from OTA broadcasters. Not many folks watch some of the fringe channels that are crammed down their throats by the cable network owners. The top 20 channels and scripted programming from OTA alone would be responsible for approximately $20 per month in programming costs (and that’s being conservative). To run a 40% EBITDA margin on this number would require a monthly bill of $50 (in cable networks some of this is lowered due to advertising, which Netflix doesn’t do). Of course, Netflix has other expenses which cable networks don’t since Netflix is a content owner/licensor and ALSO a distribution platform with the attendant costs of advertising, customer service, billing, etc. So the bill could look even higher. This would be revenue side of the ledger.

But why should Netflix try to earn margins equal to cable networks? Could it be okay with less? To say that Netflix can run with margins less than traditional cable networks could work for Netflix as a company, but not for the $180 billion valuation placed upon it by the investors. My point is that the company can do fine even as investors grow poorer. A $180 billion valuation means Netflix needs to earn at least $8-9 billion at most 3-5 years out. This cannot happen without higher margins. Increased margins can come from two sources. First, more customers without an increase in content spend (i.e., people join Netflix to watch older shows). Second, price increases.

As to the first, I believe content life is shorter than many investors assume. The company needs to keep buying (like all media companies) and the so called “moderation” in content-spend is not in sight. As noted above, Netflix will find itself needing to invest to replace the total content production of the top 20 cable networks and OTAs if it is to indefinitely retain their customers.

Further, the company WANTS to keep buying globally to drive subs. The need to drive global subscribers is self-inflicted. If Netflix was just a US platform, I don't think they'd necessarily face a threat from some platform in China or India (unlike social networks, payment systems, etc. which have demonstrable cross-connections across geographies). But people (and management) say that shows from other countries are watched in the US and vice-versa which subsidizes costs of production by driving higher audience. But there are only 24 hours in a day! So for each person that watched a German show in the US, that person didn't watch an American show (on that day). So the American might've subsidized the German show but the German subsidized the American show. We simply cannot create something out of nothing unless people increase their TV viewing time (which is not happening according to reported figures). By trying to have a platform that's a little something for everyone, cost-wise, it starts to sound similar to the cost of a 20 channel bundle, but sold for $8-10 per month. In other words, Netflix will have to increase prices substantially.

On that $8-10 per month, it’s also unclear whether this will work very well in India (part of the bull case). That's a lot of money for most Indian people. Maybe in the cities it works for a small segment. But the competition (Hotstar) charges only $3 and the film/production industry ("Bollywood") is very advanced in India; they don't need to import shows. So why would a satisfied Hotstar customer move to Netflix to pay double? Perhaps for the occasional international show or Netflix Original. But password sharing (very common in India as it is here) will take care of that so penetration could be an issue.

As to the second source of increased margins, i.e. pricing, what seems to make today's valuation work out is a price of $25 or so (in addition to the linear TV, which customers will have to buy separately, that gives them sports and news, absent from NFLX). I don't know if people will pay that in the US, let alone in other countries. I'm not sure a price like that could be justified by "we have a lot more content that we invested in", again given just 24 hours in the day, people can only watch so much and many are focused on the latest releases (which happens to be what their friends are watching and what is on social media) and maybe something from two-three years back. Even the viewership of the great hits of just 3-4 years ago (Breaking Bad, etc.) doesn't seem that good (anecdotally).

To sum it up, I view new content as mostly ongoing customer acquisition and maintenance cost, which is similar to any other media company. But other media companies don't over-produce shows and charge little for them. So Netflix is going to have to price similar to any other media company, or continue to spend as they have and come up with reasons why free cash flows don't matter. Why this is so actually has to do with the phenomenon that launched Netflix itself: multiple distribution points for video (v/s the past) and the golden age of TV. The competition for the OTT ‘land grab’ has increased costs of video to a point that had made it unaffordable for the public. Whether the unaffordability flows through cable pipes or through Netflix (which currently subsidizes the unaffordable product in the capital markets by consistently raising debt from a currently-avuncular bond market) shouldn’t matter. I just don't see a "first mover advantage" for this industry. Customers are free to switch/cancel when the price gets too high or content reduces (due to moderation, if it is actually done), both part of the bull thesis.

Moving on to valuation, it is doubtful the company will generate free cash flow on any reasonable timeline that would support its current $420 per share valuation as shown above. Even if all works out as hoped by the bulls, the multiples are STILL high!

Update: In late July, BTIG put out a research report which calmly calculates a 17x EV/EBITDA multiple to the 2022 EBITDA which is expected to quintuple from 2018's EBITDA. So even if the most bullish case comes true, this is the multiple applied to it for the price of $360 (at the time of their report). Their PT is $420, which requires a 2022 EV/EBITDA of 20 and the same quintupling of EBITDA."

Monday, July 9, 2018

A Possible Bubble In Venture Capital

As much as I like Amazon and admire Jeff Bezos, I believe Amazon’s success (combined with the zero interest rate policy of the Fed) kicked off a type of thinking that, in my view, has now led to a bubble in Venture Capital and some areas of publicly traded tech companies (though not all; notably Google, FB are highly valued but within fair zone, Apple even has a bargain ‘multiple and growth combination’). Amazon was the initial (and possibly the only surviving) pioneer of this idea which took root in the late 90s and generally goes, "We are investing for the next 50 years, hence, earnings don't matter, we are building scale, gaining first mover advantage, profits will come later, we are plowing all our earnings into growth investments, etc.” It might be true for Amazon. But, as always, first the pioneers, then the imitators.

What has happened is that today this logic gets thrown around by every newly formed highly valued company as an excuse for losses (witness Softbank's grand 300-year plan and its investees equally grand losses). It's almost as if profits are anathema for a company with a big plan and grand dreams. Exhibit A: Uber, Lyft, WeWork, Slack, Spotify, Square, Shopify, etc. What started off with the companies has now been seized upon by investors to justify buying something (anything?) that they want to buy. The scooter companies (Lime, Bird) are the latest, but by no means the only, examples. Bird's latest valuation is $2 billion as of June 2018 funding....compared to a March 2018 valuation of... $300 million. So a 6.6x in three months. Uber invested in the rival to Bird, called Lime, and bought another scooter company called Jump. So unicorns investing in unicorns, all without profit. It started with a good idea but, in my view, we are now squarely sitting in the crazy territory where anything goes. The rationales given for losing money can even be made to sound legitimate to those only paying casual attention, to those blinded by the possibilities of high returns (drawing, of course, from the bottomless well that is past returns), to those who have not studied history, and to others who desperately want to believe. As an example, see this explanation of their investment strategy given by Softbank's investment professionals ( Softbank not only justifies large valuations on companies with gargantuan losses, but also believes that putting more money into a loss making company actually serves as a competitive advantage (which strikes me as bull market thinking). Since only companies with large losses need large external capital raises, theirs seems to be a roundabout way of saying the more money you lose the better!

I think it's a great case study of social proof, commitment tendency, and authority principals at play. At the extremes, investors even WANT to be fooled, i.e. they might agree it's not okay to just focus on DAU, MAU, subs, etc. but as long as everyone else is focused on it, they might feel that's what the company should do so that the stock/valuation can go up quickly.

There is no basis in history that would allow engaging in this type of behavior without penalty. Examples include the Nifty Fifty of the late 60s and early 70s, the 1999 tech bubble, and others. If history remains a faithful guide and laws of mathematics (particularly time value of money) remain in place, there is every reason to expect that new investors will learn old lessons again.

In the next post, I take a specific investment to further illustrate this point.

Friday, July 6, 2018

Ross Stores, A Good Investment

I recently wrote an article for a financial publication discussing why Ross Stores (ROST) represents a good investment. At a high level,

1. Ross has has been around for about 35 years and their 'formula' has worked quite well for that entire duration (with occasional ups and downs that face all businesses). All of its growth has been 'organic'. Yet, Ross is currently in 38 states with dd’s DISCOUNTS in 17 states. There's a long runway.

2. Return economics on new stores are terrific, which translates to a very high return on equity. (Ross does not have material intangibles). Hence, the above-mentioned long runway can be pursued profitably.

3. Same store sales are good and will continue to be so.

4. Excess cash flow is used to pay dividends and repurchase shares. Since the business is attractive, the valuation is reasonable, both these uses leave shareholders better off. Lack of M&A reduces chances of misapplication of capital.

5. Even though the valuation is 'fair' and not cheap (at $77 per share), the current price will likely provide better than market returns over time.

For more details, including numbers, please see link below: