The Path to Profits Isn't Always Paved in Red Ink

By Berna Barshay

Monday, April 5, 2021
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► Everyone in the market is trying to find the next Amazon (AMZN)…

When I wrote about the legacy of Amazon founder Jeff Bezos upon the announcement of his retirement as CEO in February, I noted how the success of Amazon had forever changed the markets…

Perhaps because of my financial markets bias, to me, the most resonant part of the Bezos legacy is his changing the markets (possibly forever).

The promise of something being “the next Amazon” has taught public markets investors to tolerate many years of losses in large public companies, as long as the total addressable market (“TAM”) is large enough. This simply didn’t happen before Amazon.

Investors were asked to show tolerance for many years of red ink at Amazon. Patience isn’t necessarily a common trait among investors – whether amateur or professional. But those who practiced it with Amazon were obviously handsomely rewarded, which led to increased patience in general among many investors for large-cap, money-losing companies… as long as they were deemed “disruptive” and had “big TAM.”

I speculated that this newfound patience will likely have both good and bad consequences for investors…

Because of Amazon, some incredible company will likely get built which otherwise might not have. In pre-Amazon days, an entity that needed to consume a lot of capital might die before reaching its promise… and profitability.

On the flip side, there’s no doubt in my mind that the thirst to be in early on “the next Amazon” will cause a big transfer of losses from venture capitalists to public markets investors. Some of these “big dream” companies with large capitalizations and no proof of being able to make money will eventually go bankrupt, taking a lot of public markets money with them.

If anything, the investor quest for a lottery ticket in a sea of red has only been reinforced by the remarkable performance of Tesla (TSLA). The electric-vehicle (“EV”) maker went public in 2010, and after 10 years as a public company, posted its first meaningful profits in 2020.

Debate rages over the valuation of TSLA shares, which trade at a price-to-earnings ratio (P/E) of a mere 160 times. But there’s no doubt that the stock has rewarded patient investors… It’s up roughly 7 times in the past year, as the company finally went in the black.

Not every large-cap, money-losing company with a big dream will eventually turn into Amazon or Tesla… but all of them will tell you that they will.

I’ve long believed that for every money-loser eating up billions in venture and public markets capital that eventually turns out to be a winner, there will be many other losers…

Some will turn the red ink into profits, but not enough of them to justify their peak valuations. Others will go belly up someday when the spigot of new capital runs dry.

Given this outlook, my curiosity was certainly piqued by a blog post I read last week. In a post called “Ponzis Go Boom!!!” on the excellent AdventuresInCapitalism blog, professional investor Harris “Kuppy” Kupperman wrote…

For the past few years, I have been critical of the Ponzi Sector. To me, these are businesses that sell a dollar for 80 cents and hope to make it up in volume. Just because Amazon ran at a loss early on, doesn’t mean that all businesses will inflect at scale.

In fact, many of the Ponzi Sector companies seem to have declining economics at scale – largely the result of intense competition with other Ponzi companies who also have negligible costs of capital.

I recently wrote about how interest rates are on the rise. If capital will have a cost to it, I suspect that the funding shuts off to the Ponzi Sector – buying unprofitable revenue growth becomes less attractive if you have other options.

Besides, when you can no longer use presumed negative interest rates in your DCF [discounted cash flow], these businesses have no value. I believe the top is now finally in for the Ponzi Sector and a multi-year sector rotation is starting. However, interest rates are only a small piece of the puzzle.

I generally agree higher rates are risky for high-flying, highly valued stocks… and stocks of companies that produce no earnings or free cash flow are by definition highly valued.

But interest rates, while up, are up from historically low levels… and therefore after meaningful moves upward are still low on an absolute basis. The move in rates likely doesn’t move the needle enough to pop the bubble, whether calculating a DCF or thinking about asset allocation between stocks and bonds.

But Kuppy offered two other catalysts for the bubble popping in what he calls “Ponzi stocks,” or what I alternatively deem companies enjoying “profitless prosperity.” Those catalysts are supply and taxes…

I believe two primary forces were at play that finally broke the Internet bubble; equity supply and taxes. Look at a deal calendar from the second half of 1999. The number of speculative IPOs went exponential. Most IPOs unlock and allow restricted shareholders to sell roughly 180 days from the IPO.

Is it any surprise that things got wobbly in March of 2000 and then collapsed in the months after that? Line up the un-lock window with the IPOs [initial public offerings]. It was a crescendo of supply – even excluding stock option exercises and secondary offerings. The supply simply overwhelmed the number of crazed retail investors buying worthless Internet schemes…

However, the proximate cause of the Internet bubble’s collapse was when people got their tax bills in March and had to sell stocks to pay their taxes in April. What’s the scariest thing in finance? It’s when you owe a fixed tax bill from the prior year, yet your portfolio starts declining. You start selling fast to stop the mismatch. Trust me, I’ve been there. Tax time is pushed back a bit this year, but it is coming.

Kuppy goes on to mention the mountain of insider shares associated with last year’s flood of special purpose acquisition company (“SPAC”) deals.

He also reminds readers that just as shares of an IPO may only represent 10% of the shares of a newly public company, there’s a big supply of hidden shares behind every SPAC deal…

When you look at a pre-merger deal trading at a big premium to the $10 trust value, you’re looking at an iceberg. There might be 10 or 20 restricted shares for every free trading share – all of these guys desperately want out.

It’s a game theory exercise – how do you find enough bag-holders without destroying the price? Hence, part of why the current price is determined by an artificially restricted float and the unlocks come in tranches. As restricted shares come unlocked, the promoters lose control of the float and the house of cards collapses.

If Kuppy is right and we see a flood of newly registered shares drag down the prices of many SPACs, what does that have to do with non-SPAC companies currently losing money?

Kuppy argues that a supply-driven SPAC implosion could be a contagion given high levels of leverage and an overlapping shareholder base with what I call the “profitless prosperity” companies…

You may wonder how the SPAC bubble will infest the rest of the Ponzi Sector. It comes down to collateral and shareholder bases. On the collateral side, much of the Ponzi Sector bubble is built on leverage. That could be margin debt or YOLO call options, but it’s all leverage. As asset values decline, brokers will force punters to de-lever.

This will lead to waves of selling, leading to more forced selling. As for YOLO call options? They’re not exactly firm bedrock when it comes to a bubble. The SPACs and the Ponzi Sector are all tied together, because they all have the same shareholder base. As these owners take losses, they’ll be forced to sell “best in class” Ponzis like Tesla.

Kuppy goes on to describe the club deals that defined the Internet bubble, which I remember well…

Back in 1999, there were various firms that enabled the Internet bubble. They had handshake agreements that they’d be given IPO allocations, on the understanding that they wouldn’t sell – in fact, they frequently bought more in the open market, often at many times the IPO price. This allowed VC firms to tighten up already tight floats and manipulate shares higher.

As these firms outperformed, they had inflows, allowing them to continue buying the same companies and pushing shares higher – leading to more inflows. It was a virtuous cycle and many firms worked together as wolf-packs in the same names.

Of course, if redemptions came, eventually the pacts would get broken, and the supported names would no longer be propped up… and would come crashing down.

We saw a version of this last week with ViacomCBS (VIAC) and Discovery (DISCA) in the wake of margin calls at Archegos Capital Management.

Kuppy calls out the ARK Innovation Fund (ARKK) as a player in 2021’s equivalent of the 1999 clubroom deals… and predicts that things won’t end well for ARK Invest.

If he’s right, will a fall in SPACs or what Kuppy calls ‘Ponzis’ bring down the whole market?

Not necessarily…

Kuppy specifically says he doesn’t know when what he calls the “Ponzi Sector ecosystem” will blow, but notes that “bubbles are highly unstable – if they’re not inflating, they’re usually bursting – there isn’t really a middle option.”

He also acknowledges that it’s quite possible that the Ponzi Sector blows, but a different bubble emerges to take the market to new heights.

With the real economy accelerating, I think that a big supply-driven correction in SPACs or the loss-making unicorns that he calls “Ponzis” could happen without dragging down the overall market.

Selectively, we’re seeing some IPOs of loss-making companies fall on their face, only very recently.

Among the recent IPOs that haven’t gone as planned is profitless real estate technology company Compass (COMP), which debuted on Thursday at $18 per share after planning to initially price at $23 to $26. Loss-making, U.K.-based food-delivery app Deliveroo (ROO.L) is also on the list, about which the Financial Times quoted a banker calling it “the worst IPO in London’s history.” Deliveroo shares slumped 26% last Wednesday during their first day of trading.

The poor reception of the Deliveroo IPO is reminiscent of the tepid greeting given to shares of health insurance provider Oscar Health (OSCR) following its debut last month. After the underwriters repeatedly raised the price for the offering, shares sank 21% in the first three trading sessions. The company, which is expected to be loss-making through 2025, currently stands 35% below its IPO price.

While the market sits at new highs, the appetite for IPOs has gotten decidedly more discerning. Something has shifted in the demand for unproven companies.

I don’t think this is enough to drag down the markets, although it could slow the IPO calendar.

So far, investors still seem patient with profitless prosperity outside of new IPOs. My barometer for profitless prosperity in this market cycle has been ride-hailing app Uber (UBER), which currently sits close to all-time highs.

The dream of finding the next Amazon is still alive and well… although perhaps reigned in just a touch at the edges.

In the mailbag, readers reactions to Enrique Abeyta’s guest essays on electric vehicles, with one very timely letter given today’s essay topic…

Do you think we’ve reached the peak for SPACs and IPOs this cycle, or will this be the pause that refreshes? How comfortable are you with buying stocks in companies that have never been profitable? Has that strategy worked in your portfolio, beyond just Amazon? Share your thoughts in an e-mail to [email protected].

“Enrique! Hi there. I just read in Empire Financial Daily of 3/23 that you are down on Uber. I just was convinced to invest due to its goal to have its own entire fleet of driverless vehicles and become the taxi company to the world. I don’t think you would have missed this. So, why are you down on Uber? I subscribe to all your newsletters and I believe you know what you’re talking about. Please reply or direct me to previous articles where you address this subject. Thank you.” – Glen W.

Berna comment: Hi Glen, it’s Berna answering for Enrique… but he outlined his negative thesis on Uber extensively last May. I share his skepticism.

Since Enrique shared those thoughts, Uber made a big divestment in autonomous vehicles (“AV”) – that’s not something a company would do if it thought it would dominate a market.

Like Enrique, I’ve never been a fan of Uber. I consider it a “musical chairs stock”… Its value is primarily driven by what the marginal buyer will pay for it, not its current or future fundamental earnings or cash flow. That can be profitable for shareholders for extended periods, but eventually marginal buyers start to disappear like chairs disappear in the children’s game. When that happens, stocks can quickly lose value.

I think we’re getting closer to the musical chairs game ending for the profitless prosperity cohort, which includes Uber. I’m avoiding companies like Uber with no history of profits unless I have high conviction that they’re on the path to profits in the next year or so.

P.S. I did check with Enrique, and he adds that “having the goal of having a fleet of driverless cars and having the capital and resources (management) to get there are two very different things.”

“As a longtime owner of a 2017 Chevy Bolt EV I would caution you to consult with other EV owners about the ‘charging infrastructure’ craze.

“For instance, I personally have only paid to charge my car ONCE in all the years I’ve owned it, it simply makes no sense to seek out a charging station and pay to stand around for a half hour while your car charges.

“I ask you; would you carry your phone into a store and then PAY to have them charge it for you? You know as well as everybody else, charging your phone (or car) at home is the best way.

“Charging infrastructure is gasoline thinking…” – V.S.

Regards,

Berna Barshay
April 5, 2021

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About Whitney Tilson

Prior to creating Empire Financial Research, Whitney Tilson founded and ran Kase Capital Management, which managed three value-oriented hedge funds and two mutual funds. Starting out of his bedroom with only $1 million, Tilson grew assets under management to nearly $200 million.

Tilson graduated magna cum laude from Harvard College with a bachelor’s degree in government in 1989. After college, he helped Wendy Kopp launch Teach for America and then spent two years as a consultant at the Boston Consulting Group. He earned his MBA from Harvard Business School in 1994, where he graduated in the top 5% of his class and was named a Baker Scholar.

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