By John Colley
“When it comes to investment markets, history has a habit of repeating itself again and again and again…”
2000 was remembered as the year that the dot-com bubble burst sending significant numbers of businesses to the wall. It also effectively foreclosed major investment in technology start-ups. Many similar conditions are currently present as history looks as though it will repeat itself in 2019. Investment banks are queuing up technology stock market initial public offers (IPOs) to beat the crash expected later in the year. Overvalued technology stocks, rising interest rates, volatile stock market conditions particularly for technology stocks, and poor performance of many technology businesses are unsettling the market. Most of the expected IPOs are being rushed to the market despite clearly not being ready to cross the frontier from burning cash to producing it.
In 2000 Investment banks had been encouraging major investment in dot-com ventures by launching ‘Initial Public Offers’ allowing investors and entrepreneurs to exit with vast fortunes via stock market listings. Most of the dot-coms which listed had done little more than consume vast amounts of cash and showed limited prospect of achieving a profit. Traditional metrics of performance were overlooked and high cash burn rates were seen as a sign of rapid progress. The cash burn was to build branding and create network effects which would eventually allow for future profits on the assumption that the underlying business case was sound. Most were not and almost any idea was attracting large amounts of funding.
Forward 19 years and following a similar ‘App’ boom, investment banks are bringing forward IPO’s as they foresee ‘volatile market conditions’ arriving later in the year. Investment banks are planning IPO’s (with bank investment valuations) for Uber ($120Bn), Lyft ($15Bn), Airbnb ($31Bn), Palantir (analytics, $41Bn), Pinterest (social media, $12Bn), plus others such as Slack and InstaCart. If the IPO market closes for technology firms then the supply of investment to them will be severely curtailed. Stock market volatility, particularly technology stocks plus tightening liquidity together with reducing faith in technology IPOs are mainly responsible.
Has Anything Changed?
Both Uber and Lyft are loss makers with Uber losing approaching $4Bn in 2018 after a $4.5Bn loss in 2017. Airbnb only has revenue of $3.5Bn to justify its $31Bn price tag. Airbnb apart virtually all lose significant sums of money. Traditional metrics have been ignored and user growth taken by the investment banks as a proxy for future profitability. As long as user numbers are growing rapidly then the bank models assume that they can be ‘monetised’ at some stage in the future. Unfortunately as we shall see this assumption requires an enormous leap of faith. Users have a different attitude to ‘free at some stage in the future’ compares with paying for content and services. Highly subsidised services have very different demand patterns to those sold at a commercial price.
Uber, like many, has been able to tap into a seemingly unending supply of readily available funds and has raised over $22Bn from investors so far. The problem with being able to raise funds so easily is that it discourages focus and efficiency. Uber is not only developing the ride hailing model but also bike sharing, takeaway food delivery and autonomous vehicles. The latter is also being developed by most of the major car manufacturers as well as Google.
2019 is also likely to see the demise of Snap Inc., owner of Snapchat, as whilst recently listed it is rapidly running out of funds. Valued at $24Bn at the IPO, that is 36 times 2017 sales, it is now valued at $6Bn and falling whilst burning cash at the rate of $0.9Bn. The shareholders are powerless to intervene as only founder shares have voting rights.
Yahoo and AOL have just been written down to almost zero by their recent buyer Verizon after paying $9.5Bn for them in 2015 and 16. (Yahoo famously turned down an offer of $45Bn from Microsoft in 2008). LinkedIn is still believed to be losing money after its $26Bn purchase by Microsoft. Twitter has just moved into small profits following adoption as President Trump’s main channel for US policy announcements.
FAANG Shares Collapsing
Listed technology businesses such as Facebook, Amazon, Apple, Netflix and Google have seen astronomic valuations for their shares which over the last 6 months have fallen substantially as doubts grow around future levels of profitability. Increasing interest rates and inflation, issues of data privacy and protection, slowing user growth and demand levels, increased levels of competition from others, and declining liquidity are all contributing factors. Governments are also increasing technology businesses’ responsibility for content as the argument of only providing a ‘platform’ for other users starts to lose traction in terms of limiting responsibility.
Facebook and Apple shares are down around 40% on their peak in mid-2018 whilst Netflix is down a third. Indeed they still have enormous valuations with Netflix at $144Bn which is 12 times sales and 120 times profit, whilst borrowings continue to increase with $9Bn of debt. This is despite slowing user growth and strong competition from HBO, Amazon and Disney.
Amazon are down 26% and Alphabet 19% on their recent peaks. One suspects that they will all fall further as investors are entitled to expect that a time will arrive when extravagant future forecasts of profits are actually achieved.
Investment Bank Valuation Proposition z
The investment bank valuation proposition is that network effects will build scale economies and create ‘winner takes all’ markets emulating Facebook, Google and Amazon. The reality is far from the truth as most differ in several important aspects.
Most Apps fall into two categories:
Those using content to attract users in anticipation that users can be monetised typically by selling advertising or collecting subscriptions. (Yahoo, LinkedIn, Twitter, Snapchat, Facebook, Netflix).
Those providing a service or goods (Uber, Lyft, UberEats, Deliveroo, Amazon).
Those using content have found that content can be enormously expensive to keep novel and that user monetisation is more difficult in terms of attracting advertising or subscriptions. For example Netflix is spending $8Bn a year on making content and a further $2Bn on marketing. Current subscriptions do not cover the annual cash burn and there will need to be a substantial increase. Investor funds are used to develop content in the hope of creating enough users to pay for it and eventually show a profit. The reality is that either users tend to move onto the next fad before they can be monetised or ultimately they will not pay the real cost of the content once the investor funded subsidies are withdrawn.
Where goods and services are concerned then investor funds are used to prime the market through advertising and subsidising prices to both suppliers and customers. In effect they are trying to create two sided network effects which are anticipated to persist once incentives are withdrawn. However in price sensitive commoditised markets this is the equivalent of paying suppliers more than the market rate and then selling to customers at less than the market rate without having any clear benefits in economies of scale. In markets with low switching costs such as ride hailing and home delivery of takeaway food users will simply revert to the most competitive offering once incentives are withdrawn. Indeed once the real cost has to be paid there may be a significant contraction in demand. For example research suggests that half of Uber’s rides would otherwise have been taken by public transport or walking.
In the ride hailing industry a market can be taken as a city hence local firms may still be able to prosper as economies of scale operate at that level, and the relative cost to compete will reduce once incentives are withdrawn by Uber. In the case of Uber despite an impending IPO they have struggled to withdraw incentives due to the risk of user growth collapsing. Scale economies are also rather limited as Uber are finding when trying to withdraw driver incentives. Strikes are becoming a problem. In effect the model only works with incentives which investors are needed to fund. Once incentives are withdrawn there are few advantages from the business model.
Being First Matters
The big difference with Facebook, Amazon, and Google is that they were amongst the very first to build network effects. Uber may have been first in North America but elsewhere the business model has been so easy to copy they have met staunch resistance almost everywhere resulting in enormous battles of attrition funded by investors. Snapchat have found Instagram and WhatsApp waiting for them making the market highly competitive. Netflix have HBO, Amazon and Disney to contend with. The market for IPO’s is likely to close over the next year which means investors will no longer have such a fruitful means of exit. A possible consequence is funds will be much reduced in flow for technology start-ups. Valuations will plummet and many technology start-ups will disappear.
When it comes to investment markets history has a habit of repeating itself again and again and again…
About the Author
John Colley is Professor of Practice in Strategy and Leadership at Warwick Business School where he is also an Associate Dean for the MBA. Following an early career in Finance, he was Group Managing Director of a FTSE 100 business and then Executive Managing Director of a French CAC40 business. Currently, he chairs two businesses and advises private businesses at board level. Until recently he chaired a listed PLC.