Cancel the unicorn hunt

The recent rush towards young companies, most of which are in the tech sector, means Ms Lee’s definition of a rare and wonderful new business is losing its significance. The $1bn valuation marker, once seen as an elusive goal that only the very best start-ups could achieve, is now being handed out to any company that can spin a good enough story to deep-pocketed private investors.

Venture capital firms, crowdfunding websites, angel investors and even mutual sovereign wealth funds have clamoured to invest in the latest wave of innovative tech companies. Meanwhile, today’s giants are also receiving a disproportionate amount of investor attention: while private investors gravitate towards unicorns, the FAANGs – Facebook (US:FB), Amazon (US:AMZN), Apple (US:AAPL), Netflix (US:NFLX) and Google-owner Alphabet (US:GOOGL) – have benefited from huge public fund inflows. Passive investing in market-cap-weighted indices means larger companies receive the lion’s share of capital. As we highlighted in last year’s article Fear the FAANGs, the virtuous circle of high demand and growth means the biggest just get bigger.

So, while the FAANGs and unicorns might have been born decades apart, they are now thriving off the same quality: they have become seemingly indispensable to both their consumers and the funds that have fuelled their growth. But as unicorns trot out onto the public markets, investors should proceed with caution. The market’s tendency to blindly follow winners could be inflating a bubble and paving a way towards the greatest challenge to the tech narrative since the dotcom crash.

Private money: worrying comparisons with dotcom hype

In 2018, 80 per cent of the companies that listed globally were losing money – the highest proportion of lossmaking IPOs since 2000. Now, as was the case then, the markets are awash with private money, which is being ploughed into young tech companies and allowing them to operate at hefty losses.

Worryingly, private money is even more abundant now than it was during the dotcom boom. The Jumpstart Our Business Startups (JOBS) Act of 2012 in the US lifted the cap on investors in pre-IPO firms, leading to huge private fundraising rounds, meaning today’s unicorns are arriving on the market with massive valuations and cash flow requirements. According to Renaissance Capital, IPOs could raise $100bn this year, smashing through records set in 2000, despite the fact that the total number of IPOs is expected to fall well short of the record (552) set at the peak of the dotcom boom.

Table 1: Recently-listed tech groups in the US have huge cash flow requirements

FAANGs vs unicorns: when worlds collide

Evidence of the blind mania for tech-focused private companies has been aptly captured by Maëlle Gavet, chief operating officer at real estate software group Compass, which is hoping to IPO in the next few months. When asked by the Wall Street Journal about the company’s path to profits, she said: “We’re not yet at a stage where I have a very clear monetisation strategy because we haven’t really talked about it.” At its last private fundraising round, Compass was currently valued at $4.4bn.

It certainly isn’t the only unashamedly loss making company to have captured a huge private valuation which is now being transferred onto the public market. Uber currently holds the dubious record of losing more money in the 12-months preceding its IPO than any public company, ever. It reported an operating loss of $3bn in 2018, but managed to list with a valuation of $80bn in April this year. Flexible office owner WeWork, which is hoping to list in the summer, reportedly lost $2bn last year and has a pre-IPO valuation of $45bn. One Wall Street commentator has described the company as “a financial sandcastle built on a rainy day using sand that SoftBank bought at a 500 per cent mark-up”.

Table 2: Largest 12-month loss before IPO

Source: Bloomberg

What makes the valuations even more impressive (or maybe ludicrous) is the fact that many of these companies were nothing more than ideas as recently as five years ago. According to Reid Hoffman, serial tech investor, LinkedIn co-founder and author of the 2018 book Blitzscaling: The Lightning-Fast Path to Building Massively Valuable Companies, “it really matters to establish these companies on a global footprint as fast as possible”. The “modern way to build companies” is to capture market share incredibly quickly in the early stages of development, profits will come later. Clearly that strategy has risks, but Mr Hoffman says that “taking those risks is the only way you can win”.

It’s the same type of ‘growth at all costs’ strategy that has been used at Amazon. The company has dominated every market it has attempted to enter by undercutting the incumbent on price and quickly capturing huge numbers of customers. Its revenue growth 25 years after it was first created continues to be extraordinary. Profits have been a far more recent (and less impressive) reward.

Amazon filed to go public 10 years before the launch of the first iPhone – a time when pagers were still more popular than mobile phones and the internet operated at 0.1 per cent of the fastest speeds available today. Back then, few imagined it would change the way consumers shop for almost everything. The company’s IPO document contained the warnings that will be very familiar to recent unicorn investors. Management was preparing public investors for a company whose sales momentum was unlikely to be sustained and which might never make profits. Investors who heeded those warnings and failed to invest have missed out on a 120,000 per cent investment return.

So perhaps unicorn-bashers are being short sighted when they say they cannot imagine a world where these companies can make profits. After all, the technological advances that are required for unicorn profitability – for example, driverless vehicles and robot-dominated workplaces – are far closer to reality now than cloud computing – the key to Amazon’s profits – was when the company listed. It could be the fear of missing out again that has driven so many investors into Uber and its peers.

But investors should be aware that unicorns have arrived on the market with very different financial backgrounds to the successful companies they are being compared with. When they listed, none of the FAANGs were hyped up on private money which was helping fuel exorbitant losses. Apple, Google and Facebook were profitable and very cash generative when they joined the stock market, and in the two years preceding their respective IPOs, Amazon and Netflix reported net cash outflows of $2m and $22m, respectively. That is a drop in the ocean compared with the $3bn and $674m of cash spent by Uber (US:UBER) and Lyft (US:LYFT) in the past two years.

Table 3: FAANG numbers at IPO

Source: Data collected from company S-1 documents

FAANG dominance has ruined everything

But put financial frailties aside and it is hard to deny that modern unicorns are having a similar impact in society to their established FAANG cousins. For the past few decades, Facebook, Amazon, Apple, Netflix and Google have changed the way we communicate, shop and consume content. More recently, Uber, Lyft, WeWork, Pinterest (US:PINS), Airbnb, Zoom (US:ZM) and their peers have changed the way we travel, work, share ideas, book holidays and communicate in the office. If they are allowed to, they are likely to continue to change the modern social landscape for years to come.

But therein lies the problem. The dominance of the FAANGs has made consumers far more aware that companies that change the way we behave carry huge influence. Today, we are appalled by Facebook’s apparent disregard for political policy, angry at Amazon for not paying enough tax and shocked every time we are made aware of our reliance on Google. The behaviour of the FAANGs has revealed that if we let a small number of companies control the way we live, it becomes far harder to control them. And that might make it very difficult for the newer disrupters to keep disrupting.

Indeed, Uber has encountered far more criticism of its business model than any of the FAANGs had done by this stage in their development. It has already been banned from several cities around the world for unfair practices, and the week of its IPO was marred by drivers protesting about wages and working conditions. Airbnb has faced similar criticism for its role in changing city dynamics. WeWork has been questioned for conflict of interest between the company and its founders.

That is why, if we are generalising, we don’t think either the FAANGs or the unicorns make great long-term investments. Our preference is for the software stocks that operate under the radar, quietly collecting copious volumes of recurring revenue – the hidden tech gems.

But we shouldn’t generalise. Scooping together the FAANGs into a convenient acronym and the unicorns into a herd has blinded many investors to the very different sets of challenges facing individual companies. It could also prevent investors from spotting opportunities as the shine comes off these two sections of the huge US tech market. So, having spent the first half of this article referring to these companies as one beast, lifted by the same opportunities and tied down by the same challenges, we will now attempt to differentiate them. Starting with the tech leaders and descending to the companies on the bottom rung of the ladder, which we think are facing challenges from which there is no escape.

1. Top of the table: Microsoft and Amazon

Microsoft (US:MSFT) is neither a FAANG nor unicorn, but it is also not an ‘under-the-radar’ tech company. This software giant is evidence that no amount of regulation can taper growth if the company and its products are truly excellent. In the past five years, Microsoft has reported average operating margins of 66 per cent, return on capital employed of 43 per cent and free cash flow conversion of a whopping 133 per cent. Its cloud software Azure is completely integrated into daily life without its users even realising it. The same is true of Amazon’s web service, which is far and away the biggest cloud provider in the world.

True, regulators are trying to get to grips with Amazon’s dominance, but it seems as though that will be hard to achieve. Proposed new tax laws aren’t likely to be that painful for a company that generated $60bn of revenue in the first quarter of 2019 alone. Splitting Amazon into two separate companies (one a retailer and one a software provider) would hardly be a punishment either – investors would simply be left with two excellent companies rather than one.

2. Worth the hype: Zoom and Pinterest

In his initiation note on Zoom, Stifel’s Tom Roderick said: “If you’re unable to find many negatives about a business that just raced through the $400m annualised run-rate level, while still growing at more than 100 per cent, you aren’t alone.” Investors are excited about the video conferencing specialist because it is one of a rare number of cash-generative, profitable unicorns. Its share price has almost doubled since the IPO in April.

The problem now is that even expectation-beating earnings are baked into the shares, which trade on over 5,000 times forward earnings. Even chief executive Eric Yuan has described the valuation as “crazy”. Still, a profitable unicorn operating in a fast-growing segment of the software market should not be overlooked.

Pinterest is also doing a better job than most unicorns of living up to the hype. Its losses are narrowing fast and it has a clear route to profits. At a time when Facebook and Google are coming under fire for dubious advertising, Pinterest could be well placed to pick up new business. The digital advertising market is forecast to grow at a compound annual rate of 12 per cent in the next five years.

3. Embrace the era of software dominance: PagerDuty and Okta

While the IPOs of consumer-facing unicorns have grabbed headlines, the public debuts of lesser-known software unicorns have gone largely unnoticed by mainstream media. That’s not to say the stock market missed the arrival of young software specialists: PagerDuty (US:PD) leapt 60 per cent on the day of its IPO in April, while Okta (US:OKTA) closed up 38 per cent on its public debut in late 2017.

Both companies have built their software solutions on the cloud and sell them to businesses via a software as a service (SaaS) model. Although PagerDuty and Okta both reported widening net losses in their most recent financial reports, their business models lend themselves to high profitability.

PagerDuty specialises in tech incident management and Okta software verifies identities – both products are in big demand as hacks become more prevalent, The two companies reported revenue growth of 48 per cent and 88 per cent, respectively, in the nine months to December 2018.

4. New competition: Apple and Netflix

When Apple launched its new television subscription earlier this year, it took itself into direct competition with Netflix for the first time in its history. Apple has always had rivals – Microsoft, Samsung (KRX:005930) and IBM (US:IBM), for example – but historically it has managed to differentiate itself with its premium product portfolio. Now, for the first time, it is struggling. Demand for expensive smartphones is dwindling and Chinese rivals are beginning to innovate faster than Apple. The launch of new products such as its TV subscription or credit card makes Apple a challenger rather an incumbent – something it isn’t familiar with.

Netflix is also facing more dangerous competition than it has ever done before as better established peers enter the content streaming space. Walt Disney (US:DIS), Comcast (US:CMCSA) and ITV (ITV) are launching their own digital TV offerings this year, backed by much stronger production companies. Netflix is having to spend huge amounts on its own content to compete.

5. Regulatory minefield: Facebook and Alphabet

Regulators, especially in Europe, are not giving up on their pursuit of companies that use personal data as payment. Facebook and Alphabet are the biggest culprits. For years, they have happily collected huge volumes of data on millions of individuals and used that to deliver targeted advertising campaigns for companies that pay them big bucks. The revenue growth and profit margins that come from this data-led business model (or surveillance capitalism if we’re being critical) has made them excellent investments.

But key to that business model is access to personal data that is slowly becoming more difficult to access thanks to laws such as the new general data protection regulations (GDPR) in the EU. Regulators are not alone in tackling Facebook and Google. Consumers are being more cautious with how their data is used and Apple has made a mission of denting the business model with its aggressive advertising campaigns and the launch of a new sign-in system that will break the link between internet users and their digital profiles.

Google and Facebook are incredibly reliant on advertising revenues. A shift in the way they are allowed to conduct business could prove very problematic.

6. Chinese scepticism: Yunji, iQiyi and Futu

After the financial crisis, several American investment firms profited from the hype surrounding the China growth story by reversing Chinese companies into the shells of defunct US businesses. Many of these companies were reporting revenues and profits to their American investors that were completely fabricated. The level of fraud was uncovered by a collection of short sellers, lawyers and regulators and the story told in excellent Netflix documentary The China Hustle. Anyone who has watched the film will be rightly wary of Chinese start-ups listing in the US.

In 2018, 33 Chinese companies listed in the US – the highest level since 2010. That included several lossmaking unicorns such as e-commerce business Yunji International, online video platform iQiyi and fintech platform Futu Holdings. Despite the fact that all three of these companies reported fast-growing revenue, progress towards profits and operating cash inflows in 2018, we would recommend caution. Financial results contain a lot of adjustments and the market opportunity remains very unclear.

7. Meaningless margins: Uber, Lyft and WeWork

Reid Hoffman’s ‘growth at all costs’ strategy to price out the competition only works if those competitors aren’t as well funded. That is the problem facing Uber as low-cost, deep-pocketed Lyft invades its domestic market. Uber’s decision to cut prices to compete with Lyft means average revenue per trip has fallen from $3.57 in 2016 to $2.16 last year. In the same period, Lyft’s average revenue per trip has risen nearly sixfold to $12.09.

To deal with the costs of competition, Uber has also had to slash payments and perks for its drivers, who are getting angry. Uber and Lyft drivers aren’t currently classed as employees and therefore the companies don’t have to comply with wage and hour laws or pay social security contributions and taxes. If the regulators heed the calls of the drivers, both companies could end up being forced to classify their drivers as employees, which would add huge costs. Uber’s IPO document warns that, “any such reclassification would require us to fundamentally change our business model, and consequently have an adverse effect on our business and financial condition”.

WeWork is also facing a regulatory backlash. The company’s founder, Adam Neumann, has been criticised for renting the company office space in buildings he partially owns. Although the company disclosed that it paid $12m in rent in 2017 to buildings “partially owned by officers”, this is surely a conflict of interest that won’t sit well with investors once the company lists on the stock market.

And then there’s the much more pressing problem of WeWork’s ludicrous accounting. In April 2018, when it launched its $500m bond offering, WeWork introduced the world to the ‘community adjusted Ebitda’ figure which, among other things, strips sales costs out of its profit figure on the basis that it is unrelated to the day-to-day running of the business. WeWork claims it was profitable on a ‘community adjusted Ebitda’ basis in 2017 by excluding the $184m of general and administration costs, $23m in office pre-opening expenses, $98m put towards new market development and $139m of sales and marketing expenditure. Costs have reportedly rocketed again since then. WeWork is a commercial real estate business, which comes with all the same mundane costs as a traditional property company. Its extraordinary ability to disguise itself as an innovative tech company is its only impressive attribute.

WeWork, Uber and Lyft may be hugely popular with their consumers, but profits are an incredibly long way off, meaning their valuations are ridiculous. We would stay well clear.

What goes up…

Last year, bright-eyed investors batted away evidence of a new tech bubble. “Valuations are stretched, but the tech giants of 2018 are quality companies that  are deeply embedded in society”, they argued. It’s true, there are several excellent tech companies. But they are not the problem.

As unicorns arrive on the public markets and their mythical valuations become reality, it is right to question how long this level of hype can be maintained. The money that has propped up valuations at both the FAANGs and the unicorns can be taken away just as quickly as it was given: stock market momentum could reverse, leading to massive passive fund outflows and private investors might seek to cash in their winnings from hugely successful IPOs.

Unicorn hunters are playing a dangerous game. Those who seek a glimpse of their elusive headquarters from the top of San Francisco’s Millennium Tower should ascend with caution. The tower is sinking, tilting and has gobbled up $100m of emergency cash to save it from complete collapse: an ominous metaphor for the shiny new companies it looms over.