There's Something Happening Here

| About: SPDR S&P (SPY)

Summary

Probably, all investors are familiar with the dot-com bubble of early 2000s.

However, most of them do not seem to be acquainted with exact examples of general failure during that time.

A study of failed business models and riskiness of participation in financial markets is crucial for informed investment decisions.

Growth can be (and often is) competed away.

Ignore information at your peril.

There's something happening here, but what it is ain't exactly clear. But it seems more and more likely that memory is short-lived. Don't get me wrong - I am not going to preach that S&P 500 is going to 1,000 tomorrow. Maybe this time is different indeed, at least for some of the current market darlings and their followers. Alas, it should be worrying when one so often sees a complete lack of humility, irrational conviction in never-ending bullish trends and widespread boast about the amount of money made on the unrealized trades. If you do not know what I am talking about, I encourage you to compare comments below the articles on Berkshire Hathaway (BRK.B) (BRK.A) and on Amazon (AMZN), Tesla (TSLA) or Netflix (NFLX). Of course, there is a fair amount of bearish sentiment under the pieces on the three latter ones, to balance the euphoric bullishness. However, as for BRK, which managed to outperform S&P 500 (SPY) by a fair amount (LTM return of 31% vs. 22%), you can mostly see a modest satisfaction, discussion about what is the appropriate cash hoard, Warren's succession or something like that. On the other hand, looking at comments on Tesla, Amazon or Netflix, you can easily find people bragging how they made millions on a recent earnings surprise, how they bought the stock for a few bucks quite a long time ago and how people trying to debate different points of view are simply named losers who cannot deal with the bitterness resulting from not joining this wild ride.

What I would like to achieve by this article is a simple introduction to a few examples of failed growth stories from almost 20 years ago, with which most of the people seem to be familiar, but as a general historical event, not as concrete examples. In my opinion, this lack of specific acquaintance can lead one to distancing oneself from drawing conclusions about some resemblance between various businesses and their fates throughout the history and their successors in present times. Before I begin, let me repeat myself: this is not a gloom and doom piece, nor an investment advice - this is simply an educational piece, allowing investors to make a more informed decision.

As I will evoke the financials of the fallen ones from the past and try to indicate some resemblance of their businesses with today's stock market darlings, please first have a look at a brief of their financials and stock price history (I am deliberately focusing on income statement, as for the dot-com busts, the balance sheet evolution is not really indicative, as they often managed to have sizeable equity positions [bloated by frenzied VC financing] in one quarter and then went down so fast that they failed to even file the next quarter report, including updated balance sheet).

Amazon financials

Metric ($ '000 000) 2012 2013 2014 2015 2016
Revenue 61,090 74,450 88,980 107,000 135,980
Gross Profit 15,120 20,270 26,230 35,350 47,720
EBIT 835 859 311 2,400 4,420
Net Income / Net Loss -39 274 -241 596 2,370

Source: Capital IQ

Netflix financials

Metric ($ '000 000) 2012 2013 2014 2015 2016
Revenue 3,600 4,370 5,500 6,770 8,830
Gross Profit 983 1,290 1,750 2,180 2,800
EBIT 50 203 403 306 380
Net Income / Net Loss 17 112 267 123 187

Source: Capital IQ

Tesla financials

Metric ($ '000 000) 2012 2013 2014 2015 2016
Revenue 413 2,010 3,190 4,040 7,000
Gross Profit 30 456 882 933 1,570
EBIT -396 -61 -717 -717 -617
Net Income / Net Loss -396 -74 -294 -889 -675

Source: Capital IQ

Chart: Amazon stock price history

Chart: Neflix stock price history

Chart: Tesla stock price history

Dot-com bust review

1. Webvan

Business model:

Quite similar to today's grocery home-delivery offered by most retailers, Webvan, founded in 1996 in California, focused on food, non-prescription drugs and general housewares, consumer electronics etc. It was the first company to deliver groceries ordered over the internet. Deliveries were supposed to be completed in 30-minute windows, making it convenient for customers.

IPOed in November 1999, went bust in June 2001.

Trivia: back in the days, most of the tech startups weren't led by 20- or 30-somethings (unlike today). The CEO, George Shaheen, was then 56 years old, CFO Robert Swan 40 years old and VP HR, Terry Bean 53 years old.

Financials:

Metric ($ '000) 1998 1999 2000
Revenue 0 13,305 178,456
Gross Profit 0 2,016 47,217
EBIT -12,895 -153,893 -479,191
Net Loss -12,004 -144,569 -453,289

Source: SEC filings

Reasons for failure:

  • Inappropriate pricing/too aggressive expansion - 'the quality and selection of Whole Foods, the pricing of Safeway'. Webvan managed to grow its top line very quickly, but failed to make any profit on it, focusing on growth and expansion at any cost.
  • Excessive operating leverage - shortly after launching the operations and before proving the business model, the company started to deploy massive capital, pledging $1 billion to develop warehouses in 26 cities. With the expansion, along came a huge amount of fixed costs, resulting in immense cash burn.
  • Mistaken acquisitions - in year 2000, Webvan made a huge acquisition of HomeGrocer.com for $1.2 billion in a full-stock deal. The transaction, supposed to bring synergies and cost-savings, in the end brought further burden of a failed business plan and contributed to the ultimate shutdown.

Finally, the company couldn't bear the mounting losses and, amidst the bursting dot-com bubble, was not able to source any more capital to finance operations.

Chart: Webvan stock demise

Source

2. Pets.com

Business model:

Pets.com - founded in 1998, California. Its business model was straightforward, but in the era of mass introduction of the Internet to households - seemingly revolutionary. The company's mission was to sell pet food and pet accessories over the Internet. The value proposition for the customer was to cut the middleman out of the purchases (as if Pets.com wasn't one) and to capitalize on strong buying power of the company, leading to discounted pricing.

IPOed in February 2000, went bust in November 2000 (yes, 9 months after the IPO).

Financials:

Having gone public in February 2000, unfortunately, the company didn't even manage to publish its first 10-K filing, as it filed NT 10-K in April 2001, notifying about inability to timely file the former statement. Hence, below you can find 9 months results in 2000 and 1999.

Metric ($ '000) 9 months ended Sep 30, 1999 9 months ended Sep 30, 2000
Revenue 619 25,780
Gross Profit -1,223 -6,890
EBIT -20,055 -86,746
Net Loss -19,355 -84,870

Source: SEC filings

Reasons for failure:

  • Overoptimism of sales projections/failed marketing plan/brutal competitive environment - the company failed to differentiate itself in any other way than by using its famed sock puppet (see below). There were already quite many on-line retailers providing similar product portfolio as Pets.com, so the competitive environment was really harsh. At any moment of the fundraising, the company was not able to demonstrate the validness of its business model and, unfortunately, there was no one, even among the investors themselves, to ask some questions and verify the projections. Reportedly, the company spent more than $70 million on marketing and spent roughly $400 per each new customer acquisition.
  • Inappropriate pricing - traditionally, pet food sales was a low-margin business and at the same time, the shipping was costly. Hence, by selling on-line at prices competitive to traditional brick-and-mortar stores, Pets.com actually put itself at a huge, strategic disadvantage, materially embedding impossibility of turning a profit into its business model.
  • Mistaken acquisitions - in June 2000, the company decided to acquire its competitor - Petstore.com. With many different parts coming together with the acquisition, including, among others, live fish businesses, the move only magnified the losses and accelerated the meltdown, exposing all the flaws already present in the business model prior the acquisition.

Table: Pets.com stock price free fall

Source: SEC filings

3. eToys.com

Business model:

What could go wrong if you sell toys over Internet, like eToys.com did? Apparently quite much. The company was founded in 1997 in California. The idea was simple - sell children's products, including toys, video games, books, videos, music, etc. over the Internet. Perks of shopping at eToys.com were supposed to be 24/7 availability from either home or office, shopping experience more convenient than tiresome touring a retail store, broad offering, product reviews, etc. Quite normal, by on-line retail standards.

IPOed in May 1999, went bust in March 2001.

Financials:

Metric ($ '000) 1998 1999 2000
Revenue 687 29,959 151,036
Gross Profit 119 5,713 29,063
EBIT -2,270 -29,099 -193,027
Net Loss -2,267 -28,557 -189,626

Source: SEC filings

Reasons for failure:

  • Supply chain failure - during the Christmas of 1999 the company was flooded with unexpectedly high amount of orders. The company found itself unable to process and deliver the orders, leading to enormous frustration on the clients' side and the company's credibility and brand took a large hit. Considering toys are quite a seasonal product, a failure on such an important front was a major flag for business conduct at eToys.com.
  • Failed international expansion/brutal competitive environment - 'being first was not enough.' The company did not manage to differentiate itself from the local competitors in the foreign markets and position itself above them, with the key battleground being UK. The local brick-and-mortar retailers rapidly copied the concept, which was easy to do, because of nothing proprietary about it. In the moment of the ultimate failure, eToys.com had to compete with as many as 20 companies selling toys over the Internet in the UK alone. Far more than it had expected.
  • Liquidity constraint - Most of the eToys.com competitors had a backing of their traditional retail operations to finance the expansion over the Web and stay above the water. Unfortunately, it was not the case with eToys.com, which depended on the, that time, embryonic-stage e-retail alone, which couldn't provide sufficient cash flow. 'What they did wrong was to operate a business without the financial capacity to weather a downturn in the retail market. Everyone expected sales to continue to be robust last Christmas and they weren't. Their balance sheet couldn't handle a hiccup like that.' - said T.K. MacKay, a Morningstar analyst.

Table: Somewhat dissatisfying return on eToys.com stock

Source: SEC filings

After notorious failure of its common stock to perform, the company ceased to disclose much information on that topic:

Excerpt from eToys.com last 10-Q filing

Source: SEC filings

This time is different... but is it?

Yes, this time is indeed different in some part, although in some other part maybe it isn't.

What's different?

  • Financing/liquidity constraint - most of the dot-com companies were financed exclusively through equity financing, whereas the current stock market sweethearts already tap into both equity and debt capital markets. Tesla is a notorious example of multiple successful fundraisings, having just raised $1.8 billion this year, despite its repetitive losses. Of course, they all began with equity financing only, but having debt capital indicates a certain maturity, which leads us to another point, which is...
  • Track record - the post-IPO life of the dot-com busts, is not so impressive: Webvan - 19 months, Pets.com - 9 months, eToys.com - 22 months. On the other hand: Amazon - 20 years, Netflix - 12 years, Tesla - 7 years. That may lead to a conclusion that these businesses are more solid, resilient and execution is better. However, this is a bit more complicated - Amazon almost exclusively focused on its web-based retail for most of the time, before storming the Internet of Things, autonomous driving, cloud computing and so on. Netflix is widely known for its previous core business, which was video rental over the traditional mail. Tesla is much more of a start-up, with no legacy like Amazon or Netflix to build on, nonetheless having been funded in 2003 or 14 years ago, it still has much more of a track record, compared to just a couple of years of birth to bust, survived by short-lived dot-com disappointments.
  • Profitability - all 3 mentioned dot-com failures were net profit-negative, to the extent of net loss exceeding the sales in their final year of operations. On the other hand, both Netflix and Amazon managed to turn a profit in their last full fiscal year, but with Tesla still mounting losses. However, as for the net profitable ones, their % net margins are not very impressive with both Amazon and Netflix hovering around 2% net margin in their last full fiscal year (2016).
  • Times - the times are different. The awareness of the customers, the cost of employing technology, the knowledge and experience drawn from the events from the past are much more favourable. Amazon is the best example of that difference - a huge chunk of its business is based on the same idea of web-shopping, that was present back in the days of the dot-com bubble. But the customer awareness, the cost, development and reliability of the required technology is much better, which allows for smoother business operations and employment of tremendous economy of scale.
  • Macro financial environment - at the times of the dot-com bubble, the Fed Funds rate was around 5% and for most of the past decade, it was 0%. It's very important to note that all of the current stock market champions mentioned (AMZN, TSLA, NFLX) really took off after the financial crisis of 2008; that is, in the 0% interest rate environment. With cheap money all over the place for such a prolonged period of time, the propensity to invest in various innovative (and speculative) projects is high. Furthermore, low cost of capital leads to depressed required return, which inflates the market valuations, which leads us to...

What's not different?

  • High valuations - to be fair, like I mentioned in the previous sub-section, there's a difference between not turning a profit (like it was a case 20 years ago) and being net profit-positive. However, at current valuations, like the LTM P/E of 275x, Amazon would need to increase its net income more than 9x, to arrive at a modest, growth stock multiple of 30x P/E (so, still implying further growth to come). For Netflix, it would mean a 6.5x increase in current LTM earnings to turn from current 196x P/E to a more sustainable growth P/E of 30x. And for Tesla, it would mean to first emerge from losing $-766 million into a break-even level, and then to earn around $1,750 million a year. I am not saying that this growth is surely not achievable, but one important thing, that many people seem to forget about is - when will it happen (time value of money) and the other is that both bullish market and favourable economy will end at some point. Remember, there is a huge possibility that the current growth rates will be severely halted during the next recession and $100 to be received in 10 years is worth only $38.50 today and only $24, if received in 15 years (discounted at 10%).
  • Fueling growth through acquisitions - it's a strategy known for riskiness and a red flag signaling potential lack of organic growth opportunities. Amazon is notorious for its numerous acquisitions, with the most recent being $13.7 billion Whole Foods takeover. Tesla is too, known for its itchy trigger finger, acquiring (and effectively, bailing out) SolarCity for $2 billion last year. Netflix, on the other hand, is quite conservative in this space, with only a single acquisition, of comics publisher Millarworld, a deal struck this year. The extent to which these acquisitions are adjacent to the current businesses of the acquirers can be discussed, and fairly often it can make sense. However, the acquisition of Petstore.com by Pets.com mentioned above, also made sense at that time.
  • Large operating leverage/intense capital expenditures - the first obvious thought is Tesla, with its Gigafactory at an estimated cost of $5 billion, to be accompanied by another high-profile factory in China. Netflix, known for its broad deployment of original content, also commits significant capital to take the market share: lately, the company announced a new, $1.6 billion note offering and a total spending of $7-8 billion in 2018, dedicated to new content creation. Amazon is projected to spend $7.9 billion on capex in 2017 alone. The key destinations of those dollars are the distribution network or technological back of the house. But as rightly noticed by WSJ's Dan Gallagher: 'When it comes to ambition, Amazon has yet to find a price its investors aren’t willing to pay'. It's worth to remember that operating leverage is not that much different from the more notorious, financial leverage. The huge capital expenditures and/or fixed costs can lead to enjoying economies of scale and improved profits during heyday, but when things go downhill, it's just another liability or forgone liquidity, seemingly like a millstone hung around one's neck.
  • Brutal competitive environment - it's very easy to fall into the trap of thinking that any given idea is so marvelous, that it cannot be easily copied and even if it can, it would take many, many years to do so. For me, one of the most memorable quotes about business strategy is that 'growth can be competed away' (Accounting for Value by Stephen Penman). It is also true for the stars of today's stock market. Tesla seems to be the most endangered species, with several automotive giants creeping closer and closer behind its back (to have some idea look here, here or here). Netflix, being a quite successful first-mover, also shouldn't be getting too comfortable as big league players like Hulu with huge financial firepower, are more and more of a risk. Amazon too, faces competition, both in traditional, grocery-retail business, where Wal-Mart (NYSE:WMT) is still a potentate, and in consumer-tech, where it has to engage in a skirmish with behemoths like Apple (NASDAQ:AAPL) and Google (NASDAQ:GOOG) (NASDAQ:GOOGL). Nobody is saying that it's an economics textbook perfect competition, with ultimate margins at 0%, but surely, the current competitive environment will exert influence on the future profitability and the current market shares shouldn't be taken for granted, as many things can change.
  • Possibility to fail in business plan execution - the darlings of today's stock market are often mentioned as 'priced for perfection' (interesting reads also here and here), which also connects with the aforementioned pricey valuations. 'A brilliant strategy, blockbuster product, or breakthrough technology can put you on the competitive map, but only solid execution can keep you there.' Not putting any discount or a too little one, on a value of a business (especially a growth-oriented one) due to ignorance of the execution uncertainty, can lead to an unrealistic investment appraisal and ultimately end in a huge disappointment, when the management unexpectedly fails to deliver. Especially in the environment, where reckless growth chasing, not sustainability, seems to be rewarded the most.

Conclusion

In today's market, it seems that the motto has been reversed and the majority of people is 'prepared for the best.'

It's a truth universally acknowledged that it's extremely hard to time the market, predict financial events and so on. However, it's as true (but seemingly, much less known), that as an investor, you 'ignore information at your peril' and failure to thoroughly study the businesses you invest in and ignoring the past events doesn't lead to happy endings.

Lastly, for a bit more context: if you base your current investment decisions mainly on price targets and guidance of 'sophisticated investment analysts' from major bulge bracket banks and brokerages, I encourage you to get familiar with how such reliance worked out during late 90s/early 2000s - read this short piece about Henry Blodget (especially, if you are not familiar with this persona).

Nobody's right if everybody's wrong.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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