In what might turn out as apt timing, I wrote earlier this month about how markets can turn on a dime. My modeling from last week indicates we may be very late in the business cycle and the current market downtrend is the likely final leg. That leaves the question how a significant pullback in the market and ultimately in the economy will affect many of the tech companies and unicorns whose business models are built on debt-financed growth, typically from the high-yield bond market. Let’s take a look at a few examples: Tesla (TSLA), Lyft (LYFT), Netflix (NFLX), and Okta (OKTA).
High Yield Meltdowns
The high-yield bond market has a history of meltdowns in economic downturns. Especially at the end of the dot-com crash and the financial crisis, we saw intense spikes in junk bond yields and default rates.
Below are the increases in junk bond yields during the past two recessions. In 2000-2002, yields reached 14% and the average default rate was 9.2%. The quick spike in the yield to 22% during the financial crisis hit many companies and investors like a freight train. During the financial crisis, average defaults reached an all-time high of 13.4%.
Xerox's Debt Is Downgraded, Renewing Pressure to Sell Assets
Shares of Xerox fell 20%, cutting more than $800 million from the company's market value. At 4 p.m. in New York Stock Exchange composite trading Monday, the shares were down $1.25, in heavy volume, to $5, nowhere near the 52-week high of $29.75 a share.
Last December, we got a glimpse of how the credit markets react when things get tough. The high-yield markets almost dried up. Already in November the sky darkened in the high-yield debt market. When SpaceX intended to raise $750 million, it was not able to raise the full sum (WSJ, November 20, 2018):
Elon Musk’s SpaceX raised $250 million from its first-ever high-yield loan sale, shrinking the size of the loan by $500 million after the company encountered a mixed reception from investors and worsening credit-market conditions.
Tesla’s business is built on a growth story of electric vehicles for the masses. Tesla likes to position itself as a tech company rather than a car company, but fundamentally it faces the same capital intensive investment requirements as any car maker. That implies large investments in factories, research and development, sales and delivery, etc. Tesla has financed these high costs primarily with junk-rated debt. Given the current performance of its stock price, it becomes clear that many investors are starting to doubt this growth story. As a luxury brand, it would be hard to argue that demand for its products increases as consumer spending decreases in a weakening economy.
Many others have dissected Tesla's financials in detail, so I am not going to go through a full analysis. There is value, however, to look at how Tesla sees this risk, based on their own 10-Q. Specifics can be found in three sections:
- Servicing our indebtedness requires a significant amount of cash, and there is no guarantee that we will have sufficient cash flow from our business to pay our substantial indebtedness.
- Our debt agreements contain covenant restrictions that may limit our ability to operate our business.
- We may need or want to raise additional funds and these funds may not be available to us when we need them. If we cannot raise additional funds when we need or want them, our operations and prospects could be negatively affected.
Tesla is referring to its $10.33 billion in debt and is aware that this "substantial consolidated indebtedness may increase [Tesla's] vulnerability to any generally adverse economic and industry conditions".
I’ve written in detail about Netflix before. There is no doubt Netflix is a well established company in millions of households, providing great entertainment. For many it would be unthinkable to see Netflix in trouble. But can Netflix sustain an economic downturn? From a demand perspective, the impact on Netflix is not clear cut. It's hard to imagine, though, that there would be no negative impact on subscriber growth. The bigger risk, however, may be its debt load and the inability to generate sustained positive free cash flow in time and maintain it through a downturn.
It is best to look at Netflix’s own words. From the 10-K filing, the following risk factors where identified:
- We have a substantial amount of indebtedness and other obligations, including streaming content obligations, which could adversely affect our financial position.
- We may not be able to generate sufficient cash to service our debt and other obligations.
- If we are not able to manage change and growth, our business could be adversely affected.
- We could be subject to economic, political, regulatory and other risks arising from our international operations.
- We may seek additional capital that may result in stockholder dilution or that may have rights senior to those of our common stockholders.
- Our stock price is volatile.
Netflix highlights the potential difficulties of refinancing debt, if credit markets start to seize:
“Our ability to refinance or restructure our debt and other obligations will depend upon the condition of the capital markets and our financial condition at such time. Any refinancing or restructuring could be at higher interest rates and may require us to comply with more onerous covenants, which could further restrict our business operations. If our cash flows are insufficient to service our debt and other obligations, we may not be able to refinance or restructure any of these obligations on commercially reasonable terms or at all and any refinancing or restructuring could have a material adverse effect on our business, results of operations, or financial condition.”
With $10 billion in debt and an estimated content budget of $15 billion this year, it is unclear how Netflix intends to fund its content on declining revenues and rising debt costs.
As a success story transforming transportation, it would be hard to argue Lyft isn't a growth company. This growth, however, has come with a big price tag. So far Lyft investors are apparently not that concerned yet about Lyft's unprofitably. Although the IPO was a bit of a dud, it still has quite a lofty valuation.
Below is a taste of how Lyft sees its financial risks in its latest 10-Q:
- We may require additional capital, which may not be available on terms acceptable to us or at all.
- We have a history of net losses and we may not be able to achieve or maintain profitability in the future.
- Our actual losses may exceed our insurance reserves, which could adversely affect our financial condition and results of operations.
- Our revenue growth rate and financial performance in recent periods may not be indicative of future performance and such revenue growth rate may slow over time.
Lyft has historically been equity funded. Should the stock price suffer further, there is a significant risk of dilution, if additional cash is raised through equity. Financing through debt would bear other risks. Unfavorable or unavailable high-yield markets could close that path as well, leaving Lyft struggling for cash.
One of the high flyers of late is Okta, providing cloud-based access management solutions to businesses. Since their IPO in 2018, the stock price has sky rocketed. Still unprofitable, it is another growth story, albeit in a very competitive space - competing against the likes of Microsoft (MSFT), Oracle (ORCL), and RSA.
Again, let's take a look at the various risk factors Okta outlines in their 10-K, specific to finances that can be impacted by an economic downturn:
- Adverse general economic and market conditions and reductions in workforce identity and customer identity spending may reduce demand for our products, which could harm our revenue, results of operations and cash flows.
- We have experienced rapid growth in recent periods, and our recent growth rates may not be indicative of our future growth. As our costs increase, we may not be able to generate sufficient revenue to achieve and, if achieved, maintain profitability.
- Our failure to raise additional capital or generate cash flows necessary to expand our operations and invest in new technologies in the future could reduce our ability to compete successfully and harm our results of operations.
Okta specifically addresses the demand issue and its implications of a prolonged downturn:
"Our revenue, results of operations and cash flows depend on the overall demand for our products. Concerns about the systemic impact of a potential widespread recession... energy costs, geopolitical issues or the availability and cost of credit could lead to increased market volatility, decreased consumer confidence and diminished growth expectations in the U.S. economy and abroad, which in turn could result in reductions in workforce identity and customer identity spending by our existing and prospective customers. Prolonged economic slowdowns may result in customers requesting us to renegotiate existing contracts on less advantageous terms to us than those currently in place or defaulting on payments due on existing contracts or not renewing at the end of the contract term... As a result, broadening or protracted extension of an economic downturn could harm our business, revenue, results of operations and cash flows."
Often risk factors in regulatory filings are overlooked as simply "CYA language" - but that doesn't make these statements false. They frequently contain valuable nuggets of information and additional food for thought. The above companies are only a small sample - this story is similar across most of the unicorns of highly debt-financed companies. A recession will be coming, the question is just when. Are companies really prepared?
Disclosure: I am/we are short OKTA, TSLA, NFLX. 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.