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Terminal Value Companies - Buyer Beware!

|About: Netflix, Inc. (NFLX)

Investors should be more skeptical of companies where all of the value resides in the terminal state.

The "cloud" is giving false confidence of superior economies of scale and impregnable business models for many technology companies.

Required rates of return are falling and so should growth rates for the "Disruptors".

Netflix’s market value is $140 billion versus 2019 operating income of $2.7 billion (52x). Tesla’s market value is $42 billion versus 2019 operating loss of ($257 million). UBER’s market value is $70.0 billion versus 2019 operating loss of ($8.9 billion). Square Inc., a provider of point of sale software sits at $34 billion in market value versus 2019 operating income of $21 million (1,619x). These are a few of the long list of “disrupters” with huge market values in the market today. How do investors make sense of such enormous multiples and how big is the risk imbedded in these market values?

In a $20 trillion U.S. economy, how large can single businesses grow? There are already 3-4 companies with market values at or approaching $1 trillion. Is competition increasingly stymied by these behemoths, thus providing disproportionate “winner take all” returns to market leadership, and encouraging patience with the red ink needed to get there? Has the profit motive been exorcised from entrepreneurs - and for the rest of us - how much of these valuations are just a result of “brand awareness” rather than solid fundamentals? Let’s start with what I believe is represented in some of the gargantuan technology related valuations.

First, there was the Internet and now there is the “Cloud”. The “cloud” represents the shift to off-premise server and software products and services from the prior domain within a corporation’s physical properties. Warehouses full of servers run by all sorts of real estate and technology companies have replaced on-site tech support people that lived in the server room (often in the basement). With the ubiquity of access to the internet, companies like Amazon and Microsoft have built “cloud computing” server farms to offer all the hosting, software and support, and web services to help businesses move to an e-commerce world. Many investors believe that these cloud-based platforms will provide permanently superior economies of scale (i.e. new customers with very little incremental investment) and a strong moat against new or existing competitors entering the business. No doubt that many new publicly traded technology companies that offer cloud-based services are finding investor salivating to own them. While growth has been spectacular, we can already see nascent levels of erosion in these business models. For example, Amazon is facing “tough comps” and is making incremental investments in its crown-jewel Amazon Wholesale Services Division. AWS revenues for the most recent quarter grew 37% but profits grew only 24% suggesting dis-economies of scale. Netflix is another example of being first to a cloud-based movie and TV series entertainment platform that is under increasing competitive assault from other movie studios such as Disney, Amazon Prime, and AT&T (which owns Time Warner) among others.

Second, there is the belief that newer cloud-based business models receive better insight into consumer behavior. Registering your personal information to receive products and services online create enormous databases that can be cross-referenced with other databases to create a consumer profile that is much more robust than in the past. These intelligent databases can then be used to create new related or unrelated revenue streams in the future. Management teams, private equity firms, and the sell side therefore like to promote the idea that new revenue streams should be incorporated into long run projections for the company.

Third, there is a belief that “platforms” like Apple’s eco-system are impregnable and that the platform owners can collect royalties from all the third-party apps or games developed for that platform into perpetuity. Whether one considers the many other historical “platformesque” businesses (e.g. Microsoft’s Office or Nintendo’s gaming platform), the conclusion is that competition does eventually arrive and results in slower growth rates and lower margins. The old German proverb, “Bäume wachsen nicht in den Himmel” or “Trees don’t grow to the sky” should be taped on the computer screen of anyone doing business valuation forecasting.

Finally, the titanic windfalls for early private equity investors in many of these businesses have allowed the industry to adopt more of a modern portfolio theory approach to their investment strategy. Simply put, if they invest in 50-100 ideas and a few of them eventually result in huge public market exit events, their required rate of return on the portfolio can be lower. This strategy will work for as long as the capital markets are accommodative and the speculative fever around many of these companies keeps its momentum.

So, these are some of the things you would have to believe to accept the accompanying valuations. There may be logic in them but let me suggest that logic is overstated. In the world of business valuation, discounted cash flow (DCF) analysis remains a core analytical tool. Other determinants of value such as comparative analysis to recent transactions or publicly traded peers are suggestive. Shorthand value measures such as P/E, forecasted total addressable market (TAM) x market share opportunities can be even more crude and lazy. DCF, when properly focused on free cash flow or “owners’ earnings”, however, offers the mathematical rigor required to fundamentally value a business.

Bear with me for a little math. The users of DCF are familiar with an “explicit” forecast period (e.g. usually 3-5 years) followed by a terminal value. The terminal value formula (using a free cash flow versus dividend version of the Gordon Growth Model) is stated as [FCF6 / (K-G)] where FCF6 is the free cash flow one year after the explicit forecast period (in the case of a 5 year forecast period) divided by the sum of the required rate of return (K) less the long term growth rate of the company’s free cash flows (G).

In today’s growth crazed market, there are many companies with current losses or paltry profits that are maintained into the explicit forecast period. Then, like the proverbial phoenix rising from the ashes, these companies will arrive at steady profit margins and maintain above average growth rates into perpetuity. The hope is that these companies create enough “terminal value” either through substantial growth in free cash flow or a very high exit multiple to another buyer to recover the exorbitant current market value for the business.

Terminal Value” Companies ($bl)

Company Tesla Netflix Square Uber

2015-2019E Cum FCF ($7.0) ($10.9) $.62 ($12.3)

2020 FCF Est $.98 ($3.5) $.53 ($3.4)

Market Cap $41.8 $140.0 $34.2 $70.0

Market Cap / 2020 FCF 42.6x NMF 64.2x NMF

Enterprise Value $52.6 $149.0 $34.1 $73.0

LEAP Implied Option Volatility 51.8 38.8 44.3 41.0

Source: Bloomberg

As interest rates have fallen globally, the required rate of return (K) has also fallen. Whether one looks at negative yields on sovereign debt, low credit spreads for high yield bonds, or high P/E’s, the required rate of return on risk assets has fallen. This is the by-product of a slower growth world. Whether demographics, trade disputes, or climate change is the culprit, the world’s growth rate has slowed and investors by relative necessity have become comfortable with lower returns on risk assets. This lowering of required returns means that terminal values for high growth businesses have exploded as the denominator in the Gordon Growth model has declined.

This seems one-sided to me. Surely, if global growth is slower, the ability to grow free cash flow in a perpetual way must also be lower. Disruptive technology may produce incredibly high top-line growth rates during some explicit forecast periods, but to do it into perpetuity in a slower growth world is not something I would build into a terminal value growth rate. Competition and inertia find a way to undermine even the best business models. The options markets capture this high level of risk through the long-term implied volatility of the options for large “terminal value type” companies. Anything above 30x suggests highly variable outcomes in the long term. Finally, what if interest rates surprise all of us and begin to rise. A few emojis come to mind for me……!

Maybe value investors will never fully grasp the huge value shift from offline to online disruptors that exclusively benefit the early, the fast and the few, in a permanent value creating way. But this is not the history of commerce and there are many different outcomes that can and will develop too the surprise of all investors. After all, cognitive science teaches us that humans are biased to extrapolate straight lines in a world full of curves.

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