I wrote a blog post in September of last year arguing that gross margins and operating margins really matter when valuing companies. I argued that “software companies with software margins” are better businesses than tech companies that are not really software companies but a tech-enabled version of some other business.
But gross margins, in particular, can be tricky to compare. In some cases, a software business is in the middle of the revenue flow, takes the revenue, and then passes on a lot of it, and is left with what looks like a low margin, but is in fact a high margin.
So Adyen operated in the last twelve months with an 18.7% gross margin. Many would think that was a “very low margin business.” But the truth is Adyen is simply passing through that $2.1bn of revenue to financial institutions in the form of interchange and other fees. They do very little with that money.
So Macy’s operated at a 40.1% gross margin over the last twelve months, more than double what Adyen operated at.
That $15bn cost of revenue on Macy’s Income Statement is the cost of purchasing everything you might find in a Macy’s store, the inventory costs associated with that, and the cost and effort of displaying all of that inventory in the stores.
So while it is the case that Macy’s has more than double the gross margin of Adyen, I believe Adyen has a much more attractive business from a margin perspective than Macy’s.
That is because Macy’s expends enormous amounts of working capital and operating expense and effort in its $15bn cost of revenue where Adyen expends very little working capital and operating expense and effort in its $2.1bn cost of revenue.
The trick, I think, is to wrap your head around the cost of revenue or cost of goods sold line item in the income statement and think about what is going on there. If it is very little to no effort, and largely just an accounting entry, then you may have a “low margin business” that is actually a high margin business. On the other hand, if it is a lot of work and capital investment to produce those margins, well then you have what you have and that is often a low margin business.
When bad news hits, I have seen traders sell quickly, get to cash, and then take some time to evaluate the situation before acting on the news. That is true of a company missing its quarter, a sudden management change, and many other forms of bad news. It is also the case when macro events hit the market.
So when a macro event hits the markets, all assets get sold in a “risk off” trade to increase liquidity and buy some time to figure out what is going on.
But soon enough, the market starts to sort through winners and losers. That’s when things stop correlating.
The obvious example is Zoom which is clearly a major beneficiary of this macro event we are in the middle of.
Zoom sold off with the market over the last week and a half but has rebounded nicely and year to date is up something like 75%.
Blue Apron, which the market had left for dead, is another example of a business that will likely do well in this macro environment, or at least it seems that the market thinks so.
Contrast that chart with Bookings, one of the largest (the largest?) online travel businesses, and you can see the lack of correlation.
I believe this downturn will see a greater number of winners and losers than most of the downturns I have lived through. That is because we are already into a pretty meaningful transition from an industrial/physical economy to a knowledge/digital economy and the very nature of this macro event is accelerating that transition in many ways. We just won’t go back to doing some things the same way.
I do plan to go out to my favorite restaurants as soon as I can. But I also plan to fly even less for business when this thing is over. Some things will return to normal. Others won’t.
And that is what the market will sort out over the course of this downturn and is already busy sorting out.
Which takes me, naturally, to crypto. Crypto, to true believers like me, was supposed to be a place to go for safety. We can trust crypto when we can’t trust banks or governments, right?
Bitcoin crashed harder than anything in the first few days of the market selloff. It was down 60% over five days from March 7th to March 12th. But since then it has recovered nicely and is now only down about 30%.
Howard’s guest was right. In panics, all assets are correlated because the market needs to deleverage. Margin loans get called. Leveraged bets go bad. Weak hands fold. And in crypto that happened faster and more furiously than any other asset class. That’s because the market infrastructure is less mature, there are places (largely outside of the US) where you could (and maybe still can) get 100x leverage on a crypto trade, and because these markets are not as liquid and other markets.
But now that the deleveraging has happened, we can look at what crypto has to offer.
Bitcoin is “hard money.” There is a fixed supply of it. 21mm bitcoins to be exact, some of which are gone and are never coming back.
Contrast that to what the central banks are doing right now. The printing presses are melting down there is so much money being printed to stabilize the global economy.
So if you want to hedge your portfolio from that risk, where can you go? Actually a few places. But one of them is Bitcoin. And I suspect that will be where some smart money will go over the next few months, quarters, etc.
But that’s not all that crypto has to offer. The entire decentralized finance stack (fintech 2.0) is being built on Ethereum. And we are seeing decentralized bandwidth, storage, and other critical infrastructure being developed in a number of new protocols.
I’m not going to write an entire crypto thesis here. But my point is that crypto won’t be correlated with the overall market for long. It’s doesn’t even appear to be a week in.
One of the best things about writing is all of the feedback you get. It helps to sharpen your arguments and also makes you rethink them too.
Here are some of the takeaways:
Some readers interpreted the post as arguing for only investing in high gross margin businesses. I don’t believe that is the right takeaway. The better takeaway is that high margin businesses are often less dependent on capital markets because they can internally generate cash more easily. That is not the case with low margin businesses. So how you value and how you finance low margin businesses becomes very important. They can’t be valued too highly or you risk a financing crisis.
Apple and Amazon were put forth as great lower margin businesses. Amazon is a roughly 25% gross margin business and trades at a little over 3x revenues. Apple is a roughly 40% gross margin business and trades closer to 4x revenues. I think that emphasizes the point that revenue multiples ought to reflect gross margins.
Many people argued that operating margins and growth rates should be the two numbers that matter most in valuing a business. I totally agree. But it is hard to have 40% operating margins if you have 40% gross margins. The truth is that operating margins will be highly dependent on gross margins. But there will be edge cases where that is less true.
I got a lot of people saying “isn’t this totally obvious?”. To which I say “it should be but clearly it is not.”
The most important takeaway for me is that the public markets are showing us in tech/startup/VC land that the economic fundamentals of a business, even those that are driving massive disruption in their markets, really does matter and that we need to pay attention to them when we finance these companies.
Public market investors have become less willing to leave their comfort zones, and it’s manifesting most obviously in the IPO market. Novel disruption has fallen out of favor, with many preferring more time-tested models like enterprise SaaS and biotech. Peloton yesterday raised over $1.1 billion in its IPO, pricing at the top of its $26-$29 range, but its shares then got crushed (although still valued well above the last private mark). Its CEO talked to Axios yesterday about the falling stock price. Endeavor, the live events and artist representation firm led by Ari Emanuel, last night canceled an IPO that originally was to raise over $600 million, before it was later downsized. WeWork… well, you know the story there. Yes, all three companies have dual-class shares. Yes, all three were highly valued by venture capital or private equity investors. Yes, all three were unprofitable for the first half of 2019. Those characteristics are also true of Datadog and Ping Identity, both of which had successful IPOs this month and continue to trade above offering. The trio’s real similarity was that each had a very complicated story. Peloton is a high-end hardware and SaaS business that produces original media content, sells apparel, and runs its own delivery logistics. Endeavor began life representing movie stars and Donald Trump, but later expanded into a massive live events business that includes the UFC and Professional Bull Riders. Plus, it’s got a streaming platform. WeWork… again, it’s different. All of this comes against the backdrop of Uber, which also had a very complicated story and an IPO that emboldened short-sellers. Up next: A lot of biotech startup IPOs, but no high-growth, complicated tech unicorns. “We’re about to get a bit of a break from those sorts of deals, which I think is good for everyone,” a top Wall Street banker told me this morning. Private markets follow public markets, so don’t be surprised to see some valuation and/or deal size pullback for these “hard to comp” companies. Particularly if SoftBank fails to raise Vision Fund 2. Goodbye to egregious governance terms. Dual-class will survive, but WeWork laid a third rail for others to avoid. U.S. IPOs have still outperformed the S&P 500 in 2019, although the gap has shrunk significantly this month. Or, put another way: The sky isn’t falling, but it’s gotten a lot darker. And, for some, downright stormy.
While all of this is true, I think it is a lot simpler than that.
The public markets are a lot different than the private markets.
Financial transactions in the private markets are controlled by the issuers, happen when the issuers want them to happen, and are generally auctions, particularly in the late stage markets.
Public market investors can buy and sell stocks every day based on what is attractive to them and what is not. If they feel like they missed out on something, they can get into it immediately.
For this reason, valuations in the private markets, particularly the late-stage private markets, can sometimes be irrational. Public market valuations, certainly after a stock has traded for a material amount of time and lockups have come off, are much more rational.
For the last five or six years, I have been writing here that I very much want to see the wave of highly valued and highly heralded companies that were started in the last decade come public. I have wanted to see how these companies trade because it will help us in the private markets better understand how to finance and value businesses.
And now we are seeing that.
And what we are seeing, for the most part, is that margins matter. Both gross margins and operating margins.
If you look at the class of companies that have come public in the last twelve months, many of the stocks that have performed the best are software companies with software margins. One notable exception to that is Beyond Meat.
Zoom – 81% gross margin
Cloudflare (a USV portfolio company) – 77% gross margin
Datadog – 75% gross margin
If you look at the same list, many of the stocks that have struggled are companies that have low gross margins.
Uber – 46% gross margin
Lyft – 39% gross margin
Peloton – 42% gross margin
Some other notable numbers:
WeWork gross margins – 20%
Spotify (down almost 30% in the last two months) gross margins – 26%
I believe that we have seen a narrative in the late stage private markets that as software is eating the world (real estate, music, exercise, transportation), every company should be valued as a software company at 10x revenues or more.
And that narrative is now falling apart.
If the product is software and thus can produce software gross margins (75% or greater), then it should be valued as a software company.
If the product is something else and cannot produce software gross margins then it needs to be valued like other similar businesses with similar margins, but maybe at some premium to recognize the leverage it can get through software.
But we have not been doing it that way in the late-stage private markets for the last five years.
I think we may start now that the public markets are showing us how.
Here are Uber’s profit and loss numbers from their S1:
We can compare this to Lyft’s profit and loss from my prior blog post:
I put all of these numbers into a spreadsheet and added some estimates for 2019 that are nothing more than back of envelope guesstimates.
What you can see from this is that Uber is 4-5x larger than Lyft, growing a lot more slowly, has slightly better gross margins, and both are still losing a lot of money but both are moving towards getting profitable on operations in a few years.
Finally lets look at market valuations. Lyft is currently trading at a market cap of $17bn. If you say that Uber is 4-5x larger than Lyft, then Uber ought to be worth in the range of $70bn to $85bn.
There are other factors that will be in play when Uber eventually prices their IPO and trades. Uber owns minority interests in a number of other ridesharing businesses that could be worth as much as $10bn of additional value. On the other hand, Lyft is growing more quickly than Uber.
Ultimately we will see how the market values Uber. But from this analysis, and the public market comparables from Lyft, we can see that Uber should be worth quite a bit when it goes public.
I am not exactly sure what it is about this year, as opposed to any of the last five years, that has drawn all of these highly valued private companies into the public markets, but here we have it.
It does take a number of years for a privately held company to prepare to be a public company. They need to get their finance and legal houses in order, they need to beef up their teams in these areas, and they need to make sure they have a repeatable business that they can manage under the spotlight of the public markets.
Already we have seen S1s from Lyft, Pinterest, and Zoom. And we are likely to get them soon from Uber, Slack, Airbnb, and a host of others, in the coming months.
I see this as largely beneficial to the startup sector for the following reasons:
1/ We will have benchmarks from highly liquid markets in terms of what these high growth tech companies are worth. Until now, most of these benchmarks have come from illiquid private market auctions, which are not exactly the best price discovery mechanisms.
2/ Many employees, angels, seed investors, VCs, and growth investors will get liquidity from these investments and recycle it back into the startup sector. More capital means more startups and more innovation.
3/ Limited Partners, the providers of capital to venture capital and growth equity funds, will get large distributions which will give them more confidence in the startup sector and they will continue or perhaps step up their commitment to invest in early stage technology.
4/ These newly public companies will be able to accelerate their acquisition programs now that they have liquid stock and cash to fund those deals. That will further flow capital back into the startup sector.
Of course there will be negatives. It will be harder than ever to afford to live in the bay area. But tech folks from the bay area are certainly welcome in NYC, LA, and any number of other startup regions around the US. Get paid on your stock and move to a more affordable and liveable region!!!
And the monster funds that have been advocating staying private forever will have to argue why these IPOs are not what every other startup should be aiming for. And I think that argument is going to be harder and harder to make with this IPO bonanza under way.
All in all, I think the IPO bonanza that is under way in 2019 is a good thing. I have been expecting it and wanting it for years and I am pleased that it is now upon us.
We are now seeing a wave of longtime private companies coming public and with that we are getting data on usage, financial performance, and a host of other issues that is very useful market data.
I spent some time looking at Pinterest’s S1 today. They filed it a week or two ago.
I found this chart of user growth quite interesting:
That shows monthly active users in the US and International over the last few years on a quarterly basis.
Pinterest is rapidly growing its user base outside of the US but usage in the US has stalled out.
This chart, also from the S1, shows revenue growth in the US and Internationally:
So what you can see is that Pinterest has been growing its US revenues rapidly but not its US user base. And on the other hand, Pinterest has been growing its International user base but its International revenue is still nascent.
So the question is whether Pinterest will be able to monetize its rapidly expanding international user base.
That is the kind of insight you can get from reading these S1s. I find them fascinating and try to read them when they come out.
I don’t plan to buy Lyft or Pinterest when they come public. That’s not really my thing. And I don’t have an opinion on whether they are attractive investments or not. But I do think we can learn a lot about these businesses from reading S1s and that can help us with the investments we do have.
I expect we will see IPOs from big names like Uber/Lyft/Slack, although I also expect those deals will get priced well below the lofty expectations they have in mind right now. Some of that will be because of weak equity markets in the US, but it is also true that most of the IPOs in 2018 also priced below the lofty “going in” expectations of founders, managers, boards, and their bankers. The public markets have been much more sanguine about value than the late stage private markets for a long time now.
When I see an IPO price range, I like to go look at the S1 that the issuer has filed with the SEC prior to the road show. Here is Lyft’s S1.
Here are the things I like to look for in a S1:
1/ The total shares outstanding. You can go to the table of contents of the S1 and look for the section called “Description Of Capital Stock”. In Lyft’s S1, it says there are ~240mm shares of Class A common stock plus some amount of Class B common that is not yet detailed. The Bloomberg article I linked to above says the company is going to sell 30.8mm shares at $62 to $68 per share. So there will be at least 270mm shares outstanding plus the Class B shares. The Bloomberg folks seem to be using a post deal share count of 288mm share so that is close enough. You get to fully diluted post deal valuation by multiplying the share count (288mm) by the range ($62/share to $68/share).
2/ Revenues and earnings/losses. You can go to the table of contents of the S1 and look for the section called “Selected Consolidated Financial And Other Data” and you will find the audited financial data. I like to find the quarterly numbers because that will give you a good idea of current growth rates. These are the numbers for Lyft:
As you can see the quarterly revenues are growing at roughly $80mm a quarter so a back of the envelope guess on revenues for 2019 are [$750mm, $830mm, $910mm, $990mm] for a total of ~$3.5bn, up from $2.1bn in 2018 (yoy growth of 65%).
You can also see that the contribution (net of cost of goods sold) has been about 45% over the past few quarters so if that ratio holds in 2019, there would be contribution of roughly $1.6bn in 2019.
For the operating costs, you can look at the difference between contribution and EBITDA, which you can see here:
Lyft spent ~$1.85bn on opex in 2019 ($921mm of contribution plus $943mm of EBITDA losses). That number grew from $1.1bn in 2017. I would expect Lyft’s operating expenses to be at least $2.25bn to $2.5bn in 2019.
Which gets you to this possible P&L for 2019:
Revenues – $3.5bn
Gross Margin – $1.6bn
EBITDA (loss) – $600mm to $900mm
3/ Valuation Ratios:
At the mid-point of the offering range $18bn, the price to revenue multiple is roughly 5x (18/3.5) and the multiple of gross margin (what Lyft keeps after paying significant COGS) is roughly 11x (18/1.6).
4/ Time to cash flow breakeven. This is harder because you have to make some assumptions about growth rates beyond 2019 and opex growth rates. But if Lyft can grow revenues at 60% per annum for a few more years and keep opex growth rates to 25-30% per annum, then it could get profitable by sometime in 2021. This suggests that the $2bn it is raising may be sufficient to get profitable, but it will be close.
So what does this mean for other late stage high growth high flyers?
To me it says if you have company focused on a big opportunity (like transportation) that is growing at north of 60% per year it is worth in the range of 10-12x net revenues to wall street right now. Because Lyft only keeps about 45% of its revenues after very high COGS, that works out to be 5x revenues.
Many late stage private companies are getting financed at valuation ratios in excess of this so they will have to grow into their eventual public market valuations. But that has been the case for quite a while now as the late stage private markets continue to pay higher prices for high growth companies than the public markets do.
Today, as is my custom on the first day of the new year, I am going to take a stab at what the year ahead will bring. I find it useful to think about what we are in for. It helps me invest and advise the companies we are invested in. Like our investing, I will get some of these right, and some wrong. But having a point of view, a foundation, is very helpful when operating in a world that is full of uncertainty.
I believe and have been telling those around me that I think 2019 will be a “doozy.” I think we will see major dislocations in the leadership of the United States, a bear market in stocks, a weakening economy, a number of issues with the global economy including a messy Brexit and a sluggish China. All of this will lead to a more cautious stance by investors in the startup economy. And crypto will not be a safe haven for any of this although there will be signs of life in crypto land in 2019.
Let’s take each of those in the order that I mentioned them.
I believe that we will have a different President of the United States by the end of 2019. The catalyst for this change will be a devastating report issued by Robert Mueller that outlines a history of illegal activities by our President going back decades, including in his campaign for President.
The House will react to Mueller’s report by voting to impeach the President. Which will set up a trial in the Senate. That trial will go so badly for the President that he will, like Nixon before him, negotiate a resignation that will lead to him and those close to him being pardoned for all actions, and Mike Pence will become the President of the United States sometime in 2019.
I believe this drama will play out through most of 2019. I expect the Mueller report to be issued sometime in the late winter/early spring and I expect an impeachment vote by the House before the summer, leading to a trial in the Senate in the second half of the year.
The drama in Washington will have serious impacts to the economy in the United States starting with our capital markets.
The US equity capital markets enter 2019 on shaky ground. Though the last week of the year brought us a relief rally, the markets are dealing with higher rates, some early indications of a weaker economy in 2019 (possibly due to higher rates), and, of course, the potential for the drama in Washington that we’ve already discussed. Here is a chart of the S&P 500 over the last five years:
I expect the S&P 500 to visit 2,000 sometime in 2019 and then bounce around that bottom for much of the year. This would represent a decrease in the S&P’s trailing PE multiple to around 15x which feels like a bottom to me given the recent history of the equity markets in the US:
Interest rates have been rising gradually in the US for the last three years. The Fed has taken its Fed Funds rate from essentially zero three years ago to almost 2.5% today:
The rates that are available to consumers and businesses have followed and I expect that to continue in 2019. Here is a chart of the interest rates on the three most popular mortgage products in the US:
When it gets more expensive to borrow, marginal projects don’t get funded. And what happens at the margin has a much larger impact on the economy than most people understand. No wonder the President wants to fire the Fed Chairman.
I expect the combination of higher rates, uncertainty in Washington, and storm clouds globally (which we will get to soon) will cause business leaders in the US to become more cautious on hiring and investment. Consumers will make essentially the same calculations. And that will lead to a weaker economy in the US in 2019.
The global picture is not much better. The eurozone is about to go through the most significant change in decades with some sort of departure of the UK from the EU (Brexit). It remains unclear exactly how this will happen, which in and of itself is creating a lot of uncertainty on the Continent. I don’t expect most businesses in Europe to do anything but play defense in 2019.
Probably the biggest unknown for the global economy is the resolution of the ongoing trade tensions between China and the US. It seems inevitable that China will make some concessions to the US to resolve these trade tensions. But, of course, what happens in Washington (first issue) may impact all of that. In the meantime, the uncertainty around trade and exports hangs over the Chinese economy. China’s GDP has been slowing in recent years as it achieved relative parity with the US and the Eurozone:
Any significant trade concessions from China could impact its growth prospects in 2019 and beyond, which will take the most powerful engine of global growth off the table this year.
So all of that is a pessimistic take on the broader macro environment in 2019. How will all of this impact the startup/tech economy?
The startup/tech economy is somewhat immune to macro trends. Many startups and big tech companies were able to grow and expand their businesses during the last financial downturn in 2008 and 2009. Some very important tech companies were even started in those years.
The tech/startup economy is driven first and foremost by technical and creative (ie business model) innovation. And that is not impacted by the macro environment.
So I expect that we will continue to see big tech invest and grow their businesses and do well in 2019. I expect we will see IPOs from big names like Uber/Lyft/Slack, although I also expect those deals will get priced well below the lofty expectations they have in mind right now. Some of that will be because of weak equity markets in the US, but it is also true that most of the IPOs in 2018 also priced below the lofty “going in” expectations of founders, managers, boards, and their bankers. The public markets have been much more sanguine about value than the late stage private markets for a long time now.
However, I do think a difficult macro business and political environment in the US will lead investors to take a more cautious stance in 2019. It would not surprise me to see total venture capital investments in 2019 decline from 2018. And I think we will see financings take longer, diligence on new investments actually occur, and valuations to come under pressure for even the most attractive opportunities.
But all of that is going to happen at the margin. I expect 2019 to be another solid year for the tech/startup sector as we are in a possibly century-long conversion from an industrial economy to an information economy and the tailwinds for tech/startup vs the rest of the economy remain in place and strong.
Any set of predictions for 2019 from me on this blog would not be complete without some thoughts on crypto. So here is where my head is at on that topic.
I think we are in the process of finding the bottom on the large, liquid, and lasting crypto-tokens. But I think that process could take much of 2019 to play out. I expect we will see some bullish runs, followed by selling pressures taking us back to retest the lows. I think this bottoming out process will end sometime in 2019 and we will slowly enter a new bullish phase in crypto.
I think the catalyst for the next bullish phase will come as the result of some of the many promises made in 2017 coming to fruition in 2019. Specifically, I think we will see some big name projects ship, like the Filecoin project from our portfolio company Protocol Labs, and the Algorand project from our portfolio company Algorand. I think we will see a number of “next gen” smart contract platforms ship and challenge Ethereum for leadership in this super important area of the crypto sector. I also expect the Ethereum open source community to ship a number of important improvements to its system in 2019 and defend their leadership in the smart contract space.
Other areas of crypto where I expect to see meaningful progress and consumer adoption happen in 2019 are stablecoins, NFT/cryptoassets/cryptogaming, and earn/spending opportunities, particularly in the developing world.
There will also be pressure on the crypto sector in 2019. The area I am most concerned about are actions brought by misguided regulators who will take aim at high quality projects and harm them. And we will continue to see all sorts of failures, from scams, hacks, failed projects, and losing investments be a drag on the sector. But that is always the case with a new emerging technology that allows anyone to set up shop and get going. Permissionless innovation produces the greatest gains over time but also comes with the inevitable bad actors and actions.
So that’s where my head is at on 2019. Do I sound pessimistic? I suspect I do, but I am not. I am incredibly optimistic, like my partner Albert and can’t wait to get going and make things happen in this new year. It is going to be a doozy.