Today I thought it is worth discussing the success of three companies in particular Netflix (NasdaqGS:NFLX) Amazon (NasdaqGS:AMZN) and Xero (NZSE:XRO).
All of these companies have performed extremely well despite not producing consistent or any profitability.
As many value investors anchor to profitability metrics to base their investment decisions it is worthwhile discussing how these companies can be so successful without being profitable as it is outside the typical value investing framework.
I will first discuss the benefits of this approach and then the downsides.
Positives
The positives are there is no tax paid to the government as the companies are investing significant amounts of cash flows such that they typically will be making losses. This is beneficial as it allows for more capital to be used for investment than if taxes were being paid. Arguably that capital is being used to deepen their economic moat.
Previously companies would invest in plant and equipment which would be depreciated over many years, however it is more tax advantageous to invest from an operating expense perspective whereby the tax deduction can be claimed immediately
This tax efficient investing has also used by entrepreneurs such as John Malone when investing in Cable TV assets which were protected by a depreciation shield. His companies often recognised accounting losses while reporting strong cash.
Secondly companies can outcompete their rivals by lowering prices or investing more to develop a better product or obtain more customers than their competitors which are trying to maintain a particular positive profit margin.
Importantly Amazon Netflix and Xero have also managed to minimise the dilution from issuing extra equity and increase sales in a much faster rate than their share issue count. This is extremely important as maintaining a tight shareholder register will ensure greatest share price appreciation and enable equity to be raised at a higher price in future equity raises. Amazon and Netflix have also utilised debt to minimise dilution. Minimising dilution could be a atgtributable to the large insider ownership these stocks have and the people to benefit the most from minimising dilution are the founders.
Amazon's book value per share since 1997 has increased at 37.1% p.a, sales by 42.5% and its share count by only 3.3%. For every $1 of incremental equity retained sales have increased by 6.54x compared to Netflix at $3.29:$1 and Xero at $1.36:1.
All of these companies have compounded book value at a significant rate, despite not producing much profitability as they have been able to raise equity at higher and higher valuations.
Investors have been willing to look past the losses or breakeven position as the NPV of new customers signed up is greater than the cost to acquire those customers. This is a difficult exercise as the churn rates for the customer's lifetime are unknown and also the pricing that is achievable. We must take a short timeframe and extrapolate that behaviour out over the life of the customer. For the services that have been priced at an attractive level to obtain customers may experience a higher churn as prices are increased to try and increase profitability.
Negatives
The downside to the strategy is that it requires capital to be raised at some point and to some extent this puts fate outside the control of the company. Although the owners of these companies suggest that they can slow down the growth rate and return to a cash flow positive situation this would be often regarded as negative by the investment community as the share price and revenue multiple is correlated to the level of growth and it may mean competitors could obtain the upper hand.
To date it hasn't been so much of an issues as these companies have benefited positively from strong equity markets and have not needed to raise capital in a depressed equity environment.
There have been other examples of companies that have been reliant on the capital markets which have withdrawn support and the companies have perished into receivership such as Wynyard formerly (NZSE:WYN) etc.
The difference between Wynyard and Xero is Xero has a much more predictable revenue profile as its revenue was subscription based whereas Wynyard was contract based license sales which were are much more lumpy.
Conclusion
The approach to reinvest significantly can be very worthwhile as it allows companies to gain a first mover advantage and widen their economic moat. However, it doesn't get away from the fact that these companies will need to earn positive cash flows in the future to justify their valuations. THe length of time investors are willing to wait until positive cash flows are delivered is unknown but is likely to be more acute when capital becomes more expensive as interest rates increase and risks appetites wane.
