Most investors think about the world in terms of growth or value. Growth investments tend to be in companies relatively early in their growth curve with high revenue growth. Growth companies are often unprofitable as they invest heavily to capture the dominant position in their market. Growth valuations are based on assumptions about future growth and profitability. A value investment assumes some company is underpriced relative to its intrinsic value. Traditionally, value investments are in companies that are relatively mature with profits off of which to value the business.
In either case, an investor’s job is to buy an asset that should be worth significantly more based on its underlying earnings and assets. Growth investing is about future underlying earnings and assets, assuming they come to fruition. Value investing is about current underlying earnings and assets, assuming they are sustainable.
We believe this framework obscures the reality of tech investing (perhaps all investing, although we are not experts beyond tech), where there are five categories of investing, not two:
- Customer discovery
These categories of tech investments are also the natural progression of a technology company along a market growth curve via the work of Everett Rogers, built on by Geoff Moore. Understanding these categories is important because if a tech investor doesn’t understand the category an investment fits in, their expectations will veer from reality and results will disappoint.
A true technology company is either growing rapidly or harvesting tremendous profit from winning a huge market. Otherwise, the company is dying.
Five Categories of Tech Investing
Customer discovery is where pre-seed and seed-stage investors live. These investors fund companies that have yet to answer the core question: for whom does our product solve a real problem? Pre-seed and seed investors are looking for a potentially large market with a decent team capable of figuring out if their solution addresses a real customer need. Growth isn’t the key goal of this phase — defining your customer is — though growth is the key indicator of finding a real customer need.
The customer discovery phase is where every company must start, selling to innovators willing to try new solutions. Most companies die in this phase, some pivot to try to serve different customers, some pivot to completely different ideas, and a few graduate to the growth phase.
Growth investing is what most commonly comes to mind for tech investing. This makes logical sense because innovative technology companies should be growing rapidly if their products resonate with the market. However, growth investing spans a wide swath of an industry growth curve — from early market through much of the early majority — and each subset has particular nuances.
Growth investors can be early-stage venture investors who are looking for companies that have found customers for their solution and need to build a repeatable success engine for bringing those customers into their business. Early-stage investors typically deal with companies addressing the early market phase of the curve.
Growth investors can be late-stage venture investors looking to supply companies that have a proven success engine with large amounts of capital to scale quickly and win the market. Late-stage investors typically deal with companies in the late early market or the beginning of the early majority of a growth curve.
Growth investors can also be public market investors. Generally, these investors look for companies similar to late-stage venture investors, but with diminishing capital requirements as the companies work deeper into the early majority of their growth curve and transition to sustainable businesses.
In our view, the best growth investments come when the market is in the later stages of the early market to the beginning of the early majority period and the investor community under appreciates the true size of the market. Any time the investor community fully appreciates or, even worse, over appreciates a market opportunity, the potential for returns is diminished because the opportunity is factored into the valuation of the equity.
Of all the tech investing categories, we believe the transition category is the least well understood. As a tech company matures along its market growth curve, it has to demonstrate a profitable underlying business for the company to be self-sustaining. Every tech company eventually reaches a phase in its lifecycle where investors don’t really view it as a growth company anymore, but the company also hasn’t yet crossed into the value or compounder category. Per our mantra above, a true technology company must either be growing rapidly or harvesting profit. The transition phase is the period of shifting from the former to the latter.
Transition companies generally have a strong market position, otherwise, they would have died along the way. They’re also usually still “growth” companies by the raw numbers. The minimum hurdle to be a growth company as a public entity is 20% annual revenue growth, although many investors expect much higher growth to give a company a true growth multiple. Where exactly the transition category hits on the market growth curve is therefore not driven solely by slowing revenue growth and varies company to company. It seems to be driven by some combination of the stage of the company’s market curve and the valuation of the company.
Uber and WeWork are transition companies. Uber, based on revenue growth, had matured fairly deep into its market curve. It grew gross booking 31% in its first quarter as a public company. On the other hand, WeWork showed 100%+ revenue growth in its S-1 in the first six months of 2019. Based on those revenue growth rates, Uber appeared to be far deeper into its market curve than WeWork, but WeWork’s valuation at the time, $47 billion, more than priced in the company’s growth potential despite the rapid growth rate. With a large-cap growth valuation, investors want to see beyond large-cap growth potential that would have enabled WeWork to transcend to the holy grail of technology investments — the compounder. Instead, investors only saw rapid growth with poor margins and WeWork got a bailout.
The transition category is difficult to invest in because the only way for the investor to continue to see returns is if the company in question can become a compounder with solid growth and a high return on invested capital — a status reserved for truly rare companies. If the transition company can’t become a compounder, the investor has to believe the company can build into another market in the near term that can augment growth, move the company back down into the growth category of the tech investment framework, and ultimately have that new market become the core business of the company. More often than not, transition companies turn into tech value plays, which are not good long-term investments.
Transition companies can live in this category for several years on the path to proving compounder status or falling into the value category.
There is no such thing as a value company in tech. We’ve lived by this mantra for more than 10 years and still believe it true today.
When technology companies stop growing, best case it’s because the underlying market is mature but stable with underwhelming growth prospects. More often than not, the company’s technology is obsolete and the market is ripe for disruption. The value category in tech is comprised of companies with modest to poor revenue growth rates — generally 20% or below — and disappointing profit margins with minimal chance for improvement.
Tech companies that fit into the value category live in a sort of purgatory. There is minimal opportunity to reaccelerate growth in their existing markets, and investors aren’t likely to be excited to give value tech companies more capital to explore new markets. Modest margins also make it difficult for the companies to self-fund exploration into new markets. On top of capital constraints, retaining tech talent is difficult with a languishing stock price.
Capital accrues to winners in tech, per Alfred Lin. Capital accrual comes in the form of both investment and profit for tech, particularly in Internet-distributed companies where winners often take all. Locality encourages winner-take-all dynamics, and the Internet makes the world local.
Value tech companies will not accrue capital in the form of profit or investment for seeking new market opportunities, making them long-term losers. Investors should only consider tech companies in the value category as shorter-term trades, if at all.
Best to just avoid value tech companies because there is really no such thing.
Compounders are the true unicorns of tech investing — the exceptional company that you should invest in at a fair price and hold indefinitely. Morgan Stanley defines a compounder as ”high quality, franchise businesses, ideally with recurring revenues, built on dominant and durable intangible assets, which possess pricing power and low capital intensity.”
We define tech compounders internally as market-leading companies with high profit margins driven by a differentiated product and defensible business model. Tech compounders also require a culture that embraces constant innovation at a relentless pace. Because of the competitive position of compounders, they often also have solid to strong growth in the low-double digits y/y even at relative maturity. These companies generate significant free cash flow that can be reinvested in the business at high rates of return and/or returned to shareholders.
One or two companies often win dominant positions in local markets. For example, most towns or neighborhoods only have one or two pizza places, not five or six. Over the long term, customers will gravitate to whichever has the best product, creating a winner that takes most or all.
The Internet made the world local. As a result, compounders almost always show winner-take-all dynamics in the markets they compete in. Software businesses demonstrate this most obviously. Tech businesses that require physical infrastructure can easily make states and countries local instead of towns or neighborhoods, but tech infrastructure companies deal with more friction to make the world local than software companies.
Investors can easily fool themselves about the progress of a company at every stage, but because there are so few compounders, this category is especially easy to incorrectly assign. As a rule, if you think you have a compounder, you probably don’t.
If you do have a compounder, it should stand alongside companies like Apple, Google, and Facebook.
Uber reported Q4 2019 earnings with revenue in line with the Street and a net loss 6% better than expectations.
We are incrementally more positive on the Uber story, given the company’s cost-cutting in December did not impact revenue growth, a leading indication that the business model can trend towards profitability. That profitability is now said to come in Q4 2020, ahead of Uber’s previous target of full-year 2021. Longer-term, further upside to margins is in play as autonomy becomes a bigger part of the story, likely starting with a fractional number of vehicles in “a couple of years.”
- Uber is going to be around for a long time. It remains unclear what the long-term model is going to look like, but the company is moving in the right direction with its focus on profitability and the secular tailwind of shared mobility at its back.
Uber makes good on its commitment to cut costs with December adjusted EBITDA losses of $615M vs expectations of $702. Spending remains investors’ primary concern, with December results a step in the right direction.
We’re in a slightly different camp than most investors and believe that demand is what’s most important. Overall, while revenue was in line with expectations, it was the 2nd consecutive quarter of GAAP revenue acceleration, finishing the quarter up 39% vs up 30% in Sep. We’re also encouraged by 28% growth in Trips vs 31% in Sep and 36% in Jun. The deceleration had moderated, which is a positive.
We believe that Uber is losing market share to Lyft in the US. We estimate rides in the US were up mid-single digits and expect Lyft will grow 40%+ in the US in Q4. For perspective Uber has two-thirds of the market in the US.
Dara says regulation has been and always will be a conflict for the company.
Uber is cutting costs but maintaining robust revenue growth outlook (high teens %) for 2020 due to pricing power. Lyft and Uber are both getting more expensive to use.
The end of 2020 is when Eats financials start to improve. Overall we see it as a business worthy of investment, given its on mark with cultural shifts and their competitive advantage of cross-leveraging Rides and Eats.
California has a more strict regulatory environment for drivers, and the associated costs have yet to kick in. The company said they are raising prices in CA faster than other states to subsidize what will be an increased cost of operating. In itself, this is largely a non-event, but if CA’s approach to gig economy workers is adopted more widely, it may jeopardize Uber’s track to profitability. It will likely take several years for the regulatory piece to stabilize.
In 2020, Uber plans to push subscriptions, which investors should appreciate. Subscription revenue in 2020 will be fractional but will become a greater part of the Uber story. In 10 yrs, we see subscription-based mobility as the most popular option for moving away from car ownership.
Uber expects that Level 4 autonomy is “a couple” years away, and cautions that companies like Waymo and Cruise that do not have a network of demand (aka Uber, Lyft) will not be a viable solution. We believe Waymo could funnel Google Maps and Waze users (more than 1B) into an AV service but largely agree with the fact that ridesharing networks will be the go to market for many self-driving startups. We believe Telsa’s crowdsourced autonomous ridesharing fleet, while years away, is conceptually a viable rival to Uber and Lyft’s autonomy strategies.
Bottom Line: Tesla’s market cap has nearly doubled over the last month and has tripled since the end of Q3. The excitement driving such a dramatic rise presents short term risk. We believe current pricing may be overlooking:
- Sequential delivery decline
- Negative free cash flow
- Margin pressure from production ramps and fewer deliveries
The market has fundamentally repriced Tesla as a technology company with a market cap of $136B, more than the Big 3 US automakers combined (GM $50B, Ford $34B, Fiat Chrysler $27B). Tesla shares dropped 17% to $734 on Wednesday, coming back to earth after a meteoric run up to $969.
Tesla’s Q4 was a golden holiday quarter full of tailwinds. Notably, deliveries outpaced production by 7k vehicles, fueling a FCF beat of 133% ($429M street vs $1B actual). As tailwinds shift to headwinds in Q1, we believe expectations have risen too quickly ahead of Q1 results. We believe the repricing is justified, but caution that the Street is overlooking the following short-term headwinds:
- Q4 demand pull-forward from incentive phaseouts in the US & Netherlands. Potential buyers were incentivized to purchase Tesla vehicles in Q4, as the effective price of a base Model 3 in the US increased from $38,025 to $39,900. Tesla did not reduce prices to offset the tax credit phaseout, which is an indication of strong demand. Interest in Tesla is at an all-time high, which helps vehicle demand.
- Tesla removed “Deliveries should increase sequentially” from the Q4 shareholder letter. In both Q2 and Q3, Tesla’s Delivery Outlook read, “Deliveries should increase sequentially and annually, with some expected fluctuations from seasonality.” The removal likely indicates Q1 deliveries will decline significantly from 112k vehicles in Q4. Tesla Q4 Volume Outlook: “Due to ramp of Model 3 in Shanghai and Model Y in Fremont, production will likely outpace deliveries this year.” Throughout its history, Tesla has never delivered more vehicles than it has produced in Q1. Vehicle production will likely outpace deliveries significantly in Q1, which may lead to negative FCF for the quarter.
- Q1 is seasonally weak for automakers due to poor weather, end of year holiday discounts, and new model releases. Tesla’s CFO: “For Q1, please keep in mind that the industry is always impacted by seasonality.” Tesla will not have to deal with the severe overseas logistics headwinds they experienced in Q1 ’19. However, the Street is likely underestimating the negative impact of Q1 seasonality.
- Finished vehicle inventory decreased sequentially from 17 to 11 days of sales. Q4 shareholder letter: “Our finished vehicle inventory levels reached just 11 days of sales at the end of Q4, the lowest level in the past 4 years.” Tesla delivered every vehicle they could in Q4, leaving many showrooms empty and online inventory searches yielding “no results”. Tesla will likely build vehicle inventory levels during Q1, which may widen the gap between vehicle production and deliveries, negatively impacting FCF and profitability.
- Model S&X Osborne effect due to upcoming “Plaid” Powertrain. Elon: “[The Plaid] Powertrain is like mind-blowing… Coming out later this year. That’s our goal. This is like alien technology. It’s insane.” Elon’s comments and the ever-present rumored interior “refresh” incentivize potential Model S & X buyers to hold out, which may lead to fewer Q1 deliveries than expected.
- Fremont Model Y and Shanghai Model 3 ramps. CFO: “We are in the process of ramping two major products, Model 3 in Shanghai and Model Y in Fremont, which I expect will temporarily weigh on our margin… We were negative gross margin on the products that we built in Q4. But the team in China, I think did a great job managing cost during the launch. And so, there was a slight drag associated with it, but not terribly significant.” Shanghai factory shutdown and negative/thin gross margins for China Model 3 and Fremont Model Y programs will negatively impact Q1 financials.
- Coronavirus impact on Shanghai production, Model 3 delivery delays, and Fremont supply chain. CFO: “We’re expecting a 1 to 1.5 week delay in the ramp of Shanghai-built Model 3 due to a government required factory shutdown. This may slightly impact profitability for the quarter.” Yesterday, Tesla executive Tao Lin said Chinese Model 3 deliveries scheduled for early February will be delayed until the coronavirus outbreak situation improves. Tesla’s Shanghai factory has been closed since January 25th, the Lunar New Year, and creates uncertainty around Q1 vehicle production and deliveries out of China, further pressuring profitability on lower production.