03 March 2015

Is the Uber ecosystem sustainable ?

Will Uber get an opportunity to grow up?  Armed with a $40B valuation, many investors think so.   Whether you believe in the app based taxi hailer or not,  Uber’s impact can be felt all around the world.  There are millions of people using it everyday, momentum that its lofty aspirations will prove true, and intense controversy everywhere it goes.   Is this the world changer that it purports to be, or just the latest multi-billion dollar company to go bust?

Strategically, Uber is in a strong position.  Its logistical system, army of drivers, and competitive intelligence gives it a first mover advantage in its ambition to become the Walmart of personal services.  Cabs are just a platform for worldwide domination of local distribution.    But Uber is asset light, and its not  hard to see big players move into its space.  Amazon’s 2 hour delivery is gaining momentum.    Upstarts like Favor and Grubhub are cornering specific niches like food.   And how can you bet against Google or someone with significant physical infrastructure like Fed Ex?  The barriers to entry are not clear particularly against well capitalized companies.

Speaking of capitalization, Uber’s dot-com esque valuation has helped them act as a much bigger player than its revenue would suggest.  Even if Uber could continue to grow its value and raise gobs of money (hard to swallow by every conventional metric), some of its challenges cannot be resolved by throwing more money at it.    Governments, lobbyists, and pretty much every existing transportation company have vowed to fight Uber.  Even tech savvy cities like Austin and Vancouver have even banned the service.  Further, Uber faces a very micro problem;  it has to fight county by county, city by city, and country by country.  How long can it continue these individual battles?  And don’t forget about all the other legal battles such as data breaches and personal security cases from bad drivers. 

The more intriguing facet  of Uber’s uncertainty relates to the company’s mysterious pool of drivers.  Who are they and will they continue to support the company?  Uber recent survey showed glowing demographics of the people that drive for them (underemployed segments like the elderly and minorities).  A big question is how reliable is Uber for its drivers.  Starts and stops in markets have reduced the recurring nature of this income.  Few of its drivers derive their primary income from it.  The disparate nature of its drivers makes it hard to fathom that all of  these contractors will be available to support the service levels that Uber’s valuation implies.  Can a group of part timers be leveraged into a massive service provider all around the world?  It is very opaque, but a very interesting question nonetheless.    

Despite Uber’s uber-unicorn status, it is hard to bet against it.   It’s the poster child for the sharing and distributed economy.  Its challenges are greater than its tech giant predecessors have faced.   In fact, the laws actually supported Amazon and Google early on through a sales tax ban and broadband subsidies.  Uber’s road seems long and unchartered, but it has not blinked an eye through adversity.    Call it entrepreneurial, innovative, and principled.  But will we call it a survivor ?

18 January 2015

The New New Bond Market

Forget everything you know about fixed income investments.  The days of corporate bonds, treasuries, and real estate income properties are over.  In are crowdfunded startups, movie projects, and student loans.   The new class of exotic asset backed securities promises investment choice, high yields, and upside.  But are the risk and fees worth the return?

I remember in 1997 when the “Bowie Bonds” turned heads.  For the first time, one could invest in the individual portfolio value of the rock icon’s song library.  Since then, alternative bonds have come in large baskets of regulated instruments such as mortgage backed securities and REITs.  But a loosening of regulations coupled with an increase in investor demand has brought excitement back into fixed rate securities.  The website SoFI gives access to a yield-producing basket of student loans from your alma mater.  Upstart can help you provide loans to individual people or career paths.   I got an email last week from a Hollywood producer who was looking to fund her next movie with a guaranteed 20% return.   There is something for everyone.  

Despite the implied steady returns, I wonder if they are sufficient enough to cover the risk.  Even back then, the unproven Bowie Bonds only offered a 1.5% premium above the 10 year treasury rates.  I don’t know if a 5% interest rate for Harvard loans are worth it (certainly a personal decision), but people should be cognizant of the risk associated with them.  Remember the AAA mortgage bonds?  Even the top credit agencies in the US failed to understand these novel complex securities.  It is tempting to chase yield in the current near zero interest rate environment, but the returns should be commensurate for the incremental risk taken.   

Fees associated with these securities also come into play.  Taking a page out of the hedge fund playbook, many charge both a management fee to participate and a “carry” percentage of the profits.  For the asset managers, it is a good way to shift capital risk to investors while taking fee income and participating in the upside.  Some will promise a “preferred return” which is far from guaranteed (despite a stated interest rate) and the ones that don’t charge a start fee (such as the crowdfunding sites) will take a larger percentage of the profits.   While I can understand this hefty cost in an equity-type scenario when the upside is tremendous if the next Facebook hits, it’s hard to justify them in a fixed interest rate arrangement.  A 2% charge on an 8% net return is a 20% fee.  Large fees don't always mean good performance;  remember the popularity of actively traded mutual funds that charged big loads despite most of them doing worst than their benchmarks.

Simply put, equity risk should not be taken for fixed income investments.  While I like the flexibility and ease in which to get into some of these new investments, it is imperative to assess the quality, diversification attributes, and fees associated with them.  There are many creative instruments out there with a limited track record and opaque risk disclosures.  While we'll never know whether the Bowie bonds were a financial success (Prudential bought them for the in-house portfolio), the choice is ultimately yours.  Do  you want to merely listen to “Ziggy Stardust” or invest alongside it?

29 December 2014

Selling in a seller's market

From residential housing to Uber's dizzying $40B capital round,  asset valuations have never been so high. Understandably, many small business owners looking to sell expect to write their "own number."  While it may be possible in a few situations to do so, these expectations along with other perceived business risks have created substantial difficulty in executing deals in the small to mid market space.  As we wind down the year, I thought I would write about some tips (from a buyer's perspective) to prepare a small business to fetch top dollar while minimize the risk of remaining on the sidelines.

Grow, Grow, Grow: Even though most deals are based on a multiple of earnings, top-line growth is probably the single most important characteristic that increases business valuations.  Layer in two or three years of steady gains and a seller will see much more cash in a sale.   In any market, buyers struggle to find growth; they particularly recognize the premium required for entry in today's climate.  Smart buyers know how to cut costs and and improve profitability; finding sustainable growth avenues are much harder to manufacture.  This is why growth stocks yield a larger P/E ratio than dividend or stable companies.

Stay in (sort of):  Most owners know not to wait to sell the day he or she is ready to walk out the door.  By that point, the business has probably declined as would the valuation.  But even more importantly from a buyer's standpoint, they need people to run acquired businesses.  Some may claim they can bring in experts or leverage existing operations, but they all recognize the importance of keeping the existing entrepreneurs involved post-close  By keeping even a sliver of equity in the business (even 5-10%), buyers will be willing to increase their purchase price due to reduced risk.  A go forward interest may be viewed as an insider continuing to invest in the business and a seller might pick up some are all of the reduced cash upfront through increased valuations.  Timing is key; at least two to three years prior to exiting the business is ideal.

Address customer concentration proactively:   Many small business owners dance or try to conceal the fact they have one or two customers that drive much of the company sales.  If this is the case, it's best to discuss this early and openly with a potential buyer.  If you have a strong relationship with the customer, talk to them about a potential deal.  Even offer to introduce a serious buyer to them.  Trump up the fact that you have penetrated a large customer and have the savvy to do this with other similar ones.  Buyers often use this as a way to structure deals so that sellers take most of the risk (i.e. earnout, minority investment).  If this is not ideal for you as a seller, get the buyer involved in the customer relationship to get them comfortable with taking on some of the perceived risk.

Keep the books clean:  A common piece of advice, but it's very important.  It's very easy to use your business account to pay for college, vacations, and cars.  Sellers take pause in this advice because doing so will increase tax bills.  Too many personal expenses will raise red flags.  Buyers see this as increased risk and bankers sometimes do not allow all of it to be considered when potentially financing a transaction.  Conversely, a "clean" company will often be seen as easier to transition and yield a greater valuation.

Know your industry: I often hear that the buyers that show interest are not the ones originally anticipated.  A successful business should be courted by a host of different types of buyers.  If utilizing a banker or formal process, make sure the firm understand the full industry dynamics and are open minded to explore different types of potential partners. Also,  when in discussion with a potential buyer, understand their endgame. Ask them a lot of questions. By doing so will help in negotiations (i.e. is this a stretch deal or blank check situation).

With most markets at an all time high, it is a good time to get your small business ready to take to market.  As we've seen before, an economic downturn usually has a magnified effect on small businesses.  What's most important is to find the appropriate partner to make sure that the enterprise will continue to have a lasting impact in the space it operates;  a successful business will find lots of suitors, so it's good to pick wisely.   By following a few simple steps and keeping your eyes wide open, you can actively participate in this white-hot seller market.

02 November 2014

The S&P Paradox

Despite all the complex options available, one of the most effective investment strategies has been to simply play the S&P index.  I readily complied with success without giving much thought to the underlying paradox that was always in the back of my mind.  Large companies are riddled with inefficiency, myopia, and an overall lack of agility; so it seems counterintuintive to bet on them.  I never quite understood why S&P returns were higher than others because in my mind bigger is not always better.

For one scale matters.  In the past, large capital expenditures were required for entry into top industries like automotive, real estate and oil and gas.  Even today, most markets still tip to the big players.  In healthcare, it is required to extract better rates from payers.  In distribution, size helps gain operating leverage over fixed costs.  In retail, the likes of Amazon and Walmart use it to squeeze unmatched purchasing savings from suppliers.  Large companies use its power to build barriers that make it difficult for smaller companies to compete with them.   Warren Buffett calls it a "moat".

The numbers don't lie.  Over the past 50 years, the S&P 500 has gained 10% a year on a compounded basis compared with 3% for the US GDP over that same period.  Despite what people say about small companies being the "growth engine" and "lifeblood" of the country, large companies have grown more than three times faster than the overall economy over a long period of time.  Further, valuations of the S&P have historically been around 15 times earnings (with a current P/E closer to 20), which is at least twice as much as private companies.  Simply put, larger enterprises are valued more than smaller ones.

But isn't this counter to those in the inside of a large company know to be true?  Meetings to discuss meetings.  Consultants to develop ten year strategic plans.  Steering committees to make even the smallest decisions.  Meanwhile, nimble entrepreneurs come up with new products and services, focus on customer service, and find new approaches to enter established markets.  At some point, diminishing returns come into play as companies grow.  And it today's market, that size is getting smaller and smaller.

"Moats" are harder and harder to keep thanks to rapidly deployed technology and more open markets.  Uber and AirBnB, for example, are scaring some of the most powerful oligarchies in the world.  Further, some of the tailwinds that have been fueling S&P companies such as global gains and consolidation are in the rear view mirror.  For years, successful private equity firms have yielded superior returns in the small company space; perhaps there will be a more broader movement towards entrepreneurial companies.  It is very interesting and hopeful to think about; but no question it will be hard to fight a trend that has withstood the test of time.

09 September 2014

Will local come back ?

Is the age of the local services company over? Outsourced call centers, online help tickets and IVRs have been around for decades, but the progression towards centralized support has now moved into the once untouched neighborhood service provider. Rapid consolidation and the introduction of technology into fragmented service industries have brought about some positive changes, but has the pendulum swung too far the other way? Or is Joe the Plumber on his way out?

To be sure, many of the local businesses you normally frequent are consolidating at a fast clip. Local auto repair concerns like Service King, for example, have been recently purchased by PE firms with large expansion plans. The last three pest control companies that serviced my house have all scooped up by Terminex, a subsidiary of publicly traded Servicemaster. Even the local medical providers and lawn care concerns have become targets of consolidators. All of these companies employ similar playbooks: cut costs, centralize functions, and grow a small menu of highly controlled services into new locations. In many instances, even if customers want more beyond the 800 number, there are very few options on the table.

Walmart and Amazon has trained us to think that only price matters. Big business wins when we as a society expect no frills, price matching, and a ubquitious customer experience. I think this is helpful for some things, but not all of it. Today’s airline experience is very uniform - it sucks. Online shopping has gained mass adoption in commodity items, but still only represents 8% of total retail purchases. People still stop at local stores and want customized solutions and local touch points.  There is probably a finite saturation point.

Many of the big entrants try to delicately balance the best of both worlds. Whole Foods has done a good job of localizing their stores to cater to its serving area. Nordstroms and Best Buy have been successful at an omni-channel solution brings both the power of scale and good customer service. But local players are responding using similar playbooks as evidenced by the emergence of multi-location local restaurants and retailers.

But the current trend is real.  A recent study conducted by HBS highlights, for the first time, the diverging performance of small business compared with its larger peers in the most recent economic turnaround. Simply put, big business is taking market share and jobs away from small business. However, I think there are cyclical trends at play here and pockets of the small business sandbox that wont't get "rationalized." As I like to say, Dallas has cheaper food at the chains, but I don’t mind paying extra for the PHD wait staff at Shady Grove.

04 August 2014

The Bankruptcy Boon

The US bankruptcy process is amazing. When a large mismanaged company goes under, it is a boon for many parties. Consultants and attorneys bill four figures an hour, opportunistic investors prey on the carcass, all in the vein of cashing in on a distressed situation. Despite all the excess, however, the process does work in many instances. The high priced consultants are often able to make the structural changes required to create a sustainable business. Is it the process in play, or should we hire these experts on the front end in the business building game? More importantly, while it may work on the large business side, why isn’t there a similar process for small business?

The GM bankruptcy is a classic example. They needed over $30B in debtor financing just to navigate through the process. Like most in similar situations, they hired high priced advisors to lead them through the intricacies of the bankruptcy code (including a $16M a month contract to a single firm). I never understood why maneuvering through the process is so complex, but it is extremely lucrative for the few that are versed in it. As the city of Detroit was paying lawyers millions of dollars a month during its bankruptcy, their citizens would wait more than 30 minutes in response to a 911 emergency call due to lack of funding. Is there really no other way?

Sure it is easy to fault the winners in the process; but there is something to be said for how often the trustees are able to turn these companies around so quickly. Generally speaking, there are large fundamental issues that need to be resolved in a short time window. These turnaround specialists cut costs, prioritize payments, cut deals with debtors, and divest assets in such a manner that oftentimes entities thrive post-bankruptcy. Certainly leveraging the benefits of the process helps (ie. cramming down creditors), but there have been some impressive successes. Most of the airlines, for example, have all gone through the process; now just this week they announced record profits and huge stock buybacks. Six Flags, Trump, and many other household names are also in this group.

And what do small companies do that can’t afford $1000 lawyers? The law of small numbers works against them as they don’t have access to bankruptcy financing or experts to navigate through the process. When a small entrepreneur over-leverages the company, he or she loses all personal assets. When private equity pays too much for TXU Energy, they get most of their money back. Small companies generally don’t get a second chance like the big boys do and are usually forced to liquidate. It’s a complicated process for small business owners and creditors aren't as willing to work with entrepreneurs as they are in bigger deals.

So perhaps there is an opportunity for the experts to move downstream into the SMB market. Or maybe small business owners should look to take a page out of the GM bankruptcy playbook. It would seem reasonable that at least in the instances in which struggling entrepreneurs could be helped, they should. One idea is an SBA loan restructuring program for those that are behind; perhaps banks can have more flexibility to convert the loans to equity or higher interest loans. There could also be programs to incent creditors to give businesses some more time. While bankruptcy is never good situation to be in, it would be great to afford small businesses similar support that big businesses have during this dire time.

20 May 2014

The Disruption of the Disruptors

I am like no other pundit waiting for the shoe to drop. Like the late 1990s. For yet another cloud storage company to shelf its IPO (sorry Box). Frothy valuations based on solely on a disruptive story are already becoming harder to come by. I wonder what will happen to the struggling ones that have already raised cash under lofty expectations; how will they handle the fallout? Now that a fresh batch of funding is no longer in the cards (at least not at current valuations), how will the newly minted blue chips change themselves amidst new market conditions?

I was the first to surprised to read that Square might be on the block due to cash flow issues. Mobile commerce has already hit mainstream and certainly the leader in the payments space should be minting money like its predecessor Paypal, right? But Square is struggling. They lost $100M in 2013 and faces a business model that doesn't scale well to profit (~20% gross margins after processing fees). Paypal was not forced to sell to Ebay in the 2000's, but does Square need a lifeline? No question it can raise fresh money if it has to, but probably not at the clip its existing investors would seek. As a standalone concern, it will likely face layoffs, cash conservation, and significant pressure towards monetization. These are not concepts that are in the Jack Dorsey DNA.

Reinvention is nothing new for tech firms of the past, but it will require a significant mindshift for the next generation of startups. IBM has gone through many periods of peaks and troughs and transformation throughout its long history. Amazon has experienced the same. However these companies had a culture of top grazing and restructuring. For the foosball playing startups with lofty aspirations, making money was never on top of the list. The last time around, the playbook was to hire MBA’s and black belts to “babysit” the business-lite founders. Does that logic still apply? I'm a bit skeptical in any approach that jeapordizes the culture of a promising startup, but perhaps a fresh mix of skill sets can bring new approaches to the problems. Maybe rightsizing will be modernized into a cool buzzword like "uncrowding" that the newbies can huddle around.

To be sure, Snapchat is no eToys. The companies of today are generally in a much better position than the late 1990s. Companies like Twitter have large cash warchests to buffer downturns. There are more fundamentals and less extraneous cash backing today's startups than two decades ago (remember price to eyeballs?). But the shakeout will be swift and painful. Once hot SaaS companies like Bazaarvoice and Fireeye, for example, have seen their valuations drop by more than half and face employee exodus and liquidity concerns shortly after their IPOs.

Lofty expectations have an ugly downside. As the second internet bull run comes to an end, the high flying startups that sought out to change the world will have to start with themselves. As external financing slows, these companies will have to become profitable and change their business models in order to keep their independence (with the exception of the fortunate Google and Apple acqui-hires). Cash flow forecasts and customer acquisition will take precedence over iterative coding and disruptive mentalities. This hard reality is not only necessary for saving face or generating returns for investors, but also for survival in itself. Expect the early signs of consolidation, bankruptcies, and growing impatience from their backers to continue. But then again, aren't we just getting started with virtual reality and 3D printing?