In years gone by, ploughing billions into companies that don’t make a profit seemed certifiably insane — but now the old rules don’t apply.
More frequently, huge valuations are being placed on companies (either by public markets or by private equity firms) that are essentially a bet against future profits rather than investment in a good balance sheet.
While there have certainly been cases in the past where companies have been unprofitable for a fair while only then to become behemoths (such as Tupperware), it seems it is becoming more common that the market is willing to overlook the fundamentals in exchange for potential.
In fact, back in 2017 hedge fund manager and value investor David Einhorn made waves by suggesting the traditional methods for evaluating companies were effectively dead — thanks to the continued growth of the likes of Amazon and Tesla.
His point was that despite glaring red flags in their balance sheets, their sheer disruptive business models and new technology made them good bets.
He’s certainly not alone.
In the wake of Einhorn’s call, several speculated that value investing as a viable investment strategy was dead — and of course several disagreed.
But the nature of the companies which are unprofitable and yet attract huge investment make for interesting analysis, and figuring out why they haven’t made a profit yet is also a useful exercise.
Unprofitable (but great) companies
While Elon Musk’s Tesla recently posted back-to-back profitable quarters for the first time ever, it has yet to post a full-year profit.
It’s also been trying to cut back costs by announcing that it was shutting a swathe of showrooms — mostly because people were ordering cars online anyhow (it’s more recently announced that it’s shutting fewer showrooms than expected).
But the fact remains that if it had as much traction with sales as it had with the press then its balance sheet would be in stellar health.
While revenue at the company has been growing, so have costs.
Costs have mostly been ploughed into R&D and production capacity upgrades, such as the Gigafactory in Nevada.
The former is needed if Tesla is to remain at the forefront of EV and AI research (known as its sweet spot) while the latter is needed to catch incumbent auto manufacturers from a standing start.
Investors, while they’d love to see a profit, remain long-term holders as they fundamentally believe in the long term vision.
Uber is furiously trying to prepare for an IPO, mostly as a way to reward the private equity investors who have shown so much faith in the company so far.
Uber, the company which doesn’t own the cars its company is known for, continues to operate at a loss — and it’s all about chasing scale.
While it’s diversified into food delivery and is doing some interesting stuff with big data analytics, Uber has been all about trying to create scale (notably in international markets) by subsidising rides.
Its hope is that it will be able to monopolise the ride-sharing market and grow its IP to a point where it’s able to gradually turn the dial on margin.
But with competition intensifying in both ride sharing and meal delivery it will need investors to keep the faith.
Great news! In the fourth quarter Spotify actually made an operating quarterly profit for the first time ever!
The bad news is that it’s expected to immediately swing back to quarterly losses.
The reason for the loss is actually eerily similar to that of Uber, in that it’s been chasing scale and R&D, but it also has the added crinkle of needing to pay licensing fees.
Like Netflix before its original content boom, it’s reliant on the music of others to get people to pay subscriptions.
It’s likely hoping that by becoming the dominant player in music and podcast streaming that it’s able to use its scale to drive better deals (but that is totally speculative on our part).
So, what did we learn?
Some of the biggest companies in the world don’t make a profit — whether that’s okay is up to the individual investor, but it seemingly hasn’t harmed their valuations.
It’s also interesting to note that two are software companies, while one operates very much as a software company.
In the case of Uber and Spotify, a lot of the costs in their businesses can be put down to the fact that they’re chasing scale — and truly global scale costs money.
In Tesla’s case, starting a manufacturing operation and establishing a supply chain from scratch to match the likes of General Motors is going to cost a lot of money — but in the case of all three, R&D spending is seen as absolutely vital.
Spotify and Uber are in the tech game, which means they have to constantly evolve and upgrade their core tech offerings to remain relevant to the user — or find themselves the victim of disruption.
In the case of Tesla, it can find itself outspent by capitalised competitors quickly if it stops moving. If it puts out disruptive tech, larger companies can just copy the tech and get it to market quicker.
So its competitive advantage is to be at the forefront of innovation.
In all three cases, not making a profit hasn’t held them back…yet. Because they’ve been able to demonstrate that they need to burn through cash to fulfil their promise, their investors have given them leniency.
But these are giant companies with billion dollar valuations — there are examples of companies which don’t make a profit but are still investable companies right here in Australia.
Searching for rocks (and profit)
Australian investors are probably some of the most sophisticated investors when it comes to resources investing.
And small cap investors in this space will be familiar with companies that don’t make a profit. Mining exploration companies are a prime example.
From exploration to pre-feasibility studies to bankable feasibility studies, these companies spend millions in expenses on the promise that one day they’ll be able to sell a resource — or be snapped up by a bigger player.
As with the new breed of tech stocks, profitability has little to do with where shareholders find value.
They find value either in speculative investing or in the longer-term vision of the company that will hopefully result in a shared appreciation.
It all begs the question: is profitability the key marker of a ‘good’ company for investors?
Not anymore, it seems.
This content does not constitute financial product advice. You should consider obtaining independent advice before making any financial decisions.
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