{"id":79903,"date":"2019-05-20T00:03:42","date_gmt":"2019-05-19T22:03:42","guid":{"rendered":"http:\/\/beta.next-finance.net\/opinion\/unicorns-and-growth-from-sales-stories-to-profit-fantasies\/"},"modified":"2020-01-02T22:07:48","modified_gmt":"2020-01-02T21:07:48","slug":"unicorns-and-growth-from-sales-stories-to-profit-fantasies","status":"publish","type":"post","link":"http:\/\/beta.next-finance.net\/en\/opinion\/unicorns-and-growth-from-sales-stories-to-profit-fantasies\/","title":{"rendered":"Unicorns and Growth: From Sales Stories to Profit Fantasies"},"content":{"rendered":"

Uber\u2019s quest to raise $10 billion is making big headlines. It\u2019s one of a group of privately held firms
\nworth at least $1 billion, known as the unicorns, including AirBnB and WeWork. Globally, there are
\nmore than 300 unicorns worth about $1.1 trillion, according to CB Insights. These companies have
\ngarnered millions of users and customers around the world and many have generated strong sales.
\nBut collectively, they’ve racked up billions of dollars in losses, and few have posted any profits at all.<\/p>\n

Perhaps coincidentally, investors in US stocks have been enamored by sales growth recently. In the
\nfirst quarter of 2019, shares of US companies with high sales growth delivered relative returns of
\n3.4% versus the S&P 500, while those with high profitability fell by 2.9% (Display, left). This contrasts
\nwith the long-term tendency of high-sales-growth companies to underperform those with high
\nprofitability, as measured by returns on assets. What\u2019s more, our research shows that companies
\nwith the strongest sales growth are also the least profitable (Display, right<\/em>).<\/p>\n

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Risk Appetite Reduces Sensitivity to Profitability<\/strong><\/p>\n

So what\u2019s been going on? In some ways, these performance patterns aren\u2019t unusual. During the first
\nquarter, markets shifted back to risk-on mode after the late-2018 downturn. When risk appetite
\nimproves, investors feel more comfortable buying stocks with little or no profitability. Like the
\nunicorns, strong sales growth in a publicly traded company looks like an appealing attribute that may
\nsignal future profitability potential, especially in a world of slowing macroeconomic growth. <\/p>\n

But for that potential to be real, you need to ask how the company is generating sales. The tech
\nunicorns are very young companies operating in \u201cland-grab markets\u201d; in other words, they\u2019re
\nthrowing massive resources at gaining market share in newly created markets for things like ride
\nshares or desks for rent. The result is high sales growth and no profits.<\/p>\n

In their defense, some unprofitable companies have high free cash flows. However, we believe that
\nthese cash flows may be fueled by deferred revenue and distorted by the use of stock-based
\ncompensation on the expenses side.<\/p>\n

Late-Cycle Concerns<\/strong><\/p>\n

These trends raise some red flags for investors, in our view. In a strong economy and market, the use
\nof stock compensation is less worrying. That\u2019s because when the stock vests, the employee benefits
\nfrom the higher strike price and the company enjoys a tax benefit that flatters its cashflows.<\/p>\n

But what happens in a weakening economy and softer market? Then, it becomes more difficult to
\nretain employees with stock-based compensation. This, in turn, makes it harder to maintain sales
\ngrowth and ultimately leaves shareholders out in the cold.<\/p>\n

We don\u2019t think we\u2019re facing a tech bubble, like the one 20 years ago, which featured a concentration
\nof extremely expensive stocks and very inexpensive \u201cold economy\u201d stocks. That said, there are some
\nsimilarities. The price\/sales ratio of the S&P 500 has reached 2.1x, similar to the levels seen in the
\ndot-com bubble, while young, unprofitable tech companies are quite expensive, in our view. At the
\nsame time, we\u2019re witnessing a deluge of IPOs as private companies seek to cash in on a buoyant
\nmarket before it\u2019s too late. <\/p>\n

Recent trends serve as a reminder for investors. Whether investing in a unicorn IPO or a publicly
\ntraded company, always look beyond the headline sales figures, as seductive as they may seem. And
\nbe wary of companies that don\u2019t have real cash flows to support the top line. In our view, high and
\nrising profitability, backed by solid business models, is the best formula for identifying investments
\nwith solid growth and return potential that can stand the test of time.