Most former Unicorns and fast-paced growth focused companies haven’t had it easy lately. From DROPBOX to Slack, Twitter, SNAP and UBER, their stock price had gone down between 30 and 50% since their IPO, even before the outbreak of the corona virus. Other even more dramatic examples are Norwegian Air Shuttle, balancing on the edge of bankrupcy, and the scam-tainted WeWork. The reason for this is that these companies still bleed money or are barely profitable after 10 years or more in operation. Investors have lost their patience.
How can we identify this type of companies early on and avoid similar failures in the future?
What happened? These companies where supposed to become enormously profitable once they achieved a dominant position in their industry and could stop investing in growth!
Even more important, how can we identify this type of company early on, so that one can avoid investing in similar hopeless cases in the future?
Enter the classical Boston Consuting Group GROWTH – SHARE matrix.
This matrix is a powerful tool, originally thought for corporations looking to diversify their business. In a nutshell, it shows that companies should invest decisively in “Star” business units, characterized by high market shares in rapidly growing markets. These would then become hugely profitable and “Cash Cows” later on when the market stabilizes. The alternative is indeed terrifying. This game’s losers will either end up as “dogs”, eating resources without ever turning a profit, or as “Question marks”, in real danger of falling back to “dog” status.
This urge for gaining market share is exactly the argument that all Unicorns and their managers have insisted on when defending the huge amounts of money they burn in order to grow as fast as possible. And yet, these same companies have failed to deliver on this promise.
Does it mean that the BCG matrix is wrong? Or should these companies have burned even more money and grown even faster?
The problem with all these companies is that they have ignored some additional factors that become essential to make the matrix work properly.
First of all, established corporations have one or more cash cows already generating healthy profits. These cash cows are the ones that must supply the “Stars” with resources to grow. In order to minimize investments and their impact on shareholers, these “Stars” must deliver positive operational cash flows and profits as soon as possible.
Losers in growth stories are characterized by absence of competitive advantages, lack of other operational cash cows and business models that crave huge market shares before reaching positive cash flows.
For technology start ups, this lessson is even more important. On one side they don’t have any operational cash cows to borrow resources from. They have to rely on the investors patience and the merciless bond market. On the other side, the longer it takes to combine market share with profits, the more probable it is that something changes and invalidates their assumptions for profitability.
Therefore, the higher market share the core offering of such a company needs to reach and defend profitability, the more vulnerable it becomes.
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The other reason these companies struggle is that they lack real competitve advantages. Most of the products and services launched by aspiring Unicorns are easy to copy, have no proprietary technological edge and potential lojal customers can be relatively easily stolen by new or established competitors. This is specially true in B2B markets or in markets with long replacement cycles, like cars for example. In those cases established corporations with a firm griop on sales channels may have plenty of time to put their resources at work and defend their position.
The bottom line for investors should be the following: Losers in growth stories are characterized by absence of competitive advantages, lack of other operational cash cows and business models that crave huge market shares before reaching profits and positive cash flows.
These are the same reasons why Netflix and Tesla will probably crash too.
Netflix is still growing and finally profitable, but it is also running out of cash fast. Profits are actually dwarfed by the many billions invested every quarter in new content in order to keep its service attractive. Debt is piling up rapidly and competition is getting serious while markets outside the United States remain much less profitable per user. At this pace, even if Netflix doubles its current profits, debt service and cost structure will probably force the operating margin down to around twenty percent, a common figure in the industry. The PE ratios of competitors Disney and Comcast are currently 17 and 13 respectively. The PE of Netflix is 102. You can imagine what will happen with the stock price when the growth story is over for Neflix, unless the company is acquired or changes its business model radically.
A similar story holds for Tesla, with the additional challenges posed by the long market cycles of the car industry. Besides, Tesla is still not consistently profitable and has recently announced a new stock offering in order to rise two more billion dollars.
The joker here is of course the stimulus packages and near-zero interest rates launched now and after the COVID crises. If they succeed and we experience a replay of the effects of the ones unleashed after the 2008 financial crises, markets will be distorted again for a long time. Indeed, we are seeing the first effects of those measures. For example, Snap has announced that it is rising another 750 million USD in debt, even when this company has yet to turn a profit despite increasing its revenue over 40% thanks in part to the COVID effect .
Still, technology companies and Unicorns are not magical. They obey the same rules as any other business. Next time you are offered an investment in a company with a story based on growth and world domination, remember the Boston Consulting Group matrix and try to figure out if the story indeed makes sense.
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