All the chatter about one recent IPO got us thinking about an underappreciated question: “How exactly should you value a money losing company?” In a former life as an auto analyst, I covered a lot of loss-making companies, and there are basically 5 types of cash burners. Four represent potentially good investments: cyclical firms at a trough, early stage companies, takeouts and breakups. Only one is toxic for equity investors: the irredeemable loss maker with high debt levels, and even then it usually takes an external catalyst to bang the last nail in the coffin. Today we review a checklist of fundamental questions to help readers categorize these opportunities.
Imagine an adorable golden retriever puppy, wide eyed and eager. Now imagine a big stack of clean, crisp brand new $100 bills. Both are attractive images, each in their own way.
Now put the puppy in a large box with the $100 bills and wait an hour. What you will get is a soppy mound of shredded paper and a puppy with a possibly upset tummy. Two good things become one unhappy outcome.
This is a lesson I learned covering the US auto industry from 1991 to well into the 2000s, and even now I still read Automotive News every week. Manufacturing and selling cars and trucks is a tough business. Demand varies by 50% or more across an economic cycle. Pickup trucks and SUVs sold in America make excellent profits; small cars do not. Financing the vehicles sold is a pretty good business as well. But for all the stacks of $100s sitting around, there always seemed to be a puppy somewhere nearby ready to chew them up.
Vehicle manufacturers are a case study in how to analyze businesses that (at least sometimes) don’t make any money. At the economic trough of the early 1990s business cycle, I helped sell $140 million of Chrysler stock for $5/share. The deal had two selling points. First: Lee Iacocca – then CEO and Chairman – could sell ice to Icelanders. Second: assuming an economic upturn and the success of the freshly launched Grand Cherokee, the company would be able to eventually earn $5/share. The deal got sold, the company survived, and when it sold to Daimler in 1998 for $48/share it was earning $5/share.
Unlike Chrysler, which was +70 years down the road when it sold in 1998, many companies print red ink because they are still in the initial investment phase of their growth. Given investor interest in “Disruptive technologies”, there are plenty of popular equities investment stories at the moment that fit this bill. Here’s how I evaluate their investment merits:
- Do they reliably hit their operational milestones, both in terms of sales and new product introductions?
- Do they have a core base of “True believer” shareholders ready to pony up more equity capital when it is needed?
- What permanent advantages does the company’s business model enjoy? These can be technological or first-mover or network effect related, but they need to be sticky.
- When the company does hit profitability, what are the operating margins and asset requirements? Do these equate to a return on capital higher than 10% (a notional cost of equity capital)?
- Is the company being built to operate profitably, or to be sold to a larger entity at some point? Both are viable strategies, but generally you have to choose one and run quickly to that goal.
Then there are unprofitable companies that still have value simply because another industry player wants to increase its scale and/or scope. The old-school name for this strategy is a “Roll-up”: take a group of companies in similar businesses, buy them and eliminate duplicate costs like Finance, HR, and general management. All those savings drop to the bottom line and revenue grows from cross selling. Do it right, and it is a very attractive investment story for the acquirer.
Even if there are no industry players in Roll-Up mode, a money losing business can play the “Puppy and the $100 game” by simply shutting down money losing operations. Now, if the business only has money losing operations this is obviously not a viable option. But in the case where there are some money-spinning divisions, giving the puppy to your cousin and his 4 kids (closing or selling the money-loser) may be the only way to preserve the company. This is, of course, is a favorite strategy of activists when they own a company with some sound businesses layered in with real losers.
But for these myriad ways to “Win” with a money-losing business, there is one very bad way to lose: the business goes bust. I covered one of those in the 1990s, the “Mr. Hyde” to the “Dr. Jekyll” Chrysler success story. It was called Big A Auto Parts, and it is out of business now. You’d have thought that a replacement auto parts company would be essentially unkillable, but you’d be wrong. Here’s what I learned from that experience:
- Financial leverage truly cuts both ways. It improves return on equity on the way up, and kills you on the way down. Moreover, there are debt-like contingencies like leases that create fixed costs even if the “Long Term Debt” line on the balance sheet looks reasonable.
- It’s the grimy stuff that gets you in the end. The company had a visionary CEO that got along well with the Street. He had a compelling story about being a viable #2 to industry leader NAPA by acquiring small parts distribution businesses around the country (classic Roll-Up). What was missing was the operational playbook to consolidate those purchases and make 1 plus 1 equal 2. In the end the actual math proved to be “0”.
- Secular trends matter. Cars and trucks have been getting more reliable and technologically advanced since the 1980s. The same goes for everything from tires (1970s bias plies lasted 20,000 miles but radials go +40,000 miles) to engine management (computer controlled, and solid state rather than mechanical). Demand for many parts declined in the 1990s as a result and put real pressure on the company. This headwind simply proved too much to bear for a company with iffy operational practices and excessive leverage.
In the end, the one thing all these scenarios have one thing in common: cash. Unprofitable companies don’t make any, and that is the fulcrum issue that capital markets will always force to resolution. Nature abhors a vacuum, especially when it is hoovering up $100 bills. The trick to work out the best possible answer from an equity holder’s perspective and compare it to the current share price.
Easier said than done, of course, but the key lesson is that unprofitable companies are not necessarily worthless.