WAAAX on, WAAAX off: multiples are fickle, but value is forever
Some things are eternal. In an era of Spotify, with even iTunes now old hat, a Walkman positively prehistoric and an absence of even a listing category for an audio turntable on eBay, the Beatles Abbey Road has just resumed its rightful position on the top of the British music charts, 50 years since it last occupied that spot. Irrespective of the medium for transmission, it seems that great music endures. Which is not to say all top ranking music will revert to number one in the charts 50 years on – we doubt Joe Dolce’s Shaddap Your Face will be heading the Australian charts again in 2030, nor indeed will most leading artists of the last 50 years be played at all 200 years hence, as Mozart and Beethoven are today. But truly great music – whether it be composed by the great classical masters or the Beatles – will no doubt be touching hearts, again, 50 years hence. And so it is with company valuations, equity price movements and company cashflows. Amid all the noise in investment markets, some things are eternal and ultimately prevail. Cashflows drive valuations, for example; an eternal truth which will prevail 50 years hence, no matter the interest rate, trade war, Brexit or other issue de jour in 2069. The past month has seen this play out to some degree, with the short lived “value rotation” interrupting what had been a monochromatic style environment for equity markets for several years. It had seemed intuitive and inevitable that a globally co-ordinated zero interest rate policy in the Western world led to high equity multiples for those companies offering the siren song of yield, or growth. Alas, the past month has highlighted that multiples are fickle, and lower discount rates don’t just presage higher multiples; they also in theory, and now increasingly in practice, presage lower cashflows as well.
Why WeWork stopped working
We Co, the corporate parent of WeWork, is a great case in point. Its proposed IPO was an unmitigated disaster, to the soundtrack of the Beatles “You Never Give Me Your Money” from Abbey Road: “… You never give me your money, you only give me your funny paper, and in the middle of negotiations, you break down …”. Losing US$1.4bn in the first half of 2019 on revenues of US$1.5bn, for being a serviced office providing tenants with complimentary soy lattes and red meditation balls to sit on instead of office chairs, saw We Co’s valuation soar through recent years and peak at US$47bn. As the founder and former CEO Adam Neumann said: “We played the private-market game to perfection”. Until the private market game came to end with the proposed IPO two months ago. Since then, not only has the IPO been abandoned, but We Co’s valuation has broken down. Indeed, landlords are refusing to sign new leases with We Co, and 15% of the global WeWork workforce are no longer WeWorking. They are now ElsewhereWorking (perhaps at Servcorp, which has done the same as WeWork but for one difference: Servcorp have almost always made a profit). So much for the allure of growth. We Co investors have learnt the Abbey Road of investing: the value of revenue growth without cashflows is ultimately a fickle lure for investors, prone to dramatic change. And, as for those waiting for the “catalyst”, yet again it is impossible to precisely define why the perception of value for We Co changed through the past quarter, other than to say that an unstable system will ultimately stabilise, and valuations will, ultimately, revert to those supported by sustainable cashflows.
Heroic valuations require brave assumptions
The unravelling of We Co may yet prove a salutary lesson for investors in the ASX growth stocks, the famous WAAAX names. As Scott McNeely, the then CEO of Sun Microsystems, said soon after the TMT bubble: “At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?”
Of course, with current bond yields, a more appropriate payback period may be 30 years rather than 10 years. Either way, that quote is from 15 years ago; who today uses Sun Microsystems products? The duration being imputed into the market capitalisation for many listed entities today is far greater than is likely to be the case, and for those companies transitioning from private markets to a public listing, the pain may even be greater. For example, Uber and Lyft were like WeWork, in that both disruptors have grown aggressively, but incurred large losses in doing so before listing earlier this year. Lyft listed valued at US$25bn but had lost 25% of its market value within a fortnight and is now trading at circa half the IPO value. Uber hence took a more measured path and reduced its valuation for listing from the US$120bn imputed by its last private funding round late last year to list with a US$82bn valuation. It has since lost a quarter of this market cap.
In the end, cashflows still drive value
The WeWork phenomena has ASX implications in paradigms besides just “growth” companies. We noted the ASX REIT tale of two cities between Dexus (office) on the one hand, and Unibail Rodamco (retail) on the other, in our June commentary. As we noted then: “It’s easy to say that in a yield compressed world, defensive assets are well sought and repriced accordingly. It is true; except when earnings start to go the wrong way, however modestly. As Unibail exemplifies; a 5% fall in earnings for the year to December 2019, even with a modest increase in forecast thereafter, has seen a 30% fall in equity value. Plenty of retail property assets in the Australian market are for sale, and even at much lower multiples than that being commanded by their sexy cousins in office and industrial property, buyers are hard to find”. Interestingly, since the issues at We Co, concerns at the rate of growth in demand for Office property have taken a bearish tinge. Dexus has recently lost half of its outperformance of recent years. And Unibail has gone in the other direction, with material outperformance through the past month, making up half of its underperformance through the prior year.
This eternal lesson that cashflows drive value, prevails for even old world industrial companies. Nufarm has been a drag on portfolio performance for some years, but especially through the past year until the last month, when it went from zero to hero in one transaction. The sale of the South American business to Sumitomo for A$1.2bn was left field in many respects. Firstly, having been a serial acquirer for the past decade, and persistently describing itself as a global business for the past five years, to sell one of the group’s five geographic segments – Latin America – was itself a surprise. Secondly, given Latin America was the source of much of the working capital drain that has beset Nufarm in recent years and promoted the blow out in gearing, its sale ensured future cashflows should be more proximate to sales and at the same time reduce financial and accounting complexities which had attracted the ire of investors related to factoring, and currency and interest rate hedging. Thirdly, the multiple achieved of 12 times EBITDA was immense given Latin America would be seen by many as Nufarm’s least attractive geographic segment and yet the group overall was trading at a 40% discount to the ebitda sale multiple. Finally, even after the recent convertible preference share issue to Sumitomo, Nufarm was overgeared, and with adverse climatic conditions in several regions and ongoing supply disruptions in Europe, near term earnings pressures were not seen as abating. The sale effectively sees Nufarm become close to debt free, reversing the financial risk that had dramatically depressed share price performance through the past year. Again, an eternal truth: mixing operating and financial leverage is ultimately toxic for equity investors. The energy companies suffered this fate five years ago and the miners several years earlier, and both sectors learned their lessons and have accepted that while there is nothing they can do about operating leverage (other than maintaining cost discipline such that the harm from adverse cyclical price changes is mitigated as much as possible), they can certainly control financial leverage. The level of debt in each sector has hence continued to be at very low levels. Nufarm, and many other industrial companies operating in industries with material operating leverage, need to absorb the same lesson, and maintain discipline for years to come, as the energy and mineral companies continue to do.
Equities outlook: idiosyncratic opportunities amid dislocated prices
Low to no interest rates are causing large dislocations in the price of Australian equities perceived to offer security of income, on the one hand, and growth on the other, with a squeeze in the ugly centre where a downgrade pimple is priced in a flash as a de-rated mole, no matter the sector. Sustainability of earnings and, more importantly, cashflows, has never been more important, nor securities more harshly dealt with if expected levels of cashflow evaporates. The better opportunities that exist in the current market tend to be idiosyncratic, where cashflows are hit, albeit not by structural factors, and where derated multiples become attractive.
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