A Return to Rationality

In July, the current U.S. expansion became the longest on record. Gross Domestic Product (GDP) in the second quarter increased at an annual rate of 2.1% and there are still new jobs being created. While these and other government figures suggest that U.S. and global economies are continuing to expand, there is growing evidence of weakening economies internationally and signs that the current U.S. expansion is losing momentum.

Manufacturing activity is falling in most of the world’s advanced economies and, in the U.S., total output has declined since 2018 (we are continuing to grow, but at a slower rate).  Germany, the world’s fourth-largest economy, contracted in the second quarter. Some economists believe Germany has already entered recession.  The trade war with China continues.  And, U.S. business spending has pulled back in recent months reflecting growing pessimism among purchasing managers.  Their mood is clearly a reflection of uncertainty about the future. 

Fed Chairman Jerome Powell, speaking at a news conference in July, expressed concerns of an immediate pullback in growth: “The outlook for the U.S. economy remains favorable,” but the Fed decided to cut interest rates to “insure against downside risks from weak global growth and trade policy uncertainty.” My personal view is that any ongoing strength in the U.S. economy is partially driven by loose economic policy and low interest rates. My concern is that we may find that the U.S. is living off a credit card with the debt coming due in the future.

There is no rule that expansions have to end, but recessions (and expansions) are a normal part of the business cycle.  None of the above proves that we are on a precipice, but the warnings signs seem to be flashing a bit brighter.  In this instance, a recession would likely be driven not by what we see every day here in the U.S., but by a global economic slowdown arising from our overseas partners and spreading to our shores.  In December of last year, I boldly stated that the increasingly contentious trade war would soon end with both sides finding a way to declare victory and work towards restoring global trade.  It was a logical assumption, but this clearly did not happen, and the relationship has only gotten more contentious in recent weeks including rumors of The White House pushing to delist Chinese firms from U.S. markets. The positive news is that the U.S. doesn’t seem to be burdened with excesses to unwind as was the case in the 2000s with the tech bubble and 2008 with the housing boom. In fact, I am seeing signs of increasing rationality entering market pricing.  I am seeing it both in companies that I am researching and news coverage that has focused on recent “busted” IPOs.

  • The ride share companies Uber (UBER) and Lyft (LYFT), both went public this spring and are trading at (-35%) and (-45%) respectively, below their IPO prices.
  • Peloton (PTON), the at-home fitness company, priced its IPO at the end of the September only to see its shares decline over 11% on the first day of trading.
  • And WeWork reached a private market valuation of $47B only to reduce valuation expectations to below $15B before canceling their IPO and firing their CEO. 

These are negative headlines, but positive developments for the market as they reflect rationality in investor sentiment.  The common theme for all three companies is that they became public before they were profitable and they continue to lose money at an alarming rate.. Traditionally, IPOs are priced to see a significant “pop” on their first day of trading and momentum carries them forward for months.  When these IPOs failed to pop, the Market was signaling that investors are not willing to support money losing companies into perpetuity. Investors are also beginning to question the business models.

Uber and Lyft are ride-sharing platforms and both benefit from network effects as they become more valuable the more users (buyers/riders and sellers/drivers) that join the platform.  Both companies keep their costs low by categorizing their drivers as independent contractors as opposed to employees who must be paid at least minimum wage plus health benefits.  Uber lost $3B in 2018 and is expected to lose $8.3B in 2019.  Lyft performed a bit better losing only $900M last year.  The obvious solution for both is to eliminate the cost of drivers through the deployment of autonomous vehicles. But the technology for true driverless vehicles is many years out, and the burdens of legislation and regulation are only beginning for these companies.  Additionally, there are numerous other companies racing to the same autonomous solution including Tesla, GM, Google, and others. 

Peloton relies on sales of fitness equipment and associated gear for consumers to exercise at home. This is a great concept that incorporates social competition, top rated instructors, and subscriptions as low as $39 per month. Peloton has more than 500,000 monthly subscribers and has sold more than 580,000 fitness devices globally. But fitness solutions are faddish. (Remember Thighmaster, P90X, or Bowflex?)  The number of consumers willing and able to purchase a $2,000 fitness bike or a $4,000 treadmill is smaller than advertised.  And it remains to be seen how long the programs will keep consumers interested before the bikes become expensive clothes racks.  The company lost $200M in the fiscal year ending June 2019.

WeWork has positioned itself as a technology company but is really nothing more complex than a real estate company buying long term leases and selling short term leases. This is not an unusual business model as International Workplace Group (the parent company of Regus) has been the leader in this space since its founding in 1989.  What is unusual is the size of WeWork’s losses.  The company lost $1.9B in 2018 on revenue of $1.8B. Management continues to point to their investments in growth, but their current business model appears to be buying long term leases for $1.00 and then reselling shorter-term leases for $0.50. 

These companies have been able to grow exponentially through Private Equity/Venture Capital subsidies. Typically, Venture Capital firms work with the founders to grow these businesses exponentially, and most importantly, to profitability (or a path thereto). At that point, the VCs exit their investments with huge profits by taking the companies public. That has not been the case with these IPOs.  These companies have been made public with the promise of future profitability (but no clear path to it), if the public markets will continue funding the losses until they get there.  The poor performance of these IPOs says that the market is becoming rational and not willing to make the same mistakes of 1999.

There is an increasing focus on fundamentals.

This is a positive. 

The question for these money losing companies is, if they can’t reach profitability during a 10-year bull market, how can they possibly survive a recession?

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