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1-15-2019

As I watch the rain pour down in San Diego, I feel compelled to discuss an issue that many investors believe will rain on the bull market parade: tech’s debt bubble. After dozens of discussions, I feel that my colleagues and clients don’t fully understand how debt markets affect economies; hence this harangue.

 
Debt is an elephantine topic, and while nobody has the ability to tackle it to the extent that predictions can be surmised, as always I intend to educate on a few fundamentals as best I can. Therefore, none of the below is investment advice. 
 
The general debt market can be roughly summed up, as most other investments can, as a speculation of theoretical arbitrage. The idea is to increase net income more than the borrowing cost of the debt. The ability to outearn previous years is much easier to determine at lower price to earning multiples, rather than where we find ourselves, near historic highs. The end result we face is speculation about whether companies have the ability to justify the high prices and multiples at some point? Or will there need to be government intervention to prop up growth? 
 
If a corporation can borrow at 4% and yield a 5% higher return (all other things equal), there exists a 1% theoretical arbitrage. The following breaks down what influences the 1% arbitrage in today’s markets, and what might happen if the returns don’t pan out – using current evidence. Again, not investment advice.
 
There are several theories about how interest rates are determined. Save government intervention, the yield curve is most of all directly determined by Supply and Demand. If investors want to play it safe, more bonds are bought and interest rates fall, and vice versa. Nothing is static in markets, with debt being arguably the most stochastic due to both volumes (supply and demand) and inputs (riskiness). Therefore, the overarching interest rates are directly and indirectly determined by at least the following:
  • Total Net debt Issued, government and corporate. When you see the word ‘issued’, think ‘sold’ – A country/company believes its debt is overvalued relative to another asset.
  • High Yield Junk vs. Treasuries (higher yield is safer, with identical credit ratings). See OAS spread toward the end of this memo.
  • Average maturity/vintage (shorter time horizon is safer, all else equal)
  • GDP/ Revenue Expansion due to technology
  • Margin Expansion due to technology
  • Political Risks
  • Currency Risks
So what’s different? 20 years ago, product companies like Coca Cola, Royal Dutch Shell, Exxon, and GE were the 4 most valuable companies. As of Year end 2018, Amazon, Apple, Microsoft, and Google are the most valuable. The internet has caused a massive shift of power from basic materials and product oriented companies to service companies. Why does this matter? Margins.
 
High margin businesses and automation have changed every market, and have put debt speculation in a spotlight. Previous Gross margins were in the vicinity of 30% and now we are seeing 60% (Facebook Gross margin is almost 90%). Early market share acquisition is painful, however as companies must grow while losing money. 
 
Amazon’s Jeff Bezos famously said, “Your margin is my opportunity”. Many tech firms incorporate heavy losses into a long term business model to get new customers to try products. The “Freemium”* business model allows customers to sample products before buying into a deeper relationship. Paypal gave new customers $10 each just for trying the service, which would be anathema for most product oriented companies. Imagine if Coca Cola did the same? The margins on a retained customer are so high and sticky these days that companies are often in the black on a customer within a full fiscal year, despite the handouts. 
 
*Interestingly, in the basic materials sector this practice of lowering prices and then raising them later is called predatory pricing and is illegal. Tech firms were smart enough to work around this law by not having direct competitors for their products. Who can say what Facebook’s competition is? However, the goal of a tech firm is attention captured and information gained.
 
So, investors see companies losing money today and think how great the business model must be once all of the users begin paying for the service or surrendering information. Snapchat is a prime example of how much hype can be generated over a new network-oriented product, only to get left for dead when user growth stalls (or goes in reverse). If the average investor understood API’s, you would know just how lucrative and high margin that network-oriented products can be. Beyond the scope of this email.
 
My mind goes back to Netscape founder Marc Andreesen when he told readers of his “Why Tech is Eating the World” memo that tech would take over large swathes of the economy. A bit myopic for old school economists, though the mind capitulates in light of recent success.
 
 Almost every company in the tech field today sells debt to investors, because of the high margins, and investors have so much interest in the debt, that the high demand commands a low interest rate and an ‘investment grade’ stamp. 
 
This is one of the largest issues we face in the global economy – are these companies the “subprime” borrowers we have seen in the past? Do they deserve an “investment grade” rating? Almost weekly we hear about hacks among tech companies (mostly ‘network-oriented’), and the issue is that the negative publicity may cause users to drop the service, which leads to performance headwinds and the snowball gaining momentum down the hill. This is precisely what played out in the Dot-com bubble from 1996 until 2000. 
 
Thus, the argument in many professional circles is ‘pricing to perfection’ both for stocks and bonds. The challenge with high margin businesses is that the company needs to continually convert losses to profits, without stumbling. The hacks we see are minor and typically patched quickly. If there is regulation on API and network-orientation, we are nose-diving. Because the dramatic downturn that regulation of API’s would cause, it is all the more unlikely. 
 
This doesn’t mean that companies have the ability to justify prices, even if they are far more responsible and profitable than in the Dotcom era. 
 
Take Twilio, an application that hosts cloud-based communication and also multi-factor Authentication. So, Twilio allows phone calls to be encrypted between users, such as when you receive a call from an Uber driver from a scrambled phone number. Obviously, Twilio’s experience in the cloud has led the management team to adopt the PaaS (Platform as a Service) Business Model, leading to an eye-popping price multiple – The market cap of 9.7 Billion is currently 173 times sales of $560 Million. Analysts all over talk about the users Twilio has, and how profitable it can be in reference to that 60-90% gross margin statistic. 
 
Here’s where it gets interesting – Twilio surreptitiously issued $550 Million of convertible debt in 2018 when its price was $58. Seems Twilio needed cash to continue growing, but didn’t want to issue stock at $58. The conversion price is $70.90, currently at a relative loss of $208 Million. The issuance of the debt seemed like a desperate move, not only based on the terms, but also because the company lost 67% more money in the first 9 months of 2018 than the first nine months of 2017 in spite of the capital injection. Based on this performance, we might expect Twilio to issue more notes and/or stock to continue burning. So, will it be possible to dig out of the hole and justify the price at 173 times revenue while selling its stock? Probably not. 
 
This situation is happening frequently in private markets, also, where acquirers are buying targets with mostly debt. The problem isn’t the debt, it’s the performance after the debt. If Twilio can use the cash proceeds to grow users and it’s PaaS model, the debt is well used. However, Twilio, like many other companies, is losing cash quicker after the injections. As I mentioned at the beginning, if you borrow at 4%, you want to make more than 4% incremental gain. 
 
In the past, we have reviewed Salesforce and saw similar things – the price to earnings multiple of 60 will be virtually impossible to justify when Salesforce only earns about $2.50 in the calendar year 2019 but trades close to $150. However, the user growth and API’s are definietly there…. 
 
So, what happens when prices can’t be justified? Impaired assets. Goodwill is the first to be impaired, and inventories, if there are inventories. A company’s workforce is impaired (read: Laid off), and forecasts are cut. Very often, losses are amortized over several years so profit can be normalized and obligations managed. In such times, investors need to buy companies with defensive earnings and high free cash flow so debt collectors don’t make a run to liquidate further assets. If the company can still pay interest on debts, the company will survive. 
 
However, due to the reduced guidance and profitability expectations, investors will sell tech debt quickly, in favor of safer debt with lower interest rates. At this time, there isn’t much of a spread between ‘high yield’ and treasuries (AKA the High Yield OAS). This is troubling, because it signals that investors have demand relatively similar to the safest bonds available (i.e. treasuries) – in October the spread was 3.16%. With the Federal Reserve dovishness in the past two weeks, the OAS has jumped back up to 4.55%. To provide perspective, the only two times the OAS has been below 3% were in 1998 and 2007. The OAS is an extremely useful tool for professional traders, and I encourage you all to get acquainted.
 
Again, if a company’s debt is sold off in favor of safe-haven debt, the price will drop also, causing a jump in rates. This is when the OAS spread is highest and when economies experience significant corrections – in 2008 the OAS approached 20%. In such times, a company needing to issue debt or refinance existing debt will pay a relative premium to previous issues. 
 
For all of the problems with corrections, there will always be a rebound for corporate debt. Why? 
 
If the company can service the debt, not only will the company survive the correction, but its debt will be a very attractive asset. Valuing a company in the new-age economy is different, and requires knowledge of users and network API’s to determine whether it can continue operations. After all, the keys to the network-oriented economy we find ourselves in are resilience of users, profitability of users, and the (API-based) long term business models. 
 
Keep an eye on how network-oriented companies are capitalizing on the big data movement as well as the debt they issue. We may see some hard times if there are stumbles for such companies in the form of regulation, hacks, or poor user retention/profitability. 
 

 

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