The sustainability of debt-fuelled business

As long as unprofitable companies grow quickly enough to dominate the market, there is an expectation that they will eventually repay investor confidence. But what if their business plans aren’t as solid as first thought?

 
It is no longer the case that a successful company is necessarily a profitable one, as many firms are happy for profits to be simply a pipe dream, a long-term ambition
It is no longer the case that a successful company is necessarily a profitable one, as many firms are happy for profits to be simply a pipe dream, a long-term ambition 

Uber, Netflix and Tesla are three hugely successful companies, ones that have disrupted their respective industries by implementing new technologies and innovative business models. But they have something else in common: they are all billions of dollars in debt.

Although these companies have cultivated enthusiastic followings and encouraged investors to part with huge sums of money, it is not yet clear whether they possess a long-term profitable business plan. Quarterly losses are not only commonplace, they are often eye-wateringly large. Yet these businesses seem able to subvert reality; though profits are low or even non-existent, growth rates are rising rapidly. As long as customer numbers are increasing, there is an expectation that profits will follow. At least, that’s what investors are hoping.

The difficulty lies in the fact that many of these companies are operating in uncharted territory. The ride-sharing, online streaming and electric car industries are all in their infancy. There is no winning formula for Uber, Netflix or Tesla to follow – they must create one of their own. As valuations and losses alike continue to rise, it seems as though these companies can do little wrong. Complacency, however, is the first step on the path to failure. If regulatory changes begin to eat away at existing business models, if competitors encroach on market share, or, indeed, if growth slows, these businesses may find that their equity becomes less appealing to investors.

It seems a given that a successful company would also be a profitable one, but this is no longer necessarily the case. Many firms, particularly digital innovators based in Silicon Valley, are happy for outside investors to fund their operations instead. Profits are simply a pipe dream, a long-term ambition that they are in no rush to achieve. But a pioneering vision cannot sustain loss-making endeavours forever.

The long game
Examining the financial statements of some of the world’s fastest-growing companies can be a surprising exercise. In late 2017, Uber achieved a valuation of $68.5bn, yet it also posted losses in excess of $3bn. As of the third quarter of last year, Netflix owed $4.89bn in long-term debt, despite being the leader in the online streaming market. Over the last 12 months, Tesla became the most valuable car manufacturer in the US, overtaking the likes of Ford and General Motors, in spite of production bottlenecks and quarterly losses of more than $500m.

Of course, these kinds of figures are not limited to the world of hi-tech digital innovators. Clothing company French Connection has posted losses for five years in a row. The Royal Bank of Scotland has managed nine. The financial pain being incurred by these businesses, however, should not be viewed in the same way as the losses incurred by the likes of Tesla and Uber. The increasing debt at many companies may be the result of poor management, changing consumer tastes or increased competition, but it is not usually part of a long-term plan.

Henrique Schneider, Chief Economist of the Swiss Federation of Small and Medium Enterprises and author of Uber: Innovation in Society, believes that debt-fuelled business plans can be sustained over long periods, as long as organisations are transparent with their investors. “I know of many platform businesses that factored seven to 10 years of loss-making operations into their business models,” Schneider said. “When businesses plan like this, they and their investors usually agree on other criteria for assessing progress. Such criteria may include growth of market share, velocity in innovation, patents or turnover.”

Borrowing money today to fuel prosperity tomorrow may have been a staple of capitalism for centuries, but a key difference today is scale. Corporate debt stands at a record high of $62trn at present (see Fig 1), and is predicted to hit $75trn by 2020. Corporate leverage ratios are spiralling across developed and developing economies alike. And yet, in the current climate of low interest rates, investors remain happy to fund increasing debt levels in the hunt for high future yields.

Unproven success
Size is not the only factor separating historic instances of debt-fuelled growth from present-day examples. Modern companies, even those with multibillion-dollar valuations, are racking up huge levels of debt despite possessing unproven business models. There is an expectation, or hope, that future profits will come, but evidence supporting such a view is far from concrete.

In the current climate of low interest rates, investors remain happy to fund increasing debt levels in the hunt for high future yields

A traditional taxi firm with sustained profits over a number of years may choose to go into debt so it can invest in more drivers, increase revenue and eventually recoup its losses. Supporters of businesses like Uber claim that its approach to debt is no different, but that is difficult to swallow when the company has never turned a profit. As such, whether it has a sustainable business model at all is still up for debate.

Uber’s long-term profitability hinges on a number of uncertainties: that ride-hailing will continue to grow and even cause the demise of private car ownership; that rivals like Lyft will fail to eat into its market share; that regulatory hurdles like those that emerged in London will be overcome; and that automation technology will allow the company to eliminate paid drivers altogether. Other lossmakers such as Netflix and Tesla are making similar gambles.

No money, no problem
Seeking a loan from a bank is one way for a company to pursue a debt-fuelled growth strategy, but only if losses are likely to remain relatively limited. For businesses that are expecting debt levels to reach billions of dollars, convincing investors to offer financial support is the only viable way to sustain operations.

Uber has received backing from the likes of Saudi Arabia’s Public Investment Fund, Morgan Stanley and Goldman Sachs – organisations with very deep pockets. Since it was founded in 2003, Tesla has raised in excess of $25bn over 25 funding rounds. In October last year, Netflix announced that it would be raising $1.6bn in debt financing to develop content in 2018. Investors and creditors do not offer huge sums of money out of the goodness of their hearts; they are doing so with the expectation of significant returns. This creates demand for equity, which in turn drives exorbitant share prices. “I would say that one of the main factors that contributes towards the extremely high valuations of firms incurring high losses is that investors focus on long-term potential,” said Schneider. “When profits start coming in, they really pour in.”

At the moment, backers of the major debt-fuelled companies are unlikely to be disappointed with their investments. Share prices at Tesla and Netflix have risen by factors of nine and 15 respectively over the last five years. Uber has yet to deliver its IPO, but private investors have been quick to talk up the company’s long-term prospects.

The lingering concern among some market analysts, however, is that investors in companies with untested business models are simply following the ‘greater fool’ theory, which states that the price of an object isn’t determined by its intrinsic value, but by the expectations of market participants. If the share price of these businesses is simply being driven by the belief that someone else will be willing to buy the same equity for an even higher price, then eventually there are going to be a lot of disappointed people.

Investment at its current rate cannot be sustained unless profitability starts to look achievable. If doubt starts to emerge about a company’s long-term business plan, then investment will dry up, share prices will fall, investors still tied into the company will find themselves out of pocket, and the company itself will be left with a financial headache.

The loss leader
If businesses like Uber and Tesla are willing to risk losses in search of market dominance then they may well have been inspired by one of the most successful businesses in corporate history: Amazon. The company that started life as an online bookstore run out of founder Jeff Bezos’ garage provides the definitive example of high losses eventually paying off.

As long as customer numbers are increasing, there is an expectation that profits will follow

Throughout its early years, Amazon’s losses were significant. In fact, the company failed to turn a profit of any kind until 2001, seven years after it was founded. What’s more, Amazon’s total net profit over its entire existence amounted to just over $4.9bn at the end of 2016, even as its sales figures continued to climb (see Fig 2). This is a figure that has been dwarfed by the likes of Apple, ExxonMobil and Royal Dutch Shell in a single quarter. However, profit has never been Amazon’s immediate goal.

Robert Spector, business consultant and author of Amazon.com: Get Big Fast, believes that although many other companies are now adopting Amazon’s business model, not all will be successful. “The early days of Amazon really set the stage for where we are now,” Spector said. “Through his genius, CEO Jeff Bezos was able to convince enough investors that growth was more important than profitability. Because of this precedent, investors are realising that if it worked for Amazon, maybe it can work in another sector as well. As long as you’re showing progress, can secure a large share of the market and have a convincing CEO, then success can be achieved this way. But it won’t necessarily work for every business.”

Fair and square
Although it may come as a surprise to many that some of the most lauded companies in the world are being propped up by debt, most consumers are unlikely to be overly concerned. As long as they are receiving good service and investors are happy to wait for returns, company financials will probably receive little more than a collective shrug. In the long term, however, it is worth questioning whether debt-fuelled growth could allow anti-competitive practices to develop.

In an essay for The Yale Law Journal published in January 2017, associate research scholar Lina Khan argued that Amazon’s dominance raised a number of competitive concerns directly tied to its growth-over-profits approach. In particular, Amazon’s acquisition of one-time competitor Quidsi came under close scrutiny. Quidsi, which owned Diapers.com, a subsidiary focusing on baby care, first became aware of Amazon’s interest in 2009. It initially declined a takeover offer, only to see Amazon slash its prices for baby products by as much as 30 percent. Amazon deployed online bots to respond immediately to price changes on Diapers.com and launched a subscription service called Amazon Mom. In total, it is estimated that Amazon’s below-cost pricing resulted in losses of $100m a quarter across diaper sales alone.

With its huge income from other verticals, these were losses that Amazon could afford to take. Quidsi, on the other hand, saw its market share cut and investment dwindle. It eventually accepted Amazon’s acquisition offer in 2010. Following the buyout, Amazon was free to raise its prices, safe in the knowledge that another competitor had been seen off. Not only that, but it had discouraged other would-be rivals.

“Courts tend to discount that predators can use psychological intimidation to keep out the competition,” Khan writes. “Amazon’s history with Quidsi has sent a clear message to potential competitors – namely that, unless upstarts have deep pockets that allow them to bleed money in a head-to-head fight with Amazon, it may not be worth entering the market.”

Undercutting competition
Antitrust law, at least in the US, used to pose a more significant barrier to firms using below-cost pricing to take out their opposition. In the 1970s, however, a shift in economic thinking led by Judge Robert Bork changed how the US Supreme Court viewed anticompetitive practices. Instead of focusing on preventing monopolies, consumer welfare became the focus. It became a widely accepted economic truth that predatory pricing was irrational and came with no guarantee that losses would ever be recouped. As such, it was decided that the threat to competition posed by below-cost pricing was low.

If doubt starts to emerge about a company’s long-term business plan, then investment will dry up and share prices will fall

“It is important to keep in mind that only a small fraction of companies operating at a loss actually survive,” Schneider said. “It is up to the market – not the regulators – to judge. If you operate at a loss and don’t convince anyone of your product, in over 90 percent of cases you get wiped out.”

And yet, investors do expect the likes of Uber, Tesla and Netflix to recoup their losses. In the meantime, industry incumbents are struggling to compete. Conventional taxi trips in Los Angeles fell by almost 30 percent in the three years following Uber’s debut in February 2012 (see Fig 3). In 2016, the number of new taxi companies in the UK fell by 97 percent year-on-year. Some of this decline can reasonably be attributed to Uber’s convenience, but undercutting competitor prices certainly helps too.

Tesla and Netflix might argue that their own attempts to secure growth at the expense of profits provides a competitive boon to their respective industries, given that they are up against long-established and very wealthy rivals in the automotive and entertainment industries. The task facing antitrust legislators is a difficult one: some businesses are cutting costs to drive out competitors, while others are doing so merely to compete.

If the competitive spirit of this debt-fuelled business model is in question, then its short-term success is not. Uber, Netflix and Tesla can all point to healthy growth figures as a counterweight to disappointing balance sheets. Some celebrate these firms as innovative trailblazers, destined to dominate their respective industries to the benefit of customers and investors alike. Others have decried them as Ponzi schemes and are waiting for a crash like the one that burst the dotcom bubble in the early 2000s. If there is one lesson to take from that particular cycle of boom and bust it is surely this: companies incurring huge losses may eventually win big, but in business, there are no guarantees.

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