A number of high-profile tech IPOs have disappointed in recent months, revealing cracks on the fringes of the market’s growth complex. As investors appear less willing to back some lofty valued tech start-ups, we ask whether this recent setback is a cautionary tale or, in fact, a canary in the coalmine.
Shares of some companies that have recently gone public are trading below their IPO price, while WeWork and Endeavor have postponed plans to go public. Investors have started to ponder whether cheap capital and a thirst for growth have created excesses in both private and public valuations, potentially setting up the market for a correction as market participants appear less willing to fund growth at any cost.
However, we would argue that recent developments offer a strong indication that investors are more skeptically assessing the sustainability and long-term profitability of disruptive, hyper-growth, but money-losing start-ups. There have been many highly valued IPOs in recent years that often look the same on the surface—companies that are growing rapidly and levered to positive secular trends (such as cloud adoption, mobile applications, data analytics, and cybersecurity), but losing money in the hope that increased scale will bring profits. However, they are not all created equal. In assessing the attractiveness of these emerging companies, we think lifetime customer value economics are critical and can be one of the best indicators of which companies will likely have a clear path to sustainable, high levels of returns.
In analyzing a company’s lifetime customer value, we consider how much a company is spending to acquire new customers (through sales and marketing efforts), the profitability of those customers once they are on the company’s platform (gross margins), and then the stickiness of those customers (renewal or churn rates). It is then possible to build a picture of the lifetime customer value economics and how sustainable it is.
This scenario analysis of the cost to acquire new customers and the lifetime value of those customers helps to more accurately value a business, in our view. It enables investors to differentiate between higher quality companies, that have more sustainable growth rates and a realistic path to profitability, and lower quality companies, where customers and revenues may be less sticky and the contribution margin of existing customers may not support sustainable long-term profits.
The most attractive companies can be characterized by having large market opportunities and positive lifetime customer value economics. Investors will likely be willing to forgive such loss-making companies if they are truly building sustainable, and scalable, businesses with sticky long-term returns and cash flow. Less attractive tech stocks may include companies that are growing at a phenomenal rate but they may not be doing it in a sustainable or differentiated way, and they could have a more challenging path to becoming meaningfully profitable over the long term.
Additionally, we think accounting validation to understand the differences between the reported income statement and the underlying cash flow dynamics of these companies is very important. Some of these high-growth start-ups have subscription models that enable significant cash flow generation well ahead of the lagging indicators on the income statement. Meanwhile, for other emerging companies in their early growth phase, working capital and capex needs may pressure returns and cash flow for a long time, making them less attractive and potentially needing to raise more capital in order to scale.
The preceding is an excerpt from our article, Are Investors Rethinking Growth At Any Cost? Read the full paper.
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