Saturday, 15 July 2017

Unicorn bubbles, Clutter, and the value of time

In recent years, Silicon Valley has witnessed something of a technology bubble Mark II, although this time the excesses have been concentrated in the private VC start-up funding market, rather than the public markets (large-cap FANG tech valuations are high, but I do not believe them to be bubblish as yet). The poster children have been the so-called 'Unicorns' - private VC-funded start-ups sporting valuations in excess of US$1bn, which are long on hopes/dreams/aspirations and rapid user growth, but short on profits (in fact large and growing losses are the norm).

Many of these Unicorns are marketing a number of cool new O2O services, and are growing active users and (sometimes) revenues very rapidly. The narrative is that everyone else - including incumbent players in adjacent old-world industries - have been too dumb to recognize the opportunity to provide such services on new-technology platforms, and that only tech-savvy 20-somethings have been smart enough to figure out both the business opportunity and how to bring such products & services to market. Mobile apps now mean every industry is ripe for 'disruption'.

As I see it, the problem with many of these business models is as follows: It is easy to come up with an idea for a cool new product or service; the hard bit is supplying the product or service economically - i.e. persuading customers to willingly part with an amount of cash greater than the economic cost of providing such a service. It is easy to grow users and top-line if you're prepared to sell products or services at prices well below cost, but this does not mean you have a viable business model (see my satirical post on Dollar-discount). Elon Musk - someone I greatly admire - is sometimes justifiably criticized for this. It's easy to be an innovator/disruptor if you are not constrained by the need to make a profit or generate a satisfactory return on capital (to Musk's credit, he has been quite explicit about his goals/motivations being non-economic in nature).

An unfortunate truth: Most consumers undervalue their time

All bubbles are built on fallacies, and in my opinion, one of the important fallacies behind many Unicorn business models is the implicit presumption that consumers are willing to spend money to save time (i.e. many of the cool new online services are designed to save customers' time), whereas in reality, most people place a very low economic value on their time.

There is only a small minority of the world - the most privileged and prosperous minority - that has more money than time, and who is therefore willing to exchange money for time. For the vast majority of people, money is scarcer than time and therefore they are more willing to do just the opposite - exchange time for money.  This was one of the core reasons Webvan failed (a era company attempting to provided delivered groceries over the web): the problem was that you needed to pay people to pick, pack, and deliver groceries, which is expensive, whereas at conventional supermarkets, consumers do that themselves for free, and when consumers price compare, they seldom include the cost of their time in the price comparison calculus.

Privileged Silicon Valley VCs and tech-entrepreneurs hailing from Ivy League universities tend to forget that reality. They are wealthy and successful and therefore are willing to exchange money for time, and assume that most of the rest of the world is like that as well, but they are out of touch with the realities faced by most of the world. Consequently, in many cases they are likely radically over-estimating the size of the addressable market for such services.

Not all of the cool new services Unicorns are promoting are focused on saving customers time, but many of them are.

Clutter - one of the more egregious examples

A great example of this is a start-up called Clutter, which is trying to 'disrupt' the self-storage industry, by having representatives come to people's houses/apartments, photograph and box their stuff, shuffle it to a remote storage location, and then allow people to select individually-photographed items online when needed, which will then be promptly delivered. The company just completed a US$64m third funding-round, lead by Sequoia.

At face value, this is a cool service - from a customer's point of view - setting aside price for the moment - it is clearly a vastly superior service to the conventional option (who wants to spend a Saturday afternoon driving out to their storage locker?) At the same price as convention self-storage, who wouldn't prefer the new service? But in my view, it is improbable in the extreme that that such a service could be provided at even a remotely equivalent cost.

The cost of paying large fleets of delivery personnel to pick up, box, transport, and drop off people's stuff will be punitively high, and because most people place a low value on their time, very few people will be prepared to pay someone perhaps $30 an hour to do it for them, when they can do it themselves for 'free'. Consequently, economically priced, the size of the addressable market will be very small and niche, at best.

Pricing below cost and making it up on volume

One way to expand the size of the addressable market in light of the above unfortunate truth, in order to keep user/top-line growth rapid (essential for the maintenance of premium valuations - Unicorns valuations can tolerate large loses but not a deceleration in user adoption), is to radically underprice your services. By doing so, one can then match or beat the prices charged by old-world competitors, while also providing a superior service and added convenience. If you are a consumer, why would you not take a company up on such an offer? But would you still be prepared to use the service if prices were significantly higher? In many cases, probably not.

This, I believe, is why you see many of these fast growing Unicorns sporting mushrooming losses. If you have a viable product that is priced economically, losses should not grow exponentially with volumes and revenue; losses should quickly stabilize and then begin to decline. If losses do grow exponentially, then it is very likely the product is not being priced economically. This is a major problem with Uber (who is losing US$2-3bn pa at present, on a business that should be functioning as a simple and scalable tech platform with relatively low costs; losses exist because in many regions it is growing users by subsidizing/underpricing its services).

Unicorns will attempt to argue that these losses are merely the temporary cost of driving scale and user adoption, but I remain skeptical in most cases. Switching costs are not high for many of these services, and if you change the price materially, in most cases you will rapidly change consumer behaviour. To the extent the above is happening, the growth many of these Unicorns are reporting is therefore in fact ponzi in nature, and requires that capital providers tip in more and more money over time. The valuations of these companies should be in free-fall, not ever-rising.

Traditional self-storage players have said that they have long considered introducing a service analogous to what Clutter is offering, but quickly concluded it was a non-starter because the price of providing such a service profitably was well above what most consumers would be willing to pay, and hence the service was uneconomic. That is sensible and rational.

Furthermore, if new technology does emerge that makes providing such services more economically viable, it would likely be relatively easy for the incumbents to roll out the service at that point (this reminds me of Fiat Chrysler's CEO Sergio Marchionne's comment that if and when it became economically viable to produce and sell a mass-market electric vehicle a la Tesla's Model 3, he would have one on the market within 12 months). Indeed, it is arguable existing self-storage players would be the best placed to exploit the opportunity, given their existing brands, facilities, cash flows, and customer relationships/data, etc. And yet it is the upstarts with ballooning losses that are attracting most investor interest.

Funding markets to close?

The problem many of these cash-burning upstarts will face in the future is that, because they are burning through cash at such a rapid clip, their continued existence depends on the willingness and ability of financiers to continue to tip ever greater amounts of money into them to replenish their constantly depleting coffers. That can (and has) gone on a while, but history shows that financial/funding markets are fickle, and at some point, capital markets are likely to change and close to such loss-making enterprises. If this happens, many of these companies will quickly face imminent bankruptcy, and the result will likely be a lot of dead Unicorns.

There is some evidence we may be approaching or have even started to reach that point, although Softbank's US$100bn tech-start-up fund may keep the music playing a little longer (although I expect most investors in the fund will realize significant losses). 'Down rounds' are becoming more common (funding rounds done at a valuation below prior funding rounds - something considered sacrilege in the Valley and hence done only out of absolute necessity). The IPO of Snap might prove to have been a high-point (after coming to market at US$17 and peaking at US$26, it has already retreated to US$15), and the choice of an increasing number of Unicorns to IPO may reflect tech insiders' knowledge that the private VC funding space is already starting to roll over.

Notable in particular is Blue Apron's late-June IPO at US$10, with the stock having already fallen near 30% to US$7 (Blue Apron - a recipe and ingredient delivery company for home cookers - is another great example of a company with a cool but underpriced service whose business model relies on customers placing a high value on their time). VC investors like to decry the short term nature of stockmarket investors (something that is very often a myth in my view - the market has taken an unrelenting long term view on stocks like Amazon when the economics of the business and the long term outlook have remained favorable), whereas in reality it simply harder to fool public auction markets than private controlled ones.

What's a public market investor to do?

From a public-market investor's standpoint, aside from shorting or avoiding hyped but uneconomic and cash-burning startups (which should be shorted with extreme care given the propensity of markets to be irrational from time to time), opportunities might derive from one of two places. The first is 'exaggerated demise' valuations of old-world companies, who are increasingly seen as universally ripe for disrutpion (again, shades of era thinking here). In many cases, incumbent companies are actually the best placed to leverage new technology to provide new and improved services atop their existing platform, while also improving efficiency. Rather than being disrupted, many may end up ultimately benefitting from new technologies.

Commercial banks are one example of this (an industry that has long been a beneficiary of improving technology). People have feared peer-to-peer lending and online banking will disrupt conventional banks, but I think it is quite likely that traditional banks will actually use technology to provide enhanced services and lower operating costs, through automation and branch closures.

The other might be opportunities in existing well-established and highly-profitable tech incumbents (e.g. Google, Facebook, Amazon, Alibaba, Netflix, etc - note that the above analysis does not relate to tech companies that are highly profitable platform/networked businesses). While these stocks are currently expensive, they are very robust and cash-generating businesses, and they will be well positioned to pick-off cheap acquisitions amidst any Unicorn-carnage, further strengthening their product suites and competitive advantages. While it seems improbable at present, it is possible that there will be a down cycle in general public-market tech valuations & sentiment if the private-market tech space blows up. That would be a good opportunity to buy the tech companies of strong and robust tech businesses and better entry points.