Square, venture capital and the late-1990s Internet bubble

a bubble deflating

Internet payments company Square came to market yesterday.  It has a two-letter symbol, SQ, and trades on the NYSE, not NASDAQ.  But the most salient fact about the offering is that the IPO price was a lot below the private market value that venture capital investors had placed on SQas little as a year ago.

At the same time, the small number of mutual funds which have been aggressive venture capital buyers in Silicon Valley have been, more or less quietly, writing down the carrying value of their non-public company holdings.

What we’re seeing is, I think, a smaller and much more benign–both for the economy and for us as stock market investors–analogue of the deflation of the Internet mania of the late 1990s that started in early 2000.

the late 1990s and the internet

I remember noticing in 1998, that earlier- and earlier-stage companies were coming to market successfully.  Some were little more than concepts.  Take Amazon (AMZN), for example, which IPOed in mid-1997.  The pre-offering roadshow that I saw emphasized that investors had made gigantic fortunes on buying unknown companies like Microsoft during the personal computer era and that AMZN was a lottery ticket to a similar outcome in the Internet Age.  Of course, even a success like AMZN didn’t turn profit for its first eight years as a public company, surviving on the proceed from the IPO and follow-on debt offerings.

I thought at the time, and unfortunately committed my theory to writing, that we were seeing a fundamental change in the role of the stock market in capital formation.  Portfolio managers were gradually taking on the role previously played by venture capital.  So, I mused, managers of mutual funds like me might have to think about reserving a small place–no more than, say, 5%–of their portfolios for developing companies that they normally wouldn’t have touched with a ten-foot pole.

Not my finest intellectual hour.

today’s bubble deflation

The slow escape of air from the venture capital bubble that is now going on will not have much effect on publicly traded companies, I think, for several reasons:

–the amount of money involved in this speculation is much smaller

–investors of all stripes still wear the scars of 2000-2001, so they haven’t been anywhere near as crazy this time around

–the people who are losing money now are, or represent, wealthy, seasoned speculators, not retail investors

–maybe most important, much of the original internet froth surrounded highly capital-intensive efforts to build a global physical internet transport infrastructure.  Names like Global Crossing and Worldcom come to mind.

Yes, too much physical capacity did get built back then, and some builders were highly financially leveraged.  But also dense wave division multiplexing, a technological breakthrough in technique (basically, putting glorified prisms on each end of a cable), made it possible for each fiber optic strand to carry 2x, 4x, 8x, 16x ( in 2015 the number is 240x)…  more traffic than initially anticipated.  Thanks to DWDM, suddenly, despite the rapid growth of internet traffic, an acute shortage of signal transport capacity turned to mind-boggling glut.  The transport industry was facing collapse as customers played a ton of potential suppliers against each other for lower prices.  Naturally, new construction–and related orders for all sorts of high-and low-tech components, dried up completely.   So did investment, employment in civil engineering   …and the stocks.

In today’s software world, there’s no equivalent, other than perhaps the market for software engineers.  And there are no signs I can see of recession in this arena.  Quite the opposite.


failing toll roads in the US-why?

I’m convinced that studying the behavior of Millennials –and in particular how it differs from previous generations’–will ultimately produce a treasure trove of equity investment ideas.

So my ears perked up when I began noticing recent reports of continuing failure of toll road investment projects that had been in vogue ten years or so.  Many were packaged by Australian investment bank Macquarie and/or Spain’s Ferrovial.

Chapter 11 filings have been attributed in the media to a sharp slowdown in total miles driven by Americans since 2007 (“…largest decline since World War II,” said one article).  Millennials’ aversion to autos and the suburbs are the supposed causes.

A quick check shows that’s not exactly right.

The Federal Highway Administration’s monthly Traffic Volumes Trends indicates that total miles driven by Americans has fallen from the peak of 3.03 trillion miles in 2007.  But the present level is still 2.98 trillion, a seven-year decline that totals only 1.65%.  Yes, this is a change from the pretty steady rise of just over 1% annually during the prior couple of decades.  But it’s hard to image that worst-case planning didn’t allow for a flattening out of traffic volume.

Two other characteristics of these deals stand out to my, admittedly cursory, glance, as being much more important:

–they’re very highly financially leveraged, and

–they contained a ton of derivative protection against rising interest rates–which backfired horribly, adding significantly to the already-high debt burden.

The deals also appear to have suffered from wildly overoptimistic projections of future road usage, although these were likely less linked to project survival and more to the possibility of above-average gains.

In any event, my main point is that this is not a story of differing Millennial behavior.  It’s all about bad project design and mistaken derivatives overlays.




the Tesla (TSLA) convertible issue

The new TSLA convertible issue came to market yesterday.  Demand was so strong that the company raised an extra $400 million in seven-year notes (yield = 1.25%), bringing the total amount raised, before underwriting fees, to $2.0 billion.  That breaks out into $1.2 billion in seven-year notes + $800 million in five-year (yield = 0.25%).

The conversion premium is a whopping 42.5%!

If the underwriters exercise their overallotment, the total will rise to $2.3 billion.  (The underwriters actually sell more securities to their customers in an offering than the headline amount.  They use this extra to absorb any selling by buyers who intend to “flip,” or sell quickly.  The idea is to stabilize the issue price during the period immediately following the offering.  Sounds weird.  Yes, it’s price manipulation.  Yes, it’s legal.  In this case, the overallotment is $300 million.)

Clearly, no one is in this issue for the interest payments.   It’s all about possible capital gains if the TSLA price can rise by more than 42.5% before the bonds mature.

Tells you something about what bond managers think the prospects for straight bonds are.

At the same time, the issue proceeds take TSLA’s gigafactory–which will ultimately enable the company to sell 500,000 cars, it says–out of the realm of pie in the sky.  Say the company can make $2,000 in profit per car (a number I plucked out of the air).  That would mean that TSLA could be earning $1 billion a year by, say, 2020 – 2021.  At a price of $250, TSLA is currently trading at 30x that figure.  To me, this means two things:  buyers must have a rosier future than this in mind for TSLA, and academics who insisted that at $80 a share TSLA was priced for perfection (>10x earnings at maturity) had no idea what they were talking about.

As a practical matter, anyone who thinks the company will make $5000 per car would at least be content to hold.  Is that possible?  I don’t know.  As I mentioned yesterday, if I hadn’t sold too soon, I’d be selling now.

good news from Harley Davidson

the results

Harley Davidson (HOG) reported 2Q11 earnings before the New York market opened on July 19th.  EPS came in at $.81, a gain of 37% year on year, on revenues that were up by 18%, at $1339.7 million.  The Wall Street analyst consensus for HOG was $.71.

In contrast to most of the companies I’ve been watching, whose stocks have either shown little positive reaction–or gone down–after big positive earnings surprises (look at WYNN or AAPL), HOG shot up about 9% on this news, capping a run that has seen the stock rise 50% since mid-June.

the turnaround

HOG is an intriguing turnaround story, with three elements to new management’s plans:

–recovery from very serious damage done by the recession

–broadening the customer base beyond American males who watched Easy Rider as a first-run film, secretly love the Grateful Dead and need the extra stretch HOG puts in its tee shirts to accommodate seriously expanded waistlines, and

–overhauling inefficient manufacturing and distribution.

I’m not sure that at today’s price you’ll make a lot of near-term money in the stock.  I don’t own HOG now, though I owned it for years in a small-cap portfolio I once ran (despite the fact that I consider a US company having a ticker symbol that spells a word to be a serious red flag).  I did think about buying the stock after good 1Q11 results, but decided I had enough risk in my personal portfolio without it.

Anyway, what interests me most about HOG’s 2Q earnings report is what it says about the current state of the US economy.

a little history

Like a motor boat, or a two-seater sports car, a motorcycle–especially an expensive one like a Harley–is not a very practical purchase.  The riding season is short in many parts of the country and rainy weather turns a ride into an unpleasant experience for most people.  Sales of any of these vehicles are highly sensitive to the state of the economy.

During the boom years in the middle of the last decade, lots of people were feeling wealthy enough to buy Harleys.  Many got financing from HOG.  As the recession developed, a large number of these new owners couldn’t afford their payments any more and turned the keys back over to Harley.  This had two bad consequences for HOG:  demand for new bikes dried up; and dealers’ lots were flooded with tons of repossessed next-to-new used motorcycles that needed heavy discounting to be resold.  That depressed prices across the board.

Pretty ugly.

the sound of a corner turning

What caught my eye about HOG’s 2Q11 earnings report is that, for the first time since late 2006, retail sales of new motorcycles are up year on year in the US–by 7.5%.  Dealer inventories are below normal.  The credit experience in HOG’s financing arm has been improving for four quarters–although this is probably mostly a function of better underwriting.  And the company has raised its projected shipment numbers for the second half.

This is certainly welcome news for HOG.  More important to me, the increase in demand for new motorcycles seems to show that consumers are more confident, and that therefore the US economy is on a sounder footing, than the consensus realizes.



the Fedex 4Q11 earnings report: blue skies ahead

the results

FDX reported quarterly results for its 4Q11 (the FDX fiscal year ends in May) before the start of trading in New York yesterday.  The company posted earnings per share of $1.75, up 31.5% year on year, on revenues of $10.6 billion, a 12% gain vs. sales in the fourth quarter a year ago.  The numbers, which Wall Street typically forecasts with a very high degree of accuracy, exceeded analysts’ eps estimates by $.04.

eye-popping earnings guidance for fiscal 2012

In the same earnings release, FDX gave its initial earnings guidance for 1Q12, as well as for fiscal 2012 as a whole.  For the full fiscal year, the company expects to earn $6.35-$6.85 per share;  for 1Q12 it thinks it will have income of $1.40-$1.60. Taking the midpoint of both ranges, that would imply profit growth for the full year of about 35%, and for the first quarter of about 25%.

These are eye-popping numbers.  They reflect:

–the strength of FDX management,

–the company’s high gearing to world trade, which responds in a high-beta way to world economic growth, and

–FDX’s significant exposure to international markets, which the company thinks will approach half of total revenue, and represent the majority of the firm’s profits, this year, for the first time in its history.

the stock

Let’s say the earnings guidance signals that FDX really thinks $7 a share is within reach for the fiscal 2012.  That would imply that the stock is now trading at around 13x forward earnings, or a slight premium to the market.

I’ve owned FDX on occasion over the years.  My overall take is that the management is excellent, but that the stock is so widely followed and respected that it seldom trades at a bargain price.  My first instinct is that the shares do look cheap today.  But glancing at the issue’s multiple relative to the market during the past decade, this is about where FDX normally trades.  So I’m sitting on my hands for the moment.

the FDX economic outlook

Transport and logistics companies are interesting in themselves.  But there’s also a second reason they’re so widely watched.  Because they have such intimate knowledge of the production plans of their customers, they have an unusually good understanding about how the economy is faring in the areas where they operate.  With its long experience, and its position as the premier global air transport firm, FDX has a particularly advantaged view.

Here’s what it’s expecting over the coming twelve months:

–“moderate” economic growth, with the rest of the world doing better than the US,

–acceleration of growth as the year progresses.  Why?

ο  FDX thinks that 40% of the current “soft patch” is due to the the negative effects of the earthquake/tsunamis in Fukushima during March.  The company can already see activity picking up, however.

ο  Higher oil prices caused another 40% of the slowdown, in FDX’s view.  The oil price has been falling for two months, however, in large part because consumers have reacted by using less.  FDX expects oil to stay at today’s level or lower–exhibiting the same behavior it has in similar circumstances in the past.

ο  The remaining 20% is negative sentiment, based on the previous two factors.  FDX expects sentiment will gradually recover as consumers see supply-chain recovery in Japan and lower petroleum prices.

my comments

Two things strike me about the FDX report.  First, the company’s economic forecast sounds very much like the one Fed Chairman Bernanke outlined yesterday.  Second, even a so-so economic environment is enough to allow well-managed companies to make very large profit gains–implying good stockpicking will be well-rewarded in the current environment.