Culling the Herd of Unicorns

Blain’s Morning Porridge – September 1^st, 2021: Culling the Herd of Unicorns

“Its not a unicorn. Someone’s glued a broom handle on the horse’s head.”

This morning: The extraordinary number of new unicorn companies isn’t necessarily a sign of booming corporate prospects and innovation. It’s as likely due to too much cheap money chasing the market, deliberate hype and deluding the masses as to their value.

If you are looking for proof of just how overheated markets and expectations have become, then try this nugget, for which I am indebted to Will Nutting of NutStuff: Earlier this month research firm CBInsights noted the number of emerging new unicorn companies – private companies valued at $1 bln plus – increased by 491% between Q2 2020 when 23 new unicorns were born, to 128 new unicorns in Q2 2021.

What does that tell us?

Over the past few years we have seen the emergence of a whole industry of “excitable finance”, breathlessly promoting new tech concepts; AI, Robotics, Blockchain, 3D Printing, Autonomous Driving, and whatever-next is going to completely change everything we do and buy. From Softbank and ARKK, new tech-savvy asset managers like Masayoshi-Son and Cathie Wood have established themselves as the new Market Gods. They cite the example of the internet, saying all these new technologies will see even faster adoption, generating massive profits for early investors.

It’s difficult not to get caught up in the hype and the zeitgeist of these new tech times. One “proof” (US Readers: Sarcasm Alert) is the number of Unicorns it is generating. If a new tech firm innovating something sounding new and exciting is attracting Private Equity and Venture Capital money, then of course you want to get in early…  We do live in exciting times, where the pace of innovation and invention is surging.

However, step back and breathe deep. And note how the pedestals Son and Wood have set themselves upon look increasingly wobbly.

In the wake of Covid instability, market uncertainty over recession or inflation, plus the ongoing destabilising and distorting effects of ultra-low interest rates over the last 12 years, then the least likely way to explain the growth in the number of Unicorns is that the global economy’s prospects have so improved to justify such stellar valuations in new firms. It’s equally unlikely all the 400 odd newly minted unicorns minted this year will thrive – despite the puff around them.

There have been some spectacular successes – new tech firms that are genuinely changing the planet, and the way we do things. But the questions we should be asking are not just about how swiftly they are adopted, but to question their ultimate profitability and returns – after stripping out the hype.

Telsa is the most obvious example. Its success has been to spur the whole auto sector into electric vehicles and a race towards autonomous driving – areas where it had first-mover leadership. It’s now a successful company – but not because it sold cars or delivered self-driving. It’s successful because it managed to sell itself, letting EV and Self-Driving hype swell the stock price to extraordinary levels where it was able to raise enough capital to ensure its long-term survival.

Even if Tesla becomes the biggest car company on the planet, raises its margins to industry-beating levels, and makes self-driving work exactly as Musk promises, its profits are unlikely to ever justify its current valuation.

The sheer volume and quantum of extraordinarily priced Unicorns should be a warning and wakeup about Expectations.

Price is about Demand vs Supply. When money is plentiful because rates are artificially low, then venture capital and private equity find themselves with too much capital. They need to put it to work on behalf of investors. The more capital they have the more likely they are to become less disciplined, overly desperate to use their cash, and spend foolishly. They end up pushing up prices to acquire increasingly less promising companies… which is what caused the dot.com boom to collapse. (Lesson: there is only one thing more dangerous than too little capital, and that is too much capital!)

If you are looking for a parallel today, then consider SPACs and the kind of hyped technobabble firms they are currently investing in.

A second problem is time frame.

I was giving an interview to a UK TV programme maker yesterday talking about renewable energy – my main contribution was the problem of short-termism. I explained how the venture capital investors I’ve tried to interest in some of the tidal and new battery propositions I’ve looked at aren’t interested in firms that might deliver an energy revolution 5-7 years down the road. They don’t want to invest in climate solutions with elements of research-risk. They want stuff that works now.

For instance: It’s easy to go the market for finance for a lithium miner on the basis there is proven demand for lithium today. Financing an inventive new firm seeking to innovate tech that improves the energy-density of new clean and lightweight Carbon-Ion batteries is a massive long-shot. It may be years before they deliver. Demand for lithium batteries is here today – which is why its price is shooting up. If PE puts cash into a lithium mine today, they don’t want to see it superseded by new Carbon-Ion Tech in a few years time just as the mine comes into production.

The problem is lithium comes with enormous costs: Lithium batteries are heavy old-tech that worked very well as torch batteries. But are they right solutions for the future? We are all aware of the social costs of mining lithium in 3^rd World nations, the environmental damage mining creates, and that the costs of recycling batteries are enormous. Other new battery technologies can solve many of these issues – but they are tomorrow solutions, and thus less attractive to the financing markets today.

The same is true of tidal energy. Today, tidal power costs roughly 5x the price of wind power. The fact tidal power is utterly reliable – with high tides every 12 hours and 25 minutes every single day of the year – seems to have escaped renewable energy investors. Nope, they buy wind farms instead because they deliver today – as long as the wind is blowing and you ignore the significantly under-estimated maintenance costs of offshore wind.

Firms that are innovating simple to maintain offshore tidal power units are confident the cost of their tech will tumble as it is adopted, and will be cheaper than wind or solar within a few years… There are few investors willing to finance that tomorrow risk.

However, the renewable energy sector is a tiny part of booming Unicorn market. The value of any Unicorn, or any start-up, is based on what markets expect it will be worth – which is usually taken to be when it IPOs or someone buys the firm. For the 400 new companies likely to be worth in excess of $400bln (and actually its far higher), then you have to figure they are going to generate profits in excess of, say $40 bln – but they won’t. Some unicorns are profitable. Most? Barely so.

Despite Tesla’s unravelling dreams of fully automated self-driving being tomorrow – Unicorns are being spawned in firms innovating AI and Machine learning to run self-driving cars. And you don’t even need to be new – Ford is doing it! If old dogs can learn new tricks – why can’t everyone?

Another sector with Unicorn appeal is Fintech. Value apparently comes from being a Fintech new bank that’s only successful metric is how quickly its gaining customers. The valuation metric in Fintech seems to be about 1 million new customers being worth about $3 bln in stock price – no matter what the revenue or, heaven forbid, the profitability is. If anyone can explain to me how 1 million new customers are going to generate $3 bln in revenues over, say, 20 years… I am all ears.

Another sector I’m told I should watch is Data. Whatever an “open source platform for data analytics and AI” is – I don’t rightly know – but if you can manipulate, package and sell data to clients to use in their own “predictive models”, its apparently worth about $60mm per client in stock value.

A firm that actually does stuff – like logistics software which “dynamically dispatches” stuff in such a way as to “eliminate transport service gaps”, boils down to better delivery route planning for goods and passengers. This unique startup concept is apparently worth $3 bln… but it doesn’t yet have any customers. Brilliant concept, but won’t it suffer similar HR problems as Uber?

Stuff I do understand is a guy selling sports gear off the net. His firm garners $3bln per annum in revenues selling team shirts and sport-stars shoes, but the secret sauce is to integrate the data as the company upsells these buyers into “classy” areas like sports betting on the teams they just bought. And we though team-strips were overpriced? It’s going to be worth billions.

I have a brilliant business idea selling bread that’s been sliced and then put under the grill. It causes the bread to go crunchy/crispy and is lovely if you slather it in butter, than jam or honey. I’m going to call it Crunchy Grilled Bread… Its going to be massive, if I can just think of a way of doing it digitally.

Five Things to Read This Morning

BBerg – Cathie Wood’s New ETF Shuts Out Banking, Fossil Fuels and Vice

BBerg – China May Be Its Own Worst Cold War 2.0 Enemy

FT – The rich get richer and rates get lower

FT – Norway grapples with rising political influence of $1.4trn Oil Fund

WSJ – Firms Estimate Hurricane Ida Could Cause Over $15 billion in Insured Losses

Out of time, and back to the day job

Bill Blain

Strategist, Shard Capital