A Tech Bubble Basket To Monitor

As promised in my last post, below you will find what I am calling a “bubble basket” of tech stocks I have been taking a look at to varying degrees. The Russia/Ukraine situation is taking center stage in the markets these days, but I can’t really add much insight into the geopolitical landscape. From a stock perspective, the most I can offer is that maybe trimming energy exposure, if you have a nice chunk of it, would be an opportunistic move into the current rally. What I find far more intriguing from a long-term contrarian investing standpoint is sifting through the carnage in tech-land.

The dozen companies shown here range from small cap (Redfin and Vimeo) all the way to mega cap (Amazon and Facebook/Meta) and cumulatively have lost more than half of their value from the peak. Doesn’t mean they are all automatic buys just because of a large decline from bubbly levels, but it highlights the pain that has been sustained. Surely there are opportunities here, much like in 2000-2002.

You will notice I highlight price-to-sales ratios (PSR) instead of price-to-earnings (PE). I think it makes for a more apples-to-apples comparison when you have companies at different life stages. I am not fundamentally opposed to a growth company employing the Amazon “reinvest every dollar that comes in” approach - even if it cannot possibly work for everyone - and so if you believe in certain businesses long term regardless of current profitability, using the PSR can help you weed out the “priced to perfection” crowd (e.g. 20x sales).

Even still, the PSR is not a shortcut method. An e-commerce play has a different margin profile than a software company and thus the sales multiple should reflect that. I think the key is finding a mismatch where the multiple implies low profit margins at maturity but the business positioning could indicate otherwise. As an example, we see Uber at 2.5x sales and Chewy at 2.1x. One could argue that gap should be wider.

Anyway, I just wanted to share a list I have been working off of lately. I suspect the basket itself will do well over the next few years given the depressed prices. Picking the relative winners and losers is a trickier task, but one that might be well worth digging into.

As Bubble Tech Rightfully Corrects, What Looks Good and What Doesn't?

“This time” is never different. The last few years in techland reminded many of us of the late 1990’s bubble. Sure, not every detail is identical. Back then the mega caps traded at crazy prices too (the Cisco’s of the world at >100 times earnings) but this time 25-30x for Apple, Microsoft, Google, or Facebook might be on the rich side, but not grossly overvalued. And just as last time we had Amerindo, Van Wagoner, and Navallier, now we have seen history repeat with ARK Invest.

Just as was the case 20 years ago, there will be great buying opportunities during this valuation reset. Netflix down 50%? Interesting. Amazon down 25%? Interesting.

I will share a list of tech that doesn’t look expensive anymore in the coming weeks (think: low to mid single digit price-to-sales ratios), but first let’s consider what kinds of situations still look frothy even after big declines. 15x sales isn’t attractive just because it was 30x six months ago. Current profits (or at least a clear path to get there within 1-2 years) are important.

Let me share one example where the price still looks silly; DoorDash (DASH) at a $40B valuation. Sure, it was $90B at the peak. All that tells us is how crazy things got. On the face of it, the pandemic should have instantaneously made DASH a blue chip name in the tech space that was raking in money. Other than maybe Zoom, which “pandemic play” would you have rather owned on fundamentals alone?

However, the numbers tell a different story. I think they illustrate the problem with the current Silicon Valley mentality of favoring TAM rather than profit margins when it comes to investing in the public markets. Every management team says they are mimicking the “Amazon model” but Amazon was never hemorrhaging money. They wrote the book on running the business at breakeven and reinvesting every penny generated back into the business. There is a big difference between flushing capital down the toilet and running at breakeven to try and maximize future free cash flow.

Here is how DASH’s financials have evolved as the largest food delivery service during the best possible operating environment imaginable:

DASH lost $875 million in the 24 months immediately preceding Covid and then proceeded to lose $774 million in the first 21 months since. As an investor, why own this?

There are people who believe there is a high conviction path to this business turning those losses into a billion dollar annual profit. Possible? Sure. Essentially a done deal? Hardly. It will be difficult. And the price today, even after a near-60% stock price drop, implies a 40x multiple on that billion dollars. Yikes.

Simply put, many of these businesses will make their customers smile. The trick is to figure out how to make the income statement smile too. Amazon figured it out. Many of their followers won’t be able to.

For Real: Labor Hours Likely Stunting The Business Model at The RealReal

As an only child, much of my 2021 was spent handling the estate of a loved one who passed away unexpectedly last spring. As I went through my childhood home and organized possessions that had been accumulated by my family over 50+ years it became obvious that the best way to get the job done eventually and minimize wastefulness (by finding good new homes for most items) was to go the consignment route. With a category such as apparel and accessories, the natural fit was The RealReal (REAL), a publicly-traded full service online consignment web site.

Unlike some of their competitors, REAL does the hard work for you and takes a higher cut for their efforts. While I was not considering the shares as an investment, the experience of using the service as a consignor, which I am a few months into, was nonetheless interesting from a business analysis perspective, especially with the stock having lost about two-thirds of its value from the all-time high.

My takeaway is that the main reason why a client would hire REAL (minimize the work required to sell items) is exactly what will make this a very hard business to run efficiently and profitably. With labor costs rising and worker shortages front and center due to the pandemic, the barriers to scale are likely even more pronounced now than a couple of years ago.

Consider how many labor hours REAL employees put in to make this model work. First, a local consignment representative will come to my house, go through my items, bag them up, and take them home with them. They do this for free. I also have the option to box them up myself and ship them to a REAL distribution center via UPS, also on REAL’s dime. Given the volume I have, I opted for local pickup.

Once the employee has the items they manually photograph and inventory them before packing them up and sending them in via UPS. Upon reaching their destination, another set of employees unpacks them and sorts them to be routed to the appropriate product specialist. The experts will then inspect every item for condition and use their knowledge of the current market to price and list each item on the site. And obviously once an item sells, more labor is required to pack and ship it to the retail customer.

Oh, and don’t forget returns. While REAL requires buyers who want to return something pay the return shipping costs themselves, more labor is needed to receive the items, inspect them for damage, and restock them in the warehouse and on the site. Return rates in the apparel sector are sky high, often in the 30-50% range.

Even without rising minimum wage rates across the country and a renewed enthusiasm for remote-only work, you can see how labor intensive this business model is. And it doesn’t exactly scale well with higher volumes of items. Yikes.

Okay, but don’t they make good money off of sold goods? Sure, with gross profit running at about 60% even accounting for lower margin physical stores, of which they have some. But the expense lines are nuts. For the first nine months of 2021, SG&A, operations, and technology costs totaled 95% of revenue. Add in a another 14% of sales for marketing and the operating loss was negative 49%. Pandemic related expenses are hurting lately, but even in 2019 operating margins were still negative 32%.

It’s going to be a tall order to get this business, in its present form, to profitability. Gross profits are falling despite rising revenue and they have seen no expense leverage except on the marketing line (undoubtedly due to huge labor needs).

Before this experience, I wasn’t really paying much attention to REAL stock. Afterwards, with shares trading at about 2x 2021 revenue, I don’t see any reason to start. Maybe somebody bigger buys them at some point, but other than that, I recommend merely consigning through them if you don’t want the hassle of photographing, listing, pricing, and shipping stuff yourself.

Full Disclosure: No position in REAL at the time of writing, although positions may change at any time