Letters #13/14: Danny Rimer and Bill Gurley (1998)

Index Partner & Benchmark Partner | Danny: Net stocks: Critical mass vs. profits | Bill: Internet Investors: Beware of the Proxy Valuation

Hi there! I go by KG, and I love studying the history of business and investing. I’ll be sharing some notes from one Investor/Shareholder letter per weekday (mostly from my compilations) here.

Today’s notes are on Danny Rimer’s 1998 essay: Net stocks: Critical mass vs. profits and Bill Gurley’s 1998 essay: Internet Investors: Beware of the Proxy Valuation.

If you don’t know Danny Rimer, he’s a partner at Index Venture, and responsible for their investments in Dropbox, Etsy, and Figma, among many others. Prior to Index, he was a managing director at Hambrecht & Quist, and the underwriting analyst for Amazon, Netscape, and Verisign, and helped take Netscape Public. Before that, he was digitizing famous artworks and selling those digital versions.

If you don’t know Bill, he’s a partner at Benchmark Capital, and responsible for their investments in Uber, Nextdoor, and OpenTable, among many others. Prior to Benchmark, he was an Internet Research Analyst at Credit-Suisse First Boston and Deutsche Bank, where he covered Dell, Compaq, and Microsoft, and was the lead analyst on the Amazon IPO. Before that, he was an engineer at Compaq.

As they were both Wall Street Analysts covering tech in the mid to late 90s, it is unsurprising that they often wrote about similar issues. These two essays were published within 4 months of each other, with Danny’s piece dates 4/28/1998 and Bill’s piece 8/17/1998. By this time, Bill had moved on to VC as a partner at Hummer Winblad, while Danny was still at Hambrecht & Quist (keep this in mind as your read the two essays — one was still on the sell-side, the other had just transitioned to the buy-side).

You can read Danny’s entire essay in my Danny Rimer Compilation. This particular essay starts on Page 60.

And you can read Bill’s entire essay in my Bill Gurley Compilation. This particular essay starts on Page 234.

If you have any thoughts on what you’d like to see, let me know!

Danny Notes

Logic would seem to dictate that investors would twist and turn before deciding which earnings-less company to invest in. Well, paradoxically, dollars are flooding the Internet universe of public companies.

• It seems like the internet was the end of scarcity — and thus traditional economics and traditional business models

• You no longer needed to make money to get funded — who cares about profitability???

If questions were urls, www.whenaretheygoingtomakeanymoney?.com would put Yahoo's latest traffic number to shame--and that's no small feat! While Yahoo did not really start picking up steam until after August 8, 1995--around the time of Netscape's initial public offering--www.whenaretheygoingtomakeanymoney?.com's traffic has never let up.

• Netscape changed the public equities game — interestingly Marc Andreessen, who led Netscape, also changed the venture game when he announced his full-service VC fund Andreessen Horowitz in 2009

One would suspect that, given the number of times this question gets posed, investors would be very cautious about investing in Internet stocks. Logic would seem to dictate that investors would twist and turn before deciding which earnings-less company to invest in. Well, paradoxically, dollars are flooding the Internet universe of public companies.

• Times may have changed, but people haven’t — still irrational

Not only are investors flocking to companies without earnings, but, more interestingly, they are investing in companies that, from my perspective, may never have earnings.

• Internet Bubble

Historically, growth investors and, more specifically, tech investors, have invested in companies that had earnings. While these companies may not have extremely high earnings at first, and rarely paid any dividends, it was nevertheless accepted by investors and entrepreneurs alike that growth companies would need to be profitable before bankers could be selected for an underwriting. As a result of the Internet, however, the investment landscape has changed significantly. Only very few publicly traded Internet companies have reached and sustained profitability, and this hasn't seemed to faze investors in the least.

• Before, companies had to reach AND sustain profitability. The Internet made it so companies neither had to reach NOR sustain profitability.

When it comes to Internet stocks, investors seem to be rewarding revenue growth a great deal more than profitability, and have been doing so correctly for some time. Of course, when a company has achieved what seems to be critical mass, earnings are merely frosting on the cake, and hence are paid for as such. Otherwise, revenue growth is more greatly rewarded than earnings growth.

• Anybody have a clue what he means here? Honestly a little lost…

In my opinion, the ability to reach critical mass is a tremendous advantage for a company as it provides higher barriers to entry and increases switching costs. The notion of GBF ("getting big fast") is relevant to a number of Internet companies, but is it really imperative that they all strive for ubiquity? Is critical mass really more valuable than strong earnings?

• Reaching critical mass is highly important — higher barriers to entry and increased switching costs (sounds like a very early/watered down version of a network effect)

It seems to me that, in many cases, ubiquity is necessary as Internet companies become less focused on technology and more focused on wrapping around and integrating technologies.

• People are still finding new ways to use the internet — the big winners today aren’t the people who developed the internet, it’s the people who use the internet and the people who find new ways to leverage the internet

It should be clear, though, that when a company says it will reach profitability, profitability must be achieved. I would argue that there is a direct correlation between loss of goodwill by investors and profitability being moved out. Investors should accept postponed prosperity as long as prosperity can, in fact, be reached--as long as the company's business model is built in a way that maximizes profitability when the model swings.

• I bet he didn’t foresee the rise of megafunds and megarounds… would love to hear Danny’s thoughts on the current VC landscape and what can be done to refocus on profitability (WeWork scared everyone, but it seems like most people have already forgotten about it).

Keep an eye out for companies that have promised to hit profitability in a certain quarter and then postpone their projections to a later quarter.

• Pushing back promises are never good

Bill Notes

As the market begins to grapple with the lingering effects of a seven year bull market, the financial crisis in Asia, and the undeniable shortfall in second quarter earnings, the ground underneath our feet just doesn’t seem as strong as it once did. For those of you investing in Internet stocks, gauging the solidity of the earth below is even more difficult given the daunting distance from the bottom of your shoes to the actual surface of the earth. Perhaps everything is fine… At presstime, the Internet stocks are in fact acting quite resilient. However, if recent market skittishness has caused you to reassess, make sure that you’re not overly exposed to the risks of the “proxy” valuation.

• Bill’s Value Investing training shines through here — focus on the fundamentals. Stocks are pieces of paper to be traded around — think of them as businesses. Don’t be lazy and use proxy valuations — consider a margin of safety.

Any financial academician will tell you that the only proper way to value a stock is to predict the long-term cash flows of a company, discount those cash flows back to the future, and then divide by the number of shares. As this is much easier said than done, many practitioners often shortcut the process using tools that serve as a “good enough” proxy for cash flow. One good example is the price to earnings ratio. It’s not a perfect measure of cash flow, and there are many loopholes between the two, but as John Maynard Keynes said “I would rather be vaguely right, than precisely wrong.”

• “Anyone can swing a golf club. Some do it better than others”

• DCF’s are the only real valuation method — after all, a companies present value is the sum of all its future cash flows — even multiples, to some extent, are DCFs

In certain emerging markets, particularly ones that are capital intensive, the cost of market entry is so high that even market leaders lose money for several years before eventually turning profitable. This presents a bit of a dilemma for the typical market investor as his/her standard proxy tools are irrelevant due to the fact that the variables used for computing valuation — earnings, earnings growth, cash flow per share – may all be nonexistent. Rather than throw in the towel, innovative investors must turn to new proxies based upon variables that are indeed measurable. Simply make some assumptions that tie the proxy back to standard valuation tools and you are on your way.

• When traditional methods don’t work — people make up new ones. They create short-cuts. Any parent will tell you: short-cuts never work.

The cable television and cellular telephone industries owe a great deal to the proxy valuation. The cash flow required to build these communication infrastructures was so high that most of the market players performed quite poorly when evaluated using standard valuation tools. However, many optimistic investors “knew” that these companies would eventually reach economies of scale that would then lead to profitability. Therefore, with no earnings to measure, these investors grabbed hold of any variable they could.

• Optimistic investors “knew” that after a critical mass is reached, economies of scale would lead to profitability and great rewards

• Seems like these people are more speculators than investors — “I know this will happen. Let me justify it by making stuff up”

In the cable television era, the variable that was most commonly used was “homes passed”. Divide the market value of the average cable company by the average number of homes who could potentially subscribe to the service to calculate the value per home-passed. This proved to be a useful tool for valuing cable franchises, and you could always rationalize the value by calculating a rough estimate of what the lifetime value of a single customer should actually be. Other variables that proved popular in both cable and cellular were “price-per-sub (subscriber)” and Earnings before Interest, Taxes, Depreciation, and Amortization – also known as EBITDA (more on this later).

• John Malone coined the term EBITDA

• For more on Malone, check out my John Malone Compilation

The Internet is currently going through a similar stage. Investors, who are rightfully optimistic about the future and potential of the Internet, are anxious to invest in companies who are clearly many years away from profitability (perhaps many, many years). Not to be shut-out for lack of a valuation tool, these investors have also created proxies that are tied to the variables that we happen to be able to measure. Some popular ones include market capitalization per subscriber, market cap-to-subscriber, market cap-per-unique visitor, market cap-to-page view, and the most popular of all — market cap-to-revenues.

• Given Bill’s observations (the public equities world seems like the VC world today), is it any surprise that VC AUM has skyrocketed?In some ways, nothing has changed, the capital has just flowed from traditional investing world into the VC world

• Many of these metrics are still in use by banks today — wonder who that says more about — the banking world or the investing world

While abstract proxy valuation tools are indeed risky, there is no reason to belittle those that use them. Keep in mind that while these tools are inaccurate, they still offer a distinct advantage over the alternative of holding one’s finger in the air. Additionally, the advanced risk that is apparent in these situations is typically offset by a greater potential upside. Columbus would have never discovered America if he had waited around for someone to invent the Global Positioning Satellite. Many investors in both the cable and cellular industries were handsomely rewarded for betting big and betting early, and the same reality has already been proven true on the Internet.

• Interesting — I would almost think that gut feeling > wrong metrics. If you use the wrong metrics, you could be mislead and go down the wrong path

• Risk is necessary — but perhaps it’s more the business fundamentals that matter. In Telecom, optimistic investors saw how the businesses would work, and were willing to take the risk that it would

However, as emerging markets begin to mature, the dangers of proxy valuation become more apparent. These proxy risks can take several forms. First consider symmetry risk which flows from the fact that not all “variables” are created equal. When you base your valuation on cash flows, it is safe to assume that a dollar of cash at one company is equal to a dollar of cash at another. However, as we move down the proxy continuum to earnings, and subscribers, and visitors, and page views, the likelihood that we are still comparing apples to apples diminishes. Is an E-Trade customer worth the same as a CDNow customer? Does a page view on Yahoo equal a page view on GeoCities? It’s hard to say.

• This is why comps are hard. Does one ride for Uber count for one ride for Lyft? Does one view to Google count for one view to my website?

• The further away you get from cash and the more specific to your company you get, the further away you get from comparables #financialengineering

A second risk is assumption risk. After proxy valuations begin to stick, we begin to treat them as fact. For instance, we might divide companies’ market capitalization by its customer base and decide that a customer is worth $X. However, we should really take a look at the cash flows that are likely to come from that customer and then determine if the overall valuation makes sense. Becoming too comfortable with the proxy and its assumptions can be dangerous. For many years, cable investors were convinced that EBITDA was a great proxy valuation and that cable companies should be worth as much as 15-20 times EBITDA. Unfortunately, it turned out that ignoring depreciation was a major mistake, since cable systems needed constant upgrades. The proxy was poor, and those that came to believe in it eventually suffered.

• When proxies are poor, and you rely on your proxies — things get ugly and you get burned. Focus on the fundamentals. The company doesn’t earn cash? Well think about it — will it ever? One of my biggest lessons from Bill is to focus on the unit economics.

Another reason to be skeptical of proxy valuations is arbitrage. If Wall Street comes to believe that customers, or visitors, or page views, or even revenues are uniquely valuable (regardless of profitability), than entrepreneurs are likely to rush to market with companies that can achieve these targets quite handily, but may have little chance at producing real value in terms of cash flow. With no focus on costs, it is easy to reach non-financial targets. This is the great thing about cash flow-based valuation, it’s hard to sweep costs under the rug.

• I can sell a dollar for $0.75. Now, I wouldn’t make money, but I was being valued off revenue, I’d be a trillionaire.

To highlight this point, consider the absurd example of a Web-based company whose core service is to sell dollars for $0.85 each. This company could obviously achieve record visitors and page views at its Web Site. Revenue growth would easily set records, and it is quite conceivable that sales could reach into the billions within the first few quarters of operation. Apply even the most conservative Internet price-to-revenue multiple to this franchise and we are talking about a multi-billion dollar market cap. Perhaps you are questioning how this high-flying company will ever turn profitable? You are obviously forgetting that with traffic like this, the potential for advertising and targeting will be tremendous!

• Is this the first instance of the saying “Anyone can sell a dollar for $0.XX”?

• Bill has always been good at injecting humor into his pieces… although they aren’t always the most obvious

Clearly, there are a few Internet companies that do not deserve this type of ridicule. Yahoo and E-Trade have already proven profitability, and many investors are quite confident that Amazon can achieve similar results over time. Additionally, even younger companies such as Ebay, a San Jose auction house, are achieving record revenue growth without compromising profitability. However, these are the exceptions. Investors should increasingly evaluate the potential long-term profitability of Internet businesses before they invest. If the market continues to slip, optimism will be replaced with skepticism, and the companies that are most dependent on proxies will be the ones that fall furthest.

• Great companies are often the exception — NOT the rule. Don’t simply point to Uber or AirBnB or Amazon and say — “See? They did it. Why can’t we?”

On the margin, it certainly appears that arbitrage is in full swing. We are witnessing an increase in companies that file for IPO’s with losses that are as large as (if not larger than) revenues. Recognize that this means that expenses are over twice that of revenues—economics that are actually worse than my company that sells dollars at a discount. Additionally, it is rumored that certain Internet CFOs are pushing investor’s to look at EBITDAM. The M represents marketing, and is an attempt to get Wall Street to ignore what has become the single biggest expenditure for Internet startups. This only makes sense if you truly believe that marketing costs will one day go away, which should be considered unlikely. Perhaps we should make it easier and skip straight to EBE (Earnings Before Expenses)… but that looks suspiciously similar to price-to-revenues, doesn’t it?

• Proxy valuations are ridiculous…

• Interestingly, Bill later wrote a piece on the 10X revenue club — while he argues that the 10x revenue multiple should only be for GREAT companies, I’m somewhat surprised that he uses the metric at all

Wrap-up

If you’ve got any thoughts, questions, or feedback, please drop me a line - I would love to chat! You can find me on twitter at @kevg1412 or my email at kevin@12mv2.com.

Please DM or email me any time — to share non-obvious intel, views and correct or solicit mine. I appreciate your continued support and partnership :D.

All compilations here.