The term “zeitgeist” was coined in the 18th century by German philosopher, Georg Hegel. It signifies the “defining spirit or mood of an age.” Hegel was most interested in the transitional period between ages, believing these times best displayed the zeitgeist of the age. We believe equity markets are in just such a transitional moment. If the zeitgeist of the prior decade was “growth at all costs”, the spirit of the new age is “profitable growth.” This transition will create new winners and losers and, in many cases, require investors to adjust their frameworks to succeed.
For the first time in years, investors have alternatives. Interest rates are nearing 22-year highs and risk-free assets are yielding 5% returns. The TINA (“there is no alternative”) era for equities looks to be fading. As investors react to the changing environment, the hardest hit equities have been cash-burning stocks. High discount rates erode the present value of long-dated cashflows and make it prohibitively expensive to fund loss-making business models.
The market adjusted in two stages. First, investors pulled money from long-duration assets. This cut multiples by more than half across many growth sectors. Second, companies reacted to the new incentives. No longer compensated for profitless growth, CEOs cut burn rates and focused on profitability. This second stage is still in the early innings and will take time to fully manifest in corporate strategy. For many teams it is a new muscle. The pivot to profitable growth requires a different playbook, one that we refer to internally as “No More Mr. Nice Guy” (NMMNG). It conveys the idea that companies will need to embrace a harder edge, both toward customers and employees.
By pricing-for-value, sunsetting certain customer subsidies, ruthlessly prioritizing high-return investments and streamlining their cost structures, we believe select companies will see profitability inflections over the coming years. Catching these winners early in their NMMNG transition will create meaningful value for shareholders.
To identify outsized beneficiaries of the new regime, we look for three attributes: 1) latent pricing power 2) sub-optimal capital allocation or inefficient cost structure and 3) a cash-burning competitive set. This underpins the core of the No More Mr. Nice Guy playbook: 1) increase monetization 2) improve efficiency 3) gain share from cash-strapped challengers.
- Monetization: We see significant opportunity for companies to shake off the “nice guy” persona and price products according to the value created for clients. Many companies launched or scaled during the 2010’s subscribed to the “blitzscaling” growth strategy evangelized by Reid Hoffman and others. It placed a premium on user growth and encouraged companies to price services at a steep discount to value, in order to scale up quickly and capture network effects. While it was a reasonable strategy for the time, we believe the market correction of 2022 and the new profitability regime have altered several of its fundamental assumptions. We see management teams increasingly willing to price-for-value, reduce subsidies and experiment with new revenue streams like advertising. This will create profitability inflections for select companies, though not all are positioned to benefit. Many companies will try to take price, but few have earned the right. Those who overstep the bounds risk eroding hard-earned customer loyalty and destroying long-term growth opportunities.
- Margin Expansion: Profitability was not a central KPI for many growth investors over the last decade. In many cases, “growth at all costs” gave cover to irresponsible spending and poor M&A decisions. From 2010 to 2021, the portion of listed firms with margins below -5% increased from 30% to 42%. The pandemic exacerbated the issue, incentivizing poor expense management, aggressive stock comp plans and low-quality M&A. US payments provider, Block, illustrates many of these excesses. It paid nearly $30 billion for an Australian buy-now-pay later provider, Afterpay, which had never turned a profit and had only tenuous synergies with Block’s core merchant acquiring and peer-to-peer payment platforms. Public comps suggest Block overpaid by 5-6x. Block also spent heavily on non-core projects, including a 2% opex allocation to bitcoin-related research and the acquisition of a majority stake in Jay-Z’s music streaming service, Tidal. As capital allocation deteriorated, ROIC fell and Block’s share price followed. As of writing, the stock is down more than 80% from its 2021 highs. The silver lining is that while the cheap money era encouraged sloppy capital allocation, it also created a low bar from which to improve upon today. For the NMMNG criteria, we look for companies with strong fundamentals that have room for further optimization, where the profitability regime change is catalyzing structural improvements that will enhance margins and returns on capital over time.
- Share Gains: The cheap money era helped spawn a generation of loss-making disruptors. While some had legitimate business models, many did not. The latter leveraged accessible VC capital and irrational competition to rack up rapid user gains, despite lacking sustainable businesses models and burning billions of cash in the process. Irrational competition has been a headwind for several high-quality companies over the last 3-5 years. It did much to obscure underlying moats, but we see the headwinds now abating. The new profitability regime will clip the wings of cash-burners while rewarding companies with strong unit economics. We believe investors can capture outsized returns by owning high-quality businesses as they exit periods of irrational competition.
Three companies we believe exemplify the NMMNG opportunity are Netflix, Uber and Match Group. Each offers a compelling mix of monetization, efficiency and competitive optimization opportunities that are not yet appreciated by the market.
Netflix
Netflix is the king of streaming. But to quote Shakespear, “Uneasy lies the head that wears the crown.” Netflix’s tremendous success throughout the 2010s sowed the seeds of future challenges, as its dominance attracted the attention of traditional media. Disney pulled its content from Netflix in 2017 and by 2019 had launched its own streaming service, alongside Apple. The pandemic brought even more new entrants as shelter-in-place turbocharged streaming demand and historically low rates reduced the capital burden required to spin up content creation. By 2021, HBO, Peacock and Paramount all launched similar services. The new entrants competed aggressively on price, burning a cumulative $20 billion in less than three years. While the competition was clearly irrational, it had the desired effect, reducing Netflix’s share of streaming from 46% to 33%. As saturation and competitive fears reached a fever pitch in 2022, Netflix’s multiple reached an all-time-low of 15x, down from nearly 70x two years prior.
In 2023 the tide began to turn back in Netflix’s favor, thanks largely to the profitability regime change. As investors fell out of love with subsidizing unprofitable growth, many new entrants were forced to re-evaluate their strategies. To right-size untenable unit economics, competitors raised price – 33% on average – and reduced content spend. Both developments are positive for Netflix. Price normalization gives Netflix room to breathe and makes it easier to win back lost subscribers. It also gives Netflix room for price optimization. Lower content spend erodes competitors’ value prop and gives Netflix more bargaining power with creators.
Netflix is emerging from the chaos a structurally better business. Users spend 2x as much time on Netflix as competing streaming platforms, and we expect this ratio to tilt further in Netflix’s favor as competitors pull back on content and promotional pricing. As the dust settles, we see Netflix flexing its pricing power and opportunistically phasing out certain subsidies, like password sharing, which was better received than many anticipated.
We expect the new ad-supported tier to be an important growth driver and believe it fits well under the monetization leg of the NMMNG playbook. Netflix is also executing on leg two by controlling costs. For the last decade content spend grew in-line with revenue growth, leaving little room for free cash flow (FCF) expansion. Netflix is now at the scale where it can self-finance its content budget and is comfortable holding it flat at approximately $17 billion per year, allowing incremental topline growth to flow through to FCF. We expect FCF to inflect meaningfully over the coming years and believe Netflix will create significant shareholder value as it balances margin expansion with growth investments.
Uber
Uber has been in heavy investment mode since IPO’ing in 2019. Despite 3x’ing revenue and generating a cumulative $60+ billion in sales over that period, none made it to the bottom line. The company posted nearly $11 billion of loss over the period. The mismatch stems from a culture of aggressive re-investment. Some of these investments paid off, like Uber’s expansion into food delivery. Eats now represents half of Uber’s consolidated bookings, up from 16% in 2018, and has created significant value. Bets on freight and autonomy were less successful.
Uber is now transitioning from investment mode to harvest mode, catalyzed in part by the profitability regime change. We believe FCF is in the early innings of inflecting. Uber Eats’ growth is normalizing after years of hyper-growth, setting the stage for take rate and gross margin expansion. Uber is also metering its investment in freight, which is approaching breakeven, and has sold its autonomous driving unit in favor of asset-light partnerships with Waymo and Nuro.
Competition from Lyft is also easing. Like Netflix, Uber was forced into fierce competition with smaller, cash burning rivals during the pandemic. Lyft burned $2 billion dollars since 2019 but was caught flatfooted by the profitability regime change in 2022. In an attempt to pivot, Lyft fired approximately 25% of its staff and cut driver incentives from 20% of revenue to 5%. This eased cash burn, but revealed the illusory nature of Lyft’s prior growth. Without the benefit of subsidies, Lyft’s revenue growth fell from 30% to 3%. Meanwhile, Uber’s rideshare businesses continues to grow at a mid-30’s clip. The delta between the two companies is large and we expect it to grow larger. Lyft’s retrenchment makes it easier for Uber to poach drivers, reduce its own subsidies, and increase take rates. Uber’s Mobility take rate increased nearly 300 bps over the past 12 months and it has room to move higher.
The combination of rising take rates and operating efficiencies support significant EBITDA margin expansion in the coming years. The company delivered its first quarter of GAAP profitability this year, but EBITDA margins are only in the mid-single-digit range. Uber is generating incremental margins well north of that – in the double-digit range – and we believe that in time it can operate in the 20%+ range alongside other scaled, online marketplaces like Etsy, eBay and Airbnb.
Match Group
Match Group is the global leader in online dating. We believe it has significant opportunity to execute against the first two pillars of the NMMNG playbook – monetization and capital allocation improvement. Match directly monetizes less than 20% of its users. We see room to improve payer penetration by expanding access to a la carte purchases, improving marketing and integrating generative AI tools into the profile creation and matching flow. We also see expanding revenue pools in premium tier subscriptions and advertising.
Match’s capital allocation deteriorated sharply during the pandemic. The team underinvested in Tinder marketing and used the funds for long shot projects like digital currency and live chat. It culminated in the $1.7 billion acquisition of Hyperconnect, an Asian livestreaming business with limited synergies and dilutive margins. R&D and capex both doubled from 2019 levels, yet important product launches slipped. Slowing marketing investment also weighed on top-of-funnel user growth. ROIC fell by half, from a consistent 30%+ before the pandemic to 13% in 2022. Margins contracted more than 200 bps and Tinder payer net adds turned negative by early 2023.
While Match’s execution has been weak, the underlying business is resilient and ripe for optimization. The profitability regime is catalyzing long-overdue improvements. New CEO, Bernard Kim, arrived in May 2022 from Zynga and brings a renewed focus on shareholder returns. He is executing against the NMMNG playbook with subscription price optimization and greater cost discipline. Kim also communicated a new capital allocation framework that returns half of free cash flow to shareholders, primarily through share buybacks. The company has repurchased nearly 3% of its market cap year-to-date, more than in the prior five years combined.
Arguably Match’s biggest mistake was relying too much on virality to drive Tinder growth. This “hands off” approach yielded impressive marketing leverage – sales & marketing expense fell from 35% of revenue in 2015 to 17% in 2022 – but did not do enough to protect Tinder’s brand. We expect renewed investment in marketing to bear fruit in 2024 and return Tinder to positive payer growth. The cone of outcomes is wider for Match than Netflix or Uber, but investors are compensated for the risk with a much cheaper valuation. At 12x forward earnings, Match trades at a significant discount to both its own mid-30’s long-run average and the high-teens market multiple.
We expect the market will be slow to give Match credit for its execution against the NMMNG playbook. Capital allocation is improving and margins are headed in the right direction, yet Match’s stock is down almost 30% year-to-date. The reason is short-term investors myopically focus on one metric; Tinder payer net adds. Until payers return to growth, the market will ignore underlying improvements in pricing, capital allocation and cost discipline. We believe this creates a coiled spring dynamic whereby the stock is unlikely to react to improving fundamentals for a time, then will react all at once when payers re-accelerate in 2024. It reminds us a bit of Netflix last year when the market was slow to give Netflix credit for price and cost improvements until North American net adds returned to growth. We expect a similar pattern with Match and believe it represents an attractive entry point for long-term investors.
How companies (and investors) risk getting NMMNG wrong
The transitional period from “growth at all costs” to “profitable growth” will not be positive for all companies. Management teams risk destroying long-term value and customer goodwill by pulling too hard on monetization levers and underinvesting in future growth. We see multiple cautionary tales emerging. Here are three ways companies get it wrong.
Taking price in an arbitrary or predatory manner: Companies must be careful with the optics of price increases. Any perceived strong-arming of customers will be met with vigorous pushback. The game engine developer Unity Software experienced this backlash recently. In September, Unity launched a controversial per-unit fee that many developers viewed as predatory. Users threatened to leave the platform en masse. Within a month, Unity was forced to modify the fee, issue a groveling apology and announce the early retirement of its CEO, John Riccitiello. A similarly embarrassing misstep came in early July from restaurant point of sale (POS) provider, Toast. Toast added a $0.99 processing fee to all online orders over $10, in a bid to reach profitability after posting a $115 million operating loss in 2022. The optics were terrible. Restaurants already straining under the weight of food inflation and slowing traffic did not take kindly to an arbitrary price increase. Toast withdrew the fee within days, but some measure of damage was already done. As of writing, the stock is down nearly 40% from when the fee was first announced on July 19th. The lesson in both cases is simple. Companies that pull too hard on the price lever – particularly when it appears arbitrary or predatory – risk fomenting backlash and destroying hard-earned customer loyalty.
Taking unsustainable levels of price: We also see risk for companies that have taken significant price but will struggle to maintain it in the future. We see this risk most acutely in the consumer sector, specifically in luxury and staples. Both groups took price aggressively under the cover of input cost inflation over the past two years, at a time when consumers were flushed with cash and credit was easily available. This should be more challenging as consumers deplete pandemic-era excess savings and resume student loan repayments. In May, staples giant Kellogg Co. reported North American price mix up 16% year-over-year, more than 3x the consumer price index growth rate. Richemont, a Swiss-based luxury goods purveyor specializing in jewelry and wristwatches saw margins expand nearly 10 points in the post-pandemic era. Surging demand for luxury goods and limited supply allowed Richemont to take aggressive amounts of price, which dropped to the bottom line at high incremental margins and juiced consolidated margins. As luxury demand softens in 2024, we see risk to Richemont’s margins as pricing actions slow and potentially turn negative. In both cases we see companies that have potentially over-earned for the past 2-3 years, that now face difficult comps as consumer spending slows.
Underinvesting in future growth: Lastly, we see risk in companies that cut too deeply into costs. Sacrificing long-term growth for short-term profits has historically been a bad trade. Since these errors usually take years to manifest, we would point to historical examples like Jack Welch at General Electric. His maniacal focus on short-term profit optimization resulted in systematic layoffs, a tremendous amount of M&A and a pervasive financialization that ultimately brought down the firm. Some 22 years later, GE’s share price is still more than 50% lower than when Welch retired in 2001. Elon Musk’s slash-and-burn approach at X (formerly Twitter) may provide a timelier example, though the jury is still out.
Conclusion:
Equity markets are entering a new era. Profitless growth will no longer be rewarded. While the transition has been bumpy for some, it is ultimately a healthy evolution that should play to the strengths of fundamental investors and increase return dispersion. Growth investors may need to recalibrate some of their mental models, particularly those formed during the “growth at all costs” era. A similar change is required at the C-suite. Balancing growth and margins must become a core competency for all management teams. We believe that understanding the second derivative of this change – how shifting investor expectations impact management incentives and corporate strategy – is crucial to identifying the emerging crop of winners and losers. Identifying companies ripe for optimization and catching them early in their transitions, while avoiding companies with unsustainable models that will fail to adapt, will be key to continued success.
