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Behind the bubble: the rise of zombie companies (1/2)

Updated: Mar 16, 2021

In our last article, we talked about the Food Delivery industry, its unprofitability, and the scarce probability of these multi-billion-dollar businesses turning a profit in the future. However, there is a much larger problem in today’s economy than just food delivery, as more and more businesses that are not turning a profit, (and don’t really plan to) still manage to attract investors, and see their valuations skyrocket, regardless of fundamentals. This issue doesn’t just concern the tech industry, as many companies in almost every sector of the economy are profitless, with little prospects of ever breaking even. These businesses are commonly called “Zombie Companies”: indebted businesses that, after covering running costs and fixed costs only have enough funds to service the interest on their loans, but not the debt itself. As such, they depend on banks or new investment rounds in order to exist and survive. This problem is becoming bigger, as some estimates, like the ones of Bloomberg, show that these companies currently make up 10% of the S&P 500. So, how is it that people keep investing in those businesses and why are some of them thriving despite adverse market conditions?

Modern Ponzi Schemes?

Every business, regardless of its scale, starts as unprofitable in order to develop its product or grow its customer base. But, after funding, the main goal for any functioning company is to break even and finally turn a profit, as a regular and essential part of its life cycle. The investment needed to build the company’s infrastructure is usually proportional to its scale, which means that big projects need big funding. In an effort to get more funding, the company’s owners will show to investors incredible growth goals by putting all their resources into expanding their market share. While some companies, like pharmaceuticals, naturally need time to come up with their products, others develop a “growth at all costs” mindset, with the goal of setting up multiple funding rounds to allow its owners to cash out before the company is supposed to become profitable. At this point, the main goal of the shareholders clearly isn’t investing in a long-term project that could make the business sustainable, but speculating on the valuation that will grow bigger at every funding round. There are plenty of examples of these phenomena happening right now, more than ever before, in Silicon Valley, and an increasing number of unprofitable companies having an Initial Public Offering, so that the average investor is allowed to buy shares and pump-up valuations even more. In fact, while companies have historically been profitable when having an IPO, in 2019 only one-quarter of American IPO’s were for companies that had ever turned a profit (Source: Wall Street Journal). In addition to that, the general public doesn’t always make decisions based on fundamentals and accurate market analysis but buys shares of the “hottest” stocks with the hope of having found the next Amazon or Facebook. This kind of thinking often leads to a spiral of speculation, as investors start getting rich by attracting more investors, that make money by attracting more investors, and so on, which really sounds like the concept of a Ponzi Scheme.

The risks

Unprofitable companies with crazy valuations are growing and there are some that have already been around for a while. Uber is a striking example as it provides world-wide known services, has all the market share it could possibly want in its core business (cab service), and yet has never turned a profit. In 2019 the company burned more than US$ 8.5 billion and lost another US$ 6.7 billion in 2020 (but the business was inevitably impacted by reduced mobility). Meanwhile, the company is valued at US$ 112.5 billion and went from US$ 30 a share in January 2020 to US$ 60 a share today, which means it doubled in value while burning billions, in conditions of uncertainty and while both its core businesses (cab services and food delivery) have no real prospects of ever turning a profit. The same concept is true for other dozens of listed companies, especially in the tech industry, and things are only looking worse with SPACs. A SPAC is a Special Purpose Acquisition Company, a backdoor style IPO where a shell company (a company that exists only on paper with no office or employees) goes public in order to get funded and start operating by basically selling an idea to the public. A company that has been getting a lot of attention recently and that went public with a SPAC is Nikola, a hydrogen-powered truck manufacturer. The company went public in 2020 and got a US$ 12 billion valuation after its IPO, but shortly after it has been reported that they didn’t even have a working prototype of their core product and that videos shown to investors were nothing but a truck being rolled down a hill. It has been reported that Nikola’s founder and former executive chairman, Trevor Milton, apparently is an expert at creating unprofitable businesses with no real value to sell them to the public as ground-breaking companies, which is also very common among Silicon Valley’s venture capitalists in general. This kind of management isn’t just a problem for investors, that voluntarily put their money into the company, but also for the free market in general, as companies like Uber that offer cheaper rides than taxis are able to do so only because they’re burning cash, and by doing so indirectly hurt competition in the industry. In a normally functioning market where the price of goods is determined by demand and offer, companies can’t afford to lose money for an extended period of time in order to indefinitely offer cheaper goods or services, but in the era of unlimited quantitative easing, close to zero interest rates and speculation, it almost looks normal. In our next article, we will discuss the causes and consequences of current monetary policies and analyze the threats for both the financial markets and the real economy. Stay tuned and SUBSCRIBE to become a MarketsTalk member and get free access to discussions!

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