Sunday, June 5, 2022
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Tech sector stuck in the denial phase

Originally written for The Australian

When Uber chief executive Dara Khosrowshahi quoted Jerry Maguire in an all-staff email a few weeks ago, my ears pricked. “We need to show (shareholders) the money”, he wrote. “We have made a ton of progress in terms of profitability, setting a target for $5bn in adjusted EBITDA in 2024, but the goalposts have changed. Now it’s about free cash flow.”

Good. “Adjusted EBITDA” is a scourge on the accounting profession. EBITDA stands for earnings before interest, tax, depreciation and amortisation. Those expenses after the word “before” are all very real. And there are no prizes for guessing which way the adjustments go when companies calculate “adjusted” EBITDA. And the investment community was duped into using these vastly overstated estimates of profitability to value companies.

But the companies themselves use these make-believe profit numbers for internal decision making. That results in a lot of misallocated capital and overpaid staff.

No one seems to care while share prices were rocketing. In this new-age tech bubble, even adjusted EBITDA became a boomer metric. All that mattered was revenue and growth.

But the bubble has burst. Uber’s share price is now half its IPO price and 55 per cent down on where it traded a year ago. And it is one of the better performing tech companies.

Zoom is down 75 per cent from its peak. Australia’s tech darlings haven’t faired much better. Xero’s share price is down more than 40 per cent and most smaller companies have performed even worse.

Highly valuable companies will undoubtedly emerge from this tech wreck.

Many are generating billions of dollars of revenue, unlike the Pets.coms of the dotcom bubble. Many have great products and subscription-based revenue models that make their revenue relatively reliable and predictable.

But they ultimately need to generate cashflow for their shareholders. Bubbles come and go, but share prices always, eventually, depend on investors wanting to earn a real return on their investment. Show them the cash and your share price will go up.

That’s why Khosrowshahi’s email piqued my interest. He’s an industry leader and he gets it. And Uber is already making moves to deliver on what long-term investors want to see. I’m seeing more and more chief executives follow the lead. We own ASX-listed companies Whispir, Nitro and Bigtincan in our Australian Shares Fund and all three have become recently vocal about generating cashflow for shareholders.

Many CEOs, however, are still in denial. And even Khosrowshahi hasn’t yet got the full picture. Generating cashflow is one thing. How much of that money ends up in shareholders’ pockets is just as important.

Uber issued more than US$1bn ($1.39bn) worth of shares to staff last year. Khosrowshahi isn’t talking about that expense anywhere. It isn’t in adjusted EBITDA and it isn’t in free cashflow because it isn’t a cash cost. It is a very real one.

Electronic signature company DocuSign claims to be nicely profitable already. It reported “adjusted operating profit margins” of 20 per cent in 2021. Those margins translate to healthy cash generation. But it is not counting “non-cash” share compensation to staff in those numbers. It has been issuing shares worth 20 per cent of revenue to staff every year – that’s all of the reported operating profit.

Over the past three years, DocuSign’s generous grants have translated to one-third of the company being gifted to staff. It’s not cash remuneration, but giving a third of the company away is a very real expense for shareholders.

DocuSign’s response to a precipitous decline in its share price (down more than 70 per cent from its peak) has been to suggest it might need to issue more shares to staff, not less, to compensate for the lower price.

Cryptocurrency exchange Coinbase wants to compensate staff for losses on previous share issues by – of course – issuing them even more shares.

The largesse in this tech bubble has been unprecedented. Hundreds of billions of dollars of capital have been thrown at the sector with very few questions asked. Much of that money has ended up in the pockets of founders and staff.

It cannot be easy for insiders to accept that the largesse needs to end. But with interest rates rising, share prices falling and access to capital becoming far more contingent, they are going to get the message.

When Khosrowshahi starts talking about free cashflow after stock-based compensation, then reality will finally be sinking in.

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