Weekend thoughts: Capital (mis)-allocation at high growth companies
It’s been less than a year, but it’s easy to forget how wild Q1 of 2021 was. Yes, there was some pretty crazy stuff going on in the real world, but I’m talking specifically about in the stock market. We had GameStop and gamma squeezes in January, the SPAC bubble fully inflating and bursting in February, and Archegos’ melt up / melt down in March.
I’ve been thinking about the Archegos thing a little recently. For those who don’t remember / weren’t following, Archegos bought a handful of stocks with huge leverage, and they just kept levering up and buying more and more of them as they went up (and we’re still learning more about them! Just this week, Bloomberg reported on a bank stock Archegos squeezed).
Why have I been thinking about Archegos? Because some of the stocks they bought / squeezed were old world media stocks like ViacomCBS and Discovery. Those stocks had traded for a low multiple for years, and the executives at the companies would always argue “the market doesn’t get it; our earnings are sustainable and we’re way undervalued.” When the stocks started to rip, the executives at both companies were crowing “the market is just starting to recognize our value.” For example, check out what Viacom’s CEO was saying in early March when the stock was in the $60s.
But I’m not sure that Viacom and Discovery’s actions quite matched their “this is just the start of the value unlock” words. Both Viacom and Discovery have historically been reasonably aggressive share repurchasers, and both of them repurchased exactly zero shares during Q1’21. Sure, this was likely driven by their decision to invest aggressively into streaming, but I suspect their rising share price had something to do with the lack of share repurchases as well. And Viacom even took advantage of their inflated share price to raise several billion dollars in stock and cheap convertible preferreds. Remember, Viacom is a historical reasonably aggressive share repurchaser that generates huge cash flows; for them to issue equity is a marked divergence from their past capital allocation.
So Discovery and Viacom were saying one thing to the market (that their stock was still conservatively valued), but their actions seem to suggest that they thought their stock price was expensive. At minimum, both engaged in good capital allocation: instead of leaning into the rising share price with buybacks (like many companies would do), they looked at where the best uses for their capital was and decided it was elsewhere (investing in their streaming service and, in VIAC’s case, raising cheap equity capital).
This week, Peloton (PTON) and Amyris (AMRS) raised capital. These are two really interesting growth companies; I’ve been bullish on Peloton for a while because I think the opportunity is so skewed, and my friend Randy Baron made a really compelling pitch for AMRS on the Yet Another Value Podcast and I’ve been following them ever since. I don’t currently have a position in either (I own a few shares of PTON as a tracking positive just to give complete disclosure), but I like to follow both and might own either one day in the future.
Both PTON and AMRS are growth companies that are attacking physical markets in some form (AMRS needs to build plants, distribution logistics, etc., while Peloton needs to manufacture bikes and invest in logistics as well). Attacking physical markets requires much more capital than, say, spinning up a website, but it can be quite lucrative in the long run. If you’re successful in a market with a physical dynamic, then any would be competitors face an overwhelming challenge in copying your model. For example, say Peloton successfully “wins” connected fitness; any competitor entering their markets is not only subscale in terms of Peloton’s content library, cash flow, user base, etc….. the competitor will also face a daunting challenge in terms of ramping up manufacturing and logistics to deliver a Peloton like experience (as well as needing to steal customers who already have a Peloton in their home). Sure, all of that is doable…. but it would take years and hundreds of millions of dollars in investment.
So it’s no surprise that both companies raised capital (even though Peloton’s CFO had claimed they didn’t need additional capital as recently as a month ago). But I am a little surprised by the timing of the capital raise; both companies are raising capital after their share prices have been crushed from highs earlier this year.
It begs the question: why did the companies decide now was the time to raise capital? Why not raise over the summer when the stock prices were way higher? Actually, not only were the stock prices higher over the summer, but the growth outlook was rosier. Again, growth in these industries requires capital, so you could argue the need for capital was higher when the stock prices were higher. So over the summer, not only could they have raised more money on less dilutive terms, but they probably needed the capital a little more than they do now.
To be fair to both companies, they did raise some capital when the stocks were more dear earlier this year. Peloton raised ~$1B of 0% converts in February, and AMRS raised ~$121m at $15.75 in April (the headline of that PR says $300m, but a big shareholder sold ~$180m alongside them). So it’s not like AMRS and PTON were sitting on their hands when their stocks were more dear. Still, it seems like an epic failure on their ends to not have raised more when the stock prices were really dear.
More than the missed opportunity cost, failing to raise capital when the stocks were more expensive call into question the companies’ ability to forecast and manage the business. Again, growth in these industries requires capital; both PTON and AMRS knew that they would need more capital at some point in the future in all but the rosiest of scenarios. That they chose to defer on raising capital until the stocks tanked and the growth outlook was less rosy suggests management was buying into the rosy story and wasn’t doing a lot of downside planning / mitigating. They likely thought the business would always grow and fire on all cylinders, and when it came time to raise capital the stock price would be way higher (boosted by the inevitable super successful performance) and they’d be able to raise on very attractive terms.
I get it: running a growth business trying to win a new category is hard, and it’s even harder in world where COVID has decimated supply chains. And, to be a great entrepreneur and grow a massive business, you generally need to be extremely rosy. If you’re always prepping for the downside, you’re not going to grow a multi-billion dollar business from scratch (which both PTON and AMRS’s founders / CEOs have effectively done). Remember, Peloton was turned down by dozens of VCs who said fitness was too hard and too expensive. So to grow those businesses, it’s probably not helpful to be sitting in your offices prepping for raising capital if your business underperforms. You need to think everything is going to break your way.
Still, old world media CFOs catch a lot of flack. Often, that flacks deserved. But corporate habits are hard to break, and in both Viacom and Discovery’s case they were willing to break them when the stock prices were too high and they had better uses for their capital. I don’t think they get enough credit for that, and comping them to the disaster that is AMRS and PTON’s recent capital management / raise presents an interesting contrast.