Spending your way to Profits

[jschembs]

I'm curious, and not sure how to research this through CapIQ, but is anyone aware of any company that has historically spent ("invested" in the sell-side vernacular) their way to profitability? Excluding of course start-ups, I'm thinking about any business with revenues say in excess of $500 MM.

[ItsAValueTrap]

Paypal (you can look up their SEC filings before they were taken over by eBay)

 

Intel - originally they were a memory company.  Lost money on microprocessors for years before they became profitable.  Itanium lost money for years too.

 

Starbucks lost money in the very beginning.  Google and Amazon also lost money in the beginning I think.

[jschembs]

Quick glance at SBUX's financials indicates they've been generating operating profits way back to 1991, when they were generating $3 MM of EBIT on $58 MM of revenue.

[jschembs]

PayPal's last publicly-disclosed financials indicate an operating loss of $46 MM on $174 MM in revenue for LTM 6/30/02, which is a narrower loss from $111 MM on $105 MM in revenue for FYE 12/31/01. PayPal seems to fit the hyper-growth venture capital exclusion from my initial question.

 

So 2 out of those 3 aren't valid; I haven't spent any time looking for INTC's ancient financials when they were in a similar point in their history.

[ItsAValueTrap]

starbucks was losing money when it was still owned by private equity.  (According to howard schultz's book.)

[jschembs]

That's certainly possible - and I didn't mean to shoot down your responses, I was just reporting the numbers - but again even at $58 MM of revenue they were able to generate profits.

 

The theory I'm trying to prove or disprove is whether this new mantra of "growth at the expense of profits" for large enterprises has sufficient (or any) historical precedent.

[alwaysinvert]

Skype? Youtube?

[Ham Hockers]

cable companies? but that depends if you mean accounting profits when you say "profits", or if you mean no accounting profits and no cash flow either

[jschembs]

I'm thinking operating expenses as opposed to capex. Companies that consistently generating operating losses (as opposed to negative free cash flow) with revenues greater than $500 MM.

[ItsAValueTrap]

The theory I'm trying to prove or disprove is whether this new mantra of "growth at the expense of profits" for large enterprises has sufficient (or any) historical precedent.

 

If you look around, there are some examples of industries where it might make sense to lose a lot of money in the beginning.

1a- You are developing technology so there is an upfront R&D cost.

1b- You are developing technology that might become economic in the future.  Stuff that creates value but you have no idea how to monetize it.  This describes most of the things that Google is involved in:  search, gmail, google reader (closed down), google checkout (closed down), youtube, etc.  Reader and checkout are good examples of things that reached high market share but were closed down because they were unprofitable.

 

If your criteria is over $500M in revenue, then I think Intel's Itanium product might fit the bill.

 

2- The product is believed to benefit from network effects.

Satellite radio

Video formats: VHS/beta, bluray/HDDVD

Content networks for video

Payment processing networks

Semiconductor manufacturing (this industry has historically been awful)

search engines

etc. etc.

 

Now that I think about it, Sirius XM is probably the best example of a company that lost money for years before becoming profitable.  (It was actually two companies that lost so much money that US regulators allowed them to merge and become more profitable.)

[Guest ajc]

McDonald's.

 

Even by the time they were one of the biggest fast-food businesses in the US, the book value of the entire parent company was around $25 000 or something (if I remember correctly - see 'Behind The Arches' for details).

 

Kroc exchanged profits for control over the products, consistency, etc. In the first decade or so, the franchisees were basically printing money and the customers were saving a bunch but there were times when McDonalds couldn't even afford to pay their people at corporate headquarters.

 

When Sonneborn went out looking for loans for expansion they got turned down everywhere. Eventually they arranged a meeting with an insurance company that was known for making some unusual and contrarian bets with a portion of their float, and fortunately they managed to get their first bit of real financing credibility as a result.

 

In order to get that and future financing however, they needed to show a profit at the parent company level. Because they had none, Sonneborn hired an accounting firm that was prepared to sign off on some accounts that booked future revenue streams (from franchisees and rental income I think) as existing assets.

Totally against all accounting convention, and Sonneborn later admitted that they needed to stretch the truth as much as possible just so they would actually be able to meet with potential investors or lenders.

 

I think they're a good example of a company that hardly earned a dime throughout a huge portion of their expansionary stage.

Even when they were already one of the biggest in their industry. And while all the other fast-food parent companies were rolling in cash.

Kroc wanted the franchisees and customers to make/save all the money, so he could focus on expanding.

Sonneborn made sure the real estate would eventually all belong to the parent company and that helped ensure their long-term success.

 

PS. Some of the details might be a bit off as this is from memory, but essentially that's how I think it went down.

Anyone with a better memory - please feel free to correct me, and you could also obviously pick up your own 2nd-hand copy of Behind The Arches for a buck or two if you wish.

I'd say it's probably recommended reading, regardless.

 

 

 

[ItsAValueTrap]

Jschembs, you're short Salesforce right?  I think you just have to look back at the Dot-Com Bubble to see how dopey their strategy is (e.g. Webvan).  But it will probably be very hard to make money from shorting Salesforce.  The underlying business has the potential to be highly profitable and it will take a very long time for the stock to collapse (so your rate of return won't be good even if the trade works out).

[Parsad]

Amazon.  They were losing tons of money by plowing everything they could and more into their business.  It worked!  But this often not the case, rather than often the case.  Cheers!

[educatedidiot]

Amazon.  They were losing tons of money by plowing everything they could and more into their business.  It worked!  But this often not the case, rather than often the case.  Cheers!

 

Amazon is one of the more fascinating case-studies on this point.  Not only because they ran-up a staggering $3+ billion in retained losses by 2002, just before they finally turned profitable:

http://www.rocketfinancial.com/Financials.aspx?fID=6337&p=2&i=8&pw=209079&rID=2&tID=1&stID=1&segID=-1

 

But even more fascinating to me is that Bezos still managed to hold on to ownership of 28% of AMZN at this point -- despite having to fund $3 billion in losses to get there!

[rukawa]

I don't think history is a good way of judging this.

 

Capitalism goes through phases. The first phase was very capital intensive and capital was expensive. So a measure like book value may have made sense.

 

The next phase saw the rise of advertising and brands. I think this was the reason Buffett departed from Graham. He was seeing companies trading at 5 time books value and yet on an earnings basis they were cheap. Graham had already departed from asset values but he still clung to the idea that there should be at least some asset value support for any company. Buffett and Munger absolutely broke from this idea and were willing to buy companies that were ridiculously expensive if judged on an asset value basis.

 

I believe the current phase is another transitional one and that it doesn't make sense to judge digital companies on traditional value metrics. Capitalism is a revolutionary force that is incessantly altering the modes of production. Investors have to adapt.

[wabuffo]

Amazon.  They were losing tons of money by plowing everything they could and more into their business.  It worked!  But this often not the case, rather than often the case.  Cheers!

 

I think its important to distinguish between owners & business models that show zero/negative GAAP profit and zero Taxable profit (from an IRS POV) but generate large amounts of positive Operating Cash Flow during their rapid expansionary growth phase.

 

Bezos/Amazon (large positive cash inflows from working capital) and Malone/TCI (positive cash flow used to finance cable company acquisitions for additive synergies) are good examples that are/were both misunderstood because of this focus on GAAP profits by traditional analysts.  These both had inherently profitable core businesses but felt the opportunity to grow rapidly was more important strategically than showing a GAAP profit and paying taxes.

 

A business that loses money but also shows large cash outflows on an operating basis is still a bad business and can only expand to the extent that debt/capital markets remain open to it.  That's not to say it can't work, but the failure rate is much, much higher than companies with "profit-less", positive cash flows.

 

wabuffo