Profitability beats growth at any cost
We talk to the companies we invest in on a regular basis and have made three trips to Silicon Valley during the past 12 months to meet many of those based there face to face, to understand how they have been managing the fallout from the significant share price declines in late 2021 and 2022 and other macro challenges.
One thing is striking. While we all wait and wonder whether a recession is coming, the tech sector is already in one and has been for nearly two years.
Covid-era growth in areas such as e-commerce and tech equipment were wrongly extrapolated and there has been a painful period of reckoning.
But many excellent tech companies have been extremely adaptable and fast to get stuck in, cut costs and refocus the business away from growth at any cost to profitability.
Take Shopify, which, chastened by a brutal 80 per cent stock price decline from peak to trough, has laid off 30 per cent of its workforce and scrapped its plans to build out a physical logistics infrastructure in order to refocus purely on its industry-leading e-commerce services. It is up 150 per cent from the bottom, with huge upside ahead.
Tech companies were the first to experience the macroeconomic slowdown and are the first out, stronger and leaner, while much of the rest of the economy lags behind.
It makes sense to us that tech companies are leading the market this year. But the much more important point is that this focus on profitability will be key to sustained success in a world of higher interest rates.
We do not know why many commentators have advocated focusing on capital-intensive, “old-economy” companies if interest rates stay higher. If capital is more expensive, then this favours the opposite — capital-light businesses with high returns on invested capital that can more easily clear the higher cost of capital hurdle rates. Those that have critical scale and are laser-focused on profitable growth are particularly well equipped.
A good example is Airbnb, which pre-Covid had just short of $5bn (£3.9bn) of annual revenues and was operating close to break-even. The business lost almost all its revenues during the lockdowns, but having survived this shock found that demand returned to 95 per cent of its pre-Covid level before it even had a chance to spend any marketing dollars.
This was a good lesson to learn. Airbnb is now making close to $4bn of free cash flow from revenues of around $9.5bn and is achieving a return on invested capital of more than 20 per cent.
Companies like this will love higher interest rates because they will take market share much more easily than previously against the zombified companies on the wrong side of innovation that have been piling up debt to stay in the game over the past decade.
