What's Going On: Retail Traders Love Bankrupt Stocks
Uber's profitability, the newest bankrupt "meme" stock, and Fitch's downgrade.
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Uber Managed the Impossible (Making Money)
Anyone who took an entry-level finance course in college (or, in my case, took Valuations during their first semester of business school) is familiar with the idea of deriving the present value of a company from its future cash flows.
When interest rates are high, a dollar today is increasingly worth more than a dollar tomorrow, and cash flows today are worth a lot more than hypothetical cash flows a decade from now. When interest rates are low, a dollar today is worth about the same as a dollar tomorrow, and hypothetical cash flows a decade from now can be pretty valuable!
The 15 or so years between the Great Financial Crisis and the beginning of the Federal Reserve’s current rate-hiking campaign was a really interesting time to found and grow a venture-backed company because hypothetical cash flows 10+ years out were pretty valuable! And you could get rich scaling a billion-dollar business without ever figuring out to actually make money.
Because interest rates were so low, investors were willing to invest massive sums of money in high-growth companies at insane valuations, as long as revenue was growing quickly enough. Did it matter if expenses were outpacing revenue? Did it matter if the company utilized a creative accounting term known as “community-adjusted EBITDA?” Nope! Not if growth was fast enough.
The playbook for the last 15 years was to grow as large as possible as quickly as possible, and figure out how to turn a profit later. The result? My formative years were blessed with a VC-subsidized lifestyle.
Consumers such as you and I could reserve underpriced Airbnbs in cities around the world, we could rent co-working spaces at the hottest WeWorks in NYC and LA for pennies on the dollar, and, most importantly, we could book car rides from the airport to our homes for ½ the price of a taxi.
But this party came to a grinding halt when the Fed began raising rates in March of 2022. With interest rates now far above zero, and investors having the ability to get 5% annual returns on their cash, those hypothetical cash flows projected by different companies needed to be realized, quickly. This created a real-time case study for investors and company execs alike: Could unprofitable, formerly high-growth companies cut costs, raise prices, and “flip the switch” to achieve profitability if needed?
For some companies, it proved impossible. WeWork is now a penny stock worth sub-$500M, an amount lower than what founder Adam Neumann received as a severance package.
Bird Scooters, the company broadly responsible for polluting city sidewalks with sights such as this…
Has seen its valuation fall from $2.6B to ~$30M as it struggles to remain publicly listed.
And Uber, the poster child of the low-interest rate era, looked no different at first. For 3+ years after its IPO, Uber managed to underwhelm investors with quarter after quarter of net losses, and its stock struggled to stay above its IPO price as a result.
But finally, after a cumulative $31B in net losses over its 9-year history, Uber did the impossible: the ride-sharing giant posted its first-ever profitable quarter, earning a $326M operating profit in Q2 of this year.
So how did they manage to pull it off? Was it because the ride-sharing industry is an easy area to “flip the profitability switch?” Unlikely, considering how Lyft has faired in recent years:
No, companies can’t just flip a “money switch.” Well, most companies can’t. But with enough VC funding, a playbook emerges that just might work. Outside funding buys a company time to operate unprofitably. If that company can undercut its competition long enough to put them out of business, and if that company can sustain a monopoly just long enough for its customers to get “stuck” on their solution, they just might be able to double their prices, cut frivolous costs, and maintain their control over their now slightly-less-happy customers. And if your company has dominated its market to the point that its name is now a commonly-used verb (seriously, no one is “Lyfting” anywhere), then yeah, it might have a shot.
And that’s just what Uber did. Before IPOing, the ride-sharing giant raised a total of ~$20B from outside investors. $20B buys you years to underprice cabs, experiment with different features like food delivery, and starve your competition out of business.
And you know what? It worked. Is it “good” for companies to artificially reduce their prices to the point that they own a market? I have no idea. But Uber managed to pull it off, kudos to them. Time will tell if any other companies (DraftKings, perhaps?) can pull it off as well.
Retail Traders Love Bankrupt Stocks?
One of the more entertaining occurrences in public markets over the last few years has been retail investors’ insistence on pouring their cash into bankrupt companies. In a world full of tech giants that generate tens of billions of dollars in free cash flow, a not-insignificant retail investor base feels compelled to throw their life savings into dying movie theater chains, bathroom accessory retailers, and, most recently, trucking companies.
Let me tell you about the curious case of Yellow, the freight-trucking company.
Last Sunday, Yellow announced that it was ceasing operations and planning to file for bankruptcy.
Normally, when a publicly traded company files for bankruptcy, any remaining cash held by the company or generated through the sale of the business and/or its assets goes to repay senior creditors, with there being virtually no chance that equity investors (aka, the folks who would buy shares of the now-bankrupt company) receive anything, with one notable exception being Hertz.
And that’s for companies that have a “normal” bankruptcy. Yellow didn’t just file for bankruptcy, the entire business is flat-out shutting down.
Naturally, on news that this company no longer exists, its stock is up 500%+ in the last ~week.
So what’s going on?
Ignoring the few investors who might simply be covering their short positions, there are two groups of folks still buying this stock:
1) Those who, due to their misunderstanding of the bankruptcy process and/or Yellow’s current situation, believe they can buy the dip and make money as the business recovers and/or gets acquired.
Those who realize it’s going to 0, but also realize that some individuals fall into group 1, and therefore believe they can buy Yellow shares and sell them to someone in group 1 at a higher price.
The investors in the second group are simply trying to benefit from The Greater Fool Theory, which states: “One can sometimes make money through the purchase of overvalued assets — items with a purchase price drastically exceeding the intrinsic value — if those assets can later be resold at an even higher price.”
To group 1’s credit, I kind of understand the thought process. If I saw thousands of internet strangers create generational wealth through well-timed investments in the likes of AMC, GameStop, Bed Bath & Beyond, and, God-forbid, Hertz, I too would be on the lookout for the next terrible company whose stock price would probably triple if it went out of business.
Some of those investors would have stumbled across Yellow and thought, “This company is worthless, but it is still trading on the public markets. If I buy it at $0.72, and it goes to $1.50, I can make, like, 100%.” Of course, someone else will see this same now-defunct trucking company and think, “This company is worthless, but it is still trading on public markets. If I buy it at $1.50, and it goes to $3.00, I can make, like, 100%.”
And this effect would snowball as everyone thinks they can buy this thing that someone will buy at a higher price, until sooner or later, that next buyer fails to show. And the whole thing collapses.
It’s like picking up pennies in front of a steamroller, but the pennies are about to get delisted and the steamroller is a private equity consortium that plans on wiping out 100% of shareholder equity.
So anyway, the stock will probably climb another 150%.
Does the Fitch Downgrade Actually Matter?
In politics, when two candidates emerge as the frontrunners for a particular office, the third candidate, often out of desperation, resorts to more and more extreme attention-grabbing gimmicks in an effort to remain a relevant part of the conversation.
And this phenomenon isn’t just a politics thing! Companies do it too. If I were a credit rating agency that had, say, 15% of the global market share, and the two larger players each had 40% of the global market share, in an effort to make headlines, I might downgrade the Long-Term Foreign-Currency Issuer Default Rating (IDR) of the world’s most powerful country to 'AA+' from 'AAA.'
Which is precisely what Fitch did.
I personally had never heard of “Fitch Ratings” before their recent US downgrade, but here I am writing about them. Mission accomplished.
Fitch stated that their rating downgrade of the United States reflects “the expected fiscal deterioration over the next three years, a high and growing general government debt burden, and the erosion of governance relative to 'AA' and 'AAA’ rated peers over the last two decades that has manifested in repeated debt limit standoffs and last-minute resolutions.”
Which all sounds credible, serious, and ominous, except for one small detail: The entire world kind of runs on dollars.
I’ll be the first to tell you that it probably isn’t a good idea that our federal government runs an ever-increasing deficit, especially as rising interest rates will make our government debt more expensive to service.
But… what’s the alternative?
Do we really believe that a shrinking economy like the European Union or an authoritarian regime such as China will suddenly usurp the US Dollar to claim the slot as the world’s primary reserve currency? Not likely!
But let’s wargame this a bit. Say that the US dollar did have a fall from grace, possibly in the aftermath of a US economic collapse. Are these other AAA-rated nations such as Australia and Luxembourg going to be spared from the ensuing fallout? Seems unlikely to me!
You can acknowledge that our nation’s current fiscal policy isn’t great while also accepting that most headlines surrounding said fiscal policy don’t carry much weight.
This is one of many such instances.