Estimated Reading Time: 25 minutes. Click here to read this article as a PDF. The…
“The dogmas of the quiet past, are inadequate to the stormy present. The occasion is piled high with difficulty, and we must rise — with the occasion. As our case is new, so we must think anew, and act anew. We must disenthrall ourselves, and then we shall save our country.” Abraham Lincoln, annual message to congress 1862
When Earnings Are Irrelevant
Investors and traders everywhere are about to head into a gruesome earnings season for the second quarter. We haven’t had a quarter like this one in post war history. Of course, no news there. But we believe the read coming from companies in the second quarter, particularly as it relates to earnings, will be largely irrelevant at best and possibly misleading at worst. But the discussions on what the companies did during this most remarkable quarter and first half will be highly informative. Did the companies retrench or did they have a customer-first and market attacker mindset? The two approaches have very different implications on the bottom line.
You are defined by how you respond when everything is going against you. How we act in easy times means little to shaping our character. But maintaining composure, and perhaps, even seizing opportunity during a most painful period is where we see companies transform their prospects nearly over night. Losing your cool when the world around you is in turmoil is equally brand and company destructive. When holding a mirror to ourselves, of course, this all sounds quite reasonable.
But we’ve seen substantial evidence from their notes in recent weeks that Wall Street analysts are still buried in their excel models, and are mostly concerned with quantifying the Covid-19 impact on the short-term rather than understanding the consequences of management actions and their effects in the quarters and years to come. This is a lost opportunity on their part.
Nearly all businesses have dramatically cut brand advertising and headcount associated with strengthening and maintaining customer relevance. This is a great way to mitigate near-term earnings impact, but leaves a void in which startups can come from nowhere and make impressions when consumers are most adaptable and open to change. We’ve seen from the inside how some medium-sized businesses have used the pronounced shock to physical retail combined with the paradoxical weakness in Digital advertising pricing to scale their businesses by multiples rather than percentages.
Long-Term Value Creation Usually Reduces Near-Term Earnings
The most prodigious value creators yin while most others yang, or as others have said it, they zig while the others zag. In short, contrarian behavior is one of the most common attributes to the most impressive value creative feats in history. Covid-19 will prove no exception to this rule. Companies following the traditional playbook of furloughs, headcount and advertising reductions, supplier squeezes and R&D reductions will have a softer impact in the second quarter, but are trading long-term value for short-term benefits.
In some industries we are tracking, the quarterly progression has been so dynamic that in June, certain business activities are quite nearly back to normal. For those businesses that were focused on cutting expenses, many will be caught flat footed as industry conditions normalize. Other companies focused on winning new customers and taking market share are doing so without regard to immediate profitability. In fact, putting the customer first and bringing forward product innovation and launches almost always have negative profitability effects. This is particularly the case in the modern services-dominated economy, where new initiatives, promotions, and customer acquisitions, almost always show up as an expensed hit to profit rather than a capital investment.
Of course, in certain industries, like travel, many have taken the stance that behavior will not return to prior levels for years at best. These firms have all responded with pronounced headcount reductions, with nearly all maintaining healthy R&D budgets to stay competitive beyond the next year. We wouldn’t argue with some of these measures, even though the pace of improvement in the travel impulse has been quite a bit stronger than most have anticipated (you can read about it in our recent flash note on Liberty TripAdvisor on our research page). So there are always exceptions, and many of them, to this view point of trading short term profit for long term value.
But the overall point here, is that in studying the behavior of founder-led and family-owned businesses over the past few decades suggests that these business do not prioritize profit margins, they nearly always invest in their businesses to generate industry-leading revenue growth. They grow their people more quickly, they invest in physical property more quickly and they shun acquisitions, buybacks and dividends more than their indexed counterparts.
They invest through economic downturns, and while their stocks suffer more than the index in most market declines (with the most recent one being no exception), they come back firing on all cylinders. They still have their key people. They (hopefully) made very favorable impressions with their customers when the outlook was bleakest. They kept their suppliers alive with timely payments terms. This will no doubt have wide-ranging working capital effects on free-cash-flow. They kept investing in innovation and likely have new products or offerings coming out of the downturn. All of those actions lead to a more pronounced and near-term earnings de-leverage on weaker sales, but lead to a slingshot effect when coming out of the downturn.
And so we’ve seen some sell-side analysts downgrade stocks based on the Q2 hit to earnings based on Covid-19. This is naive at best, and perhaps contrary to what many should be doing at a time like this. We’re not trying to paint the world with one color, because this observation will have thousands of caveats, so I wanted to give a few examples to underline the point – and not just with the companies we own.
Surviving or Thriving? A Few Examples
Robotic surgical company Intuitive Surgical, with no net debt (founder and family-led businesses carry systematically less debt to keep them more resilient and more opportunistic), has been offering its customers very generous payment terms. In fact, it has been giving its very expensive DaVinci robots away to some customers for free. Those surgeons that have remained open throughout this period in which traditional healthcare has suffered dramatically, have been growing like weeds. Because Intuitive gets paid for every procedure performed on its robots, these customers that are growing through the downturn, in some cases, have already seen their invoice forgiven on the additional robot they took. It will likely translate into a pronounced hit to Intuitive’s FCF in the quarter, but it absolutely has built tremendous goodwill with these quickly growing customers. Did Intuitive have to do it? Of course not, but by doing so, they’ve considerably strengthened some of their customer relationships through Covid-19.
There are countless other examples. Peloton, opened up its leading workout-from-home streaming service to non-subscribers for free during the period of lockdown. This brings zero revenue and incremental costs (to pay the music labels). Furthermore, the company is going to forgo loads of stationary bike sales to encourage exercisers to use the equipment they already have in their home. But the company’s primary motivation, believe it or not, isn’t to sell equipment. Peloton’s North Star has been to encourage everyone to exercise more frequently and live a better life, regardless if it’s on their bikes or an old treadmill already sitting in the basement. Its entire ecosystem is designed to encourage its “one peloton” to become healthier and happier. It has the second highest Net Promotor Score (NPS) in the world, and it has said it won’t rest until its NPS hits 100. Its actions throughout the Covid-19 lockdown have put it a bit closer to getting there.
In stark contrast to Peloton, a clear beneficiary of Covid-19, Rolls-Royce has been dealing with the opposite situation. It faces years of its wide-body fleet being underutilized and far below prior projections, for which it was consistently building its workforce. The company has approached unions to remove nearly half of the fixed costs in its civil aviation business so it can continue to invest in its next generation engines, which will be even more needed by Boeing and Airbus coming out of Covid-19. Rolls has contractual commitments in its service agreements that give it the legal right to demand cash from airlines even if those engines aren’t flown. Enforcing these contracts, when these airlines are walking on the razor’s edge on solvency would be very destructive to these multi-decade relationships. So Rolls has to take it on the chin while its customers do, even though it didn’t have to.
We’ve talked to numerous executives in the past couple of months that have highlighted how the more desperate companies in their industries have been taking a hostile or aggressive stance towards their customers, forcing contractual commitments to take or pay even when their own businesses have temporarily evaporated. This is a terrific way to permanently sour those relationships, but it is the profit-maximizing route that we believe some companies are taking.
A mall that we’re short responded to the government-mandated shutdown of its properties by legally threatening their tenants, and in certain instances actually sued them if they didn’t pay their rent due during the period in which physical stores saw zero traffic. In the United States, which has five to eight times the physical retail square footage per capita than other countries have, in an era in which physical retail experience is becoming increasingly irrelevant for more and more consumers, it wouldn’t be irrational to suspect the first locations that will be permanently shut will be in this REIT’s malls. Co-tenancy clauses that allow lease breaks when more than one anchor tenant leaves, will also encourage these tenants to treat their landlord in an equally hostile manner in the coming months. So was the April-May rent check worth it? Hardly.
Twitter, a recent portfolio addition, has been investing in its platform to improve the health of the conversations taking place on the site. This brought the company to start labeling misleading tweets by President Trump as false. This led to an entire movement by certain brands to #banprofitforhate. Ironically, Twitter has been captured by some advertisers in their July advertising boycott, that its own actions inspired. Throughout the period of Covid-19 and the George Floyd protests, as the global conversation has turned very serious, the platform has seen record levels of engagement and new user growth. When the conversation turns important, we think the world turns to Twitter, not any other social platform. So it has seen its new user addItions, search trends and daily utilization hit record highs in recent months. At the same time, the company just reported a very weak quarter for revenue and consequently earnings (which were very negative). So the second quarter earnings metric, while the service couldn’t be more culturally relevant, is perhaps the most irrelevant report card investors could use to gauge how well the company has gotten through this period of great turmoil.
As we were going to publish this article, Twitter confirmed exactly what we had anticipated, but it seems, tech investors more closely closely scrutinize underlying business fundamentals and the immediate reaction has been positive. Not many other sectors could be so lucky to have investors evaluating the drivers that will determine their long-term value as opposed to the last quarter’s earnings. While value maximization (over profit maximization) has a natural audience in growth-oriented tech sector, the dynamics that allow tech companies to build long-term value are nearly identical in other companies not in the tech industry.
The Global Pivot
By definition, one cannot invest in growth without having an impact either on earnings or cash-flow, or likely both. Don’t get us wrong, sometimes profit maximization is the most elegant answer for post-growth businesses. But family and founder led businesses that are constantly evolving show that there could be no such things as a post-growth business. A good friend in the industry observed with me Friday that in looking back at their most impressive value creating managers, it was their ability to pivot and change course that ended up allowing them to produce staggering returns.
2020 has brought a series of unfortunate events for all of us on the planet. We can’t chose the time we live in, we can only choose our response. When a family or medical emergency surprises us, do we think about the monetary impact? Of course we don’t. We do whatever it takes to make situation right. The response on an individual level is quite clear. We care for others as much as possible, ensure their safety and seek to alleviate suffering wherever possible. We can’t use a double standard when it comes evaluating our investments. Doing the right thing during periods of turmoil often brings a sacrifice in profitability. But in many cases, it’s the right thing to do to ensure these businesses come rocketing out of the period of turmoil.
We’d all do well to remember such as we head into a most informative, but also irrelevant earnings season. Let’s all look at what the companies have done, not what profit they printed in the quarter.
This article has been distributed for informational purposes only. Neither the information nor any opinions expressed constitute a recommendation to buy or sell the securities or assets mentioned, or to invest in any investment product or strategy related to such securities or assets. It is not intended to provide personal investment advice, and it does not take into account the specific investment objectives, financial situation or particular needs of any person or entity that may receive this article. Persons reading this article should seek professional financial advice regarding the appropriateness of investing in any securities or assets discussed in this article. The author’s opinions are subject to change without notice. Forecasts, estimates, and certain information contained herein are based upon proprietary research, and the information used in such process was obtained from publicly available sources. Information contained herein has been obtained from sources believed to be reliable, but such reliability is not guaranteed. Investment accounts managed by GreenWood Investors LLC and its affiliates may have a position in the securities or assets discussed in this article. GreenWood Investors LLC may re-evaluate its holdings in such positions and sell or cover certain positions without notice. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of GreenWood Investors LLC.
Past performance is no guarantee of future results.