Thursday, July 20, 2017

And Then You Pull the Switch

       A great many tech companies, Amazon is the most famous example and Snap is one of the most recent, are valued on what I call an "and then you pull the switch" basis.  By this I mean during phase one the company's goal is to build market share.  During this phase, the market focuses on subscriber growth and locking in subscribers, not current cash flow.  Then in some future phase two, the company is assumed to "pull the switch" and start making big profits from those locked in subscribers.  Ironically, 20 years after its IPO, Amazon is still widely interpreted as being in phase one.

       The critical valuation question is whether there will actually be a phase two in which the company pulls the switch and raises prices to customers and advertisers and, thereby, starts generating big cash flows or whether counterparties will pull their on switch and jump to another company.  I think Netflix is particularly vulnerable in this respect.  I do not see the customers being locked in sufficiently to justify the company's massive multiple of 230.  It is too easy for customers to switch if Netflix raises prices.

       In all of this it is critical to remember that value comes from cash flow, not customers.  For a comapny to have huge value today with small current cash flow, the switch they are planning to pull must be a big one indeed.  And when that big switch is pulled all the customers must stay with the company.

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