As the stock market has continued its relentless, decade-long advance, rebounding quickly after steep losses during the fourth quarter of 2018, there have been a slew of high-profile and successful initial public offerings, or IPOs, in 2019. In addition, organizations around the globe are investing heavily in digital transformation. As a result, lots of small technology upstarts have been gaining interest from investors, sending share prices soaring.
Many of these newer but fast-growing businesses are not profitable, though. That may scare many investors away, and rightfully so. A company burning through cash with little to show for it is a sure way to lose money. However, there are exceptions to the rule. Some businesses, though they're losing money, are growing fast enough that a future payoff is likely. It's a strategy that worked wonders for Amazon.com investors over the years as the tech giant built its e-commerce and cloud computing platforms, one that will work again for other up-and-coming names.
Accounting, accounting adjustments, and reading between the lines
A typical statement of operations for a business follows GAAP, or generally accepted accounting principles -- listing revenue, followed by the cost to create goods and services sold, operating expenses outside of the basic cost of goods and services, and finally other income and expenses such as interest, tax, and non-cash items, including amortization and depreciation of assets or appreciation of investments.
For many high-octane growth companies, various expenses total close to or exceed revenues from selling products or services. Take Uber (NYSE:UBER) as an example, which had its IPO in May. During the first quarter, the ride-hailing giant reported revenue of $3.1 billion, up 20% year over year, but total cost of revenue and operating expenses of $4.1 billion -- good for a massive operating loss of $1 billion, compared with a loss of $478 million in 2018.
That's where non-GAAP accounting adjustments come into play. Because GAAP accounting includes one-time expenses that may not recur again as well as non-cash expenses, most companies offer adjusted reports to give better insight on the progress of the business. Uber's method of adjusting the bottom line -- adjusted EBITDA -- backs out interest paid on debt, taxes, depreciation and amortization, and stock-based compensation -- shares paid to employees as part of a paycheck, an incentive often used to lure and retain talent. Using this metric, Uber's losses during the quarter were $869 million, compared with $280 million the year prior. Better, but still a worsening bottom-line situation for such a large company.
However, companies like Uber often run at a loss by design. Operating expenses -- which exclude cost of revenue and notably include those associated with sales and marketing, research and development, and admin support -- are elevated because the company is investing back into itself to maximize its potential. That's the case with Uber. The sales and marketing line item, for example, surged 54% during Q1 2019 to over $1 billion, and research and development moved 20% higher to $409 million. Thus, simply looking at the bottom-line red isn't a good enough reason to steer clear of a stock.
Some metrics to look for
So when is it worth dropping hard-earned money on a cash-burn operation? Here are a few items to watch:
- Revenue growth. For a company that isn't yet profitable because it's investing heavily into itself, investors should be seeing a bump in sales. The rate of expansion will fluctuate from quarter to quarter, and as a business gets larger the pace will moderate, but overall a business should be growing the top line quickly to justify its self-investment.
- Gross profit margin. Gross profit margin -- the money left over after a company pays for the production or basic cost of a product or service, divided by revenue -- can be a great indicator of future business potential. Though they may operate at a loss, a high gross margin can indicate that a business is using up cash through investment, rather than burning cash just trying to offer a service in the first place. Uber's gross margin was 45.8% in Q1 2019, down from 55.2% the year prior. It's a decent number, better than the 40.4% gross margin from rival Lyft, although it's headed in the wrong direction and not as lucrative a business model as others. Cybersecurity software start-up Zscaler and Okta, for example, boasted gross margins of 81.1% and 72%, respectively, during their last quarter.
- Operating expense growth. An ideal situation is one where operating expenses are growing slower than revenue. That would indicate that a company is on the road to turning a profit. If operating expenses are growing faster than revenue is, gross profit margin should be on the rise -- indicating that a business has not yet reached profitable scale for its services, and thus the need for higher expenses now. If neither is the case, there should at least be a new business segment the company is dumping money into, a segment investors will want to monitor for progress. For Uber, that would be the food delivery service Uber Eats.
- Free cash flow. Free cash flow is a common adjusted metric that takes revenue less basic operating and capital expenses, excluding non-cash items. As a result, it gives a clearer picture of a business' true bottom line, or progress toward digging out of the hole. As a recent IPO, there isn't enough info yet to calculate this for Uber. However, Shopify (NYSE:SHOP) is another large business making fast progress on this front and knocking on the door of adjusted profitability after years of heavy investment spending. Over the past 12 months, Shopify's free cash flow is negative-$6.14 million, compared with negative-$31.5 million a year ago, getting a boost from 50% revenue growth during the first quarter.
Of course, financial metrics are only part of the equation when deciding to invest in a visionary but loss-making stock. Management's ability to articulate its vision -- and its track record in delivering results -- is a key ingredient to a company's ultimate success or failure. A large target industry ripe for disruption also helps, especially if the disruption is helping build a new industry entirely, like Shopify's efforts to empower retailers and entrepreneurs of all sizes with e-commerce capabilities.
At the end of the day, though, investing in a company that runs at a loss can be a gut-wrenching ride. Even the best high-growth revolutionary stock can be volatile at best and cause many an investor headache. Thus, only those with years to wait and with the ability to build a position in a stock over time via multiple purchases should play the game.
Nevertheless, ignoring a business because its bottom line is in the red would be a mistake. If the business shows promise and is making solid progress toward turning an eventual corner, it could be worth investors' time to buy in and wait it out.