Reflexivity going in reverse
Let’s think back to the 2010’s. The FED had just introduced ZIRP, and TINA (there is no alternative) was the talk of the town. In search of yield, wealth managers shifted their bond allocation to blue-chip dividend stocks. In contrast, traditional dividend investors moved up the risk curve to anything that offered a safe, juicy yield.
Wall Street responded as it always does: by introducing highly financial-engineered products on which it could charge investment banking fees. More specifically, capital-intensive companies were encouraged to split off their stabilized, FCF-generating assets in a YieldCo, which would trade at a higher multiple simply because it offered a (hopefully) safe dividend yield.
The MLP (Master Limited Partnership) structure has been around since the 1980s, when it was introduced to provide tax advantages to passive investors in natural resources. But the structure was popularized in the 2010-2014 period, when the search for yield coincided with the US shale boom – a period that required vast amounts of capital to build out midstream assets.
But as the structure became more popular, it branched out. Drill rig operators, shipping companies, and developers of renewable energy projects are all parties along and set up their own YieldCo structures. Those entities were often externally managed by the parent, generating significant management fees and a performance fee called Incentive Distribution Rights.
Now, the skeptics note that a 7-8% dividend yield is nice if it’s paid in perpetuity. But since we were dealing with life-limited assets such as vessels, rigs, and pipelines, receiving dividends before the asset is retired in 15 years would merely return your initial investment. After management fees, there was very little return left for the unit holders. The shares were overvalued.
As the number of Yieldcos increased, simply offering a 7-8% dividend yield was no longer enough to stand out from the crowd. What if they could offer their investors growth on top? But how do you fund that growth if you pay out all your FCF as divvies?
The obvious solution was to issue more of the overvalued Yieldco shares and use that to buy more assets from the parent company. This was heavily encouraged by the parent companies, who, of course, launched the Yieldco to fund their growth ambitions.
And then magically, the proposition became a 7% dividend yield with 5% growth on top. Shares would rise to reflect this new reality, and more expensive shares would accelerate this reflexive process further.
And then one day, perception changed. Whether this was because the 2014 oil price crash made the market less interested in energy-related assets, or because one day the market just woke up to the level of financial engineering, MLPs lost their swagger.
And while MLP share prices fell, funding growth through equity issuance was no longer an option. The proposition of dividend plus growth became simply a story about dividends.
Because the shares went down, they became less valuable. Buying the dip got you run over.
And of course, while the MLP complex unwound, the skeptics who had been screaming all this time that a 7% dividend yield isn’t juicy at all if the remaining life of the underlying assets is only 15 years.
SunEdison was a poster child for this era. While technically a C-Corp and not an MLP, SunEdison funded its aggressive growth through dropdowns to two YieldCos: TerraForm Power and TerraForm Global. It blew up spectacularly and filed for bankruptcy in 2016, with its yieldcos both acquired by Brookfield at very distressed levels.
But why are we reminiscing about the recent past? It’s because it’s the most recent example of reflexivity going in reverse, blowing up an entire sector. We know the crypto treasury companies are competing heavily for this spot, but this is still work in progress, and frankly, we ran out of Michael Saylor memes.
With that in mind, let’s circle back to today.
Today’s companies, like any others in history, aspire to grow. And growth requires capital. Looking at today’s market with a strongly simplified view, we’ve got asset-heavy companies that funded their growth ambitions the old-fashioned way: with debt, and we’ve got an increasing number of asset-light companies whose investments run through the P&L as they increase their headcount. We wrote about this in our piece on no-earnings companies back in December.
Wall Street’s greatest trick was to convince the market that there was a way to fund this growth without running this cost through your P&L. By paying employees in a combination of option grants and restricted stock units, together called stock-based compensation, companies created an expense that did not impact their FCF metrics.
And while GAAP accounting requires companies to expense SBC, companies have gotten away with adjusting them out. Analysts on the sell side blindly copy management’s definition of adjusted earnings, and forward earnings are all based on those sell-side estimates. Keep that in mind next time someone shows you a slightly elevated S&P500 P/E multiple… most of the time those estimates exclude a very high cost.
While this trick is as old as time, the SBC-to-revenue ratio has grown significantly. Part of this might be attributed to the increased weight of tech companies in the S&P500, but once companies realized this glitch in the Matrix, it only made sense that they started taking advantage of it.
Even many of the skeptics were told that you needed to account for SBC by modeling dilution. What is 3% dilution in a company that is growing 15% per year?
Not dissimilar to MLPs, they created a situation in which they could use their overvalued shares to fund their growth.
And not dissimilar to MLPs, this worked until one day it didn’t.
This time, the shock wasn’t a selloff in oil prices, but a fear that AI would disrupt the entire world and make many business models unviable.
Regardless of what caused the shock, what matters is the impact on dilution.
3% growth on a company that used to grow 15% sounded like a great deal. But what if those companies go ex-growth? What if the share price is down 70%? Do we now have a company with 10% dilution and no growth? Suddenly, GAAP earnings are beginning to matter.
But it’s worth more than that. Imagine being a software engineer living in San Francisco, barely covering your cost of living with your base salary, simply because you believe your stock options will make you rich. That dream has just been shattered. What good is a people-intensive business once it loses the goodwill of its employees?
In short, the excessive use of SBC allowed a reflexive process that gave companies cheap capital to fund their growth. That process has now gone in reverse.
We wrote about excessive SBC in our piece on the bear market in dumb stuff. We don’t mean to beat a dead horse on this topic, but we’re a few weeks into fund letter season. We’re amazed by the number of fund managers looking at the selloff in software names without discussing the implications for SBC. “Multiples contracted with no change to fundamentals”, they say. But what if the multiple feeds into the fundamentals? Doesn’t this just echo any other reflexive process that’s gone into reverse?
Don’t be the guy who gets run over buying the dip, because you’re looking at a P/E graph that excludes a very important cost.
As a side note, some countries where SBC never took off are due to excessive taxation. FinTwit might be making fun of them for being Europoors. Still, in the current environment, tech companies with their HQ in places like Amsterdam (think Adyen (ADYEN NA) and Booking (BKNG)) positively stand out. Maybe they are AI or crypto losers (we don’t think so), but at least their earnings are real.