It has never been a pleasant experience when eventually I have had to admit to each child that Santa isn’t real.  The realisation has been devastating for them and their disappointment has been expressed by the entire gamut of emotions.

I suspect there will also be a few tears after grown-up investors realise unicorns don’t actually exit.

When a start-up reaches a private market valuation of a billion dollars its status is said to be so rare that it can only be called a unicorn.  Upon reflection, through tears, many investors will realise that the plethora of unicorns was always inconsistent with the rare status implied by their names.

The thing about these multi-billion-dollar valuations is that they are simply decided by the people making the investment. I have been seated in meetings with start-ups where investing has been agreed and then the valuation ‘discussed’.

Of course, each funding round provides the company with funds necessary to source more staff, more customers, more computers, more office space or whatever it needs to give the appearance of success. Often, if not usually, the company continues to lose money.  This latter observation is a function of the fact many of the unicorns gained market share and customers by selling their product or service at a steep discount. Consider Uber, for example; its popularity must be because its service is too cheap. It has not generated an economic return at any point in the last decade. It’s not hard to see how these businesses have scaled massively when they are selling their services at steep discounts to the value offered.

Ignoring the lack of profitability or even growing losses, investors willingly lean on the larger customer base or greater market penetration to justify a higher valuation. Of course, this pattern of higher valuations is also self-serving, as the higher valuation preserves, if only ‘on paper’ and temporarily, the previous valuation. It creates the appearance of being a profitable investment despite the lack of profitability of the underlying business model.

But there must be a limit to the willingness of investors to pay ever higher multiples for a business that is profitless, as WeWork and Peloton recently demonstrated.

Virtual office space provider WeWork – a company I warned investors earlier this year would turn into a disaster – cancelled its IPO after brokers refused to support the US$47 billion valuation equal to its January 2019 funding round valuation. It was a valuation that was greater than that of the landlords it was renting its space from. To avoid subsequent bankruptcy, it was reported Softbank provided a lifeline at a valuation of ‘just’ US$8bn. In addition to the US$39 billion lost, thousands will lose their jobs and that could be another important side note as the Unicorns are relegated to their place in childrens’ fairy tales.

I remain dumbfounded how a company that merely aggregated space and re-let it in smaller parcels to start-ups could have a market capitalisation greater than the aggregate of the companies that owned the real estate.

Wework is accompanied by Peloton in the Unicorn stable of companies that believe too highly in themselves.

Unlike WeWork, Peloton managed to get its IPO away at US$8billion despite generating less than $1 billion of revenue and losses of almost US$200 million. Peloton’s US$3000 stationary exercise bikes and treadmills, along with accompanying subscription, are a fad.  Those who believe in the company say it’s a tech company. The only problem with this description is that Peloton spends only six per cent of its revenue on research and development. That’s not very ‘techy’ at all.

Other supporters see a business model akin to Apple or Gillette, suggesting it is selling and tying members into an ecosystem. The problem for Peloton’s ecosystem is climate change. Fitness is good for you but it is rife with fads and the equipment is forever changing.  Peloton’s equipment is today’s version of the vibrating belt of the 1960s, Jane Fonda’s 1980s aerobics videos, rollerblading in the 1990’s, Nintendo’s Wii Fit in the 2000’s and most recently, F45 classes or Soul Cycling/spin classes. People will soon tire of their Peloton bike taking up space in their Manhattan bedsit and will move on as surely as they did from their ab-blaster and thigh-master.

Elsewhere, Uber and Tesla prove that unicorns can survive after being seen by humans. With Porsche, VW, Audi and Mercedes all launching electric vehicles, and with Toyota investing billions in Hydrogen engine development, competition is fast approaching and Tesla may have to cut prices to achieve the volume necessary to generate enough cash flow to sustain itself. What if the company cannot manufacture vehicles cheaply enough to make a profit?

Uber’s attempt to create a network effect – becoming more valuable as more customers adopt it – appears to be failing. For the network effect to work, more users must make the service better, but one person in an Uber to the airport doesn’t make the service more valuable in an Uber heading to work. Nor does Uber benefit from scale advantages. Investors in Uber should ask themselves why taxi companies – which have been around for more than half a century – rarely, if ever, monopolise more than one city? And why has there been little desire on the part of investors to consolidate operators?

As with Tesla, Uber’s backers didn’t count on competitors rapidly setting up their alternative offers. Lyft in the US, Didi in China, EasyTaxi in Latin America, Grab in Asia, Yandex in Russia (now merged with Uber), Careem in the Middle East, Taxify (backed by Didi and now rebranded Bolt) and Gett in the UK, Israel and Russia, are sufficient evidence of lower than anticipated barriers to entry and a commoditisation of the offering.

I have little doubt that Tesla and Uber will not exist in a decade’s time in the same form as they do today. Unicorns belong in fairy tales and the idea that never-ending business losses can generate investment profits should also be constrained to fables.

Roger Montgomery is the chairman and chief investment officer of Montgomery Investment Management.
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