Trumped! A Nation on the Brink of Ruin... And How to Bring It Back

by David Stockman

  Likewise, Amazon may well be effecting the greatest retail revolution in history, but it’s been around for 25 years and still has never posted more than pocket change in profits. More importantly, it is a monumental cash-burning machine that one day will run out of fuel.

  During the LTM period ending in June 2016, for example, it generated just $6.3 billion of operating free cash flow on sales of $120 billion. It was thus being valued at a preposterous 58X free cash flow.

  So here’s the thing. The Four Horsemen last time around were great companies that have continued to grow and thrive ever since the dot-com meltdown. But their peak valuations were never remotely justified by any plausible earnings-growth scenario.

  In this regard, Cisco is the poster child for this disconnect. During the last 15 years its annual revenues have grown from $15 billion to nearly $50 billion, and its net income has more than tripled to nearly $10 billion per year.

  Yet its market cap today at $150 billion is just 25% of its dot-com bubble peak. In short, its market cap was driven to the absurd height recorded in March 2000 by the final spasm of a bull market, when the punters jumped on the last “momo” trains out of the station.

  This time is surely no different. The FANG quartet may live on to dominate their respective spheres for years or even decades to come. But their absurdly inflated valuations will soon be deFANGed.

  FACEBOOK’S BICOASTAL BUBBLE BINGE—THE ONCE AND FUTURE “FACEPLANT”

  Indeed, the so-called social media stocks represent the very essence of the bicoastal Bubble Finance prosperity of Wall Street and Silicon Valley.

  The truth is, Facebook—along with Instagram, WhatsApp, Oculus VR and the 45 other testaments to social media drivel that Mark Zuckerberg has acquired with insanely inflated Wall Street play money during the last few years—is not simply a sinkhole of lost productivity and low-grade self-indulgent entertainment. It is also a colossal valuation hoax, and one that is heading for another “Faceplant” when the third great financial bubble of this century comes crashing down.

  Why? Because at bottom, Facebook (FB) is just an internet billboard. It’s a place where people idle their time—especially millennials in or out of their parents’ basement. Whether they grow tired of Facebook remains to be seen, but one thing is certain.

  To wit, FB has invented nothing, has no significant patents, delivers no products and generates no customer subscriptions or service contracts. Its purported 1.8 billion monthly average users are fiercely devoted to free stuff in their use of social media.

  Therefore, virtually all of its revenue comes from advertising. But ads are nothing like a revolutionary new product such as Apple’s iPhone, which can generate tens of billions of sales out of nowhere.

  The pool of advertising dollars, by contrast, is relatively fixed at about $175 billion in the United States and $575 billion worldwide. And it is subject to severe cyclical fluctuations. For instance, during the Great Recession, U.S. advertising spending declined by 15% and worldwide spending dropped by 11%.

  And therein lies the problem. Due to its sharp cyclicality, the trend growth in U.S. ad spending during the last decade has been about 0.5% per annum. Likewise, global ad spending increased from about $490 billion in 2008 to $575 billion in 2015, reflecting a growth rate of 2.3% annually.

  Yes, there has been a rapid migration of dollars from TV, newspapers and other traditional media to the digital space in recent years. But the big shift there is already over.

  Besides that, you can’t capitalize a one-time gain in sales of this sort with even an average market multiple. And that’s saying nothing about the fact that FB’s recent $360 billion market cap represented a preposterous multiple of 225X its $1.6 billion of March 2016 last-12-months (LTM) free cash flow.

  For the June 2016 LTM period, in fact, its multiple was infinite because its free cash flow was actually negative $1.5 billion.

  In any event, the digital share of the U.S. ad pool rose from 13.5% in 2008 to an estimated 32.5% last year. But even industry optimists do not expect the digital share to gain more than a point or so per year going forward. After all, television, newspapers, magazines, radio and highway billboards are not going to disappear entirely.

  Consequently, there are not remotely enough advertising dollars in the world to permit the endless gaggle of social media entrants to earn revenue and profits commensurate with their towering valuations and the sell side’s hockey-stick growth projections. In social media alone, therefore, there is more than $1 trillion of bottled air.

  In fact, in a milieu built around the concept of free stuff, the massive amount of speculative venture capital that has entered the social media space is certain to drive customer-acquisition and customer-service costs ever higher and margins to the vanishing point.

  The fact is, none of the social media competitors, not even Facebook, have a permanently defensible first-mover advantage. That is evident in the current tally of 140 so-called venture capital “unicorns.” Each has a private pre-IPO “valuation” of $1 billion or more, or at least did until recently when the drought of IPOs has begun to puncture the fantasy. Even then, the group is still “valued” at $500 billion in the rarefied precincts of Silicon Valley.

  But the unicorns are doing two things that will eventually eviscerate FB’s massively bloated valuation.

  First, they are hatching new competitors like there is no tomorrow.

  Secondly, and more importantly, they are burning venture capital by the tens of billions attempting to find “users” and customers and attain business viability by buying mobile advertising from . . . yes, Facebook!

  As we learned from the dot-com bust, when freshly minted companies start taking in each other’s laundry in Silicon Valley things get way out of whack. Capital morphs into revenue and “burn babies” temporarily and deceptively appear to be a booming new customer base.

  That is, until the bubble implodes, new capital flows dry up, startups disappear en masse and revenue from their purchases of equipment, services (for example, Amazon’s cloud services) and advertising vanishes.

  And that gets us to the ludicrous hockey sticks on which FB’s current valuation is based—even as the end-of-bubble handwriting is already on the wall.

  Startup-company space, for example, is being vacated all over the place in San Francisco, and real-world consumer-products companies like the mighty Proctor & Gamble have already decided to stop paying exorbitant rates for Facebook’s ineffective targeted mobile advertising.

  Nevertheless, Merrill Lynch is currently projecting that Facebook’s $16.6 billion of ad revenue in 2015 will grow by 84% to $30.5 billion by 2017.

  But what would happen if it turns out that the central banks have not abolished the business cycle after all?

  Assume that the growing signs of global recession are not irrelevant and that a downturn materialize between now and then, and that it results, for example, in an ad spending decline about half as severe as the Great Recession.

  Accordingly, this time world ad spending would drop by only 5%, not 10–15%, to about $545 billion. Furthermore, assume optimistically that the digital ad share gains another two points per year, rising from 26% of global ad spending last year to 30% by 2017.

  Under those perfectly sober assumptions, digital spending would rise by about $15 billion over the next two years from the $150 billion level achieved in 2015. And in the non-search segment where FB competes—that is, the portion outside of Google’s near monopoly—the gain would be about $7.5 billion.

  In short, the Wall Street hockey stick brigade is essentially projecting that FB will pick up 200% of the available new ad dollars that would likely materialize under an even moderate global-recession scenario.

  But that isn’t even the half of it. Even a hint of recession would knock the props right out from under the monumentally bullish financial-market bubble that has been fueled by the Fed and other central banks since the 2008 crisis.

  History leaves little d
oubt about what happens then. The massive amount of venture capital pouring into Silicon Valley and the social media space would dry up in no time; and the “burn baby” ad spending by the unicorns and other startups would quickly vanish.

  So instead of growing at 40% per year, there is a very distinct possibility that FB’s sales will slump to the single-digit range not too many quarters down the road.

  Stated differently, Facebook is a valuation train wreck waiting to happen. It is spending tens of billions on acquisitions of companies that do not even have revenues and ramping up its internal operating costs at staggering rates of gain.

  This means that when ad spending hits the recessionary skids in the months ahead—look out below. Its stock price will crater.

  In short, Bubble Finance hype is the sum and substance of Facebook’s crazy valuation and its modus operandi. But its founder, controlling shareholder and CEO, the brash young Mark Zuckerberg, is no Bill Gates. Not by a long shot.

  Gates was a true business genius who created an essential component—desktop operating systems—of the internet age. By contrast, Zuckerberg happened to be hanging around a Harvard dorm room just as the central bankers of the world were cranking up their printing presses to warp speed.

  The hallucinatory sense of grandeur that accompanied Facebook’s IPO eight years later in May 2012 has been on display ever since. But Zuckerberg’s madcap M&A frenzy—culminating in the insane WhatsApp deal—may well become the defining moment for the third and final bubble of this century.

  To wit, Zuckerberg paid the stunning sum of $22 billion for a social media outfit that had just $10.2 million of revenue. The purchase price thus amounted to 2,150X sales.

  And while you are at it, just forget about the fact that WhatsApp actually lost half of a billion dollars during the year prior to the deal’s close in October 2014.

  Then again, the way you lose such staggering amounts of money on virtually no sales is quite simple. That is, you adopt a business model that even the most intellectually challenged hot dog–stand operator would not have contemplated before the age of Bubble Finance.

  Namely, plow headlong into a huge business operated by the biggest telecom companies in the world—in this case, one that generates $20 billion in annual billings for the wireless carriers. And the key to grabbing market share in that brutal neighborhood: offer your service for free!

  That’s right. WhatsApp is just a text-messaging service that challenged the paid SMS services of AT&T, Sprint, Verizon and the rest by reducing the transmission charge from $10–$20 per month to, well, nothing.

  The CEO of a competitor succinctly explained why this tactic works:

  “It always comes down to the economics,” said Greg Woock, the chief executive of Pinger. “Free is a compelling price point.”

  Yes, it is. Not surprisingly, WhatsApp’s free messaging service had gone from a standing start in 2009 to 400 million users by 2014. Now that’s the kind of “growth” that social media bubble riders can get giddy about.

  But it amounted to this: Facebook paid $55 per user for a business that had 13 cents per user of revenue.

  But never mind. Having virtually his own legal printing press—FB issued $17 billion of freshly minted stock to pay for most of the deal—Zuckerberg explained it this way:

  Our strategy is to grow and connect people. Once we get to 2–3 billion people there are ways we can monetize.

  In fact, WhatsApp now has nearly 1 billion users, but still no revenue and has actually eliminated a minor annual user charge. If this sounds vaguely like the dot-com mania in early 2000, it is and then some.

  TESLA—BONFIRE OF THE MONEY PRINTERS’ VANITY

  But the social media billionaire brats are not the half of it. The central bank money printers have transformed Wall Street into a nonstop casino that has showered a tiny slice of hedge funds and speculators with unspeakable windfalls from the likes of monstrosities such as Valeant and hundreds of similar momentum bubbles.

  Just consider the shameless mountebank who has conjured the insane valuation of Tesla from the gambling pits of Goldman Sachs and Wall Street. The company has never made a profit, never hit a production or sales target and has no chance whatsoever of becoming a volume auto producer.

  Indeed, at this late stage in the bubble cycle, the Wall Street casino is festooned with giant deadweight losses waiting to happen. But perhaps none is more egregious than Tesla—a crony-capitalist con job that has long been insolvent, and has survived only by dint of prodigious taxpayer subsidies and billions of free money from the Fed’s Wall Street casino.

  Not surprisingly, the speculative mania on Wall Street has reached such absurd lengths that Tesla is being heralded and valued as the Second Coming of Apple and its circus-barker CEO, Elon Musk, as the next Henry Ford. Indeed, so raptured were the day traders and gamblers that in the short span of 33 months between early 2012 and September 2014 they ramped up Tesla’s market cap from $2.5 billion to a peak of $35 billion.

  That’s a 14X gain in virtually no time—and it’s not due to the invention of a revolutionary new product like the iPad.

  Instead, we’re talking about 4,600 pounds of sheet metal, plastic, rubber and glass equipped with an electric-battery power pack that has been around for decades and that is not remotely economic without deep government subsidies.

  Beyond that, the various Tesla models currently on the market carry price tags of $75k to more than $130k. So they are essentially vanity toys for the wealthy—a form of conspicuous consumption for the “all things green” crowd.

  But notwithstanding all the hype on Wall Street, there had been nothing remotely evident in its financials that justified Tesla’s market cap of $35 billion at its peak, and which still floats in the financial stratosphere at $29 billion.

  Net sales for the LTM period ended in June 2016 amounted to $4.6 billion, meaning that speculators were putting a Silicon Valley–style multiple of 6X sales on a 100-year-old industrial product—and one sold by a fly-by-night company distinguished from its auto-company peers, which trade at 0.5X sales, only by marketing hype and a high-cost power plant that could be made by any of a dozen global car companies if there was actually a mass-market demand for it.

  Needless to say, Tesla’s meager LTM sales were not accompanied by any sign of profits or positive cash flow. June’s LTM net income clocked in at -$1.13 billion. Worse still, its cash flow from operations of $333 million was further compounded by CapEx of $1.32 billion.

  Altogether, then, its operating free cash flow for the last 12 months amounted to -$1.7 billion, and that was on top of $4 billion of red ink during the previous five years.

  Unless you are imbibing the hallucination-inducing Kool Aid dispensed by Goldman Sachs, which took this red-ink machine public in 2009 and has milked it via underwritings, advisories and early-stage investments for billions ever since, Tesla’s valuation was patently absurd.

  Yet the gamblers had earlier piled in based on the utterly improbable assumption that oil would remain at $115 per barrel forever; that a mass market for electric-battery autos would soon develop; and that none of the powerhouse marketing and engineering companies like BMW, Toyota or even Ford would contest Tesla for market share at standard-industry profit margins.

  The truth is, there is massive excess capacity in the global auto industry owing to government subsidies, bailouts and union protectionism that keep uncompetitive capacity alive; and that chronic condition is now especially pronounced due to the wildly soaring growth of excess production capacity in China.

  This means, of course, that the global economy is literally saturated with expert resources for auto engineering, design, assembly, machining and component supply.

  Consequently, if a mass market were to develop for battery-powered vehicles these incumbent industry resources would literally swarm into Tesla’s backyard. In so doing, they would eventually drive margins to normal levels, sending Elon Musk’s razzmatazz up in the same cloud of smoke that
has afflicted many of his vehicles.

  Here is the simple proof. There is no reason to think that any long-term mass-market player in the auto industry could beat Toyota’s sustained performance metrics.

  In the most recent period, its net profits amounted to 7.5% of sales and it traded at 11X LTM net income. So even if you take as granted the far-fetched notion that in a world of $2–$3 per gallon gasoline—which is likely here for a sustained duration—that a mass market will develop for electric-battery vehicles, Tesla would still need upward of $50 billion of sales at Toyota profit rates and valuation multiples to justify its current market cap.

  So, given Tesla’s $4.6 billion of LTM sales you would need to bet on an 11X gain in sales over the next few years, and also that today’s rag-tag startup manufacturing operation could achieve levels of efficiency, quality and reliability that it has taken Toyota 60 years to perfect.

  Yet take one hard look at Tesla’s historical financials and it is blindingly evident that there is no reason for such an assumption whatsoever. It is not a Toyota in the making.

  To the contrary, it’s a Wall Street scam in plain sight. It has been a public filer for nine years now, and here are the horrific figures from its financial statements.

  Since 2007 it has booked cumulative sales of just $12.5 billion, and that ain’t much in Autoland. In fact, it amounts to about two weeks of sales by Toyota and four weeks by Ford.

  Likewise, its cumulative bottom line has been a net loss of $2.9 billion, and the losses are not shrinking—having totaled nearly $1.5 billion in the last six quarters alone.

  More significantly, during its entire nine years as a public filer, Tesla has failed to generate any net operating cash flow (OCF) at all, and has, in fact, posted red ink of $1.1 billion on cash flow from operations. During the same nine-year span ending in Q2 of 2016, its CapEx amounted to a cumulative $3.9 billion.