Volume 105: A lost decade of unproductive capital.

1. A lost decade of unproductive capital.

tl;dr: VCs, startups, financialization, Meta, and more.

One of the most immediate effects of rising interest rates was widespread panic among the investor class. VCs immediately penning screeds such as this from Sequoia Capital, which across its 52 pages essentially says, “Growth is out, profits are in, capital is more expensive; get ready to cut spending now.” Ironically, this is eerily similar to how they reacted to the early days of the pandemic, which immediately preceded a valuation boom. This shows that no matter how smart we think we might be, we remain appallingly bad at accurately predicting the future. I suppose that if Sequoia Capital predicts the sky is falling often enough, it’ll eventually get it right.

Anyway, the backdrop to this is years of commoditized money. While none would admit it, the venture capital industry has been engaged in a years-long knock-down, drag-out, price promotion war. With interest rates at zero, vast amounts of capital flowed into VC coffers, seduced by the valuation growth of prior generation wins like Google and Facebook. As a result, VCs were competing to fund the “best” ideas (Best, in this case, meaning ideas brought to them by wealthy white male Ivy League graduates, irrespective of that idea’s actual business viability). Now, because there were fewer wealthy white male Ivy League graduates with startup ideas than there was capital to invest in these ideas, the VCs found themselves fighting each other for the right to invest in even the silliest and most unproductive of companies. A battle fought by offering founders more capital for a lower ownership stake at a higher company valuation. In practical terms, this is the same as you or I clipping coupons and then pitting Walmart and Target against each other on price.

To set the elevated private market valuations necessary to justify these capital infusions, VCs (loosely) use public companies as their benchmark. Something that works out awesomely when publicly traded tech firms rise in value because you get to increase the value of your VC portfolio businesses and neatly hide the fact you gave them a whole bunch of money at a huge, whopping discount. However, publically traded tech firms are now sliding, which means VCs can no longer justify fantasy valuations, which means the money is drying up.

Where once the candy jar was left out at reception for any Ivy League grad to gorge themselves, today it’s hidden away, and only the most ruthless will be allowed to have any.

Now, let’s look at an interesting second-order effect. Estimates are that 43c of every VC dollar ends up in the hands of Meta and Google. This means the more money VCs give to startups; the more revenue is generated by two of the world’s largest tech firms. This, in turn, increases their valuations, bringing other publicly traded tech stocks with them. As publicly traded tech stocks increase in value, VCs can then value their portfolios more highly, which justifies handing out more money at ever-increasing valuations…I think you can see where I’m going here. The interdependence of the whole system acting like a financialized Ponzi flywheel for the VCs, the startup founders, and Meta.

Well, that was then, and this is now, and the whole interdependent system has gone into reverse. Yesterday, Meta reported Q2 numbers, and they were ugly.

The why is simple. Startups are following VC advice and cutting spending, Apple privacy changes continue to play merry hell with the Meta business model, TikTok is eating its lunch, it’s distracted by disembodied cartoon characters with no legs, and it’s busy destroying the only good product it has by making it feel like Facebook and TikTok had an ugly baby called Instagram.

Bad results will drive Meta’s valuation down, dragging other tech stocks down too, which means the value of VC portfolios slide further, meaning less money for startups and, thus, less revenue for Meta…

Anyway. I bet you never thought an answer to Meta’s uncoordinated flailing would be increasing VC capital to startups. But there you go. Long may the world’s most dangerously unethical corporation struggle.

On a more serious note, the sad thing is that it represents the end of a decade-long infusion of what we now know to be unproductive capital. We didn’t get the next value-creating tech behemoth like Google, Amazon, or Meta. Instead, we got profitless (and likely never to be profitable) dross like Uber. Now that the antibodies in the financial system are beginning to kick in, we’ll see any number of such profitless businesses going bankrupt or getting snapped up for pennies on the dollar. And what will remain? Few built any meaningful new technology, few innovated breakthrough new business models, and few built brands with long-term value. So it’s actually kind of sad when you consider what all that capital could have gone to be long-term productive.

As an aside, this is an excellent dive into the unproductive reality of the past ten years of startups. The author points out that 67% of publicly traded former “unicorns” are so unprofitable that their cumulative losses exceed yearly revenue. If these businesses were to magically achieve 10% profitability today, it would take them until 2032 just to get out of the red. And most are nowhere near hitting 1%, let alone 10% profits.

2. Like a phoenix from the flames, the store brand rises.

tl;dr: Inflation, recession & big brand price increases = opportunity.

When I first moved to the US in 2004, I remember being struck by the awful supermarket experience. Grubby, poorly lit, narrow aisles, lousy signage, illogical layouts, and horribly designed store-brands. (I also did what I subsequently found every British ex-pat does, which is buy half & half thinking it’s half fat milk. It isn’t; it’s half milk and half cream. So let’s just say it doesn’t taste great on cornflakes and leave it at that.)

Unlike in the UK or across Europe more generally, where the most common approach to store brands has been to prominently showcase the store name via a clearly labeled cross-category approach, this didn’t seem to be how it worked in the US. Instead, the approach is more commonly one of copying the category leader and hoping the consumer doesn’t notice, which CVS, among others, still does, having launched “Gold Emblem” just last year.

At the time, I remembered what I’d been told about Tesco Value years earlier, where the point had been made that “Kellogs might be bigger than Tesco in cereal, but it isn’t bigger than Tesco,” which was a justification for the idea that copying category leaders is almost certainly the worst way to leverage a strong retail brand.

Which is a roundabout way of saying that I think most American retailers fundamentally get their store-brand strategies wrong. It’s crazy not to leverage your biggest and best-known brand inside your own stores, especially since it’s almost certainly the only brand you’re spending any money on building. (As an aside, I’m not surprised to see rumors of Amazon shuttering gazillions of its sub-scale brands as a sop to a government pursuing them for anti-competitive behavior. It’s a strategy that didn’t work for pretty obvious reasons. I guarantee, however, they won’t be killing Amazon Basics)

Anyway, the reason I’m talking about this right now is that with inflation running hot globally, big brands responding with price rises to maintain margin rather than share, and many consumers facing an unprecedented cost of living crisis, the conditions are ripe for store brands (and value brands more generally) to take advantage.

Which is exactly what’s happening. According to recent figures from the Wall Street Journal, store brands have lifted market share by over 1% to now sit at just over 26%. This suggests that an even greater shift toward value is likely if/when we slide further into a recessionary cycle.

So far, the big CPG/FMCG corporations have responded bullishly by claiming to have learned from a Latin American playbook vis a vis inflationary conditions. Now, that’s all well and good as long as the margin they maintain more than makes up for the share they’re losing. But, if history and this cycle’s earnings reports, which show a load of businesses completely whiffing on post-pandemic demand, are any guide, this bullishness will likely switch quickly once retailers take advantage of the opportunity to increase pressure by promoting their own brands, and value brands more generally sense an opportunity to grow.

More broadly, what’s interesting about market shifts driven by changes to macro-economic conditions is how quickly some companies sense opportunity while others get stuck playing defense. For example, during the financial crisis, Hyundai took advantage of GM and Chrysler going bankrupt to launch a program allowing customers to give their cars back if they lost their jobs, doubling global market share. At the same time, Italian wine growers used the financial crisis as an opportunity to reposition Prosecco from cheap fizzy plonk to an alternative to Champagne.

Looking forward, I’ll be curious to see how the value landscape shapes out, which brands take the opportunity to re-position, make brave moves, and grow their businesses, and which get caught flat-footed playing defense and losing as a result.

3. One Prime PillPack Medical is a very big deal…Assuming it can deliver.

tl;dr: One Medical puts another piece in the Amazon jigsaw.

You’d think a business like Amazon would have tremendous strategic flexibility, having such scale, scope, and incredible resources that it can do pretty much anything it wants. But that isn’t really how it works. The truth is, when you reach its size, your options become heavily limited by the scale of the opportunity. Put simply, when you’re valued at $1.2trn, you need opportunities that will add hundreds of billions in revenue because a few billion here or there won’t make a difference.

This is why Amazon is buying One Medical and getting even more serious about healthcare; it’s one of the few market segments representing a $100bn+ opportunity.

Now, I need to do a quick level-set on why this is such a big deal for anyone outside the US. American healthcare is a massive, massively inefficient, massively bureaucratic, complex, and uniquely American mess. To put it in perspective, this is the only country in the civilized world where you can quite easily end up bankrupt if you get cancer due to the cost of lifesaving care. And that’s with good insurance.

The numbers are truly staggering. Between 1960 and 2020, healthcare as a % of GDP rose from 5% to 19.7%. By 2028, this is expected to rise to $6.2 trillion. To put this in perspective, yearly healthcare costs are predicted to rise by the equivalent of the total market capitalization of Apple over the next six years.

As anyone who’s ever had to use the healthcare system in the US knows, it’s unfathomable. It’s so backward that I once had to write and then mail a paper check to my son’s doctor for $2.56. This was the only payment method they’d accept, and the first I knew about it was a threatening letter from a collection agency 18 months after we’d been to the Dr. It’s just a downright nutso, bizarro mess of an experience.

But, and it’s a ginormous but, nutso, bizarro, inefficient messes are like mana from heaven for a business as ruthless and ruthlessly efficient as Amazon.

Now, there are many questions about whether we think it ethical or even acceptable for a business like Amazon that already knows so much about us to have access to our medical records. But there’s no doubt this is a market desperate for a disruptive shakeout. Amazon is one of the few businesses with the scale, technology chops, and infrastructure to make it happen.

It’s not hard to predict where this might end up. Having already purchased PillPack (and others), Amazon can mail prescriptions anywhere in the country. Adding One Medical brings the ability to see a doctor, either in person or, more likely, via telehealth. Plug in 200 million Prime members, and the potential is…significant. If they can deliver, which many doubt. (Please pardon the pun)

I can see people asking Alexa to re-up their prescriptions or schedule an appointment with a doctor to check on their child’s cough. I can see Amazon Prime Medical becoming a low-cost GP service covering all your basic needs. I can see a marketplace much like their retail marketplace for more specific medical or cosmetic care. And I could even see Amazon getting into the drug manufacturing game to drop prices further (hey, if California can make Insulin, why can’t Amazon? And if the only thing stopping them is the law, lobbying money changes laws.)

We might even see some weirdly dystopian stuff going on. Like wearers of the (already dystopian) Halo band getting a cheap insurance package in return for constant monitoring of their fitness and activity levels…and price increases if they forget to go for a jog or decide to smoke a cigarette.

On balance, though, aside from all the very real ethical concerns, it’s probably a good thing Amazon is doing this. It’ll force innovation into a space that has none and might shift an increasingly bleak cost curve in a direction that favors the consumer.

Welcome to America.