L.J. Henderson, the famed physician, chemist, biologist, sociologist, and philosopher, spent time studying Hippocrates among his many endeavors. He was quite taken with Hippocrates’ fixation on experience and common sense, and offered his own analysis of the Hippocratic Method as follows:
“The first element of that method is hard, persistent, intelligent, responsible, unremitting labor in the sick-room, not in the library; the complete adaptation of the doctor to his task, an adaptation that is far from being merely intellectual. The second element of that method is accurate observation of things and events; selection, guided by judgment born of familiarity and experience, of the salient and the recurrent phenomena, and their classification and methodological exploitation. The third element of that method is the judicious construction of a theory – not a philosophical theory, nor a grand effort of the imagination, nor a quasi-religious dogma, but a modest pedestrian affair, or perhaps I had better say, a useful walking-stick to help on the way – and the use thereof.”
In that spirit, I have a walking stick that I would like to share with you. When you look at any stock over a long period of time (say, greater than fifteen years), you will find that wealth gets created based upon gains for a particular company on a per share basis. Growing profits from $1 billion to $10 billion over time is meaningless (from a shareholder return perspective) if the total number of shares outstanding increases from 1 billion to 10 billion over the same time. If you want to understand how much share dilution matters, look at how much lower the price of Citigroup and AIG stock is today compared to its prices twenty years ago even though those companies have returned to billion-dollar profitability.
As a result, the presence of heavy stock dilution is often a strong walking-stick for determining that the management team does not respect capital. When people talk about Uber, the conversation inevitably turns towards the projected $8 billion loss over the course of 2019 or the recent California legislation about making Uber and Lyft drivers employees rather than independent contractors.
As a threshold matter, I cannot take Uber seriously as an investment because of the amount of share dilution that occurs over time. Right now, Uber has 1.75 billion shares outstanding. Over the next five years, it is slated to issue 250 million new shares that will bring the total count to $2 billion. Each year, there around hundreds of millions of dollars in stock awarded to executives.
To compensate for the coming dilution, Uber management will have to increase the value of the business overall by 15% just to get back to its present status quo on a per share basis.
Of course, the company has $7 billion in total debt, with $4.5 billion due over the next five years while it is presently losing $8 billion per year (though it does have almost $6 billion in cash in the bank). Still, the cash reserves could be fully depleted in the next 12-24 months based on the company’s current annual loss rate and higher interest debt might be in the offing.
These behaviors are often consistent with each other. When I see companies with heavy stock-based compensation, there is often a high-debt load on the balance sheet as well. There is just…indifference to what the shareholders are going to earn over the course of their lifetime as an investor.
I suppose that’s tolerable in the sense that Uber doesn’t owe any of us anything, but it is a problem that it encourages investors to purchase the stock on the basis that it is the leading disrupter in the field of ride-hailing services. That just doesn’t matter. When shares are given out freely, shareholders absorb the freewheelin’ wealth doled out to management.
I can think of no company that dilutes its shares by more than 4% on an annualized basis that has been a generational compounder for investors. Not only does this create a high hurdle that a company must offset just to get back to the starting line, but also, the types of management teams willing to dilute its investors often engage in other behavior that is not shareholder-friendly. Uber is not a company ever worth adding to your portfolio.