What’s the deal with growth mega-caps?!

Netflix & Tesla

Growth stocks are tricky. They provide head-spinning rallies on the up, and stomach-churning drops on the down. Investors can be miffed by this conundrum – why have we seen a 53% (NFLX) and 40% (TSLA) trailing-24 month drop in prices when the companies haven’t changed? Even when the Nasdaq index fell 13% and the SP500 gained 3% over the same period of time? Well, there’s a graybeard answer for this: value stock prices reflect what the company is, but growth stocks prices reflect what the company is expected to be.

Source: Google Finance

Few names have reflected this growth-stock rollercoaster better than Netflix and Tesla. Both companies are disruptors in century-old industries. Netflix broke patterns of movie production and broadcasting with their streaming service (and back in the day, with their “rent by mail” DVD service). Similarly, Tesla broke the mold of conventional internal combustion engine (ICE) vehicle manufacturers with a radical combination of battery-based electric motors and a novel high-tech driver’s experience.

This creative disruption gave both companies growth that is very rarely seen in companies of that size. Each of them managed a double whammy of:

• Capturing overwhelming market share by displacing century-old incumbent industries. 2 out of 3 adults in the US are connected to Netflix, and Tesla sells 7 out of every 10 new electric vehicles sold in the US; and,

• Creating and dominating a whole new market at the expense of an old one. Netflix is arguably the originator of the movie streaming business – which first decimated the movie theater industry, and now has overtaken cable as the main delivery mode for video content. Similarly, Tesla is the first – by over a decade – manufacturer to focus solely on plug-in electric vehicles at scale. Since the company’s start in the early 2000’s, the share of EV’s in the total new car market has grown from about 70,000 cars sold in 2015 to about 800,000 in 2022.

Netflix and Tesla’s revenue line grew at an annualized 24.6% and 51.7% compounded annual growth rate (CAGR) between 2015 and 2022, respectively (note: for Tesla, the figure reflects the 12-months to 30 Sep 2022), on the back of an increase in Netflix’s subscriber base to 230.8m from 74.7m and Tesla’s new car sales of 1.3m from about 25k.

But as good as growth is on the up, it can be a destructive “stick in the spokes” when it falls short. Because growth stocks are priced according to what the company is expected to be in 3, 5, or 10 years from now, even small changes in expansion expectations have a compound effect over a longer period. Cutting estimates from a 50% to 25% annualized growth rate means that a revenue line that is 5-years out can drop from 7.6x to only 3.0x today’s number. Still impressive, but less than half prior expectations.

Rapid growth is a challenge for mega-caps – and often proves elusive. Both these names already accumulate overwhelming market shares in the US market and face regulatory or competitive restrictions to grow abroad. Therefore, their expansion depends on both their capacity to continue growing their main business and/or expanding their product portfolio. For example, Netflix has, for a time now, expanded from pure streamlining into original productions and there is a full field ahead with live events (sports?) for the company to explore. Similarly, Tesla has so far focused on high-end personal cars and could look at commercial vehicles and cheaper alternatives – particularly as it competes in emerging markets with low-cost producers from China. But new ventures imply new risks and capital deployment with uncertain results.

Source: Google Finance

Moreso, stocks don’t care about units sold or customers connected – they care about the money made by doing so, and margins erode after the head-start is over. It is not a new phenomenon – practically every new business disruptor has a period of high margins as competitors are slow to react. For example, Tesla operates with a 26.6% gross profit margin compared to 12.1% and 14.8% for Ford and General Motors, respectively. That means that Tesla has about the same gross operating profit as F and GM despite having about half the revenue. But as incumbents and second-wave disruptors begin competing in earnest (Ford and GM as incumbents, and Rivian and Lucid for second-wave disruptors for Tesla), these high margins are challenged as companies are forced into price cuts or increasing operating expenses to defend market share (for example, Netflix’s original productions to compete with pre-existing catalogs like Disney+).

Key Takeaway

All of this to say, the case for high-quality growth stocks can be great, as they will likely, over the long run, provide excess returns for investors. However, as the market adjusts for new growth expectations, be prepared for major bumps in the road along the way. It is important for traders to regularly assess these growth stocks to determine for themselves whether these potholes are worth hitting.