Musings on Markets Fri, 11 Oct 2019 21:18:00 GMT language
To take a closer look at a subset of these IPOs, I focused on seven of the offerings this year - Uber, Lyft, Pinterest, Slack, Levi Strauss, Peloton and Beyond Meat - and looked the performance of each of these stocks since the opening trade on the offering date:
IPO Lessons for Public Market Investors
In my post on the Peloton IPO, I opined on how venture capitalists price companies and how the pressures that they have put on companies to scale up quickly, often without paying heed to building good business models, is playing out. In this one, I would like to look at the public market side of the IPO process, again looking for common threads.
- The IPO process: The IPO process is one of gauging demand and supply and setting a price based on that assessment, not estimating the value of businesses. It is the job of the bankers managing the process is to make this judgment, usually based upon the responses they get from their investor clientele. Thus, it should be not surprising that the bulk of the backing for an offering price comes from finding a pricing metric (revenue multiple, user value etc.) and relevant comparable firms (a subjectively judgment).
- Self Selection: The players who get drawn into the IPO game tend to be those with shorter time horizons who feel that their strength is in riding momentum, when it exists, and detecting shifts, before the rest of the market does. In short, the IPO market is built for traders, not investors.
- Type of companies: Most initial public offerings tend to be of firms that are younger and often less formed than their more seasoned public counterparts. Consequently, more of their value lies in the future and there is more uncertainty in assessing numbers, leading investors to abandon these stocks, claiming that there is too much uncertainty, giving pricing almost all of the stage.
2. On a shaky base
- Peer Group Framing: With most public companies, a combination of the company's operating history and market learning leads to a consensus on what its peer group should be, for pricing purposes. Thus, when pricing Coca Cola or Adobe, investors tend to agree more than they disagree about what companies to put into the peer group for comparison. For many IPOs, especially built around new business models and practices, there is much more confusion about what grouping to put the company into. Not surprisingly, the IPOs try to influence this choice by framing themselves as being in businesses that will deliver a higher pricing, explaining why almost every one of them likes to use the word "tech" in its description.
Past Pricing History: Unlike publicly traded companies, where there is a market price history, the only price history that you have with IPOs is from prior VC rounds. To understand this may be problematic, let me focus on the seven IPOs I highlighted in the last section and provide information on the private investor funding of each, leading into the IPO:
Source: Crunchbase, Yahoo! FinanceNote three problems with using this information as a basis for public market pricing. First, in most cases, the pricing for the company is extrapolated from a small VC investment. With Lyft, for instance, the estimated pricing of $14.5 billion from the most recent round was extrapolated from an investment of $600 million for the company for a 4.1% share of the company. Second, this problem is worsened by the fact that VC investors can and usually do negotiate for post-investment protections, when they invest. For instance, ratchets allow VCs to adjust their ownership stake in a company upwards, if a subsequent funding round is based upon a lower pricing for the company. In effect, VCs are being provided with options, and as I noted in this post on unicorns, the presence of these additional features makes simplistic extrapolation to pricing from a VC investment almost impossible to do. Third, even if the pricing is correctly extrapolated from the last VC investment, all you need is one over optimistic venture capitalist to push the pricing beyond reasonable bounds. In the case of WeWork, it can be argued that much of the surge in pricing in the company came from Softbank's continued investments in the company and not a reflection of consensus among venture capitalists.
3. With an unstable share count
- 64,602,124 shares of our Class B common stock issuable upon the exercise of options to purchase shares of our Class B common stock outstanding as of June 30, 2019, with a weighted-average exercise price of $6.71 per share;
- 883,550 shares of our Class B common stock issuable upon the exercise of options to purchase shares of our Class B common stock granted between June 30, 2019 and September 10, 2019 with a weighted-average exercise price of $23.40 per share;
- 240,000 shares of our Class B common stock issuable upon the exercise of a warrant to purchase Class B common stock outstanding as of June 30, 2019, with an exercise price of $0.19 per share;"
Implied Market Cap at $29/share = 277.7 * $29 + 64.6* ($29 - 6.71) = $9.5 billion
4. And a Bar Mitzvah Moment waiting!
- If your intent is to trade IPOs, you should not care about value, but mine is different. I consider myself an investor, not a trader, not because it is a more noble calling but because I am a terrible trader.
- As an investor, I have faith that when investing in equity in a business, there will eventually a reckoning, where price converges on value. I use the word "faith" because there is no mechanism that guarantees this convergence.
Young companies that go public are often adept at playing the pricing game, delivering more users, subscribers or revenues, if that is what the pricing gods want, and their stock prices often continue to rise, even though their fundamentals don't merit it. It is my belief that each of these companies will face what I call a "Bar Mitzvah" moment, where the market, hitherto focused on magical metrics, asks the company about its pathway to profitability. As I look back over time, the very best of these companies, and I would include Facebook, Google and Amazon in this grouping, are ready for this moment, since they have been building viable business models, even as they delivered on market metrics. Many of these young companies, though, seem unready for this question, and the market punishes them, as was the case with Twitter in 2014.
|Levi Strauss||Lyft||Beyond Meat||Uber||Slack||Peloton|
|IPO Offer Price||$17.00||$72.00||$19.00||$25.00||$45.00||$26.00||$29.00|
|IPO Open Price||$22.22||$87.33||$23.75||$46.00||$42.00||$38.50||$27.17|
|Price on 8/10/19||$18.96||$38.66||$25.63||$142.73||$29.28||$25.70||$23.21|
- Levi Strauss's most recent earnings report was not well received by the market, with the stock dropping 1.1% to $18.96. I see its fundamentals justifying a higher value and I bought shares at $18.96.
- I have gone back and forth on whether to buy Uber, Lyft or both. Lyft looks more under valued, but Uber offers more upside, given its global ambitions. In addition, I prefer Uber's single class of shares to Lyft's multiple voting right classes, and these factors tilted me to buying the latter at $30/share.
- Slack and Pinterest are getting close to fair value as their prices have drifted down and Peloton has become less over valued but still has room to fall. For the moment, I will add these companies to my watch list, and track their pricing.
- With my story for Beyond Meat, I find the price almost unreachable with any story that I craft, and while this was the same conclusion that I drew a few months ago, this time, I tried shorting the stock at $142, but was unable to get my trade through. I fell back on buying put options at a 120 strike price, expiring on December 20, 2019, paying a mind-bending time premium for a two-month option. While the stock has been resistant to the laws of gravity (or value) for must of its listed life, I believe that there are two things that have changed that make this a good time to make this short term intrinsic value bet. One is the listing of Impossible Foods gives investors not just another way of making a macro bet on veganism, but also an easy comparison on pricing. The other is the decision by Beyond Meat to issue 3.25 million shares a few weeks ago, with 3 million shares coming from insiders, suggests that the firm itself may think its stock is over priced.
- Levi Strauss (October 8, 2019)
- Lyft (October 8, 2019)
- Pinterest (October 8, 2019)
- Beyond Meat (October 8, 2019)
- Uber (October 8, 2019)
- Slack (October 8, 2019)
- Peloton (September 28, 2019)