“… the typical IPO buyer looks for a short-term price spurt arising from a combination of hype and scarcity.”
— Warren Buffett, in his 1996 Letter to Shareholders
Over the past few months, my business partner and I have been looking at the current economic data, but also the arc of previous cycles to assess if any learnings can be gleaned. It is often tempting to match the patterns of today to those of the past.
The reality is history does not actually repeat, but the chorus of past investing cycles can often rhyme with music playing in investing markets today.
Frequent readers of this column know we often ground our investment philosophy in the wisdom of value investing’s forefathers.
Warren Buffett, the Oracle of Omaha, has oft eschewed the initial public offering market. It is worth inspecting why, since this “going public” intricacy of capital markets is what has made Silicon Valley so famous.
Early-stage companies are often supported by family and friends, so-called angel investors. As the business begins to grow, additional capital is needed. Most banks will not loan to startups, so more equity investors are needed. Venture capital firms often provide that backing.
Over time, as the company matures and long-term viability is demonstrated, the VC firms work with investment banks to “take the company public” — selling their privately held stock to the public market.
Buffett says the timing of these sales are dramatically skewed to the benefit of the seller, not the buyer. There are never bargains in an IPO.
But that is goal of a value investor, to exploit market fears and concerns by investing in companies whose stock price happens to be trading below the company’s true intrinsic value.
An IPO seller knows more than the public, and only sells when the winds are blowing in their favor. Buffett wrote a lot about this during the last big IPO bubble in the late ’90s.
While the quote above is from 1996, Buffett warned again 2000:
“Now, speculation — in which the focus is not on what an asset will produce but rather on what the next fellow will pay for it — is not a game I wish to play. Yet investors, mesmerized by soaring stock prices and ignoring all else … piled into stocks that became decoupled from the values of the businesses that underlay them.
“Value is destroyed, not created, by any business that loses money over its lifetime, no matter how high its interim valuation may get. But a pin lies in wait for every bubble.”
There are so my parallels to today’s IPO market; the lyrics definitely rhyme with the silliness of the late ’90s.
Vitaliy Katsenelson recently published an article in Barron’s discussing today dynamics. He buckets companies into three categories: conservative, speculative and Ponzi.
- companies can make interest payments and pay off debt when it comes due from their cash flows.
- Speculative companies can pay interest from their cash flows, but they constantly have to roll over debt.
- Ponzi-like companies can’t cover their interest costs, never mind their debt, and rely on capital markets to stay afloat. These companies hope to get to “scale” through growth and one day become speculative or even conservative companies.
Katsenelson believes a lot of Silicon Valley companies reside in a “hallucinatory, Ponzi-like state,” financed by never ending flows of venture capital funds. He provides this example:
A startup has an idea and raises $10 million in the first round of funding. A private equity firm gives them $2 million at a $10 million valuation and says “Grow!”
They hire some engineers to develop a product, but they know that if they are to get more money, they need to show growth. So, some of the $2 million goes to Google and Facebook to drum up customers.
After burning through the $2 million, and there is still no profitability, they need more money. But they have proved the concept and have more users and higher revenues. Here comes the next round of funding — let’s say another $20 million.
The company is now “valued” at $100 million. The venture capital firm still owns 20% of the startup and but can show a 10-times return to its investors.
Part of the money goes to improve the product and another part goes to acquire users on Google and Facebook, with more, maybe, to Amazon Web Services (AWS) to host the product.
In an environment where returns in debt markets are 3% or 5%, and most hedge funds are not doing much better, venture capital is claiming astronomical returns.
So more financing rounds follow, each at a higher valuation. The higher valuation is driven not by higher profitability but by higher revenues. Who cares about profits when the supply of financing seems to be endless?
At some point, the craziness will end. Perhaps it will be soon?
Uber went public in May with a valuation over $80 billion, making it one of the 10 biggest IPOs of all time. It immediately posted a $5.2 billion quarterly loss (its largest ever), and shares are down over 30% from the IPO price.
WeWork — the private workspace-sharing company heavily supported by SoftBank’s Vision Fund — is seeing interest wane in its upcoming IPO. It has been shopping the idea of going public at 15 times revenues, even though its operating losses have grown with revenues.
WeWork operates 528 locations in 111 cities in 29 countries, yet “scale” has not come. The U.S. arm of WeWork’s lone public peer, London-based IWG, trades for around 1.4 times sales, which would put WeWork’s value at less than $5 billion.
That’s about 10% of the $47 billion WeWork garnered during a round of private financing earlier this year and less than half of the $11 billion its largest investor, SoftBank, has committed.
So far, SoftBank has shown handsome paper profits as it keeps marking up the value of its investment with each new round of capital raising. Perhaps the game of musical chairs is ending.
Peloton, which sells $2,000 exercise bikes with TV screens attached (and for just $39 a month, you get to watch an instructor pedaling alongside you), plans to IPO shortly. The company has incurred operating losses each year since inception, including net losses of $71.1 million, $47.9 million, and $195.6 million for fiscal 2017, 2018 and 2019, respectively.
It expects to continue to incur net losses for the foreseeable future. Peloton’s revenue was $218 million three years ago and $915 million last year... yet losses are growing, not shrinking.
What could go wrong with this IPO?
The shine may be coming off public company darlings as well.
Netflix created the market for online streaming. It accounts for an astonishing 15% of all Internet traffic and will spend $15 billion on original content this year, roughly 7 times what HBO spends. Netflix will spend another $3 billion on marketing, more than HBO will spend on programming.
Despite billions spent on original programming, the vast majority of Netflix’s content is created by other studios. Disney, WarnerMedia (HBO’s parent), NBCUniversal and CBS are all launching their own streaming services.
Disney has already decided to pull all its content from Netflix. And the most popular show on Netflix, The Office, will move to NBCUniversal’s streaming service in 2021.
Netflix burned through $1.3 billion of negative free cash flow last year and anticipates setting another $3 billion on fire in 2019. Yet, the company recently announced that its U.S. subscriber count declined for the first time in almost 10 years.
While market indices are near all-time highs, Netflix stock is down about 30% from the all-time high set last summer. Look out below.
Market darlings like Uber, Lyft, Zoom and Netflix offer tremendous products and services. Yet they continue to light money on fire. New IPO listings are beginning to fail — closing below their IPO list price. Yet value stocks are beginning to rally.
Perhaps the long-awaiting pivot away from money-losing growth names to cashflow-generating value stocks is underway. It’s about time.