Friday, October 18, 2019

Disrupting the IPO Process: Challenging the Banker-run Going-Public Model!

In the age of disruption, where young companies are challenging the status quo and upending conventional businesses, it was only a matter of time before they turned their attention to the process by which they are taken public. For decades, the standard operating procedure for a company going public has been to use a banker or a banking syndicate to market itself to public investors at a “guaranteed” price, in return for a sizeable fee. That process has developed warts along the way but it has remained surprisingly stable even as the investing world has changed. In the aftermath of some heavily publicized let downs in the IPO market this year, with the WeWork fiasco topping off the bad news, there is now an active and healthy discussion about how companies should make the transition to being public. Change may finally be coming to the going-public game and it is long overdue.

Going Public? The Choices
When a private company chooses to go public, there are two possible routes that it can take in making this transition. The more common one is built around a banker or bankers who manage the private to public transition:

There is an alternative, though it seems to be seldom used, which is to do a direct listing. In this process, a private company lets the markets set the price on the offering date, skipping the typical IPO dance of setting an offer price, which in retrospect is set too low or too high. 

The company still has to file a prospectus, but the biggest difference is that it cannot raise fresh capital on the offering date, though existing owners can cash out by selling their shares. That is not as much of a problem as it sounds, since the company can choose to raise cash in a pre-listing round from interested investors, or to make a secondary offering, in the months after it has gone public. In fact, one advantage that direct listing have is that there is no lock-up period, as there is with conventional IPOs, where private investors cannot sell their shares for six months after the listing. If you are interested in the details of a direct listing, this write-up by Andreesen Horowitz sums it up well. Let’s be clear. If this were a contest, the status quo is winning, hands down. While there have been a couple of high-profile direct listings in Spotify and Slack, the overwhelming majority of companies have chosen the status quo. Furthermore, the status quo seems to be global, indicating either that the benefits that issuing companies see in the banker-based model apply across markets or that the US-model has been adopted without questions in other markets.

The IPO Status Quo: The Pros and Cons
To understand how the status quo got to be the standard, it makes sense to look at what issuing companies perceive to be the benefits of having banking guidance, and weigh them off against the costs. In the process, we will also lay the foundations for examining how the world has changed, and why the status quo may be under threat.

The Banker's case
Looking at the status quo picture that I showed in the last section, I listed the services that bankers offer to issuing companies, starting with the timing and details of the offering, all the way through the after-market support. At the risk of sounding like a salesperson for bankers, let’s see what bankers bring, or claim to bring, to the table on each of the services:
  1. Timing: Bankers would argue that their experience in financial markets and their relationship with institutional investors give them the insights to determine the optimal timing window for a public offering, where the investment stars are aligned to deliver the highest possible price and the smoothest post-market experience.
  2. Filing/Offering Details: A prospectus is as much legal document as it is information disclosure, and past experience with other initial public offerings may allow bankers to guide companies in what information to include in the prospectus and the language to use to in providing that information, as well as provide help in navigating the regulatory rules and requirements for public offerings.
  3. Pricing: It is on this front where bankers can claim to offer the most value added for three reasons. First, their knowledge of public market pricing can help them bridge the gap with the private market pricing preceding the offering, and in some cases, reduce unrealistic expectations on the part of VCs and founders. Second, they can help frame the offer pricing by finding the best metric to scale the pricing to and identifying the peer group that investors will use in public markets. Third, by reaching out to investors, bankers can not only gauge demand and fine tune the pricing but also isolate concerns that investors may have about the company. 
  4. Selling/Marketing: To the extent that multiple banks form the selling syndicate, and each can reach out to their investor clientele, bankers can expand the investor base for an issuing company. In addition, the marketing that accompanies the road shows can market the company to the larger market, attracting buzz and excitement ahead of the offer date. 
  5. Underwriting Guarantee: At first sight, the underwriting guarantee that bankers offer seems like one of the bigger benefits of using the banking-run IPO model, but I am afraid that there is less there than meets the eye, since the guarantee is set first and the price is not set until just before the offering, and it can be set below what you believe investors would pay for the stock. In fact, if you believe the graph on offer day price performance that I will present in the next section, the typical IPO is priced about 10-15% below fair price, making the guarantee much less valuable.
  6. After-market Support: Bankers make the case that they can provide price support for IPOs in the after-market, using their trading arms, sometimes with proprietary capital. In addition, researchers have documented that the equity research arms of banks that are parts of IPO teams are far more likely to issue positive recommendations and downplay the negatives.
At least on paper, bankers offer services to issuing companies, though the value of these services can vary across companies and across time.

The Bankers’ Costs
The banking services that are listed above come at a cost, and that cost takes two forms. The first and more obvious one is the banker’s fees for the issuance and these costs are usually scaled to the issuance proceeds. They can range from 3% to more than 8% of the proceeds, with the percentage costs increasing for smaller issuers:
While issuance costs do decrease for larger issuers, it is surprising that the drop off is not more drastic, suggesting either that costs are more variable than fixed or that there is not much negotiating room on these costs. To provide an example of the magnitude of these costs, the banking fees for Uber’s IPO amounted to $105 million, with Morgan Stanley, the lead banker, claiming about 70% of the fees.

There is a second cost and it arises because of the way the typical IPO is structured. Since investment banks guarantee an offering price, they are more inclined to underprice an offering than over price it, and not surprisingly, the typical IPO sees a jump in the price from offer to opening trade on the first day of trading:
Source: Jay Ritter, University of Florida
Thus, the median IPO sees its stock price jump about 15% on the offering date, though there are some companies where the stock price jump is much greater. To provide specific examples, Beyond Meat saw a jump of 84% on the offering date, from its offer price, and Zoom’s stock price at the end of its first trading day was 72% higher than the offering price. Note that this underpricing is money left on the table by issuing company’s owners for the investors who were able to get shares at the offering price, many preferred clients for the banks in the syndicate. In defense of banks, it is worth noting that many issuing company shareholders seem to not just view this “lost value” as part of the IPO game, but also as a basis for subsequent price momentum. That argument, though, is becoming increasingly tenuous since if it were true, IPOs, on average, should deliver above-average returns in the weeks and months after the offering date, and they do not. If momentum is the rationale, it should also follow that newly listed stocks that do well on the offering date should deliver higher returns than newly listed stocks that do badly and there is no evidence of that either. 

Revisiting the IPO Process
Given the costs of using banks to manage the going-public process, it is surprising that there have not been more rumblings from private market investors and companies planning to go public about the process. After the WeWork and Endeavor IPO debacles, the gloves seem to have come off and the battle has been joined.

The Bill Gurley Case for Direct Listings
Bill Gurley has often been an atypical venture capitalist, willing to challenge the status quo on many aspects of the VC business. For many years now, he has sounded the alarm on how private market investors have paid too much for scaling models and not paid enough attention to building sound businesses. In the last few months, he has been aggressively pushing young companies to consider the direct listing option more seriously. His primary argument has been focused on the underpricing on the offering date, which as he rightly points out, transfers money from private market investors to investment bankers' favored clientele. In fact, he has pointed to absurdity of paying for an underwriting pricing guarantee, where the guarantors get to set the price much later, and are open about the fact that they plan to under price the offering. I don’t disagree with Bill, but I think that he is framing the question too narrowly. In fact, the danger with focusing on the offer day pricing jump runs two risks.
  • The first is that many issuing companies not only don’t seem to mind leaving money on the table, but some actively seem to view this under pricing as good for their stock, in the long term. After all, Zoom's CFO, Kelly Steckelberg seemed not only seems untroubled by the fact that Zoom stock jumped more than 70% on the offering date (costing its owners closer to $250-$300 million on the offered shares), but argued that that Zoom “got the most added attention in the financial community,” and even picked up business from several of its IPO banks who she said are “trialing or have standardized on Zoom now.” 
  • The second is that Gurley's critique seems to suggest that if bankers did a better job in terms of pricing, where the stock price on the offer date is close to the offer price, that the banker-run IPO model would be okay. I think that a far stronger and persuasive argument would be to show that the problem with the banking IPO model is that changes in the world have diluted and perhaps even eliminated that value of the services that bankers offer in IPOs, requiring that we rethink this process.
The Dilution of Banking Services
In the last section, in the process of defending the banker presence in the IPO process, I listed a series of services that bankers offer. Given how much the investing world, both private and public, has changed in the last few decades, I will revisit those services and look at how they have changed as well:
  1. No timing skills: To be honest, no one can really time the market, though some bankers have been able to smooth talk issuing companies into believing that they can. For the most part, bankers have been able to get away with the timing claims, but when momentum shifts, as it seems to have abruptly in the last few months in the IPO market, it is quite clear that none of the bankers saw this coming earlier in the year.
  2. Boilerplate prospectuses: When I wrote my post on the IPO lessons from WeWork, Uber and Peloton, I noted that these three very different companies seem to have the same prospectus writers, with much of the same language being used in the risk sections and business sections. While the reasons for following a standardized prospectus model might be legal, the need for banking help goes away if the process is mechanical.
  3. Mangled Pricing: This should be the strong point for bankers, since their capacity to gauge demand (by talking to investors) and influence supply (by guiding companies on offering size) should give them a leg up on the market, when pricing companies. Unfortunately, this is where banking skills seem to be have deteriorated the most. The most devastating aspect of the WeWork IPO was how out of touch the bankers for the company were in their pricing:
    Source: Financial Times
    I would explain this pricing disconnect with three reasons. The first is that bankers are mispricing these companies, using the wrong metrics and a peer group that does not quite fit, not surprising given how unique each of these companies claims to be. The second is that the bankers are testing out prices with a very biased subset of investors, who may confirm the mistaken pricing. The third and perhaps most likely explanation is that the desire to keep issuing companies happy and deals flowing is leading bankers to set prices first and then seek out investors at those prices, a dangerous abdication of pricing responsibility.
  4. Ineffective Selling/Marketing: When issuing companies were unknown to the market and bankers were viewed as market experts, the fact that a Goldman Sachs or a JP Morgan Chase was backing a public offering was viewed as a sign that the company had been vetted and had passed the test, the equivalent of a Good Housekeeping seal of approval for the company, from investors' perspective. In today’s markets, there have been two big changes. The first is that issuing companies, through their product or service offerings, often have a higher profile than many of the investment banks taking them public. I am sure that more people had heard about and used Uber, at the time of its public offering, than were aware of what Morgan Stanley, its lead banke, does.  The second is that the 2008 banking crisis has damaged the reputation of bankers as arbiters of investment truths, and investors have become more skeptical about their stock pitches. All in all, it is likely that fewer and fewer investors are basing their investment decision on banking road shows and marketing.
  5. Empty guarantee: Going back to Bill Gurley’s point about IPOs being under priced, my concern with the banking IPO model is that the under pricing essentially dilutes the underwriting guarantee. Using an analogy, how much would you be willing to pay a realtor to sell a house at a guaranteed price, if that price is set 20% below what other houses in the neighborhood have been selling for?  
  6. What after-market support? In the earlier section, I noted that banks can provide after-issuance support for the stocks of companies going public, both explicitly and implicitly. On both counts, bankers are on weaker ground with the companies going public today, as opposed to two decades ago. First, buying shares in the after-market to keep the stock price from falling may be a plausible, perhaps even probable, if the issuing company is priced at $500 million, but becomes more difficult to do for a $20 billion company, because banks don’t have the  capital to be able to pull it off. Second, the same loss of faith that has corroded the trust in bank selling has also undercut the effectiveness of investment banks in hyping IPOs with glowing equity research reports. 
Summing up, even if you believed that bankers provided services that justified the payment of sizable issuance costs in the past, I think that you would also agree that these services have become less valuable over time, and the prices paid for these services have to shrink and be renegotiated, and in some cases, entirely dispensed with.

Why change has been slow
Many of the changes that I highlighted in the last section have been years in the making, and the question then becomes why so few companies have chosen to go the direct listing route. There are, I believe, three reasons why the status quo has held on and that direct listings have no become more common.
  1. Inertia: The strongest force in explaining much of what we see companies do in terms of investment, dividend and financing is inertia, where firms stick with what's been done in the past, partly because of laziness and partly because it is the safest path to take.
  2. Fear: Unfounded or not, there is the fear that shunning bankers may lead to consequences, ranging from negative recommendations from equity research analysts to bankers actively talking investors out of buying the stock, that can affect stock prices in the offering and in the periods after.
  3. The Blame Game: One of the reasons that companies are so quick to use bankers and consultants to answer questions or take actions that they should be ready to do on their own is that it allows managers and decisions makers to pass the buck, if something goes wrong. Thus, when an IPO does not go well, and Uber and Peloton are examples, managers can always blame the banks for the problems, rather than take responsibility.
I do think that at least for the moment, there is an opening for change, but that opening can close very quickly if a direct listing goes bad and a CFO gets fired for mismanaging it.

The End Game

As the process of going public changes, everyone involved in this process from issuing companies to public market investors to bankers will have to rethink how they behave, since the old ways will no longer work.

Issuing companies (going public) 
  1. Choose the IPO path that is right for you: Given your characteristics as a company, you have to choose the pathway, i.e., banker-led or direct listing that is right for you. Specifically, if you are a company with a higher pricing (in the billions rather than the millions), with a public profile (investors already know what you do) and no instantaneous need for cash, you should do a direct listing. If you are a smaller company and feel that you can still benefit from even the diminished services that bankers offer, you should stay with the conventional IPO listing route.
  2. If you choose a banker, remember that your interests will not align with those of the bankers, be real about what bankers can do for you and negotiate for the best possible fee, and try to tie that feee to the quality of pricing. If I were Zoom's CFO, I would have demanded that the banks that underpriced my company by 80% return their fees to me, not celebrated their role in the IPO process.
  3. If you choose the direct listing path, recognize that the public market may not agree with you on what you think your company is worth, and not only should you accept that difference and move on, you should recognize that this disagreement will be part of your public market existence for your listing life. 
  4. In either case, you should work on a narrative for your company that meets the 3P test, i.e., is it possible? plausible? probable? You are selling a story, but you will also have to deliver on that story, and overreaching on your initial public offering story will only make it more difficult for you to match expectations in the future.
  1. Choose your game: In my last post, I noted that there are two games that you can play, the value game, where you value companies and trade on the difference, waiting for the price to converge on value and the pricing game, where you buy at a low price and hope to sell at a higher one. There is nothing inherently more noble about either game, but you should decide what game you came to play and be consistent with that choice. In short, if you are a trader, stop pondering the fundamentals and using discounted cash flow models, since they will be of little help in winning, and if you are an investor, don't let momentum become a key ingredient of your value estimate.
  2. Keep the feedback loop open: Both investors and traders often get locked into positions on IPOs and are loath to revisit their original theses, mostly because they do not want to admit mistakes. With IPOs, where change is the only constant, you have to be willing to listen to people who disagree with you and change your views, if the facts merit that change.
  3. Spread your bets: The old value investing advice of finding a few good investments and concentrating your portfolio in them can be catastrophic with IPOs. No matter how carefully you do your homework, some of the investments that you make in young companies will blow up, and if your portfolio succeeds, it will be because a few big winners carried it. 
  4. Stop whining about bankers, VCs and founders: Many public market investors seem to believe that there is a conspiracy afoot to defraud them, and that bankers, founders and VCs are all part of that conspiracy. If you lose money on an IPO, the truth is that it may not be your or their faults, but the consequence of circumstances out of anyone's control. In the same vein, when you make money on an IPO, recognize that it has much to do with luck as with your stock picking skills.
  1. Get real about what you bring to the IPO table: As I noted before, public and private market changes have put a dent on the edge that bankers had in the IPO game. It behooves bankers then to understand which of the many services that they used to charge for in the old days still provide added value today and to set fees that reflect that value added. This will require revisiting practices that are taken as given, including the 6-7% underwriting fee and the notion that the offer price should be set about 15% below what you think the fair prices should be.
  2. Speak your mind: If one of the reasons that the IPOs this year have struggled has been a widening gap between the private and public markets, bankers can play a useful role in private companies by not only pointing to and explaining the gap, but also in pushing back against private company proposals that they believe will make the divergence worse. 
  3. Get out of the echo chamber: An increasing number of banks have conceded the IPO market to their West Coast teams, often based in Silicon Valley or San Francisco. These teams are staffed with members who are bankers in name, but entirely Silicon Valley in spirit. It is natural that if you rub shoulders with venture capitalists and founders all day that you relate more to them than to public market investors. I am not suggesting that banks close their West Coast offices, but they need to start putting some distance between their employees and the tech world, partly to regain some of their objectivity. 
YouTube Video

Friday, October 11, 2019

IPO Lessons for Public Market Investors

This year, I have found myself returning repeatedly to the IPO well, as high profile companies have chosen to go public, and like a moth to a flame, I have been drawn to value them. There was much enthusiasm at the start of 2019 that this would be a blockbuster year for IPOs, not just for the companies going public, but also for public market investors who would now get a chance to own pieces of companies which had made venture capitalists and private market investors rich, at least on paper. While many of these companies, with the exception of WeWork, have gone public and raised large amounts of capital, many of the new listings have disappointed in the after market. The WeWork fiasco, while creating vast collateral damage, has also created healthy discussions about how venture capitalists price private companies and whether public market investors should base their pricing of the latest VC rounds, whether the IPO process itself is in need of a change, what the share count that we should be using in computing market capitalization at these young companies and whether investors should even enter this space, where uncertainty abounds and cash burn is more the rule than the exception.

An 2019 IPO Pricing Retrospective
It is estimated that nearly 200 companies will go public this year, an increase of about 5% over last year's 190 IPOs, but still well below the 547 companies that went public in 1999. The first half of the year was a good one for investors in these IPOs, but investors have soured on these companies in the last few months. One way to measure the performance of these young companies in the after market is to look at how the Renaissance IPO ETF, a fund that tracks larger initial public offerings and weights them based upon free float, has done over the course of the year:

Since the fund tracks IPOs for 500 trading days after the listing date, it is not quite a clean measure of this year's IPOs, but it is a good proxy. Notwithstanding all of the negative press you may have read about IPOs in the last few weeks, and third quarter damage, the Renaissance ETF IPO has outperformed the market over the course of this year.

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:

To compare the performance of these offerings, I standardized performance by looking at how much $100 invested in each stock at the open price on the first trading day would have done, in periods ranging from a day to the year to date:

I have tracked the returns that investors would have earned if they had invested at the offer price and at the open price on the first trading day. Note first that five of the seven stocks registered a jump in excess of 20%, comparing the open price to the offer price, when they started trading. Looking at the returns in the year to date, the outlier is Beyond Meat, on an almost unbelievable run from its offer price, but of the remaining six stocks, only Pinterest has gone up, relative to it first trade price. Uber, Lyft and Slack have been awful investments, though if you had received Slack shares at the offer price, the pain would be more bearable. Even Levi Strauss, not a young or a tech company, has seen rough going in the months since its initial public offering. Peloton has been listed only ten trading days, but it has to hope that the worst is behind it.  What does this all mean? First, in spite of recent setbacks, investors in IPOs collectively have done reasonably well over the course of the year, but only if they spread their bets. Second, in the midst of this good news, some of the most hyped IPOs have had difficulty gaining traction, and since these companies attract the most attention from investors and the financial press, they are contributing to the perception that investing in IPOs has been a loser's game this year.
   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.

1. It stays a pricing game
At the risk of repeating myself, the price of an asset and its value are determined by different forces and estimated using different tools. and while they may be good estimates of each other in an efficient market, they can diverge, creating both opportunities and dangers for investors:

It is not just venture capitalists that play the pricing game. Most public market investors do as well, and this is particularly true when companies first go public for three reasons:
  1. 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). 
  2. 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.
  3. 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.
So what if the IPO market is a pricing game? First, trying to use value tools (like DCF) or fundamentals to explain IPO pricing, and what causes these prices to move on a day-to-day basis in the after market is a recipe for frustration. The nature of the pricing game is that mood and momentum can not only cause these companies to be priced at numbers very different from value, but also cause price movements on trivial, perhaps even irrelevant, news stories. Second, playing the momentum game is akin to riding on the back of a tiger, with the danger being that you will be consumed, if the game shifts. Take a look at Beyond Meat's price movements over the course of this year, since its IPO, and you can see how quickly momentum can shift in a stock, and the decisive effects it has on pricing.

2. On a shaky base
In the pricing game, you estimate how much to pay for a company by looking at how similar companies are being priced by the market, usually scaling price to a common metric like earnings, book value or revenues, as well as its own pricing history. With initial public offerings, this process gets more difficult for two reasons:
  1. 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.
  2. 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:
    Note 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.
In the traditional IPO model, where investment bankers form a syndicate to sell the shares at a pre-set offer price, it can be argued that the primary service that bankers provide, if they do their job well, is to use their access to public investors to fine tune the pricing. This year's experiences with Peloton and Uber, where the stock price dropped on the offer day, and with WeWork, where the pricing estimates imploded to the point of imperiling the public offering, has led some founders and venture capitalists to question whether it is worth hiring bankers in the first place. 

3. With an unstable share count
We all know the process for estimating market capitalization for a firm, and it involves taking the stock price and multiplying by the number of shares outstanding. For most publicly listed firms, that calculation should yield a value fairly close to the truth, but IPOs are different for two reasons. First, an overwhelming number in recent years have had two classes of shares (sometimes three) with different voting rights and being sloppy and missing an entire share class will cause devastating errors in computation. Second, most of these companies are young and cash-poor, and they have chosen to compensate employees with equity, either in the form of restricted shares and options. The way in which investors and analysts deal with these employee equity claims ranges from the abysmal to the barely acceptable, again with significant consequences. Let's take the Peloton case, where the company in its final prospectus listed itself as having 41.8 million class A shares, with lower voting rights, and 235.9 million class B shares, with higher voting rights, after its IPO, yielding a total share count of 277.7 million shares. That is the share count that has been used by journalists in writing about the offering and by most of the data services since, in estimating the implied pricing of $8.1 billion for the company, at the offer price of $29. That is patently untrue, and the reason is in the same prospectus, where Peloton states that "the number of shares..... does not include:
  • 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;"
Focus on just the first bullet, where Peloton admits that there 64.6 million options, with an exercise price of $6.71. Given that the offer price was $29/share and the open price was $27, is there any doubt that at some point in time, sooner rather than later, these options will get exercised and become shares? In fact, in what universe can you ignore these options in estimating market capitalization? The reason this practice can lead to dangerous mis-pricing is simple. Let's assume that the Peloton bankers came to the conclusion that $8.1 billion was a reasonable value to attach to its equity, based upon past VC rounds and peer group pricing. To get to an offer price, they cannot divide that number by just the shares outstanding (277.7 million), since that will treat the options as worthless. In my valuation of Peloton, I did what I think should always be done, which is to value the options as options, which allows me to include at-the-money and out-of-the-money options, as well as time value, net that option value from my equity value and then divide by the 277.7 million shares.  If you find option pricing models too opaque, here is a simpler way to get to value per share from the estimated equity value:
Thus, if the Reuters story quoted above is correct in its judgment that the bankers wanted to price Peloton at $8.1 billion, the estimated offer price per share, counting only the 64.6 million additional options would have been:
Alternatively, it is possible that this was a journalistic error in extrapolation and that the bankers took options into account and meant to price it at $29/share, in which case the implied market capitalization for Peloton at the $29 offer price, using the exercise proceeds short cut, would have been:
Implied Market Cap at $29/share = 277.7 * $29 + 64.6* ($29 - 6.71) = $9.5 billion
To see why this matters, any enterprise value or pricing multiple that you compute for Peloton should be based upon the $9.5 billion estimate, not the $8.1 billion, if the stock was trading at $29. I think that we are generally sloppy in market capitalization calculations, but that sloppiness has much bigger consequences with IPOs. So, as investors, we should follow the Russian adage of "trust, but verify", when it comes to share count.

4. And a Bar Mitzvah Moment waiting!
At this stage, I don't blame you if you are puzzled by how I approach IPOs. As soon as an IPO is announced, I use the prospectus to value the company, but I just confessed earlier that the IPO market, at listing and in the periods afterwards, is a pricing game, not a value game. So, why bother with a DCF in the first place?
  • 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.

Go where it is darkest!
Even if you accept my proposition that price eventually converges to value, if you subscribe to old time value investing, you are probably wondering why I would want to try to put my money at risk, investing in these young companies, when it is so much easier to value mature companies like Philip Morris and Coca Cola. I don't disagree with you on your premise that there is a great deal more uncertainty in valuing Uber than in valuing Coca Cola, but I believe that the payoff to imprecisely valuing Uber is greater than the payoff to precisely valuing Coca Cola. After all, what made Coca Cola easy for you to value also makes it easy for other investors to do as well, and the uncertainty that scares you with Uber is scaring most investors away from even trying. It is for that reason that I value companies at the time of their public offerings, and repeatedly thereafter, hoping that I am able to get in at the right price. Here are my estimates of value for the companies on my list at the time of the IPO, with updates on both value and price as trading has continued:

Levi StraussLyftPinterestBeyond MeatUberSlackPeloton
IPO Value $24.23 $58.78 $25.08 $46.88 $32.91 $20.59 $19.35
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
% Difference-8.30%48.57%-5.30%-1.88%27.62%86.98%40.41%

Updated Value$26.59 $54.38 $26.17 $47.41 $35.42 $23.95$19.35
Price on 8/10/19$18.96 $38.66 $25.63 $142.73 $29.28 $25.70 $23.21
% Difference-28.69%-28.91%-2.06%201.05%-17.33%5.59%19.95%
SpreadsheetDownload Download Download Download Download Download Download 

At the time of the offering, relative to the open price, only Levi Strauss looked mildly under valued, Beyond Meat was at close to fair value and the other companies all looked over valued. Since the offering, each of these companies has released earnings reports and I updated the treasury bond rates and equity risk premiums in all of the valuations. With Uber and Lyft, the added perturbation comes from legislation passed by the state of California, requiring that drivers be treated as employees, an assumption that I had already built into my valuation, but one that seemed to catch the market by surprise. Incorporating the price changes at all of the companies, and reflecting my updated valuation stories for the companies, Levi Strauss has become more under valued, Uber and Lyft have moved from being over to under valued, Slack and Peloton have converged on value and Beyond Meat has become significantly overvalued. 
  1. 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.
  2. 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. 
  3. 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.
  4. 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.
Some of my bets will go wrong, and if they do, I am also sure that some of you will point them out to me, and I am okay with that. That said, I hope that you make your own judgments on these companies, and you are welcome to use my spreadsheets (linked both above and below) and change the inputs that you disagree with, if that helps.

YouTube Video

Valuation Spreadsheets

  1. Levi Strauss (October 8, 2019)
  2. Lyft (October 8, 2019)
  3. Pinterest (October 8, 2019)
  4. Beyond Meat (October 8, 2019)
  5. Uber (October 8, 2019)
  6. Slack (October 8, 2019)
  7. Peloton (September 28, 2019)

Tuesday, October 1, 2019

US Equities: Resilient Force or Case Study in Denial?

As readers of this blog know, I don't write much about whether stocks collectively are over or under priced, other than my usual start of the year posts about markets or in response to market crisis. There are two reasons. The first is that there is nothing new or insightful that I can bring to overall market analysis, and I generally find most market punditry, including my own, to be more a hindrance than a help, when it comes to investing. The second is that I am a terrible market timer, and having learned that lesson, try as best as I can to steer away from prognosticating about future market direction. That said, as markets test their highs, talk of market bubbles has moved back to the front pages, and I think it is time that we have this debate again, though I have a sense that we are revisiting old arguments.

Who are you going to believe?
One reason that investors are conflicted and confused about what is coming next is because there is are clearly political and economic storms that are on the horizon, and there seems to be no consensus on what those storms will mean for markets. The US equity market itself has been resilient, taking bad macroeconomic and political news in stride, and a bad day, week or month seems to be followed by a strong one, often leaving the market unchanged but investors wrung out. Investors themselves seem to be split down the middle, with the optimists winning out in one period and the pessimists in the next one. One measure of investor skittishness is stock price variability, most easily measured with the VIX, a forward-looking estimate of market volatility:

Here again, the market's message seems to be at odds with the stories that we read about investor uncertainty, with the VIX levels, at least on average, unchanged from prior years. If you follow the market and macroeconomic experts either in print or on the screen, they seem for the most part either terrified or befuddled, with many seeing darkness wherever they look. As in the Christmas Carol, the ghosts of market gurus from past crises have risen, convinced that their skill in calling the last correction provides special insight on this market. In the process, many of them are showing that their success in  market timing was more luck than skill, often revealing astonishing levels of ignorance about instruments and markets. (At the risk of upsetting those of you who believe these gurus, GE is not Enron and index funds are not responsible for creating market bubbles...)

Stock Market - Bubble or not a bubble? Point and Counter Point!
Why do so many people, some of whom have solid market pedigrees and even Nobel prizes, believe that markets are in a bubble? The two most common explanations, in my view, reflect a trust in mean reversion, i.e., that markets revert back to historic norms. The third one is a more subtle one about winners and losers in today's economy, and requires a more serious debate about how economies and markets are evolving. The final argument requires that you believe that powerful rate-setting central bankers and market co-conspirators have artificially propped up stock and bond prices. With each argument, though, there are solid counter arguments and in presenting both sides, I am not trying to dodge the question, but I am interested in looking at the facts.

Bubble argument 1: Markets have gone up too much, in too short a period, and a correction is due
The simplest argument for a correction is that US equity markets have been going up for so long and have gone up so much that it seems inevitable that a correction has to be near. It is true that the last decade has been a very good one for stocks, as the S&P 500 has more than tripled from its lows after the 2008 crisis. While there have been setbacks and a bad period or two in the midst, staying fully invested in stocks would have outperformed any market timing strategy over this period.

Is it true that over long time periods, stocks tend to reverse themselves? Yes, but when and by how much is not just debatable, but the answers could have a very large impact on anyone who decides to cash out prematurely. The easy push back on this strategy is that without considering what happens to earnings or dividends over the period, no matter what stock prices have done, you cannot make a judgment on markets being over or under priced.

Counter Argument 1: It is not just stock prices that have gone up...
If stock prices had jumped 230% over a period, as they did over the last decade, and nothing else had changed, it would be easy to make the case that stocks are over priced, but that is not the case. The same crisis that decimated stock prices in 2008 also demolished earnings and investor cash flows, and as prices have recovered, so have earnings and cash flows:

Notice that while stocks have climbed 230% in the ten-year period since January 1, 2009, earnings have risen 212% over the same period, and cash flows have almost kept track, rising 188%. Since September 2014, cash flows have risen faster than earnings or stock prices. It is possible that earnings and cash flows are due for a fall, and that this will bring stock prices down, but it requires far more ammunition to be credible.

Bubble Argument 2: Stocks are over priced, relative to history, and mean reversion works
The second argument that the market is in a bubble is more sophisticated and data-based, at least on the surface. In short, it accepts the argument that stocks should increase as earnings go up, and that looking at the multiple of earnings that stocks trade at is a better indicator of market timing. In the graph below, I graph the PE ratio for the S&P 500 going back to 1969, in conjunction with two alternative estimates, one of which divides the index level by the average earnings over the prior ten years (to normalize earnings across cycles) and the other of which divides the index level by the inflation-adjusted earnings over the prior ten years.
Download raw data on PE ratios
Note that on October 1, 2019, all three measures of the PE ratios for the S&P 500 are higher than they have been historically, if you compare them to the median levels, with the PE at the 75th percentile of values over the 50-year period, and normalized PE and CAPE above the 75th percentile. Proponents then complete the story using one of two follow up arguments. One is that mean reversion in markets is strong and that the values should converge towards the median, which if it occurs quickly, would translate into a significant drop in stock prices (35%-40% decline). The other is to correlate the l PE ratio (in any form) with stock returns in subsequent periods, and show that higher PE ratios are followed by weaker market returns in subsequent periods. 

Counter Argument 2: Stocks are richly priced, relative to history, but not relative to alternative investments today
If you are convinced by one of the arguments above that stocks are over priced and choose to sell, you face a question of where to invest that cash. After all, within the financial market, if you don't own stocks, you have to own bonds, and this is where the ground has shifted the most against those using the mean reversion argument with PE ratios. Specifically, if you consider bonds to be your alternative to stocks, the drop in treasury rates over the last decade has made the bond alternative less attractive. In the graph below, I compare earnings yields on US stocks to T.Bond rates, and include dividend and cash yields in my comparison:

Download raw data on yields and interest rates
In short, if your complaint is that earnings yields are low, relative to their historic norms, you are right, but they are high relative to treasury rates today. To those who would look to real estate, a reality check is that securitization of real estate has made its behavior much closer to financial markets than has been historically true, as can be seen when you graph capitalization rates (a measure of required return for real estate equity) against equity and bond rates. 

Bubble Argument 3: The market is up, but the gains have come from a few big companies
In a version of the glass half-empty argument, there are some who argue that while US stock market indices have been up strongly over the last decade, the gains have not been evenly spread. Specifically, a few companies, primarily in the technology space, have accounted for a big chunk of the gain in market capitalization over the period. There is some truth to this argument, as can be seen in the graph below, where I look at the FAANG (Facebook, Apple, Amazon, Netflix and Google/Alphabet) stocks and the S&P 500, in terms of total market capitalization:
As you can see, the last decade has seen a phenomenal surge in the market capitalizations of the FAANG stocks, with the $3.15 trillion increase in their market capitalizations alone explaining more than one-sixth of the increase in market capitalization of the S&P 500. In the eyes of pessimists, that gives rise to two concerns, one relating to the past and one to the future. Looking back, they argue that many investors have been largely left out of the market rally, especially if their portfolios did not include any of the FAANG stocks. Looking forward, they posit that any weakness in the FAANG stocks, which they argue is largely overdue, as they face pressure on legal and regulatory fronts, will translate into weakness in the market.

Counter Argument 3: The market reflects changes in how markets and economies work 
The concentration of market gains in the hands of a few companies, at least at first sight, is troublesome but it is not new. There have been very few bull markets, where companies have shared equally in the gains, and it is more common than not for market gains to be concentrated in a small percentage of companies. That said, the degree of concentration is perhaps greater in this last bull run (from 2009 to 2019), but that concentration represents forces that are reshaping economies and markets. Each of the companies in the FAANG has disrupted existing businesses and grabbed market share from long-standing players in these businesses, and the nature of their offerings has given them networking benefits, i.e., the capacity to use their rising market share to grow even faster, rather than slower. It is this trend that has drawn the attention of regulators and governments, and it is possible, maybe even likely, that we will see anti-trust laws rewritten to restrain these companies from growing more or even breaking them up. While that would be bad news for investors in these companies, those rules are also likely to enrich some of the competition and push up their earnings and value. In short, a pullback in the FAANG stocks, driven by regulatory restrictions, is likely to have unpredictable effects on overall stock prices.

Bubble Argument 4: Central banks, around the world, have conspired to keep interest rates low and push up the price of financial assets (artificially) 
As you can see in the earlier graph comparing earnings to price rates to treasury bond rates, interest rates on government bonds have dropped to historic lows in the last decade. That is true not just in the US, but across developed markets, with 10-year Euro, Swiss franc and Japanese Yen bond rates crossing the zero threshold to become negative.
If you buy into the proposition that central banks set these rates, it is easy to then continue down this road and argue that what we have seen in the last decade is a central banking conspiracy to keep rates low, partly to bring moribund economies back to life, but more to prop up stock and bond prices. The end game in this story is that central banks eventually will be forced to face reality, interest rates will rise to normal levels and stock prices will collapse. 

Counter Argument 4: Interest rates are low, but central bankers have had only a secondary role
Conspiracy theories are always difficult to confront, but at the heart of this one is the belief that central banks set interest rates, not just influence them at the margin. But is that true? To answer that question, I will fall back on a simple measure of what I call an intrinsic risk free rate, constructed by adding the inflation rate to the real growth rate, drawing on the belief that interest rates should reflect expected inflation (rising with inflation) and real interest rates (related directly to real growth).
Download raw data on interest rates, inflation and growth
Looking back over the last decade, it is low inflation and anemic economic growth that have been driving interest rates lower, not a central banking cabal. It is true that at the start of October 2019, the gap between the ten-year treasury bond rate and the intrinsic risk free rate is higher than it has been in a long time, suggesting that either Jerome Powell is a more powerful central banker than his predecessors or, more likely, that the bond market is building in expectations of lower inflation and growth.

Implied Equity Risk Premiums: A Composite Indicator
Did you think I would have an entire post on stock markets, without taking a dive into implied equity risk premiums? Unlike PE ratios that focus just on stock prices or treasury bond rates that focus just on the alternative to stocks, the implied equity risk premium is a composite number that is a function of how stocks are priced, given cash flows and expected growth in earnings, as well as treasury bond rates. In my monthly updates for the S&P 500, I compute and report this number and as of October 1, 2019, here is what it looked like:
Download spreadsheet

The equity risk premium for the S&P 500 on October 1, 2019, was 5.55%, and by itself, you may not know what to do with this number, but the graph below shows how this number has changed between 2009 and 2019:
Download historical ERP
There are two uses for this number. First, it becomes the price of equity risk in my company valuations, allowing me to maintain market neutrality when valuing WeWork, Tesla or Kraft-Heinz. In fact, the valuations that I will do in October 2019 will use an equity risk premium of 5.55% (the implied premium on October 1, 2019, for the S&P 500) as my mature market premium. Second, though I have confessed to being a terrible market timer, the implied ERP has become my divining rod for overall market pricing. An unduly low number, like the 2% that I computed at the end of 1999 for the S&P 500, would represent market over-pricing and a really high number, such as the 6.5% that you saw at the start of 2009, would be a sign of market under-pricing. At 5.55%, I am at the high end of the range, not the low end, and that backs up the case that given treasury rates, earnings and cash flows today, stock prices are not unduly high.

My Market View (or non-view)
I am neither bullish nor bearish, just market-neutral. In other words, my investment philosophy is built on valuing individual companies, not taking a view on the market, and I will take the market as a given in my valuation.  Does this mean that I am sanguine about the future prospects of equities? Not in the least! With equities, it is worth remembering that the coast is never clear, and that the reason we get the equity risk premiums that I estimated in the last section is because the future can deliver unpleasant surprises. I can see at least two ways in which a large market correction an unfold.

An Implosion in Fundamentals
Note that my comfort with equities stems from the equity risk premium being 5.55%, but that number is built on solid cash flows, a very low but still positive growth in earnings and low interest rates. While the number is robust enough to withstand a shock to one of these inputs, a combination that puts all three inputs at risk would cause the implied ERP to collapse and stock pricing red flags to show up. In this scenario, you would need all of the following to fall into place:
  1. Slow or negative global economic growth: The global economic slowdown picks up speed, spreads to the US and become a full-fledged recession.
  2. Cash flow pullback: This recession in conjunction causes earnings at companies to drop and companies to drastically reduce stock buybacks, as their confidence about the future is shaken.
  3. T. Bond rates start to move back up towards normal levels: Higher inflation and less credible central banks cause rates to move back up from historic lows to more "normal" levels.
I can make an argument for one, perhaps even two of these developments, occurring together, but a scenario where all three things happen is implausible. In short, if economic growth collapses, I see it as unlikely that interest rates will rise.

A Global Crisis with systemic after shocks
There is no denying that there are multiple potential crises unfolding around the world, and one of these crises may be large enough, in terms of global and cross sector consequences, to cause a major market pull back. It is unclear what exactly equity markets are pricing in right now, but the triggering mechanism for the meltdown will be an "unexpected" crisis development, leading equity risk premiums to jump to higher levels, as investors reassess market-wide risk. For the crisis to have sustained consequences, it has to then feed into economic growth, perhaps through a drop in consumer and business confidence, and also into earnings and cash flows. After a decade of false alarms, investors are jaded, but the crisis calendar is full for the next two months, as Brexit, impeachment, Middle East turmoil and the trade war will all play out, almost on a daily basis.

Bottom Line
I am not a macroeconomic forecaster, and I am going to pass on market timing, accept the fact that the markets of today are globally interconnected and more volatile than the markets of the last century, and stick to picking stocks. I hope that my choice of companies will provide at least partial protection in a market correction, but I know that if the market is down strongly, my stocks will be, as well. I know that some of you will disagree strongly with my market views, and I will not try to talk you out of them, since it is your money that you are investing, not mine, and your skills at market/macro forecasting may be much stronger than mine. If you are a master macroeconomic forecaster who believes that a perfect storm is coming where there is a global recession with a drop in earnings and a loss or corporate confidence (leading to a pull back on buybacks), perhaps accompanied by high inflation and high interest rates, you definitely should cash out, though I cannot think of a place for that cash to go, right now.

YouTube Video

Linked Datasets
  1. PE ratios for the S&P 500
  2. Stock Yields and Interest Rates: US
  3. Intrinsic Riskfree versus 10-year T.Bond Rate 
  4. Historical Implied Equity Risk Premiums: US