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)


Anonymous said...

Big thanks for this post and for your whole blog and YouTube courses. Regarding share counts, there are also worse examples such as the recent Cloudflare IPO, where reporting focused on the official 290M share count and ignored the huge 207M issued deep-in-the-money option and RSU count.

Cesare said...

Thank you for the article it was a interesting read! I believe another important factor to take into consideration in IPO is what I like to call size/to fame. If a company is very talked about but at the same time quite small (beyond meet has the lowest market cap by far among most of the other companies mentioned but I wouldn’t say it is the less talked about) there is a bigger chance of a greater demand to supply situation causing the crazy price increases. What do you think ?

Anonymous said...

Hi Professor,

Interesting post as always. I think one oversight that you missed is the survivorship bias we've had this year (and especially lately). Had IPOs for companies like WeWork and Endeavor gone through instead of being shelved; they would have likely dragged down the index performance even more.

I also wonder if it's appropriate to calculate the performance of IPOs based on the IPO price or first trade and not the last private round valuation, especially given that many mutual funds, hedge funds and pension plans are buying shares on the grey market. But now we're splitting hairs.

David B said...

How do you value esg risks? You mention not liking certain governance practices, and some disclosure frameworks are evolving. Do you reference these at all in your valuations?