Will a tech IPO bust drag the market down?

Each day brings more news of another huge technology IPO, often by businesses that have never made a profit – and perhaps never will. But there are new signs that this latest tech bubble could be coming to an end.

For some time now we have been warning that the line of unicorns racing to IPO was evidence that private equity (PE) and venture capital (VC) owners were worried about the sustainability of their model.

Could a negative feedback loop be developing where public market losses put pressure on the willingness of PE and VC firms to do deals at elevated prices, ultimately heaping pressure on revenue multiples?

For a long time, growth has trumped profits. Since the GFC, the best performing stocks have been those that prioritized revenue growth over profits fueled by an ideological winner-takes-all pursuit of the network effect. Of course, the race to win requires reinvestment of all and any margin, as well as additional capital.

All busts are preceded by a bubble, and all bubbles are preceded by a boom. Importantly, all booms are founded on a legitimate basis for expecting future growth.

But what the smart money does at the beginning the fool does at the end.

Recently we heard that Aussie web design business Canva received another dose of capital at a valuation of $3.7 billion. Less than 18 months ago, in January 2018, Canva raised $40 million in a Series A round at a valuation of $1 billion. The company’s revenue for the six months ending December was reported to be $25 million, on which it generated profit of just over $1 million for the same period.

In January 2018, Canva’s founder, Melanie Perkins, was interviewed by the ABC and was asked how she could objectively confirm Canva’s new valuation. Ms Perkins said: “That’s exactly how venture capital works — the investors determine the price of the company that they believe it’s worth.” At $3.7 billion the company is trading on an historic price-to-sales multiple of 74 times.

Over in the US, the VC world is finding massive piles of cash are easier to come by than ever. Consequently, valuations are being skewed upwards. Start-up DoorDash offers to get your breakfast, lunch and dinner delivered from your favorite restaurants right to your doorstep with one easy click. It makes a small profit on the hundreds of millions in revenue it generates but only if you exclude salaries and rent. Just over a year ago the food delivery company was ‘valued’ at US$1.4 billion. It raised US$250 million at a US$4 billion valuation in August, US$400 million more at a US$7.1 billion valuation in February. And last week it raised US$600 million. In other words, its valuation has soared by US$11.2 billion in a mere 14 months.

This isn’t normal and as the economist Herb Stein once observed, “if something cannot go on forever, it must stop”.

In the case of DoorDash it’s probably worth noting the Singaporean Sovereign Wealth Fund, Temasek, was one of the February Series F round investors. Why is that relevant? Temasek invested in ABC Learning Centres at $7.40 per share when I valued the company at less than 50 cents. ABC Learning ultimately collapsed.

I think this bubble will collapse too. But I don’t propose to suggest this Tech Bubble is like the one I experienced first-hand in 1999. That bubble was fueled by enthusiasm for internet companies that, it was hoped, would eventually work out how to generate revenue.

This bubble is not the same. Growing revenue from zero to billions of dollars is hard work and requires dedication. Many of the current crop of stock market and private equity stars have indeed achieved billions in revenue. This time however the hope is that the cost base can eventually be tweaked, or the scale will eventually be so great, that profits will ultimately flow.

Where the two bubbles are identical however is that investors are betting on ‘potential’ rather than ‘proof’.

We are today living in another bubble, so caution is warranted. I have never in my career seen so many massive-loss-making, revenue-growth-chasing companies go public and trade at such lofty, nay absurd, valuations. And the pile of red-ink at the profit line has never been higher either.

Young fund managers, those who were still in school when the last bust occurred, think it’s normal to pay almost anything for a company that must scale enormously to eventually (hopefully) generate an economic return. But excitement has always been the preserve of the young. Sadly, they have sucked in a whole bunch of old heads who should know better.

For old-fashioned value investors – those who prefer profits over promises – it’s better to now sit this one out.

Figure 1. The state of play

Source: Crunchbase

I had great fun poking holes in Uber’s prospectus. At one point the company notes its Total Addressable Market (TAM) is US$12 trillion. Take China out of the equation, which is 15 per cent of the global economy – because Uber is banned there – and Uber’s TAM is equivalent to almost 20 per cent of Earth’s GDP. Let me assure you, Uber will never, ever, ever reach that potential!

Gloss Fading – watch out for negative feedback loops

Since 2009, global private equity capital raised annually has risen from US$315 billion to over US$800 billion in 2018. Consequently, uncalled capital held by private equity firms globally now sits at $US1.7 trillion, up from US$800 billion prior to the GFC. Similarly, deal volume has exploded. At the bottom of the GFC in 2009 ‘just’ US$300 billion of deals were conducted. In 2017, more than $US1.3 trillion of deals were done.

Perhaps most tellingly, the number of Private Equity firms around the world has mushroomed from just over 4000 firms globally in 2008 to nearly eight thousand in 2017. The world’s population grows at roughly 1.1 per cent per year, so it probably doesn’t require eight per cent growth in the number of PE firms!

With so much money looking for an alternative to the punitive rates offered by cash since the GFC, it’s not surprising so many PE firms have hung the shingle up to ‘help’. It then follows, that with so many PE firms all looking to park record amounts of cash in new opportunities, revenue and EBITDA multiples (where there is EBITDA) have all expanded too. By way of example US Leveraged Buy Out (LBO) transaction EBITDA multiples have expanded from an average 7.7 times in 2009 to over 11.2 times today.

But all that may be about to change.

According to University of Florida finance professor Jay Ritter, and despite a handful of winners, 83 per cent of IPOs in the first three quarters of 2018 “lost money in the 12 months leading up to their debut.” The previous record for that stat was 81 per cent.

In Australia, Israeli-based Afterpay-wannabe, Splitit, issued a prospectus for its IPO at 20 cents per share. By March of this year, and within two months of listing, it was 1000 per cent higher at $2.00, giving it a market cap of $534 million or 1069 times its revenue. Since March, however, Splitit shares have fallen 57 per cent.

Over in the US, Uber’s shares have fallen such that anyone who invested privately in the company over the last three years has lost money. And according to Bloomberg, investors who bought Uber’s stock at the listing price of $45 lost $655 million in the first day of trading, more than any other IPO in U.S. history.

More broadly, Pitchbook’s latest report reveals that in 2018 the CAGR, since 2010, for investors who purchased shares in the first trade after an IPO, turned negative.

These changes mark the beginning of the end for unbridled enthusiastic sentiment that buying technology IPOs are a free ticket to financial freedom. And the shift in sentiment may be significant.

If retail investors begin to notice the bad taste being left in their mouths from buying recent IPOs after they float, it won’t be too long before the exit window for private equity firms looking to foist their loss-making love children, those with no clear path to profitability, on an unsuspecting public begins to close.

Nobody left to buy

Moreover, with all the money raised by Private Equity, the deals they invest in must necessarily be larger, which explains why so many companies have been in private equity hands for so long. By way of an admittedly extreme example, Uber raised US$24.7 billion over 23 funding rounds spread over a decade (and it still only generated two percent penetration (and arguably the low hanging fruit, which means it only gets harder from here)). Larger deals must be followed by larger exits but with most of the world’s institutions, endowments, high net worth and ultra-high net worth investors already backing the IPOs, there are only retail investors left to buy them after listing.

Remember, what smart money does in the beginning…

Obviously, there will always be winners. Companies with best-in-class products and services, and those able to leverage large user databases to expand and improve collaboration tools or platforms will always have a market and/or generate improving margins from the ‘network’ effect.

But the belief that all companies, especially the 83 per cent that lost money, are worth owning because they will all be winners, is a fundamentally flawed proposition that has defined many past bubbles.

Cheap and abundant money has once again precipitated a misallocation of capital and we wonder whether the declining aggregate returns from buying loss making IPOs after listing may shift sentiment in favour of a reversal of multiples for high-risk unicorns.

Unicorns are start-ups with a market valuation of more than a billion dollars. Only revenue multiples are relevant in these times as many don’t earn any profits.