Party like it’s 1999: Just like the dot-com days, unprofitable companies are driving the IPO market
In an echo of the dot-com days, Wall Street is once again obsessed with tech companies that are long on promise, but short on profits.
From producers of fake meat to ride-hailing services, businesses that promise a glorious, if rather vague, future are going public, stirring both high hopes and controversy. For most of these companies, the first dollar of earnings still lies years in the future.
Consider Uber Technologies Inc., which raised US$8.1-billion in its long-awaited, if ultimately disappointing, Wall Street debut on Friday. The ride-hailing company says it wants “to ignite opportunity by setting the world in motion.” For now, though, it is still losing hundreds of millions of dollars a year, which means it is essentially in the business of providing heavily subsidized taxi rides.
Or take a look at Beyond Meat Inc., which soared after its initial public offering (IPO) earlier this month. The maker of plant-based burgers and sausages has the high-minded goal of weaning the world off animal flesh and says it is taking aim at the US$1.4-trillion global meat market.
Unfortunately, avoiding red meat doesn’t mean avoiding red ink: In its most recent fiscal year, Beyond Meat lost roughly 34 cents on every dollar it took in.
Other unprofitable but high-profile companies that have gone public this year include Pinterest Inc., the online visual bookmarking service, and Lyft Inc., another ride-sharing service. They are expected to be joined soon by Chewy Inc., an online retailer of pet goodies, and We Co., which purveys office space for hipsters under the WeWork brand.
These half-dozen big-name enterprises collectively lost nearly US$4.2-billion over the most recent fiscal year. Yet, investors still seem willing to pour money into them.
Haven’t we seen this movie before? Anyone who experienced the dot-com boom of the late 1990s will recognize some signature moves from that era.
Once again, money-losing companies are talking in grandiose terms as they go public, promising innovations that will disrupt industries and revolutionize society. Once again, unprofitable businesses are driving the IPO market. And once again, investors are eager to take part.
The parallels between then and now are hard to miss. What is just as important, though, are the differences. The IPO market of 2019 isn’t simply 1999 redux. Rather, it’s a concentrated, supersized version of that earlier time. Investors have every reason to be wary of the risks. But they should also be conscious of what has changed over the past 20 years.
The biggest single difference is scale. The IPO craze of the late nineties featured a seemingly endless flood of small, young tech upstarts, many of them only three or four years old, and most of them with scant sales or profits.
In contrast, the latest episode of IPO fever centres around a relative handful of older, bigger companies. They have hefty revenues and well-established market positions.
These companies are much better financed than that earlier generation of tech IPOs. While many dot-com enterprises went public in the late 1990s because they had to raise cash, the businesses now hitting the markets often have large amounts of money already on hand. None of them are facing an imminent cash crunch and most are offering only a small slice of their total share float in their IPOs.
Their flush status reflects the increasing importance of private money. Institutional investors, from venture capitalists to pension funds to university endowments, have become increasingly willing to invest in ventures that are not yet public. They are searching for higher returns than public markets can provide.
One key aspect of these investors’ strategy is allowing businesses to stay private much longer than they did a generation ago. The goal is to give these companies the time and flexibility to build their empires, without worrying about making money right away.
“Investors are saying, Don’t focus on profits, focus on growth,” says Jay Ritter, a professor of finance at the University of Florida and a leading scholar of IPOs. “The key notion is that in many tech-related areas we’re in a winner-take-all world, where high fixed costs and network effects mean that a single company tends to dominate a sector.”
To be sure, private investors aren’t endlessly patient with their chosen businesses. A typical venture capitalist, for instance, commits money for 10 to 12 years, Prof. Ritter says. At the end of that period, they want to cash out, either by striking a private transaction or by taking the company public. That is one reason why several companies founded in 2009 – Uber, Pinterest and Beyond Meat, to name three – are now hitting public markets.
From an underwriter’s perspective, it helps that investors are primed and receptive. A handful of tech oligopolists – Facebook Inc., Amazon.com Inc., Apple Inc., Netflix Inc. and Alphabet Inc. – have delivered enormous returns over the past decade. With their examples fresh in mind, many people are eager to catch the next big thing.
The challenge for investors is that the relentless search for tomorrow’s big winners makes a stock vulnerable if any cracks appear in its growth story. Lyft, for instance, had a strong debut at the end of March, but its shares have since slid more than 20 per cent below their IPO price after the company reported results that disappointed analysts.
Uber is also facing creeping skepticism. Its IPO on Friday valued the entire company at US$82.2-billion. That valuation is far below the US$120-billion-plus that was rumoured last year and reflects growing concern about the business’s fading growth rate and ultimate path to profitability. Adding insult to injury, the stock finished its initial day of trading at US$41.57, below its IPO price of US$45. So much for a first-day pop.
Investors have good reason to be cautious. Ride-hailing companies operate in a market with no loyalty or stickiness, according to Aswath Damodaran, a valuation expert at New York University. Customers will go with whichever company offers the lowest fares, while drivers will flock to whichever company offers the highest compensation.
“Uber is a company that is poised on a knife’s edge,” Prof. Damodaran wrote in a recent analysis. “If it just continues to just add to its rider count, but pushes up its cost of acquiring riders as it goes along, and existing riders do not increase the usage of the service, its value implodes. If it can get riders to significantly increase usage (either in the form of more rides or other add-on services), it can find a way to justify a value that exceeds US$100-billion.”
The simplest way to value many of these money-losing companies is to look at their share prices in relation to their sales. If nothing else, this ratio does demonstrate the lavish amount of high hopes built into current share prices.
Beyond Meat, for instance, more than doubled on its first day of trading. Its stock now trades for more than 35 times the company’s 2018 sales. Just to be clear: That is 35 times the company’s sales, not its non-existent profits. By comparison, traditional purveyors of meat products, such as Tyson Foods or Maple Leaf Foods, sell for around one times their sales.
Other hot IPOs of recent months also boast elevated price-to-sales ratios. Zoom Video Communications Inc., a teleconferencing company, is selling for 60 times sales. By comparison, Pinterest (20 times), Lyft (seven times) and Uber (seven times) look more reasonable, but are still far more richly valued than the S&P 500 (2.1 times).
Investors may want to shy away from IPOs with particularly high price-to-sales ratios, Prof. Ritter says. In the years between 2001 and 2018, only 21 U.S. companies with revenues of more than US$100-million finished their first day of trading with price-to-sales ratios above 20. Based on their first closing price, 17 of those 21 companies went on to underperform the market over the next three years.
“High valuations are hard to live up to, even if the company executes well,” he says. It’s a good point to keep in mind as Wall Street once again feels the grip of IPO fever.
