2019 Unicorn Class
For readers who have been living under a rock, a unicorn – in finance jargon – is a private company with a valuation of over $1 billion. Of course, as there is no observable public market price for private companies, this valuation is gleaned from the implied valuation at their latest funding round.
2019 is slated to become a banner year for tech unicorn IPOs, with marquee names such as Uber, Lyft, Slack, Zoom, and Pinterest filing to go public with S-1s/prospectuses (investment bankers get a slew of these to work on when a big IPO window opens up and analysts and associates scramble to replace boilerplate language with buzzwords that are key to the company’s marketing strategy while the corporate lawyers have the painstaking task of reading every single word so that it cannot be misinterpreted). Other potential, noteworthy IPO candidates include Palantir and the We Company (WeWork). As such, investor interest in technology is high.
Lyft had a very high profile IPO this week to kick it all off, clearing at a level above the targeted marketing range. Lyft shares closed at 9% above the IPO price. JP Morgan led the Lyft IPO as Goldman Sachs and Morgan Stanley are leading the much larger Uber IPO that is coming up shortly after – possibly being valued over $100 billion.
However, Lyft shares have fallen below the IPO price since then. When insiders are free from their lockout period, they will want to exit in droves to diversify and possibly because they feel that the valuation is not justified. For every successful IPO such as Google or Facebook, there are stocks that run up initially before falling with no looking back – Snapchat, Twitter, GoPro, Groupon are just a few of many examples.
A positive response from the market will encourage the other aforementioned companies and their backers to continue on with the IPO path as valuations are frothy. If Lyft’s valuation craters, this may give prospective maiden issuers pause.
Is It 1999 All Over Again?
It is widely broadcast that we are in the “8th or 9th inning” of a bull market that has gone on since the financial crisis (the financial crisis was over 10 years ago!). A disproportionate amount of this run-up in stocks has come from the technology sector while traditional behemoths such as oil and gas have suffered.
For the uninitiated investor, tech stocks are synonymous with high P/E multiples. NVIDIA often trades above 30x forward price earnings while Google and surprisingly for some old school investors, Microsoft, trade well above 20x.
So knowing nothing else about these companies, this implies that for every dollar invested into these companies, they will pay back the investment every 30 or 40 years. Sounds terrible.
And then corporates such as Amazon and Shopify are profitable, but can trade above 200x earnings – so this may be even more concerning for investors that are not familiar with the field. Warren Buffett does not invest in what he does not understand, and he has made it a point to stay out of tech.
For this upcoming batch of IPOs, many of these companies have not even reached profitability (and some of them do not have an obvious path or plan towards being profitable). Is the technology sector getting back into bubble territory, led by the FANG stocks?
Winners and Losers in Tech Stocks
The answer is uncertain, but we are at least inclined to say probably not. Other than certain pockets of the tech space (such as cryptocurrency, which has already burst and is continuing to wind down), the sector remains relatively healthy and arguably continues to be investable.
Although valuations are ostensibly high, this is a function of the market pricing in strong growth with the option value of incremental exponential growth. Should there be breakthroughs in artificial intelligence, the internet of things, 5G, big data, autonomous vehicles and connectivity through cloud computing, market leaders in the space such as Google or Amazon may actually be very cheap. It is easy to swallow that Google is much more likely to grow earnings at 20% a year for the foreseeable future compared to a cash cow such as Altria (smoking).
Investment bankers often blow off stretched valuations by claiming that a company will grow into its valuation. This is even more dangerous with a debt raise because there are more serious ramifications when a company does not grow out of its leverage. However, with the technology peer universe for software and internet, if the addressable market is large enough and there is confidence that the company can carve out a large piece of that pie, this is a realistic proposition. When the right corporates are bet on, the derisking process that goes through as the company executes on capturing market share results in stock prices soaring year over year as the hypothetical value from the year before is crystallised.
While technology has been a perennial winner since the last crash, there have been plenty of losers – Snapchat is one of the best examples of one company that did not work for investors. They did not have a clear path to profitability and were a major player but not the incumbent player in their social media strategy. A major story for the year was the Snapchat platform being usurped by Facebook’s Instagram Stories. Instagram itself is seeing new competitors as TikTok/Douyin becomes viral. Nonetheless, none of these platforms have so far carved out a defensive moat for themselves – they are all vulnerable.
There will be many more Snapchats in the new Unicorn class of 2019. Lyft, Palantir, the We Company (with their much derided community adjusted EBITDA) may struggle to maintain valuations if they cannot show investors a path forward to an appropriate business model. Past market darlings continue to struggle today as evidenced by Facebook and Tesla – with many incumbents facing upcoming challenges (Netflix possibly running into a content war with Disney) or having execution problems in replacing a dominant product (Apple and declining iPhone sales in China and the inability to continue boosting price).
Direct Listings versus IPOs
Similar to Spotify’s float last year where they chose to avoid the IPO path (and accordingly not pay the financing/capital markets divisions of the investment banks). This is only possible when the issuer does not need to raise more money because they are cash positive or have raised enough money from previous funding rounds. Slack has expressed an interest in this approach.
The IPO is accordingly all secondary shares and no primary shares are issued from treasury. This means no resultant dilution but still allow for exits from early investors and employees.
Keep in mind that investment banks will still get paid for advisory services, a major boon to experts at the Elite tech Boutiques such as Allen & Co, Qatalyst and the usual suspects at Evercore/Moelis/PJT/Goldman Sachs/Morgan Stanley.