The return of loss making IPOs

Thu 30 May 2019

Is this a bubble or a source of returns for diversified investors? What is the “Uber bet”?

We live in a low interest rate super-liquid world, with a lot of money chasing too few opportunities. Overall equity issuance has stagnated over the last few years as CEO’s use buybacks to please existing shareholders, removing equities from the secondary market. Thus, investors seemingly can’t wait for a company to become profitable, and they need to get in earlier and earlier in the development stage. This begs the question, is participating in an early and loss making IPO really worth it?

Source: Sifma

Across the US numerous billion dollar IPOs have taken place in 2019; Uber, Lyft, Zoom to name just a few. Many of these businesses are typical high growth technology companies in so far as while revenues maybe rising rapidly, so costs continue to expand and margins remain supressed; in many cases, these firms are actually losing money quarter on quarter.

Uber lost a massive $1.8B in 2018 and $2.2B the year before. Is a loss making company still worth paying for? Yes, if it has growth potential. But, Uber’s sales growth has been declining as the chart below demonstrates.

The Uber team does have a long term plan to achieve profitability, however this relies on automation for driverless cars being cheap, accessible and accurate enough to replace their current labour force. Former CEO Travis Kalanick once said that autonomous car technology was “basically existential” to Uber, and the firm has been spending tens of millions of dollars on research in this area a month. An investment in Uber shares is a bet on autonomous car technology being powerful enough to replace human drivers. UK Chancellor, Philip Hammond, has promised that “genuine driverless cars” will be on the roads by 2021. But the technology for this is hardly there yet. A self-driving car killed a pedestrian in an accident in March 2018, which lowered confidence in autonomous technology.

Is the IPO too late?

This brings us to crux of the question; is this loss making stage just a necessary step in a company’s life cycle and can investors look past the financial ratios that scream this is not a good investment when truly revolutionary technologies are on the table? To investigate we will take a look at two IPOs, Facebook and Square, that turned out to be excellent investments despite the financials not being attractive.

• Facebook shares on the date of their IPO were trading at a P/E ratio of 85, which by any measure is expensive. Additionally, Facebook had posted a decline in revenue in Q1 2012, which made the earnings multiple appear even more stretched at the time. However, over the long term the stock delivered fantastic returns as the “unproven ad model”, to quote Brian Wieser from Pivotal Research Group, brought in billions of dollars of revenue at sky high margins.
• Square, the payment technology company founded by Twitter CEO Jack Dorsey, on its IPO day traded at $9 a share. Before the sell-off in Q4 2018, the stock hit a high of $99; an 11X investment in under four years. However, at the time of IPO the company was still making a net loss and did not turn a profit for a single year from 2012 to 2014. But with the right marketing, technological innovation and growth strategy it was clear to many this firm had the potential to succeed and the bet paid off handsomely for early investors.

While some argue that a lot of the returns for these modern technology companies have already been “realised” pre-IPO by rounds of venture capital, this is less of a concern to investment managers whose primary mandate is outperforming an equity benchmark. Though we do agree that alternative investments, that include private equity, infrastructure assets and absolute return funds, do have their place in multi-asset portfolios, common equities that are liquid, transparent in their filings and pay dividends should form a large part of any long term investor’s strategy. While it may be true that returns for early investors may often be higher, often the risk they took was also much greater with an unproven business model. Peter Thiel, Pay-Pal cofounder, investor and author, once said that the best investment in a successful VC fund outperforms the entire rest of the fund combined; venture capital funds are extremely risk on, with a small number of holdings driving the returns. However, VC funds and loss making IPOs do fit the time horizon of some parties, such as wealthy families, that do not require instant access to their funds.

While some of these IPOs may give the appearance of a bubble, especially in a Fed driven world, closer research per case might indicate differently. In our opinion, a loss making company with perhaps not the best financials on paper shouldn’t be looked over for a long term investment for this aspect alone. As economies of scale kick in, brand loyalty increases and fixed costs can be shared over increasing revenues, companies can eventually position themselves to earn consistent profits. To conclude, investment managers should not refrain from holding loss making companies if the upside potential is substantial and it is within a diversified portfolio of uncorrelated stocks. There are plenty of companies that once fit the definition of a loss making IPO but went on to become industry leaders and generated great shareholder value along the way.

Daniel Gorringe, Investment Analyst