IPOs: The Unicorns Moment of Truth

It has been said that in finance things take longer to happen than you would expect, but then unfold faster than you would have thought. This fact seems to be occurring in the mythical land of unicorns. I am fascinated with unicorns because their purported valuations seem to violate basic economic logic. Values not dependent on cash flow, risk and time would upset how we approach mergers and acquisitions. Rest easy as it appears unicorns do not violate the first principles of finance. Rather, their financing round based implied valuations are worse than theoretical (the usual compliant against discounted cash flow models)-they are just fanciful.

Some many unicorns are getting long in the tooth at 5-7 years of age (tech firms age in dog years). Investors are pressing for liquidity AKA an IPO. The IPO process or test is exposing some of the inconvenient facts I have previously highlighted about unicorn implied valuations. A stark example is provided by the pricing range assigned to the pending Square IPO. Last year Square was valued at over $6B based on its last financing round. Fast forward to the present and the IPO values Square in the $4B range. So what the!@#$ happened?

Something could have dimmed the prospects for Square such as the loss of Startbucks next year and continued large operating losses. Also, IPO market conditions have softened somewhat following the August correction. Worse yet is the possibly that Square was never was worth $6B. It seems that investors in the 2014 financing round did not receive ordinary shares. Rather, they received “super shares” providing them with protection against an IPO priced below their financing round value. Basically, they get more shares at bargain prices to make them whole if the IPO is priced at less than their investment. Thus, unicorn values may be inflated and exposed during the IPO process. No wonder many unicorns are trying to postpone going public for as long as they can. It will get even more interesting after they are public when they face scrutiny of real market disciple. Perhaps, things may not be so different for unicorn valuation after all.

J

Venture Capital and Rational Bubbles

This post continues my journey to explain the seemingly over priced, high risk and difficult to value venture capital market. It is well known that the empirical security market line is too flat compared to theory. This means higher risk-higher beta stocks have lower than predicted returns. Conversely, lower risk-lower beta stocks (just like the ones Warren Buffett favors) have higher than expected returns. This phenomenon is called betting against beta (BAB). Two possible reasons exist for its existence.

The first is based on leverage constraints facing institutional investors like pension and endowment funds. These investors are forced to reach for asset risk to satisfy their higher risk appetites. Furthermore, leverage constraints may impede margin and short sales ordinarily used to correct over pricing. Leverage constraints and aversion probably tightened following the great recession given the failures and near failures on many undercapitalized institutions like Lehman.

A second complementary explanation is provided by behavioral economics. The argument is as follows:

1)     Investors over weight low probability high payoff events-even those with negative expected values. A simple example is the lotto. The number of players spikes as the grand prize increases even though the winning odds fall even lower. The large unlikely payoff dominates the negative expected value. A technical explanation is players (investors?) prefer positive skew. This is especially true when the wager (investment?) is relatively small compared to investor’s overall wealth. Thus, as investor wealth tends to be pro-cyclical-so is the demand for lottery type investments like venture capital (IPOs and Private Equity as well).

2)     Two additional behavioral effects reinforce the above.

a)     Representativeness-investors focus on winners like Uber and hope their investments will be winners. They are ignoring the higher base rate failure of such investments.

b)     Overconfidence-even if investors realize “home runs” like Uber are rare they believe they possess special skill enabling them to spot “Ubers”.

Add to the above the difficult to value nature of venture investment and it is easy to see how investors can get carried away in a rational bubble.

A third more traditional factor underlying the current market is low interest rates. The Federal Reserve has keep rates artificially low following the great recessions hoping to stimulate the economy. This means projected cash flows are discounted at lower rates leading to higher values. Additionally, on the demand side, low rates forcec investors to search for higher nominal (non risk adjusted) yields by going further out on the risk curve.

Thus, the venture capital market may be experiencing a rational, albeit still dangerous, bubble.

J

Fear the Walking (Dead) Unicorn

I posted several notes here, here and here trying to make sense of inflated late round technology valuations. My conclusion was the valuations were illusory rationalizations used to justify inflated prices. The private market valuation of these firms suffered from being unregulated, questionable accounting, lack of comparability due to differing provisions (e.g. liquidation preferences), and lack of short selling. The result is momentum based pricing driven by the optimism of the last investor. The number of previously rare unicorns (private firms with values exceeding $1B) increased to 124 in July of this year. Eventually, however, you run out of optimism when an event occurs causing investors to re-examine their assumptions and reduce their risk appetite leading to lower pricing. That something was the August correction.

You only really accurately value a private firm when you make the initial investment, and then when you exit. Exits had been delayed for many later stage tech firms. Only 14% of 2015 IPOs were tech related. The reasons (excuses?) given for the lack of tech IPOs was twofold. First, the founders did not want the hassle of public market scrutiny. Second, they did not need an IPO liquidity event because they could always do a “private IPO” (oxymoron?) by accessing private investor cash in subsequent financing rounds (at assumed higher valuation levels). Both reasons are nonsense.

In reality they wanted to avoid the evaluation of numerous hard-nosed investors both at the time of the IPO and the on-going trading-including short selling. You need a public market to get liquid; it is hard to access public markets at sky high prices.

Many tech founders and investors who confused bull market valuations for liquidity are now discovering the difference between paper and real liquidity. Over 40% of 2015 tech IPOs like Novo Cure are being priced near or below their last private financing round valuation. This fact has not gone unnoticed by private investors. They are balking at high implied valuations in later financing rounds forcing firms to accept lower values. For example, Blackrock which lead a prior $350M financing round for Dropbox has marked down its investment by 24%.

Pricing represents a short term belief in expected operating performance. Investors should gauge the gap between expectations and reality. This means not falling in love with stories about market growth and technology without considering how those factors translate into revenues and ultimately cash. 

This involves understanding the following:

1)     Market Characteristics: some markets have difficult characteristics making it difficult to yield superior returns. Use Porter's 5 forces framework as a starting point.

2)     Business Model: who will the firm achieve and maintain market share and pricing power when facing competitors, new entrants and substitutes?

3)     Execution: inept managers can negate attractive markets and credible business models.

If you claim this is hard because of profound uncertainty then recognize you are not investing. Rather you are speculating based on what you hope someone else will pay for the firm. This someone else can and does change his mind leading to wild price swings like those experienced this August. This in turn can turn your hoped for unicorns into unicorpses.

J

Curb Your Enthusiasm: The Valuation Impact of Interest Rate Increases

Banks are suffering from low net interest margins (NIM) and net income growth since the 2008 Great Recession. Some believe the Federal Reserve’s low interest rate policy is responsible for this situation. In fact, the two favorite excuses provided by banks for performance issues are regulation and low rates. This post focuses on the bogus interest rate excuse. Bankers are awaiting the long expected Fed rate hike now hoped for this fall. They believe NIM, net income and hopefully stock prices will benefit from the hike. NIM and net income may initially and temporarily improve but bank stock prices are unlikely to improve.

All intrinsic valuation models capitalize expected future earnings or cash flows and their timing at a discount rate. The rate reflects two factors. The first is the time value of money (i.e. present value factor) usually represented by the risk free (Rf) rate of return. The second factor is the riskiness of the cash flows. Keeping risk, earnings and the timing of the earnings constant, rate increases will impact the time value of money thru changes in Rf. Simply stated expected earnings discounted at a higher rate have a lower (present) value.

It gets a little more complicated for banks because there may be an initial temporary increase in bank earnings when rates rise. This depends on the shape of the yield curve and how the bank’s balance sheet is positioned (asset sensitivity). Over time, the liabilities will re price and the benefit disappears.

All other things equal, rate increase are not good for stocks, banks included. Simple valuation fundamentals may be forgotten, but do not disappear.

J

Mature Tech: Valuation and Pricing Lessons

Apple’s large price drop and the Google’s large price jump occurred within days of each other. They highlight how challenging tech valuation and pricing can be in a normal trading context let alone in an M&A setting. I find it useful to distinguish the different stages of tech firms to understand the economic dynamics. My scheme is as follows:

1)     Seed: idea stage with no established business model or revenues; private market valuation set by handful of optimists of questionable reliability.

2)     Early: established business model and revenues -profits hopefully to follow e.g. Square; price based on relative value compared to “peers”.

3)     Mature: great returns/profits but growth leveling off e.g. Apple and Google; key drivers are growth and returns.

4)     Old: declining returns with limited if any growth e.g. Hewlett Packard and IBM; focus on shareholder distributions and breakup asset values.

Recently, Apple and Google experienced large stock price swings. GOOGLE increased by 16%+ or $65B on July 17 while Apple fell 7% or $60B four days later. Ralph correctly notes stock prices are based on expectations not actual results.

Expectations are frequently based on extrapolations-sometimes sophisticated, but still extrapolations based on beliefs not facts. Once a new signal (which could be information or noise) is received, investors revise their prior beliefs regarding future operating performance-Bayesian updating or learning. Tech firms are inherently volatile given short product life cycles and their uncertain operating environment. Relatively small changes in expected growth rates can have a huge valuation impact.

Apple, although it had a great quarter, gave revenue guidance that shook investor growth expectations. Specifically, concerns over iPhone, iPad, iWatch and the next “big thing” caused investors to markdown growth estimates. It is still a great firm but was priced too high based on new growth estimates. This raises another issue-will Apple’s management try regain its growth “mojo” through expensive unfocused new product R&D and acquisitions? Remember they have a huge $200B+ cash pile and could do lots of damage. Hopefully activists like Icahn will keep pressuring them to return more cash to shareholders. Interesting to see how their management reacts. The record of aging tech firms refusing to age gracefully like HP is not a happy one.

Google benefited from a “twofer”. They had a better than expected second quarter. They also provided information on improving growth prospects for mobile ads. Equally important, their new CFO provided comforting words on expense and capital discipline. The problem with maturing tech is the discipline to manage the transition from high growth to more modest growth. Managing the transition has an important impact on expectations. Whether Google’s management can deliver on these raised expectations remains to be seen. If they disappoint then expect a subsequent large downward pricing adjustment.

My take is mature tech firms are fraught with agency cost issues which make them difficult to value. They will try to fight the transition to slower growth and try to manufacture growth through undisciplined capital allocation at the expense of returns and value. New management teams unburdened by legacy culture will be needed to avoid Microsoft-Nokia type M&A misadventures.

J