Back in the tech bubble of the 1998-2000 era investors were left holding the bag because they paid up mightily for small, fast-growing companies that were losing money but promising dominant long-term businesses based on fast growing end markets. Paying 15 or 20 times annual revenue became the norm because earnings were negligible. Sell side analyst recommendations went something like “we recommend shares of XYZ at 15x our forward 12-month revenue estimate, as peers are trading for 20x.”
During the current bull market there was not a lot of this kind of froth in the tech sector, even though it has once again grown to be the largest in the market (31% of the S&P 500 by market value today). Companies like Apple, Facebook, Google, and Microsoft were growing nicely and had a ton of GAAP profits and free cash flow to back up the valuations. There were some exceptions like Amazon and Netflix, but it is hard to argue that they will not achieve solid profit margins at some point, and they are likely going to dominate their sectors on a global basis (exactly what those margins ultimately will be is an open question, and certainly up for debate).
Over the last year or two, cloud-based software companies are copying the Amazon/Netflix model. Given annual growth rates of 20-30%, investors are giving them a pass, despite stock-based compensation costs that are well into the double-digits as a percentage of revenue, and with sales and marketing budgets of 40-60% of revenue (whereas something more like 20-30% used to be the norm). These stocks trade at 10 times sales or more, and for that reason I cannot justify investing in most of them, but given that they are software businesses with high gross margins, these firms could make nice money today if they wanted to (cut sales and marketing to 20% of revenue and viola, your margins explode).
But as long as the public markets are valuing your stock as if you were already at peak margins and still growing 20-30% per annum, there is no reason to change your behavior. And since they can pay their employees with lots of stock, most of these companies are not burning much cash, if any, so the balance sheets are in good shape.
This week I believe we are seeing the next phase of the tech cycle with the Lyft IPO. These tech “unicorns” (firms with private market valuations of at least $1 billion) are about to flood the market with initial public offerings in 2019 as venture capitalists seek to cash out.
But something is different with these unicorns like Lyft; the income statements are gut-wrenching and look a lot more like 1999. But don’t take my word for it, here are Lyft’s results for 2016, 2017, and 2018, taken right from their IPO prospectus:
Losing $911 million on sales of $2.15 billion is no small feat, yet it is one the marketplace deemed worthy of a $25 billion valuation at Lyft’s $72 IPO price. With the stock peaking at $88 on the first day of trading and now fetching just $71 on day #4, the jury is out on whether the public market will accept these businesses at these prices.
The biggest problem, though, is not Lyft per se. It is that there are plenty more of these unicorns coming. Let’s take a look at a list of 10 unicorns that have talked about, or already started the process, to go public in the next 12 months, along with recent private market valuations:
That’s 10 companies worth one quarter of a trillion dollars in total (more than 1% of the entire S&P 500 index) and every single one of them is losing money hand over fist. Who is going to buy all of these IPOs? What assets are going to be sold to make room for them? How many money-losing companies really should be publicly traded? Will small investors be left holding the bag this time around too? Will a deluge of cash-burning tech stocks with “good stories” mark the top of this market cycle?
I don’t know the answers to these questions, but as we look out at the rest of 2019, I do think this unicorn IPO frenzy is a material risk to market sentiment. And if Lyft traded below its offer price on day #2, what does that say about everyone else who decided not to “go first”? In the end, is Lyft really that much more than a taxi service? We’ll find out over the next few years, I guess.
If you are a do-it-yourself investor who is thinking about playing in these IPOs shortly after they debut, please tread carefully. Sure, there will likely be at least one or two big long-term winners mixed in, but I suspect many more will be quite disappointing.
Somebody mentioned on CNBC this week that Uber and Lyft feel a lot like Sirius and XM did in the satellite radio space. Once they reached scale they make good money, but they really are just media companies. And in the end, there was only room for one player so they merged to survive. I would say the same thing might be true for the food delivery services. Do I really need Amazon Restaurants, DoorDash, Uber Eats, Postmates, GrubHub, and Bite Squad to go along with apps from Domino’s, Pizza Hut, and Papa John’s? My head hurts just thinking about it.