The IPO Market Heats Up: What Investors Need to Know

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Wharton’s David Wessels and Notre Dame’s Timothy Loughran discuss what investors in tech IPOs need to know.

Lyft has had a wild ride of late. The ride-hailing app company launched its IPO on Friday, March 29, with a valuation that rose from $24.3 billion to $26.6 billion and a share price of $87.24 — 21% above its IPO offer of $72. By the close of trading on Monday last week, amid skepticism from analysts, its share price had fallen to around $69, and its valuation plummeted to $19.8 billion. It has since inched up to about $70 with a market capitalization of $20 billion.

Several other tech companies are poised for IPOs in the coming months, including Lyft’s bigger rival Uber – reportedly at a valuation of $120 billion — online hospitality platform Airbnb, image search site Pinterest and food delivery company Postmates.

As investors wait for those IPOs, checks in hand, they need to cautiously consider if the pricing models for the companies in question are sustainable after customer-acquisition discounts wear off, and growth decelerates as they get bigger, according to experts. They also need to factor in the impact on those companies of increasing regulation – for example, more and more local governments imposing restraints on Airbnb. Another red flag is the shareholding structure at many tech companies: Dual-class shares allow founders greater control and can create problems for firms down the road.

Why Go the IPO Way?

The need for liquidity and credibility are the reasons these companies go public, and not necessarily to raise money for expansion or operations. The private capital markets are large enough to fund them for long periods, but the management and employees at these companies are looking for liquidity, said David Wessels, Wharton adjunct finance professor. “I think there is probably a lot of internal pressure for some of these firms to finally [agree to] go to the public markets.” Founders, venture capitalists or employees are looking to monetize some of the wealth they have helped create, he explained. Wessels is also co-author of the book Valuation: Measuring and Managing the Value of Companies.

“The markets are hot, and they won’t be hot forever.” –David Wessels

IPOs also help startups to gain additional credibility, Wessels noted. However, that was perhaps not a factor in the case of Lyft, because its customers were already acquainted with it, he said. In any event, in going public, firms expose their business strategies and finances to regulatory oversight, and to shareholder scrutiny.

The timing is ideal for IPOs because “the market is red hot,” said Timothy Loughran, professor of finance at Notre Dame’s Mendoza College of Business. He noted that the S&P 500 rose by a record-setting 13.1% in the first quarter this year – the best first quarter since 1988. “If I want to go public, I want to go public when investors are optimistic about my future growth,” he added. He noted that although tech companies in the IPO markets like Lyft, Pinterest and Uber are “burning cash,” they are commanding “high value” in the market.

“The markets are hot, and they won’t be hot forever,” said Wessels, explaining why a string of big-name IPOs are in line. Loughran, however, did not think they are “really red hot,” pointing out that 2018 saw only 134 IPOs in the U.S., up from 107 in 2017. “I am not worried about an overheated market,” he said. “If I were a manager, definitely now is the time I would think about going public.”

Wessels and Loughran discussed what investors in IPOs need to be aware of on the Knowledge@Wharton radio show on SiriusXM. (Listen to the podcast at the top of this page.)

Making Sense of Profit and Loss

Investors in IPOs are typically willing to overlook the losses tech companies incur in their initial growth years if they view those losses as the cost of achieving a critical mass for future growth. However, not everything is clear about the basis for those growth expectations. Lyft, for example, has seen increasing revenues the past three years, but its losses have also increased, Loughran noted, citing its IPO filing. He was particularly struck by Lyft’s performance in 2016, when it lost more money ($683 million) than its revenue ($343 million).

Some tech companies take time to establish themselves securely on a profitable path, like travel fare and lodgings aggregator Booking Holdings, formerly Priceline.com. The 22-year-old company is “wildly profitable,” Wessels noted. In 2018, Booking earned net profits of $4.4 billion on revenues of $14.5 billion.

The reasons for Lyft losing money are not entirely clear, Wessels suggested. “Are they losing money because they want to expand in new geographic regions – that’s an investment in the future – or are they losing money because they can’t make money?” Unlike Booking Holdings, Lyft has to invest in recruiting its freelance drivers and providing them incentives to stay in the system, he pointed out. Lyft also has been subsidizing rides over its seven years in existence, according to a Reuters report.

Pricing Opacity and Regulators

How robust would Lyft’s financial performance be if it reset its pricing to more realistic levels in the absence of those incentives? “We all love using Lyft and Uber, but is it because the price is low?” Wessels asked. “If we were to [pay], say, double the prices, would we be as excited to use these ridesharing services?” Or, would Lyft be able to generate “50% margins on enormous revenues” like Booking does? “They’ve grown to an enormous size because the price is artificially low,” he said. Investors want answers to questions like those, he noted.

“If I want to go public, I want to go public when investors are optimistic about my future growth.” –Timothy Loughran

On the other hand, if self-driving cars become a reality, Lyft would see a big upside as it could eliminate the costs related to drivers, Loughran said. “Now, this could be a cash cow.”

Uber’s strong performance may hold pointers to Lyft’s future, Wessels suggested. Uber in 2018 posted gross revenue of $11.3 billion on gross bookings of $50 billion, while its losses for the year were $1.8 billion. The gross bookings “are just enormous, and they’re taking a 20% slice of that,” he said. “The question, though, goes fundamentally to profitability. As an investor, that’s what you’re making the bet on.”

In the case of Airbnb, problems involving regulatory restrictions are hampering its growth outlook, even as its popularity among users continues to grow. Wessels noted that more and more local governments in the U.S. have made it tougher for property owners to list their offerings on Airbnb, and it faces similar restraints in numerous cities worldwide. New York City, for instance, found Airbnb’s business model was aggravating its “housing crisis” by making short-term rentals cheaper than long-term leases.

A Question of Control

Another potential worry for investors in IPOs is the ownership structures at tech companies that have dual-class shares. Those structures allow founders to retain shares of one class that have more voting rights than the other. Wessels explained how that could present serious problems when the going gets tough for a company.

“When you’re growing fast and all is going good and the founder is a superstar, this is not an issue,” he said. “But if the founder has a hiccup – as we’ve seen with [Travis Kalanick at] Uber and we’ve seen with Elon Musk [at Tesla] – then all of a sudden it becomes difficult for the board to step up on behalf of shareholders and make a difference.” The subject has been controversial, and a ban on dual-class shares would encourage more technology companies to remain private, according to a Harvard Business Review article.

“If we were to [pay], say, double the prices, would we be as excited to use these ridesharing services?” –David Wessels

Potential to Scale

Some tech companies were already substantially profitable when they floated their IPOs, and Loughran cited that of Facebook in May 2012. The company tapped the public capital market after posting in 2011 nearly $1.2 billion in net income on revenues of $3.7 billion. Facebook also demonstrated huge scalability: Those numbers grew by 2018 to $56 billion in revenues and $22 billion in profits.

“The scalability of these businesses [like Facebook] is just enormous,” said Wessels. Facebook has seen its user base grow to 2.3 billion monthly active users as of December 2018. However, a Lyft or Uber will find it more difficult to scale their operations as recruiting drivers is a tougher proposition than that offered by the “network effects” for a Facebook (where the value grows as more users patronize it), he added.

Going public will bring more clarity round some of those nagging issues. “There will be an analyst community following them and asking tough questions,” said Wessels. For example, in the case of Lyft, “maybe we’ll get a little bit better understanding of how much compensation is going to the drivers to subsidize that system,” he added. “The subsidies will need to disappear, and at some point, it is going to have to be profitable.” Over time, Lyft’s growth rates, too, will come down from current levels of 100%, and the primary focus for investors will shift from growth to cash flows, he noted.

“Once you become public, you also then can become a target,” said Wessels. “If a company is trading for a few billion dollars and you’re Google or Facebook with a war chest that’s quite large, it’s easy to make an acquisition of a public company. Not that they couldn’t do that with a private company as well, but it’s that much easier when the shares are publicly traded.”

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