IPOs, Revisited

Given that Uber’s upcoming initial public offering is consuming much of the oxygen in the business press lately, not to mention the recent IPOs of Lyft and Pinterest (with Slack, WeWork, and AirBnB not far off on the horizon), it might be timely to revisit the topic of tech IPOs, which I first wrote to you about in a letter some five plus years ago¹.

In 2013, Twitter was the hottest IPO since Facebook. It debuted in November of that year at around $40/share. Revenue was $665 million and operating income was negative -$635 million. Today, revenues have grown to $3 billion and operating income has swung to a positive $453 million. But its share price as of this writing? Still ~$40/share. Even though the result has been nearly identical to that of stashing cash in your checking account, the journey has been far from it. After initially popping in exuberance to over $70/share, TWTR collapsed into the ‘teens. If we did this retrospective two years ago², the number I’d be quoting you would be $15/share.

As an added twist, TWTR shares outstanding were 588 million back in 2013. Shares outstanding as of Q1 2019 is a much heftier 768 million. For all the media attention about companies supposedly wasting money buying back record amounts of their stock, the other side of the equation is that companies, especially Silicon Valley based tech companies, are voracious issuers of stock options that often outpace buybacks. The buybacks exist mostly to prop up share prices which are then sold into the open market by insiders.

This is how it works: you’re upper management. You get stock options. When the options vest, you exercise and thereby create more inventory of stock. Then the company spends money to buy back shares, partially reducing the inventory of stock. The net effect is you have more money and the company has less. You essentially got paid by the company, just in a circuitous manner. In the meantime, the shareholder has been sneakily diluted all the while the company is trumpeting how generous its buybacks are and how shareholder friendly it is.
 
The point is, if you buy a hot IPO stock based on hype, you are probably getting suckered. Some IPOs turn out well, but most don’t. It’s simply not designed for the public to get rich off of. It’s designed for founders and early investors to cash out. It’s designed for investment banks to reap fees and dole out favors to their lucrative clientele. It’s designed to create a new type of currency (stock options) to “attract and retain” employees. As far as stakeholders go, Joe Investor is just about damn near the bottom rung of the ladder.

If you’re a long term investor, you can afford to watch and wait. Every world-beating common stock in the past decade or two, be it Apple or Amazon or Netflix at times experience dramatic declines. Twitter languished for years below 50% of its IPO valuation. Even Facebook’s IPO was widely considered a flop back in 2012³. Shares opened at $40 in May but by August it was below $20. Since then: 10-bagger. The moral of the story is, if you really like a public company, eventually you will have a chance to buy its shares. Just probably don’t do it on the first possible day (or week, or month).

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¹http://blog.incandescentcapital.com/2013/11/the-ipo-of-twitter-to-buy-or-not-to-buy.html

²And, perhaps, if it were not for a certain "Tweeter-in-Chief" ascending to the Oval Office in 2016…

³https://money.cnn.com/2012/05/23/technology/facebook-ipo-what-went-wrong/index.htm

The IPO of Twitter: To Buy or Not to Buy

Media coverage of Twitter’s IPO has reached fevered proportions. It is easily the most hyped IPO since Facebook. The question I’ve gotten often lately is: are you going to buy it?

The short answer is no¹. Twitter, in my humble opinion, using any conservative method of valuation using publicly available financial figures, is overvalued. By a lot. You may think a Ferrari is a really great car, but would you buy one for $1,000,000 (assuming you can afford it)? Probably not. Price is what you pay, value is what you get.

That seems like an obvious thing to point out, but it gets complicated because 1.) the true intrinsic value a company, especially a rapidly growing tech company like Twitter, is unknown, and 2.) the fractional and liquid nature of stock markets stir gambling instincts like no other. Imagine if the aforementioned Ferrari is a limited edition model, and you can buy and sell 1/100,000th of it for $10 a share with the click of a button. Maybe a small voice deep within you will say, If I can buy this for $10 but sell it for $11 tomorrow, who cares what it’s really worth?

My former professor at NYU Stern, Aswath Damodaran, has taken a stab at estimating the intrinsic value of Twitter and published his thought process here:
http://aswathdamodaran.blogspot.com/2013/10/twitter-announces-ipo-valuation.html

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[1] Not even a few shares “just for fun”, which is literally the reason several people have told me with a completely straight face.

It’s long and fairly technical, but I’ll boil it down for you²:

1. The most important assumption in valuing a rapidly growing company is just how rapid its revenues will grow. Professor Damodaran assumes 55% for the next five years before tapering down to a 2.7% perpetual growth rate by year ten.
2. Revenues are nice, but as shareholders, we care about profits. Professor Damodaran assumes operating profit margins will increase linearly to 25% over the next ten years.
3. For companies to grow, they have to reinvest, which will delay the time when shareholders actually get to enjoy the fruits of excess profits. For now, all excess profits are plowed right back into R&D. Professor Damodaran assumes Twitter will have to spend $1.00 to generate $1.50 in new revenues.
4. All that stuff in #1-3 is risky. What returns might investors demand to take on such a risk? Professor Damodaran assumes 11.22% based on the recent price action of stocks in comparable industries.
5. Given the above assumptions, Professor Damodaran thinks Twitter is worth $17.36 per share.

That’s pretty much it in a nutshell. Notice that incredible assumptions that must be made, e.g. neck-snapping 55% annual growth, disciplined execution of business operations to generate a high profit margin, and continued innovation to drive such growth into an uncertain future. Out of such rough estimates comes a comically precise number: $17.36.

Before this spirals into a full blown lesson on academic valuation, I’ll stop here and let those who are truly, insatiably curious dig into the link above and/or give me a call where I promise I am happy to nerd out with you to as granular a level as you’d like.

The broad takeaway should be obvious. So much of the value of Twitter is guessing what the future will entail. True – in investing, it’s impossible to not incorporate a guess of the future, but some things are easier to guess than others. For example, it’s easier to assume millions of people will keep buying Coke than to assume Twitter will figure out a way to sell ads effectively and profitably and at scale and won’t be mooched away by future competition. In 1999, people³ happily assumed companies like eToys and Pets.com and Webvan and Amazon would similarly enjoy rocket-powered growth and bid all of them up into multi-billion dollar valuations. Today, only a little over ten years later, only Amazon is left.

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[2] My qualifications, for your edification, are that I got an A and an A- in the two classes I took with Mr. Damodaran.
[3] Really smart, Ivy League educated people getting paid enormous sums of money.

Predicting stuff is really hard. Most of the time, it’s just guessing, especially as you lengthen the duration of your prediction. You want as many handicaps as you can get on your side: amount of cash in the bank; proven revenue model; unconquerable strength of brand; special situations bound by clear catalysts; tangible assets, etc., etc.

Twitter has none of those. Brand strength… maybe. But it’s not “Twitter” the company, per se, that its users are loyal to, it’s the network of people and their followers. Can you be reasonably assured that something cooler won’t catch the fancy of people in the next ten, fifteen years? If you say yes, would you have applied the same argument to MySpace back in 2004?

This is not meant to be a knock on Professor Damodaran’s conclusion of a $17.36 per share fair value. The value of Professor Damodaran’s exercise is the process, not the assumptions. All investors should apply their own assumptions. It’s what makes a market a market. And if you’re reasonably assured of them and your output is $17.36 per share, then you should buy the stock if it’s falls below that price.

It might be a while, though. TWTR traded above $40 on its first day. Now, if you think 55% growth, 25% margins, etc, are aggressive assumptions to achieve a $17.36 fair value, imagine what assumptions you’d have to make to double that. Yeah, exactly. It is highly probable that the current marginal buyer of TWTR is simply gambling. Nothing wrong with that, I suppose, but I’d rather not do that with the money that my clients and I will rely on to retire in the future.

“Remember that just because other people agree or disagree with you doesn’t make you right or wrong – the only thing that matters is the correctness of your analysis and judgment.”

-Charlie Munger