Regardless of geography or sector, investors should focus on companies that have an ability to produce FCF on a sustainable basis and possess superior management with a proven track record.
The current hype about two-sided digital platforms, blitzscaling and winner-takes-most markets has fuelled a surge in IPO listings. It is perhaps unsurprising that this exuberance, especially when combined with inordinate liquidity, record levels of VC activity and multiple fundraising rounds, has often produced stratospheric valuations that are difficult to reconcile with free-cash-flow (FCF) fundamentals.
As discussed in this paper from Epoch Investment Partners, penned by CEO and co-CIO Bill Priest and Managing Director of Global Portfolio Management Kevin Hebner, a growing number of commentators suggest we are repeating the excesses of the dot-com boom – are the unequivocal bears right?
One consequence of the high valuations is that there are now over 360 unicorns* globally, with most in tech-related sectors. Given the soaring number of IPOs, it would seem reasonable to expect this list to be shrinking. However, just the opposite is occurring as the pace of business model innovation is intensifying, ensuring an escalating number of promising start-ups. To illustrate, last year delivered a sizeable herd of new unicorns, 96 according to PitchBook, with 2019 on pace to surpass that number and set a new record.
As a result, a rising tide of doomsayers have warned that we are repeating the excesses of the dot-com boom, citing several specific developments to support their alarmist view. For a start, nominal IPO supply is on track to set an all-time high in 2019, finally surpassing the record set in 1999 (Figure 1).
*Unicorn: A start-up, private company, typically in a tech-related sector, valued at over $1 billion. They have been dubbed “unicorns” because, in many cases, their billion-dollar valuations are thought to be purely mythical.
Silicon Valley has become all about applying its magic formula, all bankrolled by slabs of VC money, to as many sectors as possible. However, one must question whether this model of growth at almost any cost is actually magical, allowing investors to take home previously buried pots of gold, or just mythical, like the much sought after, but illusive, unicorn of lore. This is especially a concern given that the clear majority of IPOs are loss-making. In fact, 81% of recent IPOs are for unprofitable firms, a proportion that ties the record set two decades ago (Figure 2). This is a particular concern for tech IPOs where only 15% of firms are profitable and, in some cases, like Lyft and Uber, the pathway to profitability is anything but clear.
Further, VCs now back almost 80% of tech IPOs, up dramatically from the 1980-2010 average of 57%. Reflecting this trend, last year was a banner year for VC investments into start-ups, with 2019 expected to be just slightly lower.
Similar to the tech bubble, VC exit activity is soaring, setting records for the dollar amounts cashed out. According to PitchBook, 2018 set a record of US$126 billion in total exit value for VCs. With a host of major listings still on the horizon, it is all but assured that total VC exit values will smash this record in 2019. This has led us to wonder: Do these savvy and well-apprised private market investors who are rushing to the door know something their public market counterparts don’t?
While the arguments that say history is repeating itself are compelling, we believe unequivocal bears miss three key points:
First, since the dot-com boom the median age of tech IPOs has risen from 4 to 12 years and the median sales of tech IPOs has increased more than threefold. (Figure 3). One could interpret these developments as evidence that it is becoming even more difficult to become free-cash-flow generative. However, in most cases these are real companies that have developed robust, viable and innovative business models and are exhibiting truly impressive sales growth.
Second, most of the oft-cited excesses appear much less worrisome when expressed relative to market cap (which has roughly doubled since the tech bubble) or in constant USD (to eliminate the impact of inflation). Although it is undeniable that some excesses do exist, they are simply not in the same league as those of the late-1990s and certainly do not pose a systemic risk to equity markets.
Third, cynics who take a black-and-white view, risk tarring all unicorns and IPOs with the same brush. This is a mistake as the historical experience and empirical evidence strongly suggests that some of these companies will develop into dominant platforms and become global champions, thus amply rewarding the patience of their investors.
Fake it ‘til you make it
Aside from the “grow fast or die slow” dogma behind the mad rush into platforms, one reason for the increased prevalence of unprofitable IPOs is the burgeoning importance of biotech. While the percentage of total IPOs represented by the tech sector remains close to its historical average of 30%, biotech’s share has soared to 43%, up six fold from the 1980-2010 average of 7% (Figure 4).
This definitely skews the statistics, as very few biotech IPOs have been profitable. In fact, most biotech IPOs haven’t even generated sales, let alone bottom-line earnings. To be more specific, since 2010 only 3% of biotech IPOs have been profitable (down from 23% previously). This is even worse than tech sector IPOs, where a rather dismal average of 27% have been in the black since 2010 (down from the historical mean of 61%).
Moreover, during the last two years the statistics have been even worse. Among tech IPOs, only 17% were profitable in 2017, followed by an even more discouraging 16% in 2018. However, the corresponding numbers for biotech were rock bottom, at 0% and 0%; that is, not a single biotech IPO posted positive earnings during the last two years. This certainly raises questions about the robustness and validity of the funding model behind all these loss-making private companies.
Venture capital: phishing for phools?
“The skill you need most when raising venture capital is the ability to tell a compelling story.” This quote is a key theme of “Secrets of Sand Hill Road: Venture capital and how to get it”, by Scott Kupor of Andreessen Horowitz. He asserts that VC investors are obsessed with technology differentiation, network effects and the potential for juicy margins. This sounds eminently sensible, but he also demonstrates that even the best VCs aren’t terribly good at avoiding failures: in fact, over 50% of VC investments lose money. Rather, he shows that the entire VC business model is based on the 10% to 20% of investments that turn into home runs. Among other things, this helps to explain why the top VCs (such as Sequoia, Kleiner Perkins and Andreessen Horowitz) hold well-diversified portfolios, typically with investments in 25-40 unicorns, spread across sectors.
A second theme of Mr Kupor’s book is that “lemons ripen early.” That is, he contends a portfolio of start-ups will often have early losses as the teams without product/ market fit quickly run out of money early. However, the successful start-ups, the ones that will become dominant platforms, take time to emerge. It can take 5+ years from a company’s founding to understand its likely growth trajectory. As a result, the goal is a J-curve with the start-up initially showing losses, followed by chunky margins and impressive profitability in the later years. This is why VCs are so infatuated with huge TAMs (total addressable market) and frequently declare that few ideas are big enough.
The VC perspective is important to understand, as they backed 79% of tech IPOs in 2018, up dramatically from the 1980- 2010 average of 57%. (The corresponding percentages for all IPOs were 66% and 35%, respectively.) Reflecting this trend, last year was a banner year for VC investments into start-ups, with 2019 expected to be just slightly lower (Figure 5). However, this does raise the question of whether the spike and subsequent collapse of two decades ago will be repeated this time around.
The above trends certainly seem to enable the manic behaviour of start-ups, many of whom appear to be adopting a slightly different mantra, “move quickly and burn money,” sprinting to an IPO before the VC cash runs out. An additional and final cause for concern is the rising number of tech IPOs that are issuing dual class shares, which are typically viewed as a way to raise money but without ceding control. To illustrate, an average of 35% have issued such shares since 2015, up dramatically from the historical mean of 6% (Figure 6).
For most of the modern history of American equity markets the NYSE did not list companies with dual-class voting. However, standards have slipped during recent decades. Popularised by the Google IPO in 2004, weighted voting rights have been featured in the high-profile IPOs of LinkedIn, Groupon, Zynga, Facebook, Fitbit, Blue Apron and Dropbox. Snap took this awkward development to a new level in 2017 when it became the first company since at least 1940 to launch an IPO with shares having zero voting rights. This allowed CEO Evan Spiegel and CTO Robert Murphy to hold a combined 88.5% of the company’s total voting power. More recently, Lyft and Pinterest are among the 2019 listings that have issued dual class shares.
To illustrate why this is a problem, earlier this month 32% of Facebook’s external shareholders voted against the re-election of Mark Zuckerberg to the board, with 67% backing a proposal for the introduction of an independent board chair. However, neither of these moves stood a chance as Zuckerberg holds 58% of the voting power, even though he only owns 13% of the total company shares. Unchallengeable control by one person over such a large and complex firm is troubling, especially considering the multiple controversies the company is currently grappling with. Facebook has become the poster child for governance challenges, with an increasing number of regulators and institutional investors calling for sunset provisions or even outright bans on dual-class structures.
The complexity of voting rights can also make the valuation of VC-backed companies extremely confusing[1]. After multiple funding rounds, many unicorns end up with convoluted financial structures, which can be confusing and misleading, even for sophisticated insiders. Such complexity is a common feature of asset bubbles (this was particularly the case during the housing market excesses a decade ago), which raises the question of whether the surge in unicorns and IPOs is just the tip of a much larger iceberg.
Is the IPO frenzy just one aspect of a broader e-commerce bubble?
There have been (at least) seven clearly identifiable bubbles over the last 40 years or so (Figure 7). The first bubble is gold, which peaked in 1980 at about 5x its initial price. The most recent candidate is e-commerce, which is up over 8x since mid-2010. Although we are not convinced it’s a bubble, we must admit it shares a lot of the characteristics of one. Such excesses always involve a dislocative event that promises to upend the existing order. The current hype about two-sided digital platforms and blitzscaling, featuring a growth over profits mentality, certainly raises the possibility that e-commerce might be yet another bubble just waiting to be popped.
In addition to a dislocative event, bubbles also require that conventional valuation measures become stretched and untethered from fundamentals. Epoch has always preferred companies with business models that are capable of generating sustainable FCF, if not immediately then in the near future.
On that basis, though, the e-commerce Index appears only slightly extended. The index currently trades on an FCF yield of 4.1%, which is only moderately below the 4.5% yield of the S&P 500. This suggests the index could be marginally overpriced, but not even close to bubble territory. Taking this point further, the remainder of this paper will present evidence that the surge in unicorns and IPOs may indicate a moderate degree of froth, but nothing like what transpired during the dot-com boom and certainly not representing a systemic risk to the equity market.
Investment conclusions
It is crucial to analyse each company individually, based on its own ability to produce FCF on a sustainable basis. Although a number of the key metrics employed for valuing digital platforms are somewhat novel, the FCF principles we have been applying for years are fully relevant to start-ups that have not yet listed on public markets.
This paper has focused on unicorns and IPOs, but Epoch has always believed that, regardless of geography or sector, investors should focus on companies that:
(a) have an ability to produce FCF on a sustainable basis; and (b) possess superior management with a proven track record of allocating capital wisely, including investing today for future value creation.
We are confident that these companies are the most probable winners and the ones most likely to provide investors with the best returns. Crucially, we believe these principles are as relevant to unicorns and IPOs as they are to firms that have traded on public markets for decades.
[1] See “Squaring Venture Capital Valuations with Reality,” UBC and Stanford University, W. Gornall and I. Strebulaev, 2018.
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