A Blog by Jonathan Low


Sep 30, 2019

Unprofitable Companies Are Raising the Most Cash Since Dotcom Bubble

There is more money seeking investments than there are good ideas. And the lengthy bull market has dulled the senses of those who should be evaluating risk more carefully. JL

Esha Day and colleagues report in Bloomberg:

Unprofitable companies are raising money in initial public offerings at the fastest pace since the dot-com bubble. “Today’s technology is better than anything that was around in the Pets.com day. Logistics weren’t as well developed in the early internet era; e-commerce wasn’t as efficient. There was a lack of infrastructure.” True disruptors, like Amazon or Netflix , can deliver incredible payoffs. Would-be disruptors that fail to transform their markets can wind up like a wilted tulip.(But) “You know things are ridiculous but don’t want to miss out, so suspend your disbelief. But eventually bubble investors realize the emperor has no clothes.”
Unprofitable companies are raising money in initial public offerings at the fastest pace since the dot-com bubble when a revolution in the banking industry sparked a rush to risk.
The 2019 class of IPOs includes a number of so-called unicorns, including high-profile market entrants like Uber Technologies Inc., Lyft Inc., and Pinterest Inc. Together, the unprofitable IPOs have already raised the most cash of any year since at least 2000, according to a Bloomberg analysis of listings worth $100 million or more. Peloton Interactive Inc.’s Thursday debut on the Nasdaq is just the latest money-losing firm to go public—and also the latest to disappoint.
The fitness company tumbled in its first day of trading, in the third-worst debut of the past decade by any U.S.-listed firm that raised at least $1 billion, according to data compiled by Bloomberg. It isn’t alone in failing to gain traction: Avantor Inc. recently dropped below its IPO price, while Uber is 30% below its own and Lyft is down more than 40% from where the IPO priced.
This caution has even extended to names that haven’t yet gone public. Endeavor Group Holdings Inc. slashed its target valuation by $1 billion on Thursday before postponing the deal, to say nothing of WeWork parent The We Co., the office-share operator awash in red ink that has seen its expected valuation slashed and its CEO ousted. While We Co. had initially sought to price its offering by Sept. 27, the IPO has since been delayed, and may not occur until next year. Currently, another 108 companies have filed to go public this year.

The Cycle of IPO Risk

While still not as extreme as during the dot-com bubble, unprofitable company IPOs have surged since the financial crisis, with many outperforming the market in the short term
“It used to be an article of faith that you couldn’t go public until you turn a profit,” said Rett Wallace, chief executive officer of Triton Research Inc, which specializes in new listings. “Not a path to profitability, a profit.”
The risk inherent in this year's IPO class may evoke memories of dot-com companies that went bust at the turn of the century despite the exuberance surrounding them. But there may be a reason why investors keep going to the IPO trough—regardless of profitability or an immediate pathway to riches.

The Year of the Unicorn

Unprofitable IPOs have raised a record amount in 2019, with three months still to go

Going back to 1999, nearly half of IPOs for unprofitable companies outperformed the greater market one year after their listings. And so far in 2019, new unprofitable IPOs are on pace to outperform the market at a higher rate for the fifth straight year. Technology firms including Chewy Inc. and Crowdstrike Holdings Inc. have surged in their debuts this year for some of the best first-day pops in at least a decade.

Decent Odds of Outperformance

Unprofitable IPOs have beaten the market about 47% of the time
In past market cycles, budding upstarts like Microsoft Corp. went public only after brandishing years of positive earnings. But that started to change some two decades ago when massive investment banks took over the underwriting business from the closely held securities firms of the Glass-Steagall era. The banks, now endowed with broader ownership structures, developed a greater tolerance for risk, forever altering the profile of companies that could go public.
"With mega-banks, the capital is not really anybody’s money who you’d need to talk to in person and say, ‘I’m really sorry,’” Wallace said.
During the dot-com bubble, investors flocked to bet on the purported next big thing. A similar theme can be spotted in today’s IPO market, with some companies asking buyers to bet on unproven technology and untested revenue models. Many winners have emerged, but this deluge of disruptors has also laid down a minefield.

A car that allows you to read the morning paper in peace or even catch up on sleep as it whisks you to work during a long commute, or a magic potion that can soothe everything from pain to anxiety—how do you put a price on these never-before-seen miracles?

Ascribing a value to an unprecedented technology that may transform an industry is a unique challenge for financial experts. Traversing such uncharted territories requires major leaps of faith and can lead to wildly incorrect valuations.
Take, for instance, Tesla Inc.’s goal of dominating the self-driven taxi industry of the future. After the company initially mentioned this target a few years back, Morgan Stanley analyst Adam Jonassaid the so-called robo-taxi business alone could be worth as much as $244 per share. Expectations have since tempered, with his valuation now closer to $45 per share, while other analysts assign the potential business no value. But Jonas is not the only believer. Tesla holder Ark Investment Management has said the stock could eventually be worth an eye-watering $4,000 per share, based largely on the robo-taxi opportunity. Meanwhile, Tesla shares traded shy of $250 in early September.
Valuing these companies requires a very long-term view, Cowen analyst Jeffrey Osborne said in an interview. “That’s the issue with these valuations. You got to go out a very extended period of time, and assume some market size and then usually an obscenely high market share for the one company that is coming out.”
But such valuations pose no trouble when there is enough cash sloshing around in the system.
When Tesla made its public market debut in 2010, the company was gearing up for the launch of its Model S sedan. Nine years later, the company has sold more than 95,000 units in the second quarter of this year alone. But the explosive growth has come at a steep price, with Tesla burning though nearly $6.5 billion of cash in 2017 and 2018 as it struggled with the launch of its first mass-market car.
“Luckily for Elon Musk, he has been in a bull market for six or seven years,” Osborne said. When money is cheap, the market’s propensity to fund promising technologies rises, but when the tide recedes, so does the enthusiasm.
“These types of names go completely out of favor in a recessionary environment.”
The marijuana market is seeing a similar story unfolding. Tilray Inc., the first cannabis company to IPO on a U.S. stock exchange, became the poster child for pot-stock mania when it surged nearly 1,700% in its first two months of trading to a market value of nearly $20 billion, despite never having turned a profit. The reality of product shortages and money-losing operations eventually sank in, and Tilray’s stock has declined about 90% from that high to a current price below $30 a share.
Like Tesla’s robo-taxi promise, investors in the cannabis space are most excited about a compound that’s thought to have huge potential but is also largely untested: CBD.
Cannabidiol, as it’s formally known, is a non-intoxicating compound found in the cannabis plant. Unlike its cousin THC, CBD doesn’t get you high, but is said to help with everything from pain and inflammation to anxiety and sleeplessness. The most enthusiastic advocates say its uses are nearly limitless. CBD is already found in skin creams, pet food and hamburgers. Mainstream retailers like CVS Health Corp. and Walgreens Boots Alliance Inc. have begun selling CBD products in some of their stores. Piper Jaffray Cos. estimates the U.S. CBD market could be worth as much as $15 billion in five years.

“It is rare for an industry to get two shots at building a whole new market, but the cannabis industry has been rewarded for its decades of legalization work with exactly that,” according to a recent report from BDS Analytics and Arcview Market Research, referring to state-level legalization of marijuana followed by the federal legalization of CBD.
To be sure, there are risks to these optimistic forecasts. Scientific research into the medical benefits of CBD is just beginning, and the U.S. Food and Drug Administration is still determining how to regulate the use of CBD in food and beverages.
“Like much of the rest of cannabis, public opinion has moved much more quickly than both the science and the law,” said John Kagia, chief knowledge officer at pot research firm New Frontier Data.
Those risks haven’t made much of a dent in investors’ enthusiasm for the space, however. “You’re buying into the hype that one of these companies will create some great brands and become the next Coke or Pepsi over the next 15, 20 years,” said Greg Taylor, chief investment officer at Purpose Investments Inc. and manager of the Purpose Marijuana Opportunities Fund.
Typical booms⁠⁠ and busts⁠ can come in many forms. A quick look at the stock charts of Amyris Inc.⁠—a company that uses genetically modified molecules from yeast to create biofuels and other renewable chemicals as an alternative to petroleum products—or Ballard Power Systems Inc.⁠, which makes emission-free fuel cells, can tell part of that story.
As Cowen’s Osborne said, Wall Street has seen this dance before, when a nascent market attracts buzz and the valuation runs amok. Fuel cells experienced it with Ballard’s boom in the 1990s, and “had a 15- to 20-year period as a publicly traded science experiment, and finally is starting to commercialize,” the analyst said.
The big ambitions of recent IPOs could also be a symptom of the private fund-raising world, in which companies are increasingly injected with so much cash that they must aim for the moon to grow at a pace that justifies the high degree of investment.
“What you’re seeing is much deeper J curves,” Wallace said, referring to trend lines showing an initial loss followed by accelerating growth. “You lose more money for longer and the area in the J curve is bigger. It consumes more money than the earlier generation of comparables you saw, like Amazon.”

For companies like the above mentioned, Tesla or Beyond Meat Inc.—the alternative protein producer whose stock has soared more than fivefold since its May debut—the science experiment is playing out in the consumer marketplace.
“It’s a question of getting people to change their behavior,” Triton’s Wallace said. “You have 100-plus years of consumer behavior associated with gas powered cars and a million years of hamburgers being made out of beef. Getting people to change their orientation to accept a hamburger that’s made out of plants might turn out to be more of a challenge than making the plant-burgers.”

Faux Disruptors

While some financial flops may seem comically obvious in hindsight—Dutch tulips, most infamously⁠—analysts stressed that many failures had some kind of compelling argument behind them, even if the bull case fails to play out.
Take Pets.com. The company is probably the best-remembered implosion of the dot-com era, a go-to example for how the rush to move businesses online resulted in casualties like this pet-supply vendor. However, Wall Street recently welcomed Chewy Inc., which operates in the same market, just at a very different time.
“Today’s technology is better than anything that was around in the Pets.com day. Logistics weren’t nearly as well developed in the early internet era; e-commerce wasn’t nearly as efficient. There was a lack of infrastructure,” said Seth Basham, an analyst who covers Chewy at Wedbush.

While Basham added that parallels between Chewy and Pets were largely superficial beyond their focus within online retail, the success so far of the new company—shares are up more than 20% since their June IPO—suggests how a failure can be early or mismanaged as opposed to simply being wrong in conception.
“Technology often creates a lot of euphoria about growth, based on the assumption that what a tech company is doing will prove to be transformative, that it will disrupt an entire industry, and that these companies will be the winners and grow at a level that can’t be attained anywhere else in the market,” said Anthony Saglimbene, global market strategist at Ameriprise Financial.
Back in the 1990s, when “technology” was the buzzword, any company that put .com after their names would attract immediate investor attention. “No one was looking closely enough at whether the business made any sense,” Chuck Lieberman, chief investment officer of Advisors Capital Management said in an interview.
Instead, investors did all they could to “rationalize why the stocks would go up when the companies weren’t making money and weren’t going to. That’s a tell-tale sign of a bubble.”
True disruptors, like Amazon in retail or Netflix in entertainment, can deliver incredible payoffs. Would-be disruptors that fail to transform their markets can wind up like a wilted tulip.

Blue Apron Holdings Inc., the at-home meal-kit delivery company, is one prominent example whose compelling story hasn’t had a happy ending. According to its IPO prospectus, Blue Apron set a goal that it would eventually expand to the point where it could sell meals to 99% of Americans. Last month, it lowered expectations, saying its core product could serve 50 million U.S. households, or less than half of American homes.
“It comes down to fear and greed driving behavior,” said Mike Loewengart, vice president of investment strategy of E-Trade Financial Corp., who was speaking about the lure of bubbles in general. “It’s almost like people have to go along with it, because of the concept of FOMO,” or the fear of missing out.
“You know things are ridiculous but don’t want to miss out, and suspend your disbelief. But eventually bubble investors realize the emperor has no clothes.”


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