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IPO flops are an encouraging sign of market sanity

11 October 2019

(St, Louis Post Dispatch)

October 11, 2019 (David Nicklaus)

When WeWork canceled its initial public offering last week, it may have marked the end of a growth-at-any-price era in investing.

The coworking company had quadrupled in size between 2016 and 2018, but it was also deeply unprofitable, with losses that exceeded revenue. Underneath the hype, it was nothing more than a real-estate investor that took long-term leases on office space and rented it to short-term tenants.

Nothing about that business model justified the $47 billion value that private investors placed on the company in January. Faced with having to slash its valuation by two-thirds of more, and unable to answer questions about lapses in governance, WeWork shelved its IPO and accepted the resignation of Chief Executive Adam Neumann.

WeWork’s failure to launch followed disappointing performances by other high-profile IPOS. Shares in ride-sharing companies Lyft and Uber are down 48 percent and 36 percent, respectively, since they debuted this spring.

Both Lyft and Uber are losing money, as is fitness company Peloton, whose shares have fallen 21 percent since a Sept. 26 IPO. According to Goldman Sachs, nearly a quarter of companies going public this year are unprofitable, a level comparable to the dot-com bubble years of 1999 and 2000.

That bothers Ken Crawfod, Senior Portfolio Manager at Argent Capital Management in Clayton. His firm likes stocks with growth potential, but he finds many recent IPOs overpriced.

“If you’re buying companies that are not earning anything for the foreseeable future, that seems irrational to us,” Crawford said.

Ann Marie Knott, a professor at Washington University’s Olin Business School, says multibillion-dollar startups, like all companies, should be valued on their future earnings. The difficulty lies in estimating how much a new business can earn and how long it will take to become profitable.

With WeWork, venture capitalists made the mistake of treating a rather unremarkable real-estate business like a disruptive technology company. Uber and Lyft present a different challenge: how to value two companies that compete fiercely for the same customers.

“These are undifferentiated firms, and economics is pretty clear about what should happen if you have an undifferentiated duopoly,” Knott says. “Nobody makes money.”

The endgame might be that the companies merge, as money-losing satellite radio broadcasters Sirius and XM did in 2008. The buyer could raise prices and finally become profitable, but investors betting on that scenario must confront a panoply of unknowns, including when the deal would happen, whether is would be approved and how much money will be lost in the meantime.

The public markets clearly are more skeptical about those unknowns than Lyft’s and Uber’s private investors were. Crawford thinks that’s a healthy sign.

“Some of this was certainly an indicator of froth,” he says. “We have to bring investing back to the fundamentals of price and earnings and cash flow and not rely just on compelling stories,”

Cliff Holekamp, a partner at Cultivation Capital in St. Louis, thinks a return to saner valuations could be good for the venture capitalist business, too. Rather than pushing to become the next unicorn – a term for a venture-backed company worth a billion dollars- entrepreneurs might be content with smaller fund-raising rounds and earlier exits.

The froth, he added, was mainly on the coasts. Startups in cities like St. Louis never had as much money chasing them. ” We’re not really seeing any negative effects in the Midwest” from high-profile IPO flops, Holekamp said. “We operate in a different world than they do,”