Whitney Tilson’s email to investors discussing a more nuanced view of IPOs; comments on DOMO, TEAM, ESTC, PD, UPWK, FVRR, and SVMK; 103-year-old Julia “Hurricane” Hawkins wins the 100-meter dash… and dispenses worldly wisdom.
1) In Wednesday’s e-mail, I wrote, “We are in an IPO bubble that will end badly for the naïve and gullible investors being sucked into it.”
In response, my longtime friend Alex Rubalcava e-mailed me some wise thoughts that he gave me permission to share with Empire Financial Daily readers. Alex is the co-founder of Stage Venture Partners, a "seed venture capital firm that invests in emerging software technology for B2B markets," so he knows what he's talking about in this area... He wrote:
I've been following your comments on the IPO market in your daily newsletter, and I'd like to offer my perspective, which is a bit different from yours. It's really important to look at the composition of IPO activity before deciding whether we are in an IPO bubble or not.
For the last five plus years, a large percentage of IPOs have been zero-revenue, zero-profit biotech and medical device companies. These companies are in a sector that has always been and will always be speculative. In addition, the volume of IPOs like this has not changed much over the last few years. Most of these companies never make it into an index, and thus are never owned by the vast majority of the investing public. Only those companies whose scientific research leads to commercial revenue ever become sustainable businesses. Each investor has the choice of whether they would like to invest in IPOs with these characteristics, but I think few investors delude themselves into thinking that they're doing anything other than speculating in this class of companies.
There is a second class of IPOs, ones with solid cash flow generation and steady businesses. These are companies owned by private equity (PE) firms, which are coming public because the PE firms have limited fund lives and thus need to return capital to their limited partners (LPs). Public investors, especially value investors, tend to have an implicit bias against these companies because they believe that there is information asymmetry involved. "Why should I be buying what KKR is selling?" they ask. That question, logical as it is, misses an important point: PE firms are forced sellers, with the pace of selling dictated largely by the 10-year life of a PE fund. It's easy for public market investors, whose track records are usually measured by a singular measure, compounded annual growth, to misunderstand the incentives of private market investors, whose results are measured in a series of overlapping IRRs (internal rate of return).
I have often argued – and the full argument is beyond the scope of this e-mail – that PE-backed IPOs are a class of special situation investment with characteristics almost identical to spinoffs, companies emerging from bankruptcy, merger securities, and other investments profiled by legendary investor Joel Greenblatt in his classic 1999 book, You Can Be A Stock Market Genius. There's limited float, limited information, forced sellers, time-sensitive decision making, and natural catalysts like secondary offerings and debt refinancing that unlock value on a predictable timeline. What more could an enterprising value investor want? And the great thing about these IPOs is that there's a steady supply of them, dictated mainly by PE funds' needing to liquidate past holdings in order to return capital to LPs.
Finally, there's a third class of IPOs, venture-backed tech unicorns. It's this third category that I think you're talking about and, indeed, something has changed over the last 24 months. An entire generation of companies has now grown large enough – and old enough – to brave the public markets. And as you note in your e-mails, most of these companies do not generate a profit. But I think that one needs to dig deeper so as not to miss an important point about the mismatch between GAAP accounting developed in an industrial world and newer business models that tend to recognize costs up front and profits over time. There are a thousand and one guides to subscription accounting online, so I won't repeat the curriculum in this e-mail. But I will say that value investors, more than most, should understand that certain companies can generate GAAP losses while simultaneously generating attractive economic and cash flow profits.
Buffett himself built his most notable outperformance on stocks like the Washington Post, GEICO, Ogilvy & Mather, Blue Chip Stamps, and Knight Ridder Newspapers in the 1970s. The Washington Post in 1979 and Zoom Communications in 2019 have remarkably similar business models. Said another way, deferred revenue from prepaid subscription agreements is as powerful a form of leverage as insurance float.
Another way to analyze the issue is to look at venture-backed IPOs by vintage years. Many of the zero-profit companies of 2015 and 2016 that appeared to be part of a mania are the cash flow juggernauts of 2019, often with 3-4 times the revenue run rate of just a few years before.
That's not to say that every IPO in recent years has been successful, but there have been a lot of big winners, and the magnitude of outperformance by the best ones justifies the effort to identify them. Straightforward metrics, like churn, retention, cohort analysis, and customer acquisition cost payback can be used to sort the winners from the losers. At the time of their IPOs, anyone who knew anything about software was able to distinguish the poor economics of Domo (DOMO) from the superior economics of Atlassian (TEAM).
Every IPO is a frontier market, an undiscovered country where the value of superior analytical work is magnified by the information asymmetry implicit in anything new. Buying a compounding machine early is always preferable to buying the same compounding machine later.
Finally, I would note that the gross headline number of IPOs is not all that large, and that it appears large only relative to the abnormally low IPO volume of 2010 to 2016. Even this year, the volume of IPOs is not sufficient to keep the number of public listings constant. The Four Horsemen of the nineties – Alex.Brown, Hambrecht & Quist, Robertson Stephens, and Montgomery Securities – are long gone. I think we should be cheering the volume of IPOs we have now, and hoping for more. If not, we won't have any public companies left before our careers are over.
I thanked him for his smart comments and asked if there were any IPOs this year that he's particularly bullish on, and any he thinks are stupid bubbles that he'd avoid or short. He replied:
Yes, take two recent enterprise software IPOs, Elastic (ESTC) and PagerDuty (PD). They're both infrastructure-layer software solutions useful for running large application workloads. Elastic developed, open sourced, and then innovated around one of the best search tools in the market. PagerDuty manages notification of events and outages so that system reliability engineers can keep applications up and running 24/7.
Both companies are in hyper growth, dominate their markets, have very strong leadership. Both are unprofitable at both the operating margin level and at the cash flow level, but their margins are improving rapidly, and they have more than enough cash to get to cash flow breakeven. The unit economics and the retention stats are quite solid for both companies.
By contrast, consider Upwork (UPWK) and Fiverr (FVRR), two gig economy platforms, or SurveyMonkey (SVMK), the well-known survey tool and form builder. The first two are technology-enabled marketplaces, rather than true software companies, and they have unit economics that are just OK. SurveyMonkey competes in a very crowded application category with few barriers to entry, and their growth rate is much slower than most recent IPOs. They're not burning as much cash, but they also don't have the exponential upside potential that companies like ESTC and PD do.
Valuations on all of these companies are very high right now, but they are in line with the valuations being paid by corporate development teams in big M&A deals like the recent DATA acquisition by CRM. Every few years, the big software leaders go through a correction that takes their prices way down, and smart investors should have a watch list of the top names that they can pounce on when that happens. The last two opportunities were Q4 2015/Q1 2016 and Q4 2018.
By the way, you can look at this list of the 100 most recent IPOs and see what I mean about the three categories. My three categories represent ~80% of IPO volume.
2) Greetings from the National Senior Games, where 103-year-old Julia "Hurricane" Hawkins is again stealing the show.
She started running at age 100 (!), and two years ago at the Games – which are held every other year – she set the 100-plus age group world record in the 100-meter dash with a time of 39.62 seconds. She came back this year and, while she was six seconds slower, "she is believed to be the oldest woman to formally compete on an American track."
She was born in 1916, when Woodrow Wilson was president and World War I raged! And I'm feeling old at 52... Here's a picture of her:
And here's a New York Times article about her: She's 103 and Just Ran the 100-Meter Dash. Her Life Advice? 'Look for Magic Moments'. Charlie Munger would love her worldly wisdom. Excerpt:
Do you have any secrets to longevity and staying in shape?
To stay in shape, just keep active. Keep your weight down and exercise. Have a lot of passions, things that you are interested in. Keep interested in a lot of things to keep you busy and keep your mind busy.
What an inspiration she is! I'd love to meet her – I hope she hasn't already left.