Motley Fool Hidden Gems Investing - Revisiting the IPO Boom

Episode Date: July 23, 2022

Editor's note: This episode was recorded before news of the Coinbase's insider trading case was made public on Friday. 2021 was a milestone year for companies going public. In 2022, the tide turned. Dylan Lewis and Brian Feroldi look back on the IPO boom and discuss: - Reasons why companies go public - Newly-public companies that may never come back to IPO levels - Questions for investors to ask even when financials look strong - The trends that hit Robinhood and Rocket Mortgage - Lessons from pre-revenue companies that went public Stocks mentioned: COIN, HOOD, RKT, NKLA, SPCE, JOBY, RIVN, LCID, SEMR, INTU Host: Dylan Lewis Guest: Brian Feroldi Producer: Ricky Mulvey Engineers: Dan Boyd, Rick Engdahl Learn more about your ad choices. Visit megaphone.fm/adchoices

Chris Hillman. Many of these companies that came public during this time, that I think are actually pretty darn good businesses, have seen their stocks take similar hits to companies that have no revenue or have extremely cyclical demand. But some of these companies came public at very high valuations. They've continued to perform, they've continued to execute. Some of these companies are profitable and should be sustainably profitable, and yet they've still seen massive hits to their stock prices. I'm Chris Hill, and that's Motley Fool contributor Brian Feroldi. 2021 was a record year for companies going public. This year, that market has dried up. Feroldi joined Dylan Lewis for

a look back at the IPO boom, why so many companies went public, and the lessons investors can take from the formerly red hot market. They discussed the cyclical companies that may never come back to their IPO prices and the strong businesses making their way through a less forgiving stock market. 2021 was a milestone year for new names to the public markets. According to Ernst & Young globally, there were 2,500 public debuts last year, raising around $400 billion in the process. Different story in 2022, for the first half of the year, proceeds are down almost 50%, and global IPO volumes are down about 50% as well. Joining me to talk about the IPO market and lessons from the last couple of

years is Motley Fool contributor Brian Feroldi. Brian, how's it going? Brian Feroldi. Dylan, it's good to be here. Those numbers really show how much the sentiment has changed. It seems like a year ago on Industry Focus, we were doing a new IPO show every single week, and the volume has come to a screeching halt. Dylan Feroldi. Yeah, we would be a bit more starved for ideas, if that was the focus of what we do here on Motley Fool Money every single day. It's pretty incredible. I think it's interesting because over the last couple of years, not only has there been a lot of activity, but there's been a lot of really big name activity. A lot of the companies that have come public have really dominated headlines. We are seeing now,

as the market is moving into a less growth-friendly environment, that not surprisingly, a lot of these high-growth businesses aren't coming public, or they're deciding to delay coming public, because market conditions just aren't as supportive of those businesses right now. If the last two years have been a reminder of anything, it's that companies, at least good companies, choose when they want to come public. A lot of companies saw that valuations were very high, and it was a cash grab for a lot of them to come public, raise a bunch of capital, and with minimal dilution in 2022, with valuations collapsing, it's no surprise to see that companies that could be coming public say, I want no part of that.

And I'm sure some investors that have bought some of these new public entrants over the last couple of years are feeling a little disappointed. There's the Renaissance Capital IPO Index. It is down 45% year-to-date versus about 20% declines for the S&P 500. But you could easily look at the freshman and sophomore class of public companies and see much bigger declines from highs or even from issuance price, 50%, 60%, 70% in some cases. We're going to talk a little bit about some of the specific factors that go into that and identify some themes within the IPO market. Before we do that, though, Brian, I think we always have to remind ourselves, growth stocks have been hit incredibly hard recently. When we're talking about companies

that are relatively new to the public markets, these are often some of the growthiest of the growth stocks. That's just a huge part of the explanation right there. And that makes sense. Why do companies go from being private to public? One of the main reasons was, they want to raise capital. And one of the primary reasons why companies want to raise capital is because they are new, they are dynamic, and they are in growth mode. So, they want to reinvest in themselves, and coming public is a very popular way to do so. Yeah. And as the investor, and someone who's seen these companies come public after being private for a while, because so many of them were such big names, there was so much investor

excitement because we'd seen private valuations swell so tremendously over the last decade as some businesses opted to stay private even longer. The idea of being able to get big returns by buying into some of these high-flying startups certainly existed for a lot of people. I think one of the tough parts about all of this is, big-time consumer names were coming public, and I think people had expectations that those businesses would perform incredibly well. Often, some of them did in the first year or so that they were on the public markets and set wildly unrealistic expectations for people on what returns look like over shorter periods of time. A lot of these companies, especially the popular ones, we saw massive

single-day pops when they IPO-ed. We saw 10%, 20%, 30%, 50% jumps in their share price from their issuance price on day one. Now, the downside to having your stock go up that much is that investor expectations for what you're about to do grow with those share prices. In many cases, the expectations simply became way too far ahead of what companies could actually deliver. Yeah. What we saw over the last six to nine months or so is the long-term picture got a lot harder to forecast. There were a lot of macro factors beginning to swirl that created uncertainty in the public markets. Inflation is a pretty easy one, but obviously the geopolitical factors and what's happening in Europe, another one. Supply shocks being maybe another third major

one. All of those things make it harder to forecast businesses that are already very difficult to forecast because they are so early on in their development. Investors have decided we have to more heavily discount that than we have in the past. I think that's a really key point, Dylan. A lot of these growth companies that have been hit the hardest, they had very, very high valuations. Those valuations make sense in a world of 0% or 1% inflation. Now that we're in a world of much higher inflation than that, the discount rate that investors use to estimate stock prices has gone up tremendously, and that can have a severe impact on the valuation that investors are looking to pay today, hence the huge decline that we've seen.

Throw on top of that a more expensive market for cash, Brian, with interest rates going up as well. It's not surprising that this part of the market has been hit particularly hard, these new companies. We're going to talk through a couple of different big buckets that we've identified to explain what we've seen so far in the first couple of years for some of these new public entrants. The first one I want to talk about ties into interest rates almost directly, is companies that surged because of cycles in their businesses and are now adjusting to the reality of either the peak and trough of those cycles or just more normalized growth rates for their industries. A lot of companies that came public in 2020 and 2021, their businesses were

on fire due to the pandemic or because of what was happening in the market. One that comes to mind for me, for example, is Coinbase. Coinbase came public, and I think their market valuation the day that they launched was $100 billion or something along those lines. Crypto prices were through the roof. If you looked at the company's trailing financials, they were just jaw-dropping because interest in crypto was so high and crypto prices themselves were so high. Coinbase was incredibly profitable when it came public. More recently, we've seen crypto prices decline and so have Coinbase's profits with that. That was very much a case where Coinbase was coming public at peak times for its market, and we've seen the unwinding of that more recently.

Yeah. I think there's a really similar story with Robinhood. There was a massive surge in retail investing, I think, to a large extent, pandemic-driven as people were at home, maybe looking for ways to make money. Robinhood benefited in a huge way. The rise of meme stocks really helped this business out. The tailwinds of just generally more average people getting interested in investing also there for this company. You put some numbers to what they were seeing during that period, and you start to realize that we were probably due for an adjustment on some of the key business metrics that drive this company. Just as an example, to paint a picture, they posted 24 million monthly active users in May of 2021, a number

that was higher than their net cumulative funded accounts, which is about 22 million at that time. That's a metric they tracked to see who actually has money in the platform and can invest. Monthly actives are now down to about 15 million, and those funded accounts are a little bit higher, about half a million higher than they were a little over a year ago. Brian, we can see that some of those people that were coming on during that surge never took that step to become what would really be a long-term customer. It's kind of a testament to the fact that there was so much interest in the space. A lot of the people that were maybe coming on were a little bit less qualified for this business than some of the previous users

that they brought online. You can add into the fact that at that time, when Robinhood was reporting these fabulous numbers, stimulus checks were being handed out everywhere. Many people were choosing to invest their stimulus checks for the very first time. Robinhood was a very popular platform to do so. And that's what can be so tricky about looking at companies like Coinbase and Robinhood. If you just look at the financials, the financials in many cases looked pretty darn good or very, very enticing. But you had to go one step beyond that and saying, are these financials reliable and consistent and can grow securely from here, or are these inflated one time? I think there's a strong argument to make that both of those companies had inflated

financials at the time of their IPO. Yeah. And I think this is a great opportunity to check in and remind yourselves that even if the financials look good, there are very specific drivers for some businesses. Understanding what that is and what this business is generally going to track with is incredibly helpful. In the case of Coinbase, the success of crypto is going to drive interest in crypto broadly and activity in crypto. That's what's going to drive the numbers for Coinbase. Even if they're delivering an incredible product and a great platform that people really enjoy, it's going to peak and trough depending on what's going on in the overall crypto markets. And if you look at Coinbase in particular, a lot of investors that

have looked at this company more recently have looked at the price-to-earnings ratio, and they've seen a single-digit number for Coinbase. And in so many cases, that just makes no sense to them. But the tricky thing about that price-to-earnings ratio being in the single digits is that's Wall Street's way of saying that E, the earnings, isn't sustainable and isn't going to grow. And we've seen exactly that happen. One other company that I think fits into this bucket is Rocket Mortgage. A little bit different in that it's maybe a more established brand in a space that is a little bit more common for investors to be familiar with. But what we saw with this company was an incredible surge in interest. Their

originations in dollars doubled from 2019 to 2020. A huge driver for that was the interest rate environment. It was an incredibly good time to either buy a home, or if you already had a home and you were borrowing at a relatively high rate, refinance down and give yourself a cheaper monthly payment. I very much remember looking at Rocket Mortgage's financials when they came public and saying, are you serious? Is this company this profitable? I mean, it seemed to be a cash flow machine, and it was at the time. But to your point, they were such a cash flow machine because demand for refinances and mortgages was at record levels. Now, Rocket Mortgage is still the market share leader in its category today, but just because of the broad cooling up and

the demand for mortgages, we've seen Rocket Mortgage's profit fall substantially. And I like that you focused there on the market share, Brian, because it's not just that this trend was pushing this company forward. The company was doing a great job, and they were continuing to gain market share along the way. No beef with Rocket Mortgage. I've actually personally used them and really liked it as a consumer. It's just that this individual data point interest rates is going to have a massive effect on the overall company. And there's really not a lot that the company can do about that. I think you can make that exact same argument for all three of the companies we talked about. Coinbase, Robinhood, Rocket Mortgages. All three

of those companies were riding trends that were really outside of their control. And those trends have since reversed. And that's why their financial fortunes have since reversed. That doesn't mean that these companies have done anything wrong, necessarily. It's just that that's the nature of the markets that they're in. Yeah. And honestly, if you're a long-term crypto bull, what we've seen over the last 12 months is just part of the business for you. You just know that that's a reality of investing in this space, and it's got to be part of your long-term outlook for the space and if you're investing in Coinbase because of that for Coinbase. Yeah. And that makes valuing those companies very, very, very tricky because

you can't really look at earnings if those earnings are so reliant on a factor that's outside of management's control. Speaking of having a hard time looking at financials, the second bucket that we're looking at and broadly putting some companies into for looking for takeaways here is pre-revenue companies. There's an old adage, there's not a bad idea when cash is plentiful. And I think that with interest rates being low, with a growth on mindset, we saw a lot of more out there ideas come public earlier than maybe they would have five years ago or 10 years ago, Brian. And pre-revenue companies coming public is nothing new. This is actually a very common thing to happen in the biotech space when companies

are going through the research and development process that is hugely capital intensive. And during those times, those companies are often making $0. What was a little bit more interesting about 2020 and 2021 is we saw a few consumer-facing companies come public that were pre-revenue. A couple that come to mind would be Nikola, Joby Aviation, and Virgin Galactic. They were very much pre-revenue companies that were investing heavily in themselves, but they garnered some huge valuations at the time that they came public. I'm sure a lot of folks are familiar with Nikola, the EV company. It's gotten a lot of headlines over the last couple of years or so. For folks that are less familiar, Joby Aviation is aimed at becoming an air taxi service, Virgin Galactic

focused on commercial space travel. And I think just on the explanation of what those companies are, you can quickly realize that those are industries that aren't going to materialize overnight. Those aren't industries that are really active even right now. And it shows up in the company financials when you actually look. I mean, I think those three companies combined over the last 12 months, Brian, have about $6 million in revenue to their name. And yet they still garnered multi-hundred-million or billion-dollar market valuations. The jury is still out on all three of those companies. I think investors should have expected that up front. Those companies were saying, we're not going to be turning revenue on tomorrow. There's a number of hurdles

that they had to meet along the way. But it was still surprising to see so many of these pre-revenue consumer-faces companies not only come public, but really earn multi-billion-dollar valuations. We probably could have found a couple names for this list that were not so capital-intensive. But I think one thing to emphasize, too, with basically all three of these companies is, without revenue coming in on the top line, these are capital-intensive businesses. There's a physical product for all of them. And there are long-term investments that go into making that. And when you don't have cash coming in, and the picture gets cloudier looking further out, the fact that cash isn't coming in becomes much more important

to investors. And again, this is a spot where the market starts to more heavily discount the likelihood that these things come together and materialize the way that they'd been forecasted when that company was a SPAC before it became public or in the prospectus in the case of one that was coming public. Rivian comes to mind. Lucid Motors comes to mind. They really took advantage of the huge valuations that they saw, raising hundreds of millions, or in Rivian's case, they raised $10 billion at their IPO, even though they were pre-revenue at the time. When you compare that to the company's market cap today, that enormous valuation was a massive blessing for the business. It was. It was incredibly

advantageous if you're looking to raise capital. We talk about it often when we're looking at new entrants, where it's like, the incentives here are for this company to go out there, get capital, give themselves plenty of runway so that they can really execute on their growth plans. And for a business like this, you know that you're not getting a significant amount of money coming in on the top line for several years. You want as big of a cash hoard, as much of a runway as you can possibly have, because it's such a hard thing to do. Absolutely. But the flip side of high valuations being so good for companies that are selling stock is, they tend to be not so good for investors that are buying that stock.

Yes. And that is, unfortunately, the trade-off that we often see, Brian. Speaking of valuations, I think the third bucket that I want to end this on a somewhat inspiring note is, there were a lot of really quality businesses that continue to be quality businesses. It's just that market factors created an environment where we were willing to give these companies much bigger, much more generous valuations during a growth-on period than we are now because of the uncertainty in the market and because of the contraction we've seen in valuations in general. Many of these companies that came public during this time that I think are actually pretty darn good businesses have seen their stocks take similar hits to companies that have

no revenue or have extremely cyclical demand. But some of these companies came public at very high valuations. They've continued to perform. They've continued to execute. Some of these companies are profitable and should be sustainably profitable, and yet they've still seen massive hits to their stock prices. Yeah, backtracking nine or 12 months, it was not unusual to see companies coming public at 20, 30, 40 times sales. That was just a reality of where we were in the market. There were some very good, strong businesses that were coming public at that valuation. The problem is, we're just not necessarily willing to give those companies that leash right now. Yeah. One company that comes to mind

for me that very much interested me when it came public in 2021 was a company called Semrush. The ticker there is SEMR. This is a company that I personally became very excited at, and it was one of the very few IPO stocks that I actually purchased because I liked it a lot. The company had great margins, strong top-line growth, founder-led business, free cash flow positive, and profitable, high dollar-based net rent retention rate, all the things that I look for in a good business. The thing that's tripped this stock up is just pure valuation. It came public at about 20 times sales, currently about seven times sales. So, despite the fact that it's grown pretty strongly since it came public and it's really executed, investors like me are still

down on it, even though I still think the business is better today than it was a year ago. Yeah, it's funny, Brian. I'm a shareholder of SEMrush as well, and this was a company that we talked about in the beginning of 2022 and both felt pretty excited about. And to just give people a little bit of a check-in here on where this company was, where it is. What we saw back then was 77% gross margins, 40% to 50% revenue growth, narrow net losses, basically a company that could become profitable when it wanted to, and a dollar-based net retention rate of 124%. All of those numbers are more or less in the same spot or higher. Margins have expanded. The Dabner has actually gotten higher in recent quarters. And yet, it's just that we're not

willing to give these high growth names the same valuation multiple that we were a little while ago. Unfortunately, the stock has been punished for that. I continue to be a shareholder of this company. I'm probably going to continue to add to it over time now that it's at a more reasonable valuation. But I think that that's the check that people have to have with stuff that they own in their own portfolio. Is this down and the core metrics that I'm paying attention to for this company are also down? Or is the picture pretty similar? It's just that the market forces are conspiring to punish a company like this right now. Dylan, this is why we constantly stress to investors that it's so important to focus your energy on the business and de-emphasize the focus

on the stock. The stock is the thing that grabs all investors' attention. It's the thing the media pays attention to. It's the thing that drives your brokerage account. It's understandable why price is such the thing that people focus on. However, if you dig into these companies that down 50%, 60%, 70%, 80% or something, and you look at the business, it becomes much easier for me to be excited about and even add to a position in a business where the company is thriving, but the stock isn't, versus a company where the stock is doing bad, and so is the business. To bring us home, Brian, why don't we talk a little bit about things broadly that people should have in mind as they're looking at some of these more newly public companies during particularly tough market

conditions. The first thing that kind of comes to mind to me is, there are pretty easy financial checks that you can do, looking at a company balance sheet, looking at a company income statement, to have a good feel for just the financial fortitude of a company. And I think, perhaps more than almost any other group, it matters for these companies because they need the runway to be able to execute on their roadmap. I like to break down the companies into three broad buckets. There are companies that are raising capital. And for those companies, what we're seeing happen in the market right now is truly awful, because they can no longer raise capital at valuations. And if they chose to do so today, the dilution of shareholders would be

horrible. So, the decline we've seen in their stock prices is really, really bad. There's other companies out there that are either self-funding, so that could mean that they're free cash flow positive, or they have such strong balance sheets that they can ride out a potential wave for three, four or five years, I think that those companies will be okay and will do much better. Conversely, there's also companies that actually thrive when they see their stock price declining because they're in capital return mode. This actually gives them the opportunity to go out and buy competitors on the cheap or maybe even perhaps repurchase their own stock at very, very advantageous prices. So, when I think about the different risk levels within my portfolio, I think that the

companies that are raising capital have a big question mark over their head, and the ones that are returning capital to shareholders should be licking their chops at what they see in the market. So that listeners can kind of follow along and do the work at home for companies in their own portfolio. Brian, this is something that shows up on the balance sheet, and it's something that shows up on the income statement in a big way. And it's helpful to look and check in and see exactly where your companies fit on that spectrum. Personally, I prefer the cash flow statement to the net income statement because, as we both know, there's a big difference between being profitable on a net income basis and being profitable on a free cash flow basis. And the dynamics of

accounting make it so some companies that look unprofitable are generating cash, and we've also seen the exact opposite of that. But broadly speaking, if you want to know what stage is the company in, first, I would go to the balance sheet, just check the company's cash balance, compare that to the company's burn rate, the cash burn rate over the last year on a cash flow basis, and that will give you a rough estimate for how many years the company can go without needing to raise capital. Hopefully, the company can rapidly approach free cash flow positive and really minimize that burn. But if they are in cash burn mode, the clock is ticking. So, if you see a company with, say, a year or less of cash, they might really have to go out and

dilute shareholders significantly just to stay surviving. Yeah, I think that's important. And then you also want to check in and say, okay, from the operations, what are we looking at here? If the company is not in a spot where they are profitable, what is the reason for that? Is it because they're aggressively spending to try to grow their customer base because they're in a land grab boat? Is that something they can dial down if they need to because things get tougher and they need to show some green or at least lose a little bit less money? I think that's a core thing that people should probably be paying attention to right now as well. And another thing, just think of mine, if a company is producing a product or service,

ask yourself, because the odds are good we're heading into a recession, Is this a nice-to-have product, or is this a needs-to-have product? Ideally, it's a needs-to-have product. For example, I think that the odds are very good that companies are going to continue to spend with SEMrush, since it has so many uses in helping them with their marketing. But hey, we'll find that out in the next couple of quarters. Yeah. I like the chances of a company like TurboTax, not that they were a recently public company with Intuit, that product. I like the chances of people continuing to spend money on that, more so than a consumer product that people need to be convinced to buy often. I think that you just have to remember, where does

this company fit into consumer buying decisions? Is this something that is contractually set up already? Awesome. That's so much easier for people to be able to bank on. Or is this something that there's going to have to be heavy marketing spend in order to convince people to buy this? Or this is a new space this company is creating and needs to create the customer base for. That's even harder, Brian. That sounds like an expensive thing to do. As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill. Thanks for listening. We'll see you tomorrow.

Thank you.