These 4 IPOs are Doomed
If there’s one thing I hate, it’s when Warren Buffett is right.
He usually is, of course, and that’s one of the things that make the Oracle of Omaha worth listening to.
A Buffett adage that very few people seem to take note of is this: “In the short term, the market is a voting machine, but in the long term, it is a weighing machine.”
It’s a little cryptic. But what Buffett is saying is that on Day One, the market is going to give anything a knee-jerk reaction. It’s going to operate on its reflexes. These are often wrong, though, and over the long term the market will evaluate its initial decision based on actual results rather than initial instincts.
Early on, Pets.com looked like a great business. It had a huge target market. It had clever and memorable advertising. It offered good prices. There was just one problem: It never made any money.
That’s because a seemingly great business idea and a truly great business plan are two entirely different things. Pets.com had done no market research. It sold its wares for a third their cost — then shipped cat litter and heavy bags of pet food — low-margin products in the best of cases — for free. Now, this isn’t necessarily stupid: A lot of companies concede that they’ll need to lose money for a while as they establish their brand and find their footing. Pets.com said it would need four or five years to hit $300 million a year in revenue. In its first year, it had $619,000 in revenue while spending $11.8 million on advertising.
Even so, early on, the shares did well. They hovered at about $11. The market’s vote, in the last weeks of the dot-com craze, was positive.
Then reality set in. Investors came to realize that none of these web-based companies had any chance of justifying billion-dollar market caps on any rational, fundamental basis.
They began to weigh the results. And 268 days after Pets.com went public, the company decided to liquidate. Shares were at 11 cents.
Now: Ask yourself whether this could happen today.
Most would say absolutely not. Investors have gotten smarter. The Internet makes money now instead of losing it. And in such an argument one could point to WebMD or LoopNet and see that, indeed, some web-based companies can turn a fat profit. LoopNet nets 20% margins, for example.
But others aren’t so lucky. Many of the Web-based companies that have recently gone public are about to see a change in their market receptions. For many of these companies, the “voting machine” era will end and the “weighing machine” era will begin.
And it’s not going to be pretty.
Here are four companies to keep an eye on:
1. Pandora (Nasdaq: P)
At the current earnings multiple of the Nasdaq (about 22), a company with a market cap of $1.6 billion would need to have $72.7 million in annual earnings to be fairly valued with the index. In its most recently reported quarter, Pandora managed a net margin of less than 1% on about $75 million in revenue. This is a $2.6 million profit if annualized, which was created by 40 million listeners to Pandora’s online radio.
Let’s do the arithmetic: The company needs to increase membership from its current levels to 1.123 billion listeners to justify its current valuation. Interestingly, if it could double its user base once a year with no attrition, then it would hit this number almost exactly. But the odds of this actually happening are pretty slim.
The company posts a gross profit of 92%. If it continues its membership growth and cuts costs, then it could legitimately earn $5 million a quarter in the foreseeable future. But $5 million a quarter is $20 million a year, which places the fair value of Pandora at about $440 million — about a quarter of where it is today. Shares have fallen 42% since their June IPO. I expect this trend to continue.
2. LinkedIn (Nasdaq: LNKD)
The social networking website for the business crowd is worth more than $6.4 billion and is trading at more than 1,300 times earnings. This ought to be something of a red flag. On the other hand, the company managed a 6.3% net margin in the last full year of results, and revenue has since risen nearly 150%, to some $600 million. Unfortunately, profitability has failed to scale and has declined to about 1%. Thus a $6.4 billion company that should have underlying earnings of $290 million is actually netting about 2% of that.
My take: Value the company at 22 times annualized earnings (the Nasdaq’s current multiple) at its best net margin.
It looks like this:
Current price to earnings (P/E) ratio of 22 x (Annualized revenue of $600 million x net margin of 6.5%)
Or: 22 x $39 million = $858 million
I’ll throw in cash on hand, another $370 million, and that would add up to a fair value price of $1.2 billion –18.8% of LinkedIn’s current market valuation. These shares have also bled out 30% since their IPO. You ain’t seen nothin’ yet…
3. Groupon (Nasdaq: GRPN)
Groupon is worth an astonishing $14 billion. That’s the same as the combined market capitalization of The New York Times Co. (NYSE: NYT), Abercrombie & Fitch Co. (NYSE: ANF), Hasbro (NYSE: HAS) and Weight Watchers International (NYSE: WTW).
And yet Groupon has never earned a dime.
At $430 million in revenue in the most recent quarter, it came very close to breaking even — but still lost $10 million. Groupon needs $640 million in net profit to justify its current market cap, which puts it in the neighborhood of companies like Euronext (NYSE: NYX) and Ralph Lauren Corp. (NYSE: RL).
Are you kidding?
In a little more than a month since its debut, Groupon has lost nearly 15% of its market cap. This is a company that is just begging to be shorted. There is simply no way it can ever meet the market’s expectations. WallStreet cheered for this company because it wanted to see a big-dollar, high-tech IPO. But it wanted that because those deals make investors feel better about the future. The IPO itself? Doomed to a Pets.com-style flameout. Mark my words…
4. Angie’s List
The popular review site helps its members select people to perform certain services. If you need a plumber, for instance, you might check Angie’s List to make sure the one you have in mind doesn’t have a lot of nasty reviews.
The site has a variety of subscription services, and also charges advertisers. The revenue mix is about 50-50. Angie’s List says in its advertising that no one can pay to be on Angie’s List, a claim so bizarrely legalistic that it brings to mind Bill Clinton’s famous statement, “It depends on what the meaning of ‘is’ is.”
In any case, the trouble with Angie’s List is that it spends about $93 to acquire a customer, and that customer, in the best of circumstances, isn’t going to generate that much revenue. And marketing is only one element of Angie’s List’s considerable operating expenses. At its current $860 million market valuation, the company needs to earn only $40 million a year for its shares to achieve “fair” pricing. And yet the company loses about $15 million a quarter on revenue of about $22 million. The likely story here is that Angie’s List will use its cash on hand to build up its subscriber base, and then Wall Street will notice the company is 1) out of cash and 2) still losing money. When those results are weighted, expect Wall Street to be ruthless to these shares.
The bulls seem to be getting this point. As my colleague David Sterman recently pointed out, Zynga (Nasdaq: ZYNG), which produces the Farmville game for Facebook among other things, and actually makes money, faltered in its first day of trading. Shares have continued to be gobsmacked and are down already more than 20%. To me — even though the company is at least profitable — the shares look like they have a long way to fall. At $6.2 billion in market cap, the company needs $281 million in net earnings to be fairly valued with the market, a 585% increase from its current (annualized) levels. That type of growth is, even over the intermediate five- to 10-year term, laughably impossible. If you see any upside in these shares, please let us know.
Action to Take–> Angie’s List is a good website that people like to use. Of course, so is LinkedIn — I use it myself — and so is Pandora, which I listened to as I crunched these numbers. But Buffett is right. The market will weigh these companies’ results, and it is, in my view, likely to be a bloodbath that ensues. Please, please do not buy these shares, even on a bet. All of these companies are smart shorts. Long-term “put” options also have considerable appeal.