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Why I think we might be in a significant tech IPO bubble


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Surprisingly I agree, there is a lot of hope trading at ridiculous multiples.  That being said, one reason P/S are higher now than ever before is because tech firms figured out the business model.  SaaS companies have much higher margins (gross and net) then the traditional perpetual license model.  Thus for the same growth rates you should expect higher P/S multiples. 

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Appreciate the response. I think the Financial Times argued persuasively against some of the SaaS exuberance here - https://ftalphaville.ft.com/2019/03/27/1553662858000/The-cloud-software-kings-are-nuts--when-s-the-crash-/.

In other words, while stocks are rising employees get paid but when the tide turns where do they get the cash they need to run their business?

 

I'd also ask if profits attracting competition is basic capitalism, how long can we expect these higher margins to stay high? Hearing any sector has reached a constant superior plateau in anything financial makes me a little nervous. Call me a conventional value investing skeptic, I guess.

 

 

 

High-growth companies like paying staff in shares and share options. Not only because it aligns worker and shareholder interests, but also because it means not paying labour in precious cash.

 

But among the cloud kings, it's gone to pretty extreme levels. And in some cases, it distorts the free cash flow metric beyond all recognition.

 

Take $2.4bn Cloudera, a software platform for data engineering, as one example. In 2018, stock compensation accounted for 485 per cent of its free cash flow. If it paid workers in dollars, its free cash flow would have plummeted from $24m to -$93m.

 

It's not alone. Of the 50 businesses, 13 were free cash-flow positive, thanks solely to stock compensation. For a further 11, handing out pieces of paper to workers accounted for upwards of 50 per cent of the metric.

 

Investors don't seem to care that much, clearly. But it's worth highlighting that stock compensation carries a real cost to shareholders as it dilutes their future claims over the company's cash flow.

 

Some businesses, such as Microsoft, use share buybacks to offset dilution. But unlike the stock compensation, share repurchases run through the cash from financing statement, so there's no counterbalance in the free cash-flow figure. (A humble suggestion from Alphaville is that buybacks should be split out in the cash flow statement to reflect their purpose, but that's another matter.)

 

However, the practice also poses an existential risk to a company in the advent of a bear market. Workers, worried about a falling stock, may not be so willing to accept pieces of paper in lieu of hard cash -- exacerbating cash-flow issues during a downturn.

 

Yet software engineers still seem happy accepting funny money, and the cloud kings are willing to oblige. Indeed, in the past financial year, 32 of the group grew the dollar value of their stock compensation faster than revenues.

 

Within the cloud software space there are clearly excellent businesses. Adobe, for instance, in 2018 posted free cash flow margins of 41.7 per cent, while increasing revenues 23.7 per cent. Similarly Dell subsidiary VMware, worth just under of $77bn, last year had ebitda margins of 30.9 per cent, and grew its free cash flow 15.9 per cent.

 

So when the model really works. It really works. The question is, with valuations gazing out to an ever-receding horizon, will it work out for investors?

 

 

 

 

 

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Appreciate the response. I think the Financial Times argued persuasively against some of the SaaS exuberance here - https://ftalphaville.ft.com/2019/03/27/1553662858000/The-cloud-software-kings-are-nuts--when-s-the-crash-/.

In other words, while stocks are rising employees get paid but when the tide turns where do they get the cash they need to run their business?

 

I'd also ask if profits attracting competition is basic capitalism, how long can we expect these higher margins to stay high? Hearing any sector has reached a constant superior plateau in anything financial makes me a little nervous. Call me a conventional value investing skeptic, I guess.

 

 

 

High-growth companies like paying staff in shares and share options. Not only because it aligns worker and shareholder interests, but also because it means not paying labour in precious cash.

 

But among the cloud kings, it's gone to pretty extreme levels. And in some cases, it distorts the free cash flow metric beyond all recognition.

 

Take $2.4bn Cloudera, a software platform for data engineering, as one example. In 2018, stock compensation accounted for 485 per cent of its free cash flow. If it paid workers in dollars, its free cash flow would have plummeted from $24m to -$93m.

 

It's not alone. Of the 50 businesses, 13 were free cash-flow positive, thanks solely to stock compensation. For a further 11, handing out pieces of paper to workers accounted for upwards of 50 per cent of the metric.

 

Investors don't seem to care that much, clearly. But it's worth highlighting that stock compensation carries a real cost to shareholders as it dilutes their future claims over the company's cash flow.

 

Some businesses, such as Microsoft, use share buybacks to offset dilution. But unlike the stock compensation, share repurchases run through the cash from financing statement, so there's no counterbalance in the free cash-flow figure. (A humble suggestion from Alphaville is that buybacks should be split out in the cash flow statement to reflect their purpose, but that's another matter.)

 

However, the practice also poses an existential risk to a company in the advent of a bear market. Workers, worried about a falling stock, may not be so willing to accept pieces of paper in lieu of hard cash -- exacerbating cash-flow issues during a downturn.

 

Yet software engineers still seem happy accepting funny money, and the cloud kings are willing to oblige. Indeed, in the past financial year, 32 of the group grew the dollar value of their stock compensation faster than revenues.

 

Within the cloud software space there are clearly excellent businesses. Adobe, for instance, in 2018 posted free cash flow margins of 41.7 per cent, while increasing revenues 23.7 per cent. Similarly Dell subsidiary VMware, worth just under of $77bn, last year had ebitda margins of 30.9 per cent, and grew its free cash flow 15.9 per cent.

 

So when the model really works. It really works. The question is, with valuations gazing out to an ever-receding horizon, will it work out for investors?

 

 

Yes, I think I saw this article too.  I'm not saying SaaS companies are fairly valued, I'm just saying that part of the increase in P/S is due to increase in net margins which have been trending upward for the S&P500 for the last 10 or 20 years.  That being said on the monopoly matter, there is evidence that companies are becoming more monopolistic over time.  The increasing margins is one piece of evidence.  The other is the rise of tech companies which have some upfront cost but most of there moat comes from intangibles like network effects, switching costs, high initial marketing spend, which didn't use to be the case (back in the manufacturing days, actual physical capital was the moat which meant companies were started a lot slower and also that most only earned their cost of capital).  That being said I agree that companies are choosing ways to fleece investors like using stock compensation, or the Amazon argument ("we are in a land grab so pay no attention to our bottom line").  However, IMO there are good companies (at good valuations) that are mixed in with the bad in the tech bubble, its just not going to be as simple as P/E < 10. 

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Yes, I think I saw this article too.  I'm not saying SaaS companies are fairly valued, I'm just saying that part of the increase in P/S is due to increase in net margins which have been trending upward for the S&P500 for the last 10 or 20 years.  That being said on the monopoly matter, there is evidence that companies are becoming more monopolistic over time.  The increasing margins is one piece of evidence.  The other is the rise of tech companies which have some upfront cost but most of there moat comes from intangibles like network effects, switching costs, high initial marketing spend, which didn't use to be the case (back in the manufacturing days, actual physical capital was the moat which meant companies were started a lot slower and also that most only earned their cost of capital).  That being said I agree that companies are choosing ways to fleece investors like using stock compensation, or the Amazon argument ("we are in a land grab so pay no attention to our bottom line").  However, IMO there are good companies (at good valuations) that are mixed in with the bad in the tech bubble, its just not going to be as simple as P/E < 10.

 

 

 

Agree with that and think it's sensible.

 

I know Buffett has found his buy-and-hold religion these days (though he clearly's too big to get in and out of the market anyway), but my guess is the best thing right now is for investors in fast-growing or recently public tech companies to fish in other waters or just raise cash.

 

Once the winter comes, everyone and thing will be taken down and that's when far fairer prices should prevail.

That goes for those on this board looking at hot tech IPOs too. Ha, when value guys get turned on heavily to newly public tech companies you know something's up.

 

Appreciate the alternative view.

 

 

 

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In 1999, interest rates were about 6% and inflation around 2%. That's a real rate of 4% and you had this bubble.

Today real rates are barely above 0% and there are trillions in negative rate debt.

It is quite conceivable that the most loss-making businesses trade for a fortune in this environment.

If 1999 was a bubble , this environment could be bubble squared.

Only gravity of higher real rates can perhaps rein in the madness but only if the escape velocity isn't reached before.

Who knows. Maybe rates will have to jump in 1/2 or 1% increments at some point.

However the party could continue onward for a while, after all pensions, insurers and citizens are in desperate need of return, even if that return is nominal and not a real one.

 

 

 

 

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also if you can't find value I would suggest looking in foreign (English speaking I mainly stick to for maintaining a baseline "edge") markets.  South Africa is in a recession and I've seen small caps trade for 2 or 3 times earnings.  Most small caps trade for 6-8 and most are still profitable (or should be in a non recession enviroment).  Some things in Australia and New Zealand are interesting too. 

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also if you can't find value I would suggest looking in foreign (English speaking I mainly stick to for maintaining a baseline "edge") markets.  South Africa is in a recession and I've seen small caps trade for 2 or 3 times earnings.  Most small caps trade for 6-8 and most are still profitable (or should be in a non recession enviroment).  Some things in Australia and New Zealand are interesting too. 

 

OT: Happen to know any good South-African tracker? I've just come back from SA and must say I was not impressed much by what has been going on over there. Electricity outages (so called 'load shedding') were a daily occurence and water shortages are becoming more extreme. Not to mention the social issues. Things don't seem anywhere near to turning around imo.

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Appreciate the response. I think the Financial Times argued persuasively against some of the SaaS exuberance here - https://ftalphaville.ft.com/2019/03/27/1553662858000/The-cloud-software-kings-are-nuts--when-s-the-crash-/.

In other words, while stocks are rising employees get paid but when the tide turns where do they get the cash they need to run their business?

 

I'd also ask if profits attracting competition is basic capitalism, how long can we expect these higher margins to stay high? Hearing any sector has reached a constant superior plateau in anything financial makes me a little nervous. Call me a conventional value investing skeptic, I guess.

 

 

 

High-growth companies like paying staff in shares and share options. Not only because it aligns worker and shareholder interests, but also because it means not paying labour in precious cash.

 

But among the cloud kings, it's gone to pretty extreme levels. And in some cases, it distorts the free cash flow metric beyond all recognition.

 

Take $2.4bn Cloudera, a software platform for data engineering, as one example. In 2018, stock compensation accounted for 485 per cent of its free cash flow. If it paid workers in dollars, its free cash flow would have plummeted from $24m to -$93m.

 

It's not alone. Of the 50 businesses, 13 were free cash-flow positive, thanks solely to stock compensation. For a further 11, handing out pieces of paper to workers accounted for upwards of 50 per cent of the metric.

 

Investors don't seem to care that much, clearly. But it's worth highlighting that stock compensation carries a real cost to shareholders as it dilutes their future claims over the company's cash flow.

 

Some businesses, such as Microsoft, use share buybacks to offset dilution. But unlike the stock compensation, share repurchases run through the cash from financing statement, so there's no counterbalance in the free cash-flow figure. (A humble suggestion from Alphaville is that buybacks should be split out in the cash flow statement to reflect their purpose, but that's another matter.)

 

However, the practice also poses an existential risk to a company in the advent of a bear market. Workers, worried about a falling stock, may not be so willing to accept pieces of paper in lieu of hard cash -- exacerbating cash-flow issues during a downturn.

 

Yet software engineers still seem happy accepting funny money, and the cloud kings are willing to oblige. Indeed, in the past financial year, 32 of the group grew the dollar value of their stock compensation faster than revenues.

 

Within the cloud software space there are clearly excellent businesses. Adobe, for instance, in 2018 posted free cash flow margins of 41.7 per cent, while increasing revenues 23.7 per cent. Similarly Dell subsidiary VMware, worth just under of $77bn, last year had ebitda margins of 30.9 per cent, and grew its free cash flow 15.9 per cent.

 

So when the model really works. It really works. The question is, with valuations gazing out to an ever-receding horizon, will it work out for investors?

 

 

Yes, I think I saw this article too.  I'm not saying SaaS companies are fairly valued, I'm just saying that part of the increase in P/S is due to increase in net margins which have been trending upward for the S&P500 for the last 10 or 20 years.  That being said on the monopoly matter, there is evidence that companies are becoming more monopolistic over time.  The increasing margins is one piece of evidence.  The other is the rise of tech companies which have some upfront cost but most of there moat comes from intangibles like network effects, switching costs, high initial marketing spend, which didn't use to be the case (back in the manufacturing days, actual physical capital was the moat which meant companies were started a lot slower and also that most only earned their cost of capital).  That being said I agree that companies are choosing ways to fleece investors like using stock compensation, or the Amazon argument ("we are in a land grab so pay no attention to our bottom line").  However, IMO there are good companies (at good valuations) that are mixed in with the bad in the tech bubble, its just not going to be as simple as P/E < 10.

 

Not to rub this in ...but remember Nortel?

Employees were amongst some of their biggest cheerleaders; via the employee pension fund, and software engineers dabbling in call options. If you questioned the crowd 'wisdom' you were a heretic, and out the door within months of losing 'faith'. Every generation has its 'cool' thing, and no matter what - you aren't going to change that.

 

Then, as most likely now, the 'right' strategy was continuous roll-over of long out-of-the-money puts; on tech coy's other than the one you work in. Just be mindful that when you eventually reap that 'funny money', and everyone around you is going bankrupt; you will very likely be one of the most hated people on the planet. In a zero-sum game, nobody loves the out-sized winner.

 

I'm told that it makes the workplace an incredibly miserable place to be; and that to preserve their sanity, most people will voluntarily quit their job within a year.

 

SD

 

 

 

 

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also if you can't find value I would suggest looking in foreign (English speaking I mainly stick to for maintaining a baseline "edge") markets.  South Africa is in a recession and I've seen small caps trade for 2 or 3 times earnings.  Most small caps trade for 6-8 and most are still profitable (or should be in a non recession enviroment).  Some things in Australia and New Zealand are interesting too. 

 

OT: Happen to know any good South-African tracker? I've just come back from SA and must say I was not impressed much by what has been going on over there. Electricity outages (so called 'load shedding') were a daily occurence and water shortages are becoming more extreme. Not to mention the social issues. Things don't seem anywhere near to turning around imo.

 

Fido has trading in SA.  I use that and dont know of trackers.  Also you have to keep in mind SA GDP is like a fifth of developed countries, so turning around is different than your expectations.  The recession is only -1% growth so it's actually a quite mild recession. 

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In 1999, interest rates were about 6% and inflation around 2%. That's a real rate of 4% and you had this bubble.

Today real rates are barely above 0% and there are trillions in negative rate debt.

It is quite conceivable that the most loss-making businesses trade for a fortune in this environment.

If 1999 was a bubble , this environment could be bubble squared.

Only gravity of higher real rates can perhaps rein in the madness but only if the escape velocity isn't reached before.

Who knows. Maybe rates will have to jump in 1/2 or 1% increments at some point.

However the party could continue onward for a while, after all pensions, insurers and citizens are in desperate need of return, even if that return is nominal and not a real one.

 

 

 

 

I think this is a smart way of looking at it and very concerning.

On a different but related topic, a recent Bloomberg article about duration noted "the debt load in the world is so high now that it can’t withstand any historically-normal size of interest rate increases anymore" (https://www.bloomberg.com/news/articles/2019-04-12/hidden-bond-market-dangers-expose-traders-to-2-trillion-wipeout).

 

At the same time, lowering interest rates in a substantial way at a time when the US is already at full employment with 2.5% GDP growth would send one hell of a signal about the real strength of its economy.

In other words, I think there's kind of a sense in my mind where it seems like the Fed is a little boxed in and can't make any sudden moves either way. As you note, rates today are also so low that there are hardly any bullets left in case of emergency. Certainly far fewer than were available in the aftermath of the GFC.

 

Based on the charts below, it seems as well that all low rates have done in practice is to encourage far more irresponsible borrowing and unprofitable business of the kind that played a big part in the GFC.

The problem as I see it, is that this time central banks have very few to no bullets, government debt across the world is far higher and at a point where it can't be added to in a major way, and now net corporate debt compared to EBITDA is at levels that makes 2008 look like a picnic in comparison.

 

I hope I'm wrong, but it seems like we are reaching a point where there will be nowhere left to turn and the only choices that will be available will be extremely painful for a whole lot of people.

And I'd add that I think the trick that got pulled to solve our problems in 2008 is not really repeatable.

There are only so many bullets available and only so many times you can nationalize debt, or carry on giving cheap money to corporates, or lowering rates, until markets and people generally stop believing in your integrity and creditworthiness.

 

Again, it seems to me like based on the data we are pretty close to that point. The beautiful deleveraging I've heard about is not something that seems to be showing up from what I can tell. Anyway, I'm keeping an open mind and am looking for opposing evidence but right now I'm being very cautious based on all this.

It's not my intention to sound all Chicken Little, just trying to maintain a reasonable perspective.

So it's against this backdrop that tech IPO prices seem to be reaching exuberant levels and given how this stuff usually coincides historically, I'm not sure it's all that surprising.

 

 

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Hey all:

 

I heard a podcast the other day where a entrepreneur was interviewed about his company.

 

His company is a "subscription" coffee company.  They sell high end coffee and put an interweb enabled scale with it.  When your coffee gets down 75%, it automatically orders more coffee that is shipped to you.  You never have to worry about the complexity and difficulty of getting more coffee from the grocery store!

 

That is it, that is the business.

 

It is a multi-million dollar company.

 

Tech bubble?

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Another thing to keep in mind is that we don’t necessarily need a big recession for stocks (and long term bonds, especially corporate bonds) to go down in price over the next few years.  All we need is an uptick in inflation and an associated rise in interest rates.  To me this seems like the least discussed and most worrisome scenario because if this happens investors won’t be able to count on the Fed to bail them out.

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Zoom, an enterprise video conferencing software going ipo at 9b . 27 times price to sales, growing at 100%. There are several competitors in the market.

 

Valuations looks crazy , but let’s say they grow recurring revenue 50% cagr for 5 years, that would make this price not so crazy. Interesting times

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Zoom, an enterprise video conferencing software going ipo at 9b . 27 times price to sales, growing at 100%. There are several competitors in the market.

 

Valuations looks crazy , but let’s say they grow recurring revenue 50% cagr for 5 years, that would make this price not so crazy. Interesting times

 

 

 

 

Closer to 28x going by CNBC's latest report of a 9.2B valuation.

 

I mean Zoom is an incredibly well run company and Eric Yuan is a tremendous CEO (see Alex Clayton's great IPO breakdown - https://medium.com/@alexfclayton/zoom-ipo-s-1-breakdown-119249acadd3), but if you include a first day pop of 25% the business will trade at around 35x sales.

 

As I explained in my thread (https://twitter.com/tonyjclayton/status/1118205158721249280), these are going on 1998/1999 level valuations. The data for the last 40 years is there for all to see (image below) and these are the most extreme P/S multiples except for the height of the Dotcom bubble.

Jumia (an African e-commerce business that has been compared to Amazon) went public a few days ago and popped 85% on its opening day. It now trades for 22x sales, even though it's loss-making and revenue only grew 38% last year.

Slack, which has already filed, recently traded at a 16B valuation in private markets (https://www.dealreporter.com/info/slack%E2%80%99s-valuation-could-reach-usd-16bn-direct-listing) or 41x their sales for 2018 where they grew at 76%.

 

Even if some of these are great companies with amazing futures (and clearly there are a number that are), the multiples being paid across the board are high by any historical standard and therefore this IPO market as a whole should probably be labelled speculative.

I invest in the consumer tech space myself so I have no ax to grind, but I think this current environment is excessive in its sheer width across the entire sector so even if you buy one of the best businesses you'll still suffer when the widespread exuberance inevitably fades and the entire space likely suffers substantial multiple contraction.

 

 

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It is interesting that at a late stage of a bubble, you can see IPO’s still popping, while older issues are weakening. That’s when you know that liquidity is spilling from one vessel to another, but not much additional liquidity is coming in. It almost looks like that is what is happing right now.

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It is interesting that at a late stage of a bubble, you can see IPO’s still popping, while older issues are weakening. That’s when you know that liquidity is spilling from one vessel to another, but not much additional liquidity is coming in. It almost looks like that is what is happing right now.

 

Could you expand on this a little?

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It is interesting that at a late stage of a bubble, you can see IPO’s still popping, while older issues are weakening. That’s when you know that liquidity is spilling from one vessel to another, but not much additional liquidity is coming in. It almost looks like that is what is happing right now.

 

Could you expand on this a little?

 

Liquidity is coming almost entirely from the underwriting group, the issues are being priced at slightly below market (to evidence a marketing bump on issue), and underwriters are focused on volume (fees) - not quality. Get as much out the door as possible before the opportunity closes, and dump the inventory as quietly as possible.

 

SD

 

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It is interesting that at a late stage of a bubble, you can see IPO’s still popping, while older issues are weakening. That’s when you know that liquidity is spilling from one vessel to another, but not much additional liquidity is coming in. It almost looks like that is what is happing right now.

 

Could you expand on this a little?

 

Liquidity is coming almost entirely from the underwriting group, the issues are being priced at slightly below market (to evidence a marketing bump on issue), and underwriters are focused on volume (fees) - not quality. Get as much out the door as possible before the opportunity closes, and dump the inventory as quietly as possible.

 

SD

 

I see, definitely a good point. Ever since Venture Capital money has come into play, IPO's have been well, "disingenuous." These companies come out of the gates with massive valuations its hard to see how they are't set up for failure. Not sure if anyone watches the HBO series "Silicon Valley." But this show highlights some of these issues, such as being overvalued when you IPO. Also it's just a damn funny show.

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The numbers below are what I have for 2019 so far. The median tech P/S multiple was 8.8 in 1998, 26.5 in 1999, and 31.7 in 2000.

In 2002 at the post-crash NASDAQ low, the median tech IPO P/S multiple was 2.9 (see image at bottom of page).

I'll use average instead of median because the 2019 sample set is still small, but for 2019 so far we're at 19x average sales for major consumer, enterprise, and similar, tech IPOs using the companies below.

 

For biotech IPOs with sales, the 2019 average is 43x sales.

For biotech IPOs without sales, the multiples are clearly infinite.

Putting both 2019 regular tech and biotech IPOs together, the average P/S multiple is 30x.

That puts us roughly at the peak of the 1999/2000 range, if you accept the use of averages.

Median-wise, even though it's limited data, I get around 25x sales for 2019. Again, that's 1999 territory.

None of this means other IPOs later in the year can't bring the median and average numbers down if they're reasonably priced, but by my calculations this is where we essentially are for the first 5 months of 2019.

 

Do your own diligence, this is not investment advice, IPOs I missed would skew results, etc, etc.

 

 

 

 

Major US tech IPOs this year

 

Jumia - up 175% from last week. 22x sales

Lyft - down 23% from the start of the month. 9x sales.

Pagerduty - up 61% from a week ago. 25x sales.

Pinterest - going public today at 13x sales.

Slack - still to be priced, but recent private market prices are up 100%. 41x sales expected.

Tradeweb - up 43% from 2 weeks ago. 13x sales.

Tufin - up 59% from a week ago. 8x sales.

Uber - revenue only growing at 35%. 9x sales expected.

Zoom - going public today at 35x sales.

 

 

Major biotech IPOs this year

 

(with sales)

Alector - up 13% from 2 months ago. 53x sales.

Brainsway - flat from 2 days ago. 6x sales.

Genfit - up 21% from a month ago. 93x sales.

Guardion Health - down 37% from 2 weeks ago. 55x sales.

NGM Bio - flat from a week ago. 10x sales.

Precision BioSciences - down 23% from a month ago. 58x sales.

Silk Road - up 64% from 2 weeks ago. 29x sales.

 

(without sales)

Anchiano - down 48% from 2 months ago. no revenues. 42M market cap.

Gossamer - down 9% from 2 months ago. no revenues. 950M market cap.

Harpoon - down 10% from 2 months ago. no revenues. 306M market cap.

Stealth Bio - up 10% from 2 months ago. no revenues. 455M market cap.

TCR2 - up 20% from 2 months ago. no revenues. 428M market cap.

Turning Point - up 49% from yesterday. no revenues. 905M market cap.

 

 

 

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ok... so i was thinking about taking a flyer on ZM, but we are now looking at 45x sales... I was able to make sense of the valuation at $35/share but this is absurd! People are expecting the company to get to $7.5B in revenue and 40% margins (by year 10, if they experience the same dilution as CRM, did over the last decade) in order for this to make sense.  Considering they are profitable, maybe that is bearish on the dilution... but wow!

 

Edit: math mistake...

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IMO including biotechs into any kind of "tech" P/S calculations makes no sense. Biotechs IPO at infinity P/S all the time. That's the game in bio town.

 

Not that we can't expect 50%+ drops from IPO or post-IPO+++ prices. Look at STNE today. Might get to 50% off the top.

 

Disclosure: I am long STNE.

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