Uber has poisoned an IPO market that was sick anyway
Cooling interest in Uber makes it harder for next unicorn to finance losses by going public
Uber and Lyft have overtones of the wacky days of the dot-com bubble, when sketchy business plans and big losses were an active selling point. The obvious difference between the 1999-2000 boom and the current wave of technology IPOs is how badly this year’s high-profile debuts, Uber and Lyft, performed. Uber plummeted on Friday after ringing the NYSE opening bell and plunged again on Monday to leave it 18% below the $45 (U.S.) IPO price. Lyft has dived a third below its offering price.
Such performance was vanishingly rare during the dotcom boom: in 1999 the average lossmaking tech IPO leapt by 81% on its first day, according to data from Prof. Jay Ritter at the University of Florida.
Uber’s weak shares will put a damper on the other stocks waiting to come to market, some of which test investors’ credulity even more than the plans of the lossmaking taxi firms. One reason is that the market is quite different today than in the dot-com boom, at least from the point of view of big companies.
Back in 1999, investors were willing to buy virtually anything and companies and stock promoters obliged, supplying new shares both for staid old-world businesses trying to get online and for hopelessly optimistic startups. The dot-com boom was extreme, but it was the extreme end of something normal: when stocks are expensive, you should expect companies to issue them. The flip side is that when stocks are cheap, companies ought to buy them back. The catch in both cases is that what counts as cheap or expensive is relative to other ways companies can raise money— the debt markets.
It’s easy to think that the stock market is extremely expensive after just hitting a new high. But stocks remain cheap compared with bonds for most companies, making it more appealing to take on debt to buy back their own stock than to issue shares to pay off loans, at least on a short-term outlook. Companies worried about weaker demand because of a trade war or recession might reasonably want to bolster their balance sheets ahead of a downturn in business. But unlike in 1999, having less debt comes at the cost of more expensive financing. (An aside: a company’s cost of equity isn’t just the cash cost in dividends, but investors’ expected total return.)
The simplest way to quantify the market’s cost of debt versus equity is what is known as the Fed Model, which compares the forward earnings yield of stocks—earnings estimates for the year ahead divided by price, or the inverse of the P/E ratio— to the yield on the 10-year Treasury. This has repeatedly proved itself useless as a guide to what might happen to stock prices, with the stock-bond relationship reversing in the late 1990s. But it works as a rough guide to whether companies as a group are likely to finance themselves through debt or equity.
In the dot-com bubble equity was historically expensive to buy both in absolute terms and relative to bonds, making it a no-brainer for companies to be sellers. IPOs duly reached record levels as both tech and non-tech owners of private companies sold out. Companies didn’t bother borrowing, issuing stock to finance their takeovers.
In the buildup to the 2008-9 financial crisis stocks were relatively cheap compared with debt (or, to put it another way, interest rates were low). That made it unappealing for companies to sell shares, so there was no new IPO boom, with fewer new listings in 2006 and 2007 combined than in any single year from 1992 to 1999. Instead, there was a buyback boom, as corporate finance departments realized they could borrow cheap and retire their stock, little realizing they might need cold hard cash after Lehman Brothers collapsed.
After the recession stocks rebounded into a new bull market, but bonds got even more expensive than stocks did as interest rates hit zero. The deliberate incentive created by the Federal Reserve was to borrow like there’s no tomorrow, and that’s exactly what companies did. Buybacks soared once CEOs realized that the Fed really meant to keep rates low for a long time, and IPOs were scarce. That lasted until the Fed pulled back from its bond-buying at the start of 2014.
At that point stocks still looked much more expensive relative to bonds than they had through the previous few decades. But they were at least back to where they had been in early 2008, and there was a mini-IPO boom. Then last summer there was a sharp rise in bond yields—bonds got cheaper for buyers, so more expensive for issuers—and tech stocks soared. It made sense to issue again, and the Silicon Valley unicorns that had stayed private for so long started to file prospectuses.
Yet, it doesn’t make sense for companies to switch from buybacks to stock issuance, except in anticipation of bad times ahead. What looked like wild demand for tech stocks explains why the founders and private backers of the big lossmaking companies chose to IPO, but across the market as a whole debt still looks cheaper than equity.
Uber’s flop makes it harder for the next big Silicon Valley unicorn trying to shift its losses on to public markets, just as Snap’s dire debut did two years ago. One winner: Snap. “My heart goes out to Uber,” Evan Spiegel told the WSJ CEO Council on Tuesday. “It’s very nice to have another public company take the spotlight.”
Even if the likes of WeWork can rekindle interest in dotcom-style business plans, it’s unlikely to turn into an IPO boom as widespread as in the late 1990s, because for companies that can borrow it continues to make sense to use debt instead. At least, assuming recession isn’t imminent, in which case companies should be selling the stock while they can.