It has occurred to me that proponents of Efficient Market Hypothesis (EMH) must have never read the prospectus of an Initial Public Offering (IPO). Otherwise they would have long ago abandoned their notion that the market always attaches a rational price to an equity. Of course, their failure to compute the fundamental value of the underlying company which represents the IPO puts them squarely in line with most of the "investors" in such entities.
In most cases it is not plausible to assume that any investor who purchases such an equity could have possibly read the details which describe the nature of the business and its financial assets. Otherwise, it would be nearly inconceivable that a sane investor would engage in such blatant speculation. Rather the buyers must be caught up with the hype surrounding the IPO and the prospect of a quick gain; with the intention to sell their recently acquired shares to a "greater fool" who is equally apathetic towards the intrinsic value of the new issue.
Back in the mid to late 1990s, speculators were making money hand over fist by attaining the privilege to purchase shares of upcoming internet IPOs before they were offered to the public. It was the closest thing to a cinch on Wall Street. Preferred customers of brokerages houses and investment banks were offered first chance at attaining shares in a new issuance and they were generally able to purchase their shares at a much lower price than the investors who had to purchase their shares on the open market.
The game was simple for the preferred customers; they pre-purchased the shares at the proposed offering price and then promptly sold them during the first day they traded publicly, invariably at a huge premium to the price which they had paid for their stock. Every subsequent IPO created a buying frenzy since virtually every offering skyrocketed during their first day of trading.
Very few investors were privy to the easy money and investment houses which sponsored numerous internet IPOs were able to attract big money to their book by offering the shares as incentives to transfer their accounts. Where was Occupy Wall Street, then? Probably making big money trading Internet stocks and partying like rock stars.
Description of Business for Angie's List (ANGI)
For those of you who do not pay attention to television or radio advertising, Angie's List is a contractor referral service which professes to align homeowners with "quality" contractors, health care providers and auto repair shops. The homeowners pay a fee for that service and in turn provide purposely unbiased reviews which evaluate the contractors. Those reviews are then made available for other members of Angie's List.
The idea is to provide an unbiased customer-based evaluation system which helps consumer’s select legitimate service providers, while avoiding the "disreputable" types which tend to permeate certain professions. The company provides sort of a private Better Business Bureau model with a greater emphasis on overall contractor evaluation rather than merely weeding out the crooks and ne'er-do-wells.
Who Really Benefits from an IPO
If you ask the issuer of an IPO the reason why they are willing to dilute their position in the company; you are likely to elicit a response which suggests that they need capital to grow the business into a titan. In reality, most owners who possess potential "titans" or merely hold ownership positions in profitable businesses are not likely to sell any of their shares unless they can do so at a price that benefits them significantly. From the Angie's List prospectus:
The following table summarizes, as of September 30, 2011, the number of shares of common stock purchased from us, the total consideration paid, or to be paid, and the average price per share paid, or to be paid, by existing stockholders and by the new investors, at the initial public offering price of $13.00 per share, before deducting underwriting discounts and commissions and estimated offering expenses payable by us.
|Total Shares||Total Consideration||Average Price |
Note that the existing shareholders own their positions at an average cost of $2.76 per share while the new investors own their positions at $13.00 per share.
While it is true that most companies which go public do require capital for growth as well as solvency, in many cases the IPO also provides the private owners with an opportunity to sell a percentage of their holding at a huge profit. Further, the shares are generally sold at a price which dramatically exceeds the value assigned by the over-zealous members of the company's board. From the prospectus:
Number of Options Granted
Exercise Price Per Share
Estimated Fair Value Per Share
August 11, 2010
October 4, 2010
February 11, 2011
May 19, 2011
June 8, 2011
July 26, 2011
August 11, 2011
August 23, 2011
October 18, 2011
The prospectus goes on to explain that stock options are granted on the basis of what the board deems is their best estimation of the current market value of the stock. Note that as of October 18 of the current year, the board granted options at $9.49 per share (a price I consider wildly optimistic); however, the offering price for ANGI was set at $13 a share a month later. That represents a 37% premium to the estimation of the board. Clearly the IPO price favors the existing shareholders, management and the board of directors, rather than the new buyers.
Valuation Metrics for Angie's List
The current market cap of Angie's List is well over $800 million. Using the financial information supplied by the prospectus following the capital injection supplied by the IPO, ANGI trades approximately at the following valuation metrics:
1) 33.4X book value
2) 9.6x revenues (assuming a 46% growth rate for the fourth quarter of 2011)
In the company's 16 year existence, it has recorded accumulated deficits of $162 million without ever recording a year of profitability. For the first nine months of 2011, ANGI has yielded a record loss of $43.17 million, while burning a record $23.77 in cash flows from operations.
The company increased revenues for the first nine months of 2011 to approximately $62.6 million compared to around $42.9 million in 2010. That represents a growth rate of about 46%; however, the cost of those increased revenues was directly a result of a massive increase in advertising expenses. In 2010 the company recorded $25.13 million in marketing costs (58.5% of sales). In 2011 the company increased their marketing expense to $47.99 million (77.67% of sales).
The additional $22.86 million in marketing expenses only resulted in additional revenues of 19.7 million. In other words the company was spending more in additional advertising expenses than they were generating in sales.
Angie's list boasts a customer base of approximately one million as of the date of this article. In terms of market capitalization, that values the company at well over $800 per subscriber. Yet total revenues for the company for the first nine months of 2011 were only slightly in excess of $62 million and less than 40% of the revenues came from subscribers while over 60% percent of the revenues were provided by the company's service providers.
In other words, the company's extensive marketing campaign only increased membership dues by around 30% year over year from slightly over 18 million to slightly over 24 million in revenues. That fact illuminates the ineffectiveness of the company's marketing strategy in generating significant membership revenues despite the exorbitant costs of marketing. The real increase was in the area of service providers which increased from about 24.5 million to about 38.5 million or close to 50%.
It appears that the real source of revenue growth at ANGI is advertising revenue from businesses rather than membership revenue. Therefore, the fate of ANGI lies largely in their ability to increase advertising revenue. Ultimately, that will become a direct function of the ability of the company to increase the company's membership base since service providers are strictly interested in the effectiveness of the company in supplying their businesses with legitimate leads.
The problem lies in the fact that Angie's list is unlikely to be able to maintain a sufficient membership growth rate without reducing its per capita dues.
I suspect that at some point in time ANGI will suspend its membership dues or at least reduce them significantly in an effort to facilitate the growth of its membership base which is essential in fueling the growth of its advertising revenue. It seems unlikely that the company can maintain a high growth rate in regard to their membership revenues which currently are supplying nearly 40% of their sales.
Angie's List is a wildly overpriced IPO which is reminiscent of the new issues of the Internet boom. The company has been burning cash at an alarming rate, trades at outrageous P/S and P/B multiples, as well as being highly illiquid in terms of its current ratio prior to the capital infusion provided by the IPO. I see no reason to believe that the company will be able remedy that situation in the near future. Nor do I expect that the company's ongoing capital woes will be alleviated by the current IPO. In all liklihood its liquidity concerns will resurface in the near future.
Most IPOs result in significant losses for investors and largely serve the purpose of supplying prior owners and investment banks with the ability to record quick profits at the expense of the new shareholders. Sadly, the capital infusion frequently allows the current management the ability to continue to draw compensation with little hope of ever creating any shareholder value as well as providing them with an opportunity to sell additional shares after the end of the lock-up period.
It is apparent to me that most investors in IPOs never read the prospectus, never fully understand the underlying business model of the company, and rarely pay attention the financial reports of the business. Instead they are lured by the prospect of making a quick profit in a hot new issue. Frequently these new issues are nothing but hot air and hype. Such is the case with ANGI in my humble opinion.
Disclosure: no position iin ANGI