There has been a lot of discussion lately in the venture community about the favorability of direct listings over the IPO process. The chief complaint of IPOs is that securities are underpriced at issue. To better understand the comparison between the two methods, we took a look at 25 of the top tech IPOs in the last two years.
Before we look at the underpricing argument, it’s helpful to look at the cost of IPOs and direct listings. At the most basic level, the cost of a direct listing and traditional IPO are relatively similar in our sample. We found that the average company paid between $29.6M and $34M in underwriting fees based on the level of exercise. It’s important to note that this doesn’t include any fees incurred by sellers. Total underwriting fees in deals where sellers sold shares as part of the IPO process ranged slightly higher, an average between $32M to $37M. The two direct listings to date, Spotify and Slack, paid financial advisory fees of $35M and $22M respectively.
An appeal of the IPO process is that it allows companies to raise additional capital, which companies aren’t currently able to do during a direct listing. In our sample, the average company raised between $794M and $913M during the IPO process. This translates to ~$26M raised for every $1M in fees. If we look at the fees that Spotify and Slack paid for a direct listing, the companies could have raised an estimated $937M and $590M respectively.
This brings us to the main point of the debate: the underpricing of IPOs. When comparing the issue price to the opening price on the first day of trading, our sample found an average underpricing of 38%. Of the 25 companies we looked at, only two, Peloton and Uber, opened below their issue price. If we add the underwriting fees and underpricing costs together, the true cost of an IPO is between $333M to $382M with only 10% of the cost from underwriting fees. The vast majority of this amount is value transferred to those who are allocated underpriced shares at issue.
If Spotify and Slack had raised capital in their listings via a traditional IPO at the levels described above and their shares were underpriced at the average 38% level, it would have represented $346M and $217M in underpricing respectively.
As we noted, there is currently no mechanism for companies using a direct listing to raise capital at the listing. One potential solution that’s been mentioned is doing a private capital raise 3-6 months ahead of the direct listing. Given the amount of private capital in the market, this should be easily achievable. Another potential option is to do a follow-on offering after the direct listing establishes a fair market price for shares. Follow-on offerings typically have a discount to the most recent public price (an average of 7.3% in 2018).
Investors in follow-on offerings demand a discount. Private investors ahead of a planned direct listing are likely to do the same. The discount is necessary because if an investor wants to take a position in a public company, or one soon to be so, there’s no incentive for them to do so as part of a structured capital raise at the market price. They can just buy shares on the open market. Companies looking for the liquidity of the public markets plus capital should be able to get it cheaper than current IPOs, but they won’t get it for free.
Top 3 Takeaways:
- At the most basic level, the cost of a direct listing and traditional IPO are relatively similar. We found that the average company paid between $29.6M and $34M in underwriting fees. The two direct listings to date, Spotify and Slack, paid financial advisory fees of $35M and $22M respectively.
- When comparing the issue price to the opening price of recent tech IPOs on the first day of trading, we found an average underpricing of 38%. Of the 25 companies we looked at, only two, Peloton and Uber, opened below their issue price.
- Companies looking for the liquidity of the public markets plus capital should be able to get it cheaper than current IPOs, but they won’t get it for free. While work is being down to raise capital during a direct listing, companies have two alternative options: they can raise private capital ahead of a direct listing or do a follow-on offering after a direct listing.
- [0:30] What makes a direct listing different than an IPO.
- [1:17] In an IPO, companies paid on average between $29.6M and $34M in underwriting fees. For their direct listings, Slack paid $35M and Spotify paid $22M in financial advisory fees.
- [2:14] Based on fees paid, we estimate Spotify could have raised $910M and Slack $572M if they pursued an IPO instead of a direct listing.
- [3:43] Doug poses a question – Does brand matter for direct listings in the future?
- [4:38] In the 25 IPOs we looked at, the average underpricing was 38 percent. 23 of the 25 companies were underpriced at issue.
- [6:25] While we have a small dataset, direct listings seem to show better price discovery than IPOs.
- [7:18] Four companies (CrowdStrike, Zoom, PagerDuty, and Beyond Meat) were underpriced by over 80 percent.
- [8:31] Options companies have for raising money and going public.
Shares of NVDA were down 1% after hours following the company’s October quarter report. It’s worth noting, in the past three months shares are up 37%. We remain long-term positive on the Nvidia story given the company’s 3-5 year opportunity in providing GPU’s for datacenters and machine learning applications. Beyond five years, we expect autonomous mobility applications will support continued 15% plus revenue growth. Our takeaways from the quarter:
- Return to growth: Nvidia’s business will return to mid 30% revenue growth in Jan-20, after being down by an average of 17% over the previous 3 quarters. The return to growth is largely due to channel clean up within the gaming segment along with strength in datacenter. The Jan-20 revenue growth pace should be sustainable given the company is entering a year of easier comps following the crypto business 2019 bust.
- Soft Guidance: Jan-20 revenue guidance was 2% below the Street, attributed to softness in the gaming segment mostly offset by strength in datacenter. Gross margin guidance for Jan-20 was better than expected at 64.5%, vs 64.1% in Oct-19. As a point of reference, these margins are higher than Intel at 59% and AMD at 43% in their most recent quarters. The company noted to expect gross margins to further expand in calendar 2020 due to Nvidia’s transition to 7nm manufacturing at TSMC.
- Gaming: (down 6% y/y, accounting for 55% of revenue): Gaming was better than expected driven by RTX sales. As mentioned, the gaming business is expected to soften in Jan-20 due to seasonality from OEMs including HP, Dell, and Lenovo. Specifically, demand that would normally have fallen into the January quarter was pulled in the October quarter. Importantly, the gaming segment demand over the combined October and January quarters is essentially in line with expectations.
- Datacenter: (up 7% y/y, accounting for 24% of revenue): The majority of the earnings call was focused on the datacenter opportunity. Demand for datacenter products is being driven by hyperscaling for training and inference AI algorithms. For example, natural language-based interfaces (Apple Siri, Google Voice, Amazon Alexa) are powered by cloud computing hardware optimized with Nvidia GPUs which reduce latency. We expect datacenter to be the largest revenue segment in the next 3-5 years.
- Auto: (down 6% y/y, accounting for 5% of revenue): Today about half of auto revenue is related to infotainment and half is related to autonomous driving hardware. The infotainment center business is declining slightly compared to the autonomous driving segment which is growing at lumpy rates. On the call, the company suggested autonomous driving segment growth slowed measurably given major car OEMs are years away for rolling out autonomy at scale. Aside from Tesla, Nvidia’s hardware remains imbedded in all major car OEMs autonomy solutions. We advise patience when considering the auto segment opportunity and expect in 5 plus years, it will become an increasingly important part of the story.
- Investing in Nvidia has been a rollercoaster. We believe revenue growth will reaccelerate over the next 12 months to 30% plus after being down an average of 17% over the past three quarters. The company is entering a year of easier comps following the crypto business boom (2018) and bust (2019).
- While crypto is just under 5% of revenue, unwinding channel inventory over the past year had a negative 15% impact on revenue. As of Oct-19, we believe the crypto channel overhang has been cleaned up.
- The return to growth is reasonable, given Nvidia is a key hardware arms supplier to the long-term growth trends of gaming, AI/datacenter, and autonomous mobility.
- This Thursday (Nov 14th) Nvidia reports its October quarter. We expect positive results from the company based on upbeat macro commentary from Intel and AMD’s recent earnings reports, specifically about Dec-19 growth.
The NVDA Rollercoaster
In October of 2018 shares of NVDA hit their all-time high, and the company’s value reached $165B. Following the crypto bust, the market cap dropped to $83B in June of 2019. In the past three months, NVDA shares are up 37% (market cap $122B), compared to the Nasdaq which is up 8%, as investors gain confidence the company will return to growth in the Jan-20 quarter.
Intel & AMD Tone Bodes Well for Nvidia
In Sep-19, Intel’s desktop sales accelerated after three quarters of muted demand, a positive for Nvidia’s gaming sales.
Additionally, Intel saw early indications we are entering a multi-quarter buying cycle in the high-end performance computing space, which bodes well for Nvidia’s datacenter segment. In contrast, AMD’s Sep-19 datacenter high-end business sales declined due to what AMD described as longer cloud buying cycles. We believe part of AMD’s datacenter demand headwinds were attributed to market share loss to Intel and Nvidia.
Most importantly, both Intel and AMD guided Dec-19 top-line revenue to reaccelerate. The Street now expects Intel’s Dec-19 revenue to be up 3% y/y, compared to flat in Sep-19, and AMD to be up 48% y/y in Dec-19 compared to up 9% in Sep-19. This increases our confidence that Nvidia revenue will meet Street expectations for Oct-19 of down 9% y/y, and the company will guide Jan-20 revenue in line with the Street, which calls for a rebound to 39% growth.
Long-Term Growth Justified by Data Centers and Autonomy
Nvidia’s legacy business is selling graphics cards for gaming, which accounts for about half of revenue today. The “graphics card” description is misleading, given Nvidia’s graphics cards are used outside of gaming for applications from Matlab scripting in university labs to crypto mining which drove the ramp up in demand for gaming products in 2018. Nvidia’s 3-5 year growth story will be dominated by the datacenter space, where their GPUs are an essential computing solution to all types of machine learning algorithms being deployed by Google, Amazon, Facebook, Apple, and other fortune 500 companies. Beyond five years, we believe autonomous mobility applications will support continued 15% plus revenue growth.