TIME Startups

Here’s the Major Downside of So Many $1-Billion ‘Unicorn’ Startups

Uber
Getty Images

Billion-dollar startups aren't rare. They're practically a dime a dozen these day—and that's not an entirely good thing

We live in a magical age of unicorns, those pre-IPO tech startups valued at $1 billion or more. And unlike the dot-com bubble, most of these startups are for real. They are companies whose services–like Uber, Spotify or Pinterest–we use every day. You could even say we consumers are the ones that are helping these unicorns to fly.

There is only one problem: Most of us consumers, as individual investors, are being shut out of the party.

These days, you hear a lot of people in the tech-investing world talk about how this is not 1999. The red ink has been washed away by the black at the strongest startups. A confluence of new technologies–the cloud, social networks, smartphones–are creating the mega-brands of the future. As one CEO memorably put it, “It’s the biggest wave of innovation in the history of the world.”

This is more or less true, but another big difference between today’s tech market and the tech market of 1999 is often overlooked: During the dot-com bubble–when most of the IPOs were pipe dreams waiting to crash–individual investors were able to buy their shares freely. Today, by contrast, most of the investments in the hottest tech startups are happening behind the velvet ropes of private financing.

US securities laws set up last century ensured that only accredited investors—currently, people earning at least $200,000 a year or with a net worth of more than $1 million—could buy stocks in private offerings. Those laws were intended to protect smaller investments from the risks of traditional private investments, and they worked for a long time. But recent changes, such as the JOBS Act, allowed private companies to more easily avoid IPOs if they so desired. And most of them have so desired.

The result is that tech companies that would have been open to ownership by everyday people in earlier decades are now open only to the elite. Hedge funds and other institutional investors jockey for access to occasional venture rounds rather than the daily battle of public markets. Corporate insiders have greater control in setting valuations, while executives escape the scrutiny of quarterly disclosures.

And so, unsurprisingly, the tech IPO has become as rare as, well, a unicorn. According to Renaissance Capital, 35% of the companies that went public in 2011 were technology startups. By last year, only 20% of the 273 IPOs were in the tech industry, and most were in the enterprise space rather than the brand names consumers knew. In the first quarter of 2015, only four tech companies went public. And none of them were exactly unicorns.

Three of those four tech IPOs have a history of losses–cloud-storage company Box, online-ad platform MaxPoint Interactive, and domain registrar GoDaddy. Only Inovalon, which runs cloud services for health-care companies, went public with a profit. In the wake of the recession, it was all but impossible for companies to go public with a history of losses but that changed starting last year, when according to Renaissance, 64% of large tech IPOs debuted with net losses, the highest ratio since 2000.

The companies that are choosing to go public aren’t the cream of the crop. Box may have a bright future, but like GoDaddy it went public at the behest of its investors and did so only after months of delays. Box also priced its IPO below its last private round, following late 2014 IPOs like New Relic and Hortonworks that took so-called “haircuts.”

Which brings up another reason for other companies to avoid IPOs–why do it when you can get better valuations in illiquid private markets? True, liquidation preferences and other private perks justify some of that premium, but private valuations are often more art than science.

The pace of tech IPOs are likely to pick up, but few of the candidates in the current pipeline are the highly coveted unicorns. Next week, Chinese e-commerce platform Wowo is expected to raise $45 million. Craft marketplace Etsy is also hoping to raise $250 million in the coming weeks. And mobile software Good Technology aims to list soon as well. All three have steady histories of net losses.

When it comes to the companies with the brightest futures, they are conspicuously absent from the pipeline. Long before the term “unicorn” became popular, CB Insights compiled a list of hot startups expected to go public in 2014. A year later, their list of hot startups expected to go public in 2015 looked suspiciously similar. And now that we’re into the second quarter, there’s little sign that many of them are planning to go public.

Ride-sharing giant Uber, lodging disruptor Airbnb, online-storage pioneer Dropbox, social-ephemeralist Snapchat, social-pin star Pinterest, music-streaming king Spotify, mobile-payments upstart Square–all have been sought after and well funded in private rounds. All have intimate connections to consumers, and would be broke without them. All couldn’t care less, it seems, when it comes to sharing their success with those consumers.

Maybe that’s why they’re called unicorns. Not because billion-dollar startups are rare–they’re practically a dime a dozen these days–but because, for most investors, they might as well be myths frolicking on the far end some of some rainbow.

Read next: Why This Apple Watch Rival Is Very Important

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MONEY Tech

Why GoDaddy’s IPO Shares Look Cheap

A lot could still go wrong.

GoDaddy, the website hosting service with the provocative ads and a NASCAR sponsorship, is going public this week. Everyone loves a coming-out party, particularly for a well-known consumer brand. In general, however, investors ought to be appropriately skeptical of initial public offerings, particularly for well-hyped technology companies. In these transactions – as with any investment — price is what you pay and value is what you receive: Below, I lay out my initial thoughts on GoDaddy’s valuation.

“We have a history of operating losses and may not be able to achieve profitability in the future.”

That is one of the prominent risk factors that greets prospective investors in GoDaddy’s most recent prospectus. On a GAAP [generally accepted accounting principles] basis, GoDaddy has lost $622 million cumulatively over the past three years – hardly inconsequential for a company that generated $4.2 billion during that period. The good news, however, is that, as of last year, GoDaddy is profitable on the basis of free cash flow (which is what really matters, ultimately — not GAAP earnings).

By my calculations and based on a share price of $18 (the midpoint of the current indicative range of $17 to $19), GoDaddy’s enterprise value-to-EBITDA multiple is 7.2. Enterprise value (EV) is the sum of a company’s market capitalization and its net debt; EBITDA is a measure of cash flow, the acronym refers to earnings before interest, taxes, depreciation and amortization.

It’s cheap, surely

On that basis, GoDaddy is cheaper than all 10 companies in Bloomberg’s selection of comparable companies for which this multiple exists and roughly in line with AOL AOL INC AOL -0.79% , at 7.5. The median for the group, which includes Facebook, Google, IAC/Interactive IAC/INTERACTIVECORP IACI 0.18% , Yahoo! and Yelp is 15.1.

So, GoDaddy looks cheap, then. If only it were that straightforward. I calculated GoDaddy’s EV/EBITDA using the firm’s own adjusted EBITDA figure of $271.5 million. However, Bloomberg puts 2014 EBITDA at $90.9 million, which would lift the EV/ EBITDA to 21.8. All of a sudden, GoDaddy is more expensive than all but three of its peers and significantly more expensive than Google, for example, at 14.7. As such, using EV/ EBITDA is inconclusive until one examines the adjustments the company makes to derive its EBITDA figure. I would tend to remain skeptical and lean toward an “expensive” verdict here.

On the other hand, looking at the price-to-free cash flow multiple, GoDaddy looks like a remarkable bargain at 2.3. Alas, a whopping three-quarters of its $443.8 free cash flow to equity in 2014 was the product of an increase in long-term borrowings — not a sustainable source of free cash flow. Still, even if we substitute the operating cash flow figure of $180.6 million for free cash flow, the multiple only rises to 5.6, which looks very reasonable by comparison with AOL (9.2), IAC/Interactive (15.1) or Yahoo! (85.3). In fact, that multiple would put it at the very bottom of its peer group.

Finally, let’s resort to a blunt instrument: the price-to-sales multiple. For GoDaddy, that number is 0.73, which looks pretty darn cheap for a technology company. The S&P North American Technology Sector Index was valued at 2.92 times sales at the end of February.

May be cheap… within the indicative pricing range

I’m going to come down on the side that says, based on this preliminary assessment, GoDaddy shares look cheap. (That holds at the $18-per-share midpoint of the indicative pricing range, which could of course end up being substantially lower than the price at which they become available in the secondary market.) The Wall Street Journal reported last week that the GoDaddy IPO could see the company raise as much as $418 million and give it a market value near $3 billion.

Furthermore, the business has some attractive qualities, including its high retention rates (over 85% in aggregate and approximately 90% for customers that have been with the service for over three years). Nevertheless, I would strongly encourage investors who are considering buying the shares to read the prospectus closely, particularly the “Risk Factors” section (all 36 pages of it!). Everyone likes to imagine what could go right with an investment, but a prudent investor likes to spend more time gauging what could go wrong.

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TIME Companies

Toys ‘R’ Us Wants to Make Its Stores More Fun For, Well, the Kids

The Toys R Us Inc. logo is displayed inside a store ahead of Black Friday in New York, U.S., on Thursday, Nov. 27, 2014
Peter Foley—Bloomberg/Getty Images The Toys R Us Inc. logo is displayed inside a store ahead of Black Friday in New York, U.S., on Thursday, Nov. 27, 2014

Makes sense

In effort to contend with online retailers and discount box stores, Toys ‘R’ Us is planning an overhaul aimed at making its stores more appealing for its core market: children.

Bloomberg reports the company will start with a prototype store in New York this year that will feature interactive technology and — why didn’t they think of this before? —a play area. If the kids are enjoying themselves, the thinking goes, parents will spend more time, and money, in the store.

“It has to be something where kids want to go and play,” CEO Antonio Urceley said on Tuesday, “We have to reinforce that we are a specialist.”

Toys ‘R’ Us is struggling to compete with retailers like Amazon.com and Target, which undercut the toy brand on price. The company hopes that souped up stores will make up for that.

Additionally, the company plans to hire more staff at Babies ‘R’ Us to boost customer service that it admits has been slacking.

The struggles of Toys ‘R’ Us are not new. In 2005, it became a jointly held private corporation owned by Bain Capital Inc., KKR & Co. and Vornado Realty Trust. Since then, it has failed to garner momentum for an initial public offering with the last attempt in 2013 failing due to “unfavorable market conditions.”

[Bloomberg]

MONEY

Shake Shack Shock: Burger Joint Sees Setback in Shares After First Quarter

Shake Shack saw a dip in shares the day after posting its first quarterly earnings report.

MONEY stocks

Why You Shouldn’t Reach to Grab New Stocks

150312_ISK_SkepticalInvestor
Taylor Callery

As Shake Shack's recent slide demonstrates, while the IPO boom gives you lots of hot companies to take a flier on, you’ll most likely fall flat.

Do you regret missing out on the stunning debuts of Alibaba ALIBABA GROUP HOLDING LTD BABA 0.08% and Shake Shack SHAKE SHACK INC SHAK -1.36% ? Are you now waiting to hail Uber or snap up Snapchat when they go public, as expected?

Before you jump in, remember that when you pick a stock, you’re already taking a leap of faith—but with a newly public company, you’re taking two leaps. First, do you really know enough about the business? Second, has the market had sufficient time to draw its own conclusions so that you are buying at a fairly rational price?

“Anything that’s been trading for a while has been vetted by a whole host of investors,” says John Barr, a manager with the Needham Funds. Not so at or just after an initial public offering, and that’s why you have to tread carefully.

You’ll pay for the honeymoon

IPOs attract big headlines on day one, but surprises inevitably crop up. From 1970 to 2012, the typical IPO gained just 0.7% in its second six months, after the honeymoon effect had a chance to wear off. That’s five percentage points less than other similar-size stocks, finds Jay Ritter, a finance professor at the University of Florida. The year after that, the average IPO lagged by eight points.

Chinese e-tailer Alibaba, which soared 38% on its first day in September, is getting its dose of reality a bit ahead of schedule. Shares are down 28% lately, after the company surprisingly missed revenue-growth forecasts.

Themes get overdone

It’s easy to be lured by a story. Shake Shack doubled on its first day, thanks to the buzz surrounding high-quality fast-food chains like Chipotle CHIPOTLE MEXICAN GRILL INC. CMG -0.76% . But riding a food trend is hard. A decade ago, overexpansion killed investors’ ravenous appetite for Krispy Kreme doughnuts KRISPY KREME KKD 0.21% , and the company’s shares remain 56% off their peak.

Shake Shack has also entered a crowded battle for foodie dollars: the Habit Restaurants HABIT RESTAURANTS HABT 1.06% , Potbelly POTBELLY CORP COM USD0.01 PBPB -5.12% , and Noodles & Co. NOODLES & CO COM USD0.01 CL'A' NDLS -1.09% all went public recently, and all more than doubled in the first day. Odds are the market is overoptimistic about most of them. Since 2013, 15 stocks have doubled on day one; only two—both biotech firms—are trading above their first day’s close.

The fact is, unless you gain access to an IPO at a great price at issuance, you can’t view those stocks as buy-and-hold investments. And you should avoid any richly priced new stock altogether.

Shake Shack trades at 650 times its earnings. To justify that valuation, Ritter figures the burger chain must grow from 63 stores to nearly 700, each half as profitable as a Chipotle restaurant. That’s a big leap indeed, given that Shake Shack locations aren’t even a third as profitable at the moment.

This story was originally published in the April issue of MONEY magazine. Subscribe here.

TIME Companies

The Real Meaning of Etsy’s Initial Public Offering

The logo of Etsy Inc., is displayed for a photograph in Tiskilwa, Illinois, U.S., on Tuesday, Jan. 20, 2015. Etsy Inc., where people sell handmade crafts and vintage goods, may be the biggest technology IPO to come out of New York since 1999. Etsy is working on an IPO that could take place as soon as this quarter, people familiar with the matter said. Photographer:  Daniel Acker/Bloomberg
Daniel Acker—Bloomberg via Getty Images The Etsy logo is displayed on a smartphone in front of sewing machine in Tiskilwa, Ill., on Jan. 20, 2015

Twee jokes aside, the handmade marketplace's IPO is a test for Wall Street

Etsy’s decision to go public seems to have unleashed a wave of jokes about Portlandia, yarn crafts, and Brooklyn hipsters on Wall Street. Go ahead and get it out of your system, and when you’re done consider for a moment what this stock offering, which could come as early as April, will mean for the tech IPO market at large.

Founded in 2005, Etsy has aged better than many of the startups that have emerged during the past decade, like Yelp or Groupon. With revenue still growing close to 60% a year, the company seems to have a fair amount of gas in its growth engine. That’s because Etsy was designed to do something that didn’t really exist at scale before: create a marketplace devoted to connecting those who love to make handcrafted goods with consumers who love buying them.

Etsy’s origins lie in real-world craft fairs, tightly connecting the creators who drove the maker movement in ways that a broader marketplace like eBay couldn’t. The marketplace charges sellers a 3.5% fee on completed transactions plus a 20 cents per item to list fees on the site for four months. Sellers can also pay extra for shipping labels, direct checkout and promoted listings, and these value-added services now make up 47% of Etsy’s total revenue.

But while Etsy is one of the more successful communities to have emerged on the Internet in the past decade, it’s not exactly counted among the so-called “unicorns”, the rare and wildly popular startups, like Uber or Airbnb, that can raise megaround after megaround of private financing, skirting the need for an IPO and all the regulation and scrutiny that come with a publicly traded stock.

When Etsy filed its S-1 Wednesday, it became clearer why. Airbnb is reportedly near a $20 billion valuation, while Uber is valued at twice that amount. Etsy didn’t indicate what the company may be worth after its IPO, but it’s hoping to raise $100 million, and given that many Internet IPOs float only 5% or 10% of their outstanding shares, that could lead to an IPO that values the company between $1 billion and $2 billion.

The Etsy offering could be an important testing of the IPO waters for other companies that have growing businesses and devoted followings, but that are not able to secure large rounds of private financings. The coming months may well see more of these companies seeking IPOs if US interest rates begin to edge higher. That could bring an end to the six-year stock rally, prompting investors in both public and private markets to be choosier about where they put their money.

For Etsy, the challenge is in extending the growth in its core market to a broader range of consumers. Nearly 80% of Etsy’s sales come from repeat buyers, many of whom prefer to buy from individual producers. Etsy has 1.4 million active sellers, 95% of them running Etsy shops from their homes.

To keep growing, Etsy has had to implement changes that have alienated some longtime sellers, like expanding from handmade goods to those manufactured in small batches. And it’s decided it can’t rely mostly on the word-of-mouth referrals that drove its early growth. As a result, Etsy’s spending on search engines and other kinds of marketing rose 122% in 2014 to $40 million.

That aggressive spending caused Etsy to swing from an operating profit of $733,000 in 2013 to a $6.3 million operating loss last year. Despite the loss, Etsy still generated $12 million in operating cash flows. Meanwhile, the company’s cash on hand increased to $70 million at the end of 2014 from $37 million a year earlier. Both figures are indications of healthy business operations.

The prospectus, however, also warned of two “material weaknesses” in the way Etsy controls its financial reporting—one related to how it accounts for certain unnamed expenses and another related to “period-end accruals.” It’s not clear that either will lead to a restatement of earnings, but normally companies wait until these kinds of financial kinks are ironed out before going public. The presence of these disclosures may suggest Etsy is under pressure to complete its IPO quickly.

Another question is how Wall Street will receive Etsy’s corporate idealism. Unlike Groupon, Etsy doesn’t play up its quirkiness—a streak of humor that ultimately fell flat with investors—but its prospectus makes clear it marches to the beat of its own drum. The company’s name is taken from a phrase repeated through Fellini’s 8 ½, and its independent spirit remains strong today.

Which is why Etsy’s S-1 contained sentences like, “We eat on compostable plates, and employees sign up to deliver our compost by bike to a local farm in Red Hook, Brooklyn, where it is turned back into the soil that produces the food we enjoy together.” Or the risk factor that the company’s “focus on long-term sustainability” may hamper its short-term performance.

Google and Facebook both issued such warnings, but Etsy is raising the ante by citing sustainability and environmental concerns, rather than innovation, as the long-term objective that weigh on short-term profits. These goals are laudable and worthy in the real world, but inside the rarefied, profit-obsessed realm of Wall Street they will either be glossed over—or zeroed in on when it comes time to cut costs.

For now, though, Etsy is likely to receive a warm welcome on Wall Street. Internet IPOs with brand names familiar to consumers are a rare item these days, unlike the legion of obscure if promising drug startups. Etsy’s first test will be in showing that the spending on marketing is translating into new and loyal users. Handcrafted goods are as old as commerce itself, and Etsy has given them a modern twist. Whether that can scale up to a mainstream market remains to be seen.

TIME Tech

Etsy Files for Handcrafted IPO

The logo of Etsy Inc., is displayed for a photograph in Tiskilwa, Illinois, U.S., on Tuesday, Jan. 20, 2015. Etsy Inc., where people sell handmade crafts and vintage goods, may be the biggest technology IPO to come out of New York since 1999. Etsy is working on an IPO that could take place as soon as this quarter, people familiar with the matter said. Photographer:  Daniel Acker/Bloomberg
Daniel Acker—Bloomberg via Getty Images The Etsy logo is displayed on a smartphone in front of sewing machine in Tiskilwa, Ill., on Jan. 20, 2015

The handcrafted marketplace cited losing its authenticity as a risk factor in its regulatory filing Wednesday.

Etsy, the online marketplace for handcrafted and vintage goods, has filed for an initial public offering that is banking on the continued appetite for new Internet stocks.

Reports speculated that the company could be valued in the public markets at $2 billion. It said in a regulatory filing Wednesday that it hopes to raise $100 million in the offering, although that amount is likely a placeholder.

Etsy, founded in 2005, has ridden the “maker movement” to success, becoming synonymous with handmade crafts online. It has cultivated a devoted community of 1.4 million sellers and 19.6 million buyers, for whom the site is a sort of eBay for everything from reclaimed wood furniture to hand-made terrariums.

Last year, Etsy took in $195 million in revenue, with just over half coming from transaction fees. The rest came from services the sites offers to sellers like promoted listings, payment processing and shipping labels.

The company posted a loss of $15 million in 2014, up from $800,000 in the prior year. In a potentially worrisome sign to potential investors, it said that operating expenses are expected to “increase substantially.”

Etsy retained Goldman, Sachs & Co. and Morgan Stanley as joint book-running managers with Allen & Company as co-manager. It plans to trade on Nasdaq under the symbol “ETSY.”

A few years ago, Etsy lifted some of its stricter sales requirements, including a ban on sellers using certain manufacturing techniques and hiring staff that had been put into place to maintain the site’s homespun image. This gave the sellers that had made their Etsy shops into a full-time job the ability to expand, but critics warned that it might cause the site to lose what makes it special.

Those concerns resurfaced around reports of the company’s public offering. In its filing Wednesday, Etsy noted the importance of “authenticity of our marketplace and connections within our community,” as one of the cornerstones of its business.

“If we are unable to maintain them, our ability to retain existing members and attract new members could suffer,” the company’s regulatory filing said.

CEO Chad Dickerson has long hinted that Etsy might try to avoid the traditional IPO route, followed by the likes of giants like Facebook, Twitter and videocamera maker GoPro. The company is a Certified B Corp, after all, so it technically has a “double bottom line,” which means it must make investors happy while also following more unconventional corporate guidelines that emphasize doing good.

In 2012, Dickerson pointed to SurveyMonkey, the online survey company, as an example of a viable alternative to going public. Rather than sell or IPO, SurveyMonkey underwent an $800 million recapitalization in which it took on debt financing. This allowed the company to pay back its outside investors while remaining private and independent. However, Etsy, which raised almost $100 million in venture backing over the years, has chosen to list itself on Nasdaq.

If successful, Etsy’s IPO will be a win for New York’s tech scene, which has seen its early leaders, blogging service Tumblr and location check-in app Foursquare, sell or struggle to find their way. It would also be a win for its venture investors, Glynn Capital Management, Index Ventures, Union Square Ventures and Accel Partners. Of course, that’s a big if. But how could anyone resist a cat in a handcrafted necktie?

This article originally appeared on Fortune.com

TIME stock market

Here’s the Biggest Change in Technology in Recent Memory

Yelp Yelp. If you’re on vacation or new in town (or even not-so-new in town) and you want to learn about what’s around you — shops, restaurants, dry cleaners, gas stations, bars, you name it — Yelp has you covered, complete with user reviews so you can separate the good from the bad.

It's not some new, slick gadget or big idea

With the bulk of the earnings season behind us, the stock market appears to be in a much better mood than it was a month ago. The S&P 500 is up 3.8% over the past month, while the tech-heavy Nasdaq 100 is up an even healthier 5.9%. Tech, it seems, is a popular sector refuge in the sea of uncertainty facing 2015.

But a closer look at the tech earnings from the past month shows a more complex story as not all tech names are being favored equally. In fact, some of the companies that dished out disappointing forecasts were hammered hard. If there is one key trend that emerged from the recent parade of fourth-quarter earnings, it’s that 2015 is turning into a stockpicker’s market for tech shares.

This is in contrast to the past couple of years, when waves of enthusiasm or caution swept across the tech sector at large. Last year, for example, an early rally for tech led to concerns that another bubble would emerge–concerns that were quickly dispelled by a brutal selloff come April. By June, stocks were recovering, and the Nasdaq 100 ended last year up 18.5% and the S&P 500 up 11.8%.

One trend from 2014 that’s continuing into this year is the outperformance of larger-cap tech stocks. Smaller tech shares tend to do well in the several months following their IPOs, then have a harder time pleasing investors. A good example is GoPro, which went public at $24 a share in June, surged as high as $98 in October and and fell back to $43 last week in the wake of its earnings report.

GoPro’s post-earnings performance illustrates the selective mood of investors. The company blew past analyst expectations with revenue growth of 75% and higher profit margins. But the stock plummeted 15% the following day as analysts raced to lower price targets. Why? GoPro’s outlook was seen as too weak to support its lofty valuation and its chief operating officer was leaving.

That pattern played out in other smaller tech companies. Yelp slid 20% after its own earnings report that beat forecasts but that showed worrisome signs of slower growth and slimmer profits this year. Pandora fell 17% to a 19-month low after disappointing revenue from the holiday quarter. Zynga finished last week down 18% after warning this quarter will be much slower than expected.

What all of these companies also have in common are uncomfortably high valuations. Even after the post-earning selloff, GoPro is trading at 37 times its estimated 2015 earnings. Pandora is trading at 75 times its estimated earnings, while Yelp is trading at an ethereal 371 times. The S&P 500 has an average PE of just below 20.

So which companies did the best this earnings season? As a rule, it was big cap names serving the consumer market: Apple, Twitter, Amazon and Netflix. What these four companies have in common beyond strong earnings last quarter is that all were seen as struggling by investors during some or all of 2014.

Compare them to big-cap tech names that posted decent financials in the fourth quarter but that weren’t seen as struggling before, but instead were seen as thriving tech giants. Google, for example, is up 6% over the past month, while Facebook is up 1%. Both are enjoying steady growth that was so consistent with their past performance it has a ho-hum quality to it.

By contrast, Apple, which had been portrayed by critics as a gadget giant past its prime, has seen its stock rally 21% in the past month to a $740 million market cap, the first US company to be worth more than $700 billion. Amazon, which investors feared would suffer prolonged losses because of its expansion plans, is up 29%. So is Twitter, another object of investor worry in 2014. Netflix, a perennial target of bears, is up 40%.

So what have we learned about the technology sector so far this year? On the whole, investors are favoring tech stocks in a world of uncertainty – where negative interest rates have become bizarrely commonplace, and where the next market crisis could come from a crisis involving the Euro’s value, or China’s economy, or oil’s volatility, or Russia’s military aggression.

But at the same time, investors have grown more selective about the tech names they invest in. They might snap up hot tech IPOs, but they’ll drop them quickly if those companies can’t deliver over time. They prefer big tech, especially companies that cater to consumers. And if those tech giants can engineer a turnaround, they’re golden.

MONEY Food & Drink

Why Shake Shack’s IPO Is Too Rich for My Blood

Shake Shack founder Danny Meyer (3rd R) and Shake Shack CEO Randy Garutti (2nd R) ring the opening bell at the New York Stock Exchange to celebrate their company's IPO January 30, 2015. Shares of gourmet hamburger chain Shake Shack Inc soared 150 percent in their first few minutes of trading on Friday, valuing the company that grew out of a hotdog cart in New York's Madison Square Park at nearly $2 billion.
Brendan McDermid—Reuters Shake Shack founder Danny Meyer CEO Randy Garutti ring the opening bell at the New York Stock Exchange.

I used to think Shake Shack might be undervalued. Not anymore.

Last week, I wrote a positive article on burger chain Shake Shack’s SHAKE SHACK INC SHAK -1.36% IPO on the basis that, “in [the indicative $14 to $16] price range, the shares could significantly undervalue Shake Shack’s growth potential.” The shares began trading today, and I’m much less excited about the offering. In fact, I think investors ought to avoid the stock entirely. What’s changed?

Is no price too high?

It’s not unreasonable to think a stock that is attractive at $15 may well be repulsive at more than three times that price — which is where Shake Shack shares are now trading. (The stock was at $48.62 at 12:30 p.m. EST.) Indeed, the underwriters raised the price range to $17 to $19 — and the number of shares being sold — before finally pricing the shares at $21.

Apparently, that did nothing to deter investors once shares began trading in the second market this morning – they opened at $47, for a 124% pop! Despite solid or even outstanding fundamentals, a business will not support any valuation. Price matters.

Last week, I compared Shake Shack to Chipotle Mexican Grill CHIPOTLE MEXICAN GRILL INC. CMG -0.76% . Let’s see how the share valuations of the two companies on their first day of trading now compare:

Number of restaurants operated by the company at the time of the public offering Price / TTM Sales
(based on closing price on first day of trading)*
Chipotle 453 4.4
Shake Shack 26 16.1

*Shake Shack’s price-to-sales multiple is based on the $48.62 price at 12:30 p.m. EST. Source: Company documents.

That’s a huge gap between the two price-to-sales multiples! Given the massive appreciation in Chipotle’s stock price since the close of its first day of trading — a more than fifteenfold increase in just more than nine years! — there’s a good argument to be made that the shares were undervalued at that time.

However, had Chipotle closed at $160 instead of $44 on its first day of trading — which would equalize the price-to-sales multiples — subsequent gains would have been significantly less impressive.

Buy potential performance at a discount, not a premium

Furthermore, with Chipotle, we are looking back at performance that has already been achieved, both in terms of the stock and the company’s operations. The Mexican chain has executed superbly well during that period.

With regard to Shake Shack — however likely you think a similar business performance is — it remains in the realm of possibility instead of certainty. I don’t know about you, but when I buy possibility, I like to buy it at a discount to the price of certainty.

Although I think Shake Shack’s brand positioning is comparable, and possibly even superior, to that of Chipotle, I’m not convinced the business fundamentals are as attractive.

For one thing, Shake Shack faces stiffer competition in its segment than Chipotle did (or does) in the likes of Five Guys and In-N-Out Burger. For another, Shake Shack’s same-store sales growth is significantly lower than Chipotle’s was, at just 3% for the 39 weeks ended Sep. 24 versus 10.2% for Chipotle in 2005, which was followed by 13.7% in 2006.

Don’t swallow these shares

Shake Shack may produce a premium burger — founder Danny Meyer refers to this segment as “fine casual dining” — but the stock is currently selling at a super-premium price. Paying that price is the equivalent of eating “empty calories” — it could end up being detrimental to your financial health.

Alex Dumortier, CFA has no position in any stocks mentioned. The Motley Fool recommends Chipotle Mexican Grill. The Motley Fool owns shares of Chipotle Mexican Grill. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

 

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