One of the biggest trends in technology and software development over the last twenty years has been the emergence of agile ways of working. The agile manifesto describes the core tenets of agile as “Individuals and interactions over processes and tools; Working software over comprehensive documentation; Customer collaboration over contract negotiation; Responding to change over following a plan.”
Agile practices promise to allow the team using them to react to customer needs and validate ideas quickly, leading to less waste when compared to methods that require more planning, like a waterfall approach. One of the core features of this practice is a regular “standup” meeting, where team members discuss what they are working on, what they are stuck on, and how their goals relate to the overall goal of the team.
However, a recent study has shown that these regular standup meetings actually inhibit innovation. This was found by counting the number of standups by teams competing in a hackathon, and comparing it to the judged creativity and usefulness of the software they produced.
In theory, this is because the regular meetings encourage alignment between team-members, which in turn discourages individuals from having time and space to go down rabbit-holes. But most people aren’t software developers, so why does this matter?
Andy Wu, author of this study, explains how this finding can be applied across subject matters, from developing a screenplay to creating a complex financial analysis. Overall, allowing people, including yourself, to spend time going down rabbit holes and exploring new areas is key to creating something original. Sometimes the best way to be creative is to immerse yourself in a topic and see where it brings you, without worrying about the final goal.
But, as with most things, a careful balance is essential. Forgoing long term goals and alignment with other teams/members of your team is a recipe for chaos. But introducing some time for deeper exploration, and spending some time working by yourself, is key if you want to develop valuable insights and creations, even if they aren’t obviously useful.
Good morning and Merry Christmas!
I hope you are healthy and well at this festive time of the year. London has just entered Tier 4, which means that everything is closed, but I am fortunate enough to be staying with my parents for the next couple of weeks. Thank you to everyone who replied to the survey I sent out last week (you can still respond here). This week I talk about IPOs, SPACs, what really happened when oil prices went negative, and about what an EBITDA is.
As always, if you enjoy this article or find it valuable, be sure to subscribe at the bottom. All the best,
Callum Macdonald
IPOs and SPACs
There has been a lot of news about IPOs, SPACs and Direct Listings in the recent months. This is because of a combined surge in the number of SPACs in the last year, and because of the number of large tech companies that have IPOed this year, including but not limited to Lemonade (insuretech valued at $1.6bn), Snowflake (data cloud valued at $33bn), Unity (games and animation engine valued at $13.7bn) and in the last month, Airbnb and DoorDash (valued at $47bn and $39bn).
Before we dig into what has been happening in the most recent IPOs, and why they’ve made news so many times in the last year, I want to dig into what an IPO, a SPAC, and a direct listing are, and how they differ.
What is an IPO? IPO stands for Initial Public Offering, and, like the other methods mentioned here, is the process of taking a company public by opening shares of the company to the public. Before this process, a company is private, where ownership of the company might be split between founders, family, friends, and angel/venture investors. After the IPO, the company is also owned by a combination of institutional investors and individuals (who then own shares and are paid dividends when the company reports a profit).
An IPO is a long process, requiring the approval of the Securities and Exchanges Commission and an investment bank to back up (underwrite) the sale, like Goldman Sachs or J.P. Morgan. For early investors, and IPO is a great time to cash out some or all of their shares.
After an initial “roadshow” where the company meets with and answers questions from prospective investors, they will then meet with their underwriters to decide on the number of shares to be sold and their initial price. The underwriter guarantees that a certain number of shares will be sold at a given price floor, and will buy any leftover shares themselves, as well as sometimes having the option to buy more shares at that price.
One of the advantages of an IPO is that it decreases the company’s cost of capital. That is, it lowers the cost of borrowing money, both in the equity market and the debt market. The cost of capital in the equity market (i.e. selling more shares) is lower because they can borrow from the whole public, and because investors have more trust in the company due to the amount of due diligence and auditing that happens in the IPO process. The cost of capital in the debt market (i.e. issuing bonds) can also be lower because this transparency means their bonds are rated higher.
(Quick aside on bonds: Bonds are rated by organisations like Standard&Poor’s, Moody’s, and Fitch, on a scale that normally ranges from triple-A all the way down to D. The grade of the bond is the likelihood of the company issuing the bond to default on the loan. High quality borrowers like Microsoft are rated triple-A. Lower quality borrowers who are less certain to be able to pay back their bonds, like the DRC, are B rated (or lower). When a lower rated organisation borrows money by selling bonds, the bonds are valued lower because of their risk of defaulting, increasing the cost of capital.)
One of the disadvantages of the IPO process is that an underpriced IPO means the company has left money on the table, money that the underwriter then makes. This is exactly what happened to Airbnb and DoorDash, as we will see below.
What is a direct listing? A direct listing is where a company starts to sell on an exchange without the help of an underwriter or a roadshow. In this process, investors, founders and employees can sell their shares to the public. Some recent examples of direct listings include Spotify and Palantir. The advantage of a direct listing is that it costs next to nothing, but the disadvantage is that there is no guarantee to the price that it starts listing at, and shares might get sold well below the initial price, meaning that early investors lose out compared to an IPO.
One of the reasons why Spotify was able to successfully pull off a direct listing is because it was already a well known brand with a positive cash stream, meaning it didn’t need the capital from listing as urgently as Airbnb did, who were hemorrhaging cash throughout the pandemic. A direct listing is uncommon because the company normally already has brand equity as well as the scale and cash-flow characteristics that mean it doesn’t urgently need capital. As such, direct listings are less common than IPOs
What about an SPAC? An SPAC is a Special Purpose Acquisition Company, a company formed without commercial operations at the time of their IPO. This means that they raise funds and IPO, without having and sales or employees. The purpose of the company is to use the funds they have to acquire a private company. Over the past 12 months we have seen electric car manufacturer Nikola, space tourism company Virgin Galactic, and betting agent DraftKings all go public via SPAC. One reason why a company might prefer to go public via a SPAC is if they are operating with high risk technology, meaning that underwriters might underprice or refuse to underwrite the company.
There is currently a lot of money in SPACs. Like, a lot. In 2020 so far, 175 SPACs have gone public, raising $65bn total. SPACs solve a very real problem for many companies, but not necessarily for investors. SPACs have performed poorly over the past couple of years. Of then 93 successfully merged SPACs since 2015, the average return has been -9.6%.
What happened to Airbnb and DoorDash? On December 9th, Airbnb went public, starting trading at $139 per share. The IPO price was $68. This enormous mismatch/misvaluation has meant that Airbnb ended up leaving over $4bn in cash on the table (in their underwriter’s pockets). DoorDash IPOed at $102 (an increase of 16% from the week before) and still ended the day at $189.51, also leaving huge amounts of cash on the table.
But none of these surges make sense. Airbnb’s valuation takes it above the combined value of Expedia (booked 8.1 milion nights stayed in 2019) and Marriott (which owns 1.4 million rooms). Airbnb booked 9.1 million nights stayed in 2019, and the pandemic has been far from good for it.
And DoorDash’s valuation takes it above the valuation of Domino’s Pizza and Chipotle Mexican Grill combined, even though DoorDash lost $149 million in the year up to September (down from the $533 million lost the year before).
A third company that I’m going to add to this conversation is Tesla, who somehow has a current valuation greater than the nine largest auto makers in the world. Tesla produced 500,000 cars in 2019, compared to Volkswagen (10.8 million), Toyota (10.7 million), Nissan (1.3 million), Hyundai (4.5 million), GM (2.9 million), Ford (2.4 million), Honda (5 million), Fiat Chrysler (4.3 million) and Peugeot (3.5 million). Tesla isn’t even in the same league as these players, so how is their market cap so high? Don’t use the excuse of them being a tech company rather than an auto company. They aren’t.
I’ll attribute these overpriced stocks to two factors. First is expected growth. DoorDash is getting close to being profitable and has plenty more room for growth. Airbnb has lots of room to come back after the pandemic, and people believe in their ability to pull off a recovery. But Tesla, even in the electric car market, won’t see the 10x growth that investors seem to expect. Their technology isn’t better than rivals, they won’t have the scale to compete at lower price-points when people like Hyundai really push electric. What they have is a mid-price luxury car, without the margins of a luxury car.
This is where the second factor comes in – the value of brand. Given the increase in the number of retail “Robinhood” investors, brands that are “cool” or working in cool spaces/technologies have seen large influxes of consumer cash. This, in itself, isn’t a bad thing. What would be bad, on the other hand, is if we are experiencing a tech bubble.
What’s next? There are three routes from here. A) They deliver on expected growth and conquer their niches. B) They survive but don’t deliver returns above the rest of the S&P or NYSE, disappointing investors who move on to the next hot thing. C) We are experiencing a tech bubble that will eventually pop, losing retail investors millions of dollars in the meantime. Personally, I think that A is unlikely, but I might eat my words. No matter what, in the long run, fundamentals should matter, meaning the valuations of some of these tech companies will have to come in line with actual performance.
Why did crude go negative?
Last April crude oil futures went negative, an unheard of status for oil. This means that people who sold oil at this price were paying people to take it off their hands. At this time, many people took to LinkedIn and twitter to explain that this was possible because it was a futures contract, which many investors use for speculation, and never intended to be holding at the end of the month. If the investors were holding the contract at the end of the month, then they would be expected to take delivery, which required storage which wasn’t available.
One side-effect of this price is that people with access to storage tankers, on land or on boats, took the oil, took payment for taking the oil, paid the tanker to sail around for a month, and then unloaded the oil at the same port and selling the oil for a positive price, pocketing the difference.
But a question that I only found the answer to the other day is, why did the prices drop so quickly after 14:00? The price specifically that dropped to -$40 is West Texas Intermediate, one of the most popular oil trading instruments. What happened on April 20th is the markets went into extreme contango.
Contango is a market state where the futures price is higher than the expects spot price in the future. What this means is that the price now, for delivery at a specified time in the future, is higher than the price is expected to be at that time in the future.
The WTI market is normally in contango, due to financial institutions wanting to get close to tracking the physical price, without actually buying and storing oil. What many institutions do is roll-over their futures contract, selling it just before they have to take delivery and buying the next month’s future. Because the market is in contango, the closer you are to the delivery date, the lower the price, so the traders normally lose a bit every time they roll over (a roll cost). This is considered to be a normal part of holding “physical” and is still often less than real storage costs.
One reason the prices dipped so low in April is because many people wanted to roll over their contracts from the previous month, people who had gotten into the market because of the cheap prices, and who expected demand to return. Demand didn’t return, and containers were full, so prices dropped so that people didn’t need to take delivery.
What was special about 2:30pm on the 20th of April, is that it was four working days before the 25th, and so the date at which the TAS price is decided. This price is used by many people, and stands for Trade at Settlement. Essentially, someone agrees a contract at whatever price the market is at when the month finishes. What was special about this TAS deadline was that price pressures were already pushing down, and a couple of smart traders walked away with millions, by selling at the right moment, and having balls of steel.
The company that had the biggest impacts on the prices on that day wasn’t an oil company or large investment fund, but a small group called Vega, specifically a group based in Essex. What these traders did first was agree to buy oil at the TAS price at 2:30pm. This kind of purchase is unusual because someone can make a very large purchase and it won’t move the market. What they do next is sell that oil up to the deadline, pushing prices lower and lower, so that the price that they end up paying is less than the price they sold that oil for on the way, pocketing the difference.
Some people are calling for an investigation into Vega for market manipulation. The Commodity Futures Trading Commission is unlikely to find anything. What they did is normal practice, they just happened to understand the fundamentals better and stay in the market longer than anyone else.
EBITDA, not Profit
The term EBITDA, or Earnings Before Interest, Taxes, Interest, Depreciation and Amortisation, was invented by John Malone, a pioneer in the US cable industry. In the cable industry, the two biggest costs are infrastructure and programming. Malone realised that the biggest player in the industry has a large advantage because of the lower unit cost to serve subscribers. Because of this, his goal was to make the company as valuable as possible. His method? Load the company with debt and pay no taxes.
What Malone did was borrow money to fund rapid expansion, and then write down the value of the capital and service the loans to make it look like the company wasn’t making any money, which meant that he didn’t need to pay tax. Tax is paid on profit after you take away how much value the company’s assets have lost, and after you have paid interest on any loans. The result was a company that looked unprofitable until it was acquired by AT&T in 1999 for $48bn.
The problem that Malone faced was that no-one wanted to loan money to a company that didn’t turn a profit. And so he invented the EBITDA, to prove to the banks that despite not turning a profit hit company was still the most reliable borrower, and would always pay back debts.
Today many companies leverage this strategy. Amazon pours every penny it makes back into the business, back into innovating, so that it pays very little tax. In 2019 Amazon payed just £14mil in tax in the UK. This is also due to profit shifting to overseas organisations based in Dublin and Luxembourg, but the accounting and tax dodging creativity of Malone lives on.
Longreads
Although not a read, I highly recommend the Netflix doc Have a Nice Trip. For a succinct read on the economics of Christmas Trees click here. And for a heart warming(ish) story of a man who went from rags to riches and back again, twice, click here. And for a fascinating business read that I only sort of included, click here.
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Callum Macdonald 