IPO Valuations Matter, Even For Twitter

| About: Twitter, Inc. (TWTR)

Just when everyone can't stop talking about the forthcoming Twitter IPO, a sandwich shop, a fast-casual restaurant, one natural grocer and one technology company grab the glory.

Potbelly (NASDAQ:PBPB) priced a $105 million IPO on Thursday, October 3rd, and then promptly more than doubled on its first day of trading on Friday. To be precise, the stock was up 120%.

It is the fourth IPO of 2013 to have a 100%+ first-day pop. In addition to Sprouts Farmers Market's (NASDAQ:SFM) 124% pop in 2013, the other two IPOs that had 100%+ first-day pops are Noodles (NDLS + 104%) and Benefitfocus, (BNFT +102%).

Will Twitter join this double club? We don't think so. Why? In a word, valuation.

At a purported IPO valuation of $13 billion, Twitter would command a very full multiple of 29x last 12-month (LTM) revenue. Again, we're talking about multiples of revenue, not earnings. For some historical perspective, Facebook (NASDAQ:FB) and LinkedIn (NYSE:LNKD) had valuations of 26x and 15x LTM revenue, respectively, at the time of their IPOs. And both of those companies were profitable at the time of their IPOs. Twitter, dazzling growth prospects that it may have, is not yet profitable. Today, FB and LNKD trade at about 20x and 22x LTM revenue, respectively.

With LTM revenue of $290 million, a market capitalization of $917 million, and an enterprise value of $893 million as of the close on its first day of trading, Potbelly is sporting a very pedestrian EV/sales multiple of 3.1x. Alternatively stated, investors are willing to pay $3 for each $1 of PBPB revenue but $29 for each $1 of Twitter revenue-a 10x differential.

For all the justifiable buzz and excitement around the Twitter IPO, the key takeaway for IPO investors-or pre-IPO investors for that matter-is that valuation always matters in the long run. It will always be thus.

To put these doublings in broader context, consider the following data from IPO tracking firm Renaissance Capital:

· In 2000 alone, 84 out of the 406 IPOs, or a breathtaking 21% of all IPOs, doubled on their first day of trading. (To put the number of 406 in context, there were only 94 IPOs in 2008 and 2009-combined.)

· For the next 12 years-from 2001 to 2012-there were only eight companies that doubled on the first day. This represents a mere 0.5% of all IPOs priced during that 12-year span.

Countering the "Money left on the table" Argument

Of course, whenever an IPO has a large first-day pop, the critics cry foul and wring their hands in despair that an issuer left money on the table. Blame is pinned on the underwriter. We disagree wholeheartedly with this thesis.

Investors rightly require compensation for the information asymmetry (vis-à-vis the issuer) that they assume when buying a new stock issue. Moreover, underwriting is a competitive business, and investment banks don't win mandates by promising to get issuers a low price for their IPOs.

In fact, long-term investors such as VCs and management who do not sell their stock as part of the IPO actually win big when there is a sizable pop, because while the new shares issued might constitute only 10-25% of the expanded capital, all of the remaining stock (75-90%) benefits from the higher price and positive momentum that inevitably inures to the issuer of the hot IPO.

So while the media and financial cognoscenti remain more than fully absorbed with Twitter, investors in another comparatively mundane IPO just rang the bell again-big time.

The lesson: Highly publicized private companies are naturally likely to be fully valued at the time of their IPOs. It only makes sense. Investors seeking to make money in IPOs should take a page from Moneyball and look elsewhere (i.e., less highly publicized companies), for value and a corresponding better chance of scoring a high return on their investments.

Congratulations to Potbelly and all of the pre-IPO and IPO investors on a great first day pop.

Timothy J. Keating is the CEO of Keating Capital, Inc. (Nasdaq: KIPO), a publicly-traded closed-end fund that specializes in making pre-IPO investments in emerging growth companies that are committed to and capable of becoming public. Keating Investments, LLC is an SEC-registered investment adviser that is the external investment adviser to Keating Capital. Mr. Keating can be reached via email at tk@keatinginvestments.com.

The opinions and observations expressed herein are solely those of Timothy J. Keating and are intended to provide insights on the IPO market at large and at the current time. None of these opinions and observations should be construed as relating to any specific portfolio company held by Keating Capital (including the future IPO timing or plans of any such portfolio companies). This article is not intended to be a solicitation to purchase or sell any security (including Keating Capital). Neither Timothy J. Keating, Keating Capital nor Keating Investments, currently own, or have plans to purchase, the shares of any company referenced herein.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.