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Pinterest: Lock-Up Means Short-Term Pain, But I Expect Long-Term Gain

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About: Pinterest, Inc. (PINS)
by: James Bonifer
Summary

The lock-up on venture investors is set to expire on 10/15/2019.

I expect this event to be a downward catalyst on share prices.

Long-term the outlook on Pinterest is still positive, despite short-term headwinds.

The Moment Of Truth For Pinterest Comes Next Week

On October 15th the lock-up placed on pre-IPO investors in Pinterest (PINS) is set to expire. This event is typically associated with a massive surge in trading volumes and a rapid decline in share prices as Wall Street trade desks become inundated with sell orders from shareholders in possession of large blocks of newly unrestricted stock. Many of these investors gained these shares via an interest in a limited partnership investment vehicle with a venture capital fund that invested in the company early in its private market life-cycle. This means that these investors more often than not have a very low intrinsic cost basis, a long-term holding period, and a desire for a liquidity event regardless of the current market price.

I can speak from experience, having worked on some of these events personally, that it's not unusually to see investors whose effective basis is pennies on the dollar. Meaning that they are getting a massive return regardless of if the stock holds $25 or $22 on the market when they go to sell. What makes the value proposition of selling a lock-up distribution even more enticing is the sense of urgency created by the typical rapid decline in price. An investor with a venture distribution of 50,000 shares who sees a stock drop from $25 to $22, has just incurred an on-paper loss of $150,000. Given that they are still at often three-digits into positive returns, many see this as a call to action to quickly preserve the rest of their gain by selling their position.

What this means for Pinterest is that an uncorrelated abnormally high amount of sell orders will be weighing on the stock within the next week. Given the low levels of shares short vs. the total float, the event of a short-coverage reversal looks unlikely, and some degree of declines appears to be almost a certainty. This event will test the integrity of the company's valuation and, given the contracting multiples across the (XLC), investors should prepare for a long-term adjustment in the company's valuation.

The Valuation Today

Pinterest vs Peer Group

Source: Contributor Research

Among its peers in the internet media sub-industry, Pinterest is on the high end of valuations from a revenue perspective, behind only the Match Group (MTCH). The company is still relatively young in its growth cycle and it is yet to turn a profit on a net income, EBIT, or EBITDA basis. That being said, the fact that the company is still relatively early stage means that investors are buying the benefit of exposure to these higher levels of growth.

Chart Data by YCharts

Looking at the peer group composite, it's abundantly clear that Pinterest is the undisputed leader in growth. The company's closest American peer lags by approximately 20%. This rapid growth is partially why this company has been a growth investor's favorite since its debut, but this growth comes at the expense of profitability.

Chart Data by YCharts

Growth does not come free for Pinterest however. The company is paying for its rapid appreciation of sales in the form of much higher than category average operating expenses. Operating expenses include things such as research & development, general & administrative costs, and sales & marketing, all of which are essentially costs the company has to pay to continue operations and invest in growth. The rapid growth of the company's top-line has to lead to a strain on operating expenses because Pinterest will often have to pitch and originate new customers vs. increasing established accounts. Facebook (FB) and Google (NASDAQ:GOOG) (GOOGL) are the two most prominent internet-media advertising companies, and thus expenses towards advertising through these two platforms are usually built into established budgets of client firms. Pinterest, Snap (SNAP), and Twitter (TWTR) do not benefit from this luxury and growth via "test budgets" that are allocated to these platforms by advertisers, and winning a test budget allocation is a process that is both time-consuming and expensive. The level to which Pinterest has had to invest operating expenses into sales growth is almost 100% more than its closest peer Snap- taking some of the shimmers off its impressive top-line performance.

Pinterest Fair Value Today

Source: Contributor Research

Using current figures Pinterest has a fair value compared to peers at around $20.50, which implies a potential downside of around 21% give or take 5%. This is the fair value level at which I would be watching for a potential correction at the expiration of lock-up. Given we are also in a macro environment in which it appears we are beginning to see a shift in sentiment from growth to value, I think there is a sufficient reason to believe the integrity of the premium will be tested.

Lock-Up Has Reclaimed Impressive In This Sector Before

Lock-Up trends Source: Contributor Research

The table above shows some research I have compiled previously on notable examples of price-action at the time of lock-up expiration. I use the term "delta" in place of change as the Greek letter delta is often used synonymously with the term change. The change being observed here is from the price at the previous day's close of trading. The levels observed here are the change at the open of trading, the change at the close, and the intraday high and low price levels. As you can see, in almost every instance there was a massive increase in trading volumes, and there was a tendency for shares to move lower.

I want to direct your attention to the three companies that are most similar to Pinterest in this table; Facebook, Twitter, and Snap. At the time of lock-up expiration, each company saw a large upward influx in trading volumes from their 30-day average. Snap and Twitter both ended the day down by 1% and 17% respectively, while Facebook actually managed to close positive on the day. The reason for Facebook's positive reversal in-part due to the negative performance the stock had to that point, the first-mover advantage in social media, and comments by Mark Zuckerberg. Twitter, on the other hand, was well above its IPO levels and had seen a strong run that was not supported by financials, and ultimately the company's valuation cracked under pressure. Snap, while only closing about -1% lower than the day prior, saw shares dip as low as -5.14% intraday, and this was due in part to the already highly negative performance of that stock since its IPO. I will leave you to be the judge of where you think lock-up will leave Pinterest at the close, but I am confident in saying that there will be strong volatility towards the downside at least intraday.

The Investment Is Not A Lost Cause

Pinterest Implied Fair Value in 2020

Source: Contributor Research

A silver lining to this impending storm cloud is that, while I fear a near-term downward correction, the stock is still priced to experience appreciation by year-end 2020. Using average revenue estimates of $1.51B for the 2020 fiscal year, and assuming a stable cash balance and debt-level, you reach an implied fair valuation of about $31, or upside potential of about 20% give or take 5% from current price levels. For this reason, if you are in Pinterest for the long-haul, then I would not recommend giving into a panic in the event the stock sells off. In other words, investors should brace themselves for rough waters, but should not abandon ship unless there are fundamental changes in the growth profile of the stock.

Disclosure: I am/we are long PINS PUT CONTRACTS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.