Post-IPO Values Have Shrunk More Than 40%, and the Internet's Fundraising Stars Can No Longer Hide Their Problems

In the zero-sum stock market, someone always eats the losses when a bubble bursts. This time it isn't the people who blew it up.

Ten years ago, Xiaomi did not exist. Five years ago, Xiaomi was briefly the world's most valuable startup, worth $45 billion. A year ago, Xiaomi was preparing to go public, reportedly targeting a valuation of $100 billion. Six months ago, Xiaomi listed in Hong Kong with a market cap of $54 billion. Last week, Xiaomi delivered its first annual report since listing; the stock fell hard, and its market cap dropped to $34.4 billion, below where it stood in 2014.

And Xiaomi is already one of the most successful companies China has produced in the past decade. Plenty of others raised more, earned less (more precisely, lost more), and pumped more air into their valuations before they went public.

QDaily tallied the market caps of 35 Chinese companies that have listed on exchanges in mainland China, Hong Kong, and the US over the past two years. 74% of them now trade below their offering price. Their combined market cap is 23% lower than their pre-IPO valuations, a loss of about $57.2 billion. Measured against their market cap on the first day of trading, they have shed 12.5% of their value, or about $31.1 billion.

A weak stock market may be one outside factor, but it is certainly not the main one. Among the 35 companies we counted, the median discount between current market cap and pre-IPO valuation is 40% — far steeper than the fall in the Hong Kong and US markets over the same period.

ZhongAn Online, Yixin Group, and China Literature, all backed by Tencent, went through a stretch of wild swings after listing and now sit below their offering valuations. Meituan's market cap of $35.8 billion is 32% below its pre-IPO valuation. Among the 35, drops of 60% to 80% against the pre-IPO number are not unusual. Taken at the median, the 35 companies have lost 40% of their value.

Investors' disappointment is easy to see. And these are the companies near the top of their industries. Widen the sample and the picture only gets worse.

Going public means more than a financial reward. It also means a company takes on the duty to open its books to the public, to face investors' questions about its finances and its strategy, and to accept stricter rules on disclosure, ownership structure, and the movement of money.

Companies can no longer pick the flattering facts and "feed" them to the public and to investors the way they could while private, and they can no longer answer every hard question with "no comment." Operating and financial problems come out into the open. A falling share price afterward is only one of the results.

Faked numbers, good news trumpeted and bad news buried, utopian business models — as the books opened, the problems surfaced one after another

Among the companies whose shares have fallen hard, the most common problem is promising what they cannot deliver.

In eight years Xiaomi raised $3.4 billion from 58 investment firms, and last year it was said to be aiming for an IPO at a valuation of $80 billion to $100 billion. Its most recent funding round at the time had valued it at about $37 billion.

Lei Jun has never been stingy about promising Xiaomi and its investors a grand future. In the IPO prospectus he called Xiaomi an internet company, with hardware, new retail, and internet services as its "triathlon."

China's smartphone market had long since hit the ceiling of the online channel, and the whole industry was falling back on the most traditional form of competition: offline. Xiaomi did give up margin to big offline chains like Suning and Gome, and it hired celebrity endorsers, shot television commercials, and put up large Xiaomi ads in bus shelters and waiting rooms. Sales rebounded briefly, but in the fourth quarter of 2018 Xiaomi's phone shipments fell more than 12% both from the previous quarter and from a year earlier. In China, its most important market, Xiaomi phone sales fell 30% year on year.

Margins did not hold either. The average revenue Xiaomi earns per phone sold — the price it charges distributors — rose from 807 yuan in 2015 to 1,004 yuan now. But Xiaomi's smartphone gross margin fell from 8.8% in 2017 to 6.2% in 2018.

Internet services went wrong too. Fewer phones sold and fewer pre-installed apps hit Xiaomi's internet revenue directly; in the fourth quarter of last year that revenue fell 14.6% from the previous quarter. Squeezing profit out of overseas app stores was hopeless — Google takes almost all of it.

One problem after another drove Xiaomi's stock down 6% after the earnings report.

China Literature is also finding it harder and harder to hit the targets it once announced to investors. Its largest source of revenue is paid reading, which made up as much as 97% of revenue in 2014 and fell to 76% last year.

That is mostly because online literature is a small market to begin with. According to Frost & Sullivan, China's online literature market was worth less than 4.6 billion yuan in 2016. Growing at a compound annual rate of 30%, it would still be only 13.4 billion yuan in 2020. The industry does not hold much.

China Literature co-CEO Wu Wenhui once imagined that at least 40% of the company's revenue would eventually come from licensing its copyrights, which is why the company spent 15.5 billion yuan last year to buy New Classics Media. But in 2018 China Literature's copyright revenue was only 1 billion yuan, 20% of the total. In absolute terms and as a share of revenue, what it put in and what it got back do not match. And the ceiling on copyright licensing is itself doubtful: China's entire film and television market, movies and TV dramas included, was worth only 280 billion yuan in 2016.

Paid reading cannot hold up China Literature's valuation, which is why the stock soared after listing and then collapsed.

"If it's selling well, you generally say so." Steve Jobs used that line in a 2009 interview with The New York Times to needle Amazon for refusing to disclose Kindle sales, implying it was hiding weak numbers. The same habits show up among these fundraising stars: they disclose data selectively, or keep changing how they count.

E-commerce platforms — Pinduoduo, Vipshop, Mogujie, JD.com, Taobao — all like to invent a metric of their own. Pinduoduo reports trailing-12-month transaction volume each quarter; Alibaba moved from quarterly disclosure to reporting by fiscal year; Vipshop simply stopped reporting it. User numbers are just as inconsistent from company to company.

Since last year Mogujie has stopped giving the number of active users on its app, reporting instead how many times a day and a month the app is used — even opening the mini program counts as an active user. Vipshop, public for years, stopped reporting annual gross transaction volume in 2017 and switched its monthly active user (MAU) figure to a trailing-12-month average.

Internet companies have grown used to invoking the word "internet" as the reason their results have to be dressed up in complicated ways. But no matter how varied a physical retailer's or a restaurant chain's products get, "same-store sales" is a line they cannot avoid reporting. There is no good reason for listed internet companies to dodge the most basic questions either.

Before Meituan went public, founder and chairman Wang Xing declared that its businesses had "no boundaries" and shared "the same group of users." The company, which started in group buying, later moved into food delivery, hotels, portable phone chargers, public cloud, offline supermarkets, ride-hailing, bike-sharing, and more.

Meituan's method was to keep raising money and keep burning it, building a barrier around the industry with capital rather than technology.

When it chose what to disclose, in 2016 Meituan picked "average delivery time of 28 minutes and 7 million food-delivery orders a day," and put the ceiling of the delivery business at "1.3 billion people in China, times three meals, which comes to 4 billion meals a day."

In 2017 Meituan announced that daily completed orders had passed 12 million, daily transaction volume had passed 500 million yuan, new users had topped 10 million a month for six months running, and the average order was worth more than 40 yuan.

The one thing it never mentioned was how much money it was burning.

It could not dodge that in the 2018 prospectus: in 2015, the year Meituan started food delivery, that business had a gross margin of -123.7%. For every 100 yuan it took from users through food delivery, it not only kept nothing, it put in another 123.7 yuan of its own.

Beyond weak results, some numbers turn out to be fabricated outright. Cheetah Mobile was accused last November of ad fraud and of making up figures, and its US-listed shares fell more than 32% in a single day.

Nasdaq once lived through the same reversal

According to Thomson Financial, US IPOs raised more than $69 billion in 1999, 39% more than in 1996. First-day gains that year set records too. According to WorldFinanceNet.com, there were 117 IPOs that year, and 23% of them rose more than 100% on their first day of trading.

By March 2000 Nasdaq had more than 6,000 listed companies, the great majority of them tech companies, and they had the same traits: young, quick to list, unprofitable. The average price-to-earnings ratio on Nasdaq reached 175. If those companies kept earning what they earned that year, an investor putting in $1 would need 175 years to get it back.

A research report from CICC noted that many of the newly listed companies were still startups, some without stable revenue or a business model. Tech companies that listed in 2000 had existed for an average of four years, with median revenue of just $17 million, and fewer than 20% of them were profitable. Their valuations, meanwhile, sat far above historical norms.

pets.com was the star of the era, hands down. An internet entrepreneur five years out of college started it to deliver cat food, dog food, and pet supplies to the door. Less than six months after it was founded, pets.com raised $50 million in venture money, with the largest local e-commerce company also taking a stake.

Cans of cat food are not light, shipping them cost plenty, and neighborhood pet stores were already thick on the ground. But in the middle of a boom, money came that easily. So pets.com sold below cost and threw in free shipping.

To build a name it spent roughly 100 million yuan on expensive ad placements. The effort paid off: it went public 18 months after it was founded, and its market cap once reached $6 billion.

At 26 months old — on November 6, 2000, hours after George W. Bush was elected president — pets.com announced it was closing. The bubble burst, the money pulled out, and the business pets.com had piled up with cash vanished with it.

When the bubble burst and stocks crashed in 2000, at least 4,854 internet companies worldwide were bought or went under. Most of those that died had a story like pets.com's: a new idea connected to the internet, a few rounds of venture money, cash burned to subsidize user growth, an IPO, then the end.

Something like it is happening again, far less violently — the everyday use of the internet rests on much firmer ground now. But the companies caught up in it face the same question: how to get from burning cash forever to making money.

The valuation bubble is the work of the companies, their investors, and the underwriting banks alike

Markus Brunnermaier, an economics professor at Princeton, says a bubble usually comes with a sharp rise in asset prices; when the price passes the asset's underlying value, a bubble forms, and a crash follows.

Everyone taking part also knows exactly how much there is to gain by leaving before the bubble bursts.

After Yahoo went public in 1996, founder Jerry Yang was distinctly uneasy. He later recalled, "I remember driving home, and then driving back to the office, and thinking, 'Oh my god, what have I done.'" On listing day Yang's own fortune shot up, and the Yahoo shares held by its investor Sequoia Capital rose 8,500% in value.

Brokerage analysts, especially the star analysts who move the market, published false recommendations that misled investors. Between 1999 and 2001, Merrill Lynch never once issued a "reduce" or "sell" rating on any stock in the internet coverage it followed.

More than that, its star analyst Henry Blodget recommended stocks to investors in published research while calling them "a piece of junk" in internal emails. In 2002, after an investigation, New York Attorney General Eliot Spitzer announced that Merrill Lynch analysts had misled investors with false reports.

The motive of the analysts and the banks was simple: ride the market's excitement to pull more investors into the stocks the bank had underwritten, then take the commissions. Then use those deals and those numbers to win the next IPO mandate. A bank could make $500 million on a single IPO at the time.

Companies and banks both had reason to blow the bubble bigger. Morningside, Qiming, IDG Capital, and dozens of other firms that bought into Xiaomi's Series A mostly made more than 100 times their money. Sequoia Capital's roughly 80 million yuan stake in Meituan's Series A was worth more than 400 times that by the time Meituan listed.

The "2018 China Enterprise IPO Market Data Report," published jointly by ChinaVenture Information and the ChinaVenture Research Institute, found that the number of IPOs worldwide fell across the board in 2018, while the total raised through them rose instead of falling. Private equity and venture capital firms' overall return on IPO exits for the year held at about 240%.

The gap between valuation and market cap is paid for by the investors who buy after the IPO

Xiaomi listed with a 10 billion yuan loss; Meituan listed with a 20.5 billion yuan loss. Explaining the enormous losses in their prospectuses, both companies said these were not real losses but the result of an accounting item called "convertible redeemable preferred shares," designed to protect the interests of early investors.

In theory, the larger the loss booked under this item, the more the company's valuation has grown. Once shareholders exercise their right to convert the preferred shares, they receive shares of matching value. Between 2015 and 2017, Xiaomi's convertible redeemable preferred shares produced losses of 8.8 billion yuan, 2.5 billion yuan, and 54.1 billion yuan. In Meituan's 2018 annual report the same item showed a loss of more than 100 billion yuan.

Most institutional investors sell and cash out the moment the lock-up ends, which is what Sequoia Capital did with its Meituan shares.

That is rational investing. But while these companies' shareholders protect their enormous gains through the preferred-share arrangement, the investors who bought the shares after the IPO are the ones taking the losses from a stock that has fallen below its offering price. When a company's stock sits 40% below the offering price, anyone who bought on day one and did not sell in time has lost exactly that much.

Employees of these startups are on the losing side too. Cash plus equity is the most common pay structure at the fundraising stars. Once the market stops believing their stories, and the stock breaks its offering price and the valuation is written down, employees' income takes the hit directly. And in the queue to sell shares, employees are almost always locked up the longest and come last.

In the zero-sum stock market, someone always eats the losses when a bubble bursts. This time it isn't the people who blew it up.

Graphics/Feng Xiuxia

Cover image/Samson Creative. on Unsplash, cropped