Reddit (RDDT): Savior of IPOs?

  (Disclaimer: Excel file attached below the post) 

Reddit recently filed for its IPO, and given the raucous that it has caused in the capital markets, in particular the hedge funds, in recent years, I decided to value the company and assess whether or not the offering price of $31-$34 per share and an equity value of $6B-$6.5B is a fair value and worthy of investors' interest and greenbacks. At this point, everyone is pretty much acquainted with what Reddit is, what it does, and how its communities and users interact with each other and the rest of the world, and so I will not go into the history of it, and instead will delve right into its past and potential future with a minor detour. 

Long and Arduous Journey

This is not the first and only time when the company has filed for its IPO; Reddit pursued the public and capital markets back in 2021 when IPOs were all the hype- total value of $339B according to Bloomberg. Back in Aug '21, the company raised $410M from Fidelity Investments, one of its major shareholders, at a valuation of around $10B. Just a few months prior to that in Feb, Reddit raised approximately $500M in late stage funding at a valuation of around $6.5B. The monumental increase of around $4B in equity value from Feb '21 to Aug '21 can easily be attributed to investors' appetite for higher returns in a low interest environment. Compare that to the current macro environment, we have rates hovering around 5.25%-5.50% territory, with many projecting a 0.75% decrease in the rates over the course of the remainder of the year, and investors are less inclined towards growth stocks given higher returns in other financial products; additionally, profitability has never been a bigger concern for the masses as it now. Reddit, I believe, might have been better off going public in '21 as compared to now because I do not see this environment being friendly to growth stocks, at least for as long as rates remain sky high. 

As for the IPO,  the social media platform, along with its management and executive team, are offering 22M shares in its IPO in the $31- $34 per share range. At the top end of the range, the company is looking to raise around $748M (net proceeds of $450.9M or $552.7M if the underwriters exercise their over-allotment option in full) according to a new version of its prospectus filed on 03/19/2024. As of the filing of its S-1, the company has no debt and so intends to use the proceeds for, "general corporate purposes, including working capital, operating expenses, and capital expenditures. The company may also use the proceeds to in-license, acquire, or invest in complementary technologies, assets, or intellectual property" as well as settling some tax related issues. With this minor detour lets now move onto Reddit's financial performance over the last two years.

Ghost of Reddit's Christmas Past

In order to better understand a company, knowing its business model or reputation isn't enough, we also need to look at its numbers and see how in line they are with the general sentiment around the company. And so to better understand the company's past as well as prognosticating about its future, we need to look at the numbers and analyze its past financial history. Here is a look at Reddit's income statement as disclosed in its prospectus.

Looking at the statement, I don't think I see anything extraordinary in terms of the company's performance, margins or its costs; what I see is the stereotypical income statement of a "growth" company. The company reported $804M in revenues for FY '23, a 20.6% YOY growth; the company also reported costs of revenue  of $104M (15.7% margins) and $111M (13.8% margins) for FY '22, and '23, respectively, giving the company gross profit of $562M (84% margins) and $693M (86% margins) for FY '22 and '23, respectively. Another notable observation is the skyrocketing degree of associated operating expenses; as you can see, Reddit reported $438M (54.5% margins) for research and development, $230M (28.6% margins) for sales and marketing, and 165M (20% margins) for general and administrative, giving the company an operating loss of 140M and margins of -17% for FY '23. With all said and done, the company reported a NI of $-91M (net margins of -11.3%) on revenues of $804M. Aside from spectacular gross margins, I fail to see the attraction in Reddit as a company. It has been operating for nearly 20 years now, and still has not found the path to profitability, whose to say that the future might be different? To further elucidate its financial position, here is a snapshot of its historic balance sheet and the numbers speak for themselves.  

Despite the company's mounting losses over pretty much the entirety of its existence, it has managed to maintain a significantly healthy cash balance; the company reported cash and cash equivalents (including marketable securities) of $1.26B and $1.23B for FY '22 and '23, respectively. Additionally, company reported total assets of $1.59B and $1.59B for FY' 22 and '23, respectively. Aside from current and long-term liabilities, the company also reported a shareholders' equity (deficit) of $-413M for FY '23 due to losses over its operational history. 

What I Wish the Future Holds

I believe that by now we have a better understanding of Reddit's past and all of its financial ghosts, and so I think we should now look towards the future and see if there are ways of exorcising Reddit of its past and setting it ablaze on a path towards redemption. 

Reddit is very much a social media platform that derives a bulk of its revenue from advertising. Reddit, given how the platform works, is in a unique position and there are multitude of avenues the management can take in the future to further drive its ad revenue upwards. Continuous expansion of its current platform and capabilities, coupled with constant innovation and advancement of products, should allow the company to compete with behemoths such as Meta, Google, Pinterest, and Amazon. The company could improve its ad revenue in the following ways (not an exhaustive list):

• Marketplace optimization
• The company is still in early stages of using machine learning and prediction models to better match supply and demand and deliver ROI for its advertisers. An improvement of such models and technologies will allow the company to attract more advertisers through higher efficiency and an even better ROI. 
• Demonstrate ROI
• Another measure of improving ROI for its advertisers is by improving ad measurement and providing better data to show advertisers their ROI based on their usage of the platform.
• AI Powered audience reach
• I am not a huge fan of companies nowadays using buzzwords like AI and machine learning to attract capital, but I believe that Reddit is in a unique position to leverage its data for AI and machine learning. 
• Expanded formats and offerings
• Continual development of new products and constant enhancement of its current offerings could prove existential for Reddit as far as its ad revenue is concerned. 
• Acquire more advertisers
• This goes without saying that in order for Reddit to grow, it needs to be able to expand its current relations as well as develop and attract new advertisers through a seamless and higher ROI experience. 

In addition to ad revenue and its growth strategies, there are other avenues that the management can take in order to improve its profitability and margins. Given the vast amount of data available to Reddit, another path of growth and profitability could come in the shape of data licensing. Reddit is one of the largest depositories of public information that is not only authentic but is also constantly updated. We live in an increasingly data driven world and there should be no bounds on Reddit's imagination as far as using its data for higher profits is concerned. The company, as of this post, is in early stages of allowing third parties to license access to search, analyze, and display historical and real time data from its platform. Customers and companies can pay to access real time data streams of public discussion via data APIs. These APIs are able to provide access to evolving and dynamic topics such as sports, news, fashion, and the latest trends. Moreover, Reddit's data could prove to be an essential piece in the construction and development of large language models (LLM). Another path to profitability could come in the shape of user economy; users utilize Reddit's platform to sell everything from daily items to developed video games and so Reddit is in a place to provide these developers and sellers with additional tools and increased monetization opportunities; this will further improve user experience which will morph into additional users, and consequently, more authentic and conversational data for Reddit to leverage. 

Corporate Life Cycle

Before we move onto the valuation, I believe that it is paramount for us to understand the corporate life cycle and how a company's behavior changes, or rather should change, according to what stage of the cycle they are in; It is ever more important when valuing growth stocks such as companies on the verge of going public. 

I think that it goes without saying that Reddit is very clearly in its infancy (at least in terms of being public) and I would categorize it as being in the "Childhood" stage of the cycle. The company has been reporting growth in its revenue for the past number of years, but it has not been able to rail in its direct and indirect costs of revenue; therefore, reporting mounting losses over the years. Reddit has without a doubt been reinvesting heavily in its business, albeit majorly on generating ad revenue, but as far as the numbers are concerned, I fail to see a decent return on its invested capital. Additionally, given the industry and the players, I believe, Reddit's future will very much mirror its past and path to profitability will be constantly hindered by its costs, other major players in the industry that are well established, and waning investor sentiment- at least for the next few years. It isn't all gloom and doom, though, as I do see the company turning the table somewhere in the next ten years as demonstrated by my model down below in the valuation section. I believe as the company grows and improves its operations and asset utilization as well as innovation and better relations with suppliers, users, and the markets, it should start to see lower costs, higher growth in revenues, higher margins (both operating and net), and it should start to return capital to its investors in the form of dividends or buybacks.  

Valuation

Valuing companies is very much a subjective issue where no two valuations are the same, and it becomes even more daunting when valuing a company that is on the verge of going public. Lack of public information and financials make an already fretful task even more threatening. Additionally, IPO prices and valuations are based on pricing and relative methodologies where bankers and underwriters look at other companies in the space and apply the same multiple to the subject company to arrive at a price per share or an equity value, as such, I wouldn't be at all surprised if my DCF derived value ends up being different from the offered range. Furthermore, given that I am dealing with a company that is about to go public, I have decided to divide my DCF into two three stages: stage 1 will be a high growth and high cost stage, stage 2 will be driven by mild growth in revenues as well as lower associated costs, and finally, stage 3, the terminal stage. Before sharing my intrinsic value of Reddit, I believe that it is pivotal for me to share my assumptions so that you can hopefully better understand why and how I arrived at my price per share. 

Assumptions 

• Revenue growth
• Given the company's position in the ad industry, and the eventual possibility of using its data for good as well as fully embracing user economy, I expect Reddit's revenues to grow at a CAGR of 24.39% over the next two stages, or the next 10 years. I expect revenues to increase rapidly over the course of the first stage from $804M in FY '23 to $3B by the end of FY '28. After the high growth stage, I expect the company to be in somewhat of a better position, and its revenues should continue to increase, although, not at the pace of the first stage. In the second stage, I expect revenue growth to taper off from 35% in FY '28 to about 10% by the end of FY '33. 
• Costs (both direct and operating) and gross margins
• Given the growth that I am assuming for Reddit's revenues, I believe the costs (both direct and operating) should inflate to sustain the top line growth in the first stage; in the second stage, as the growth in revenue slows down, I expect the costs would reduce as well. Additionally, company reported gross margins of 86% for FY '23, I expect its margins to decrease over the course of the first stage due to higher costs for higher revenue growth. As the company enters the second stage, I believe its gross margins would start to improve and be in line with the historical figures by the end of the projected period. 
• Operating income and margins
• Sadly, I do not see a way for the company to turn profitable anytime in the near future. As a matter of fact, my model shows that the company will report a positive operating income and margins sometime in the late second stage, somewhere between years 7 and 8. 
• WACC
• Since I do not have access to data bases such as FactSet or CapIQ, I did not even attempt to calculate a WACC using comps for Reddit, but I am assuming a 9% WACC (very close to the industry average) initially, and as the company grows, I believe their capital structure will change and with it their WACC. I believe its WACC would increase over the high growth stage where it will be ~11% by the end of stage 1. As the company gets a better hold of its operations and capital structure, its WACC should start to revert back to around 9%. I have accounted for this anomaly in my sensitivity analysis.
• Relations
• Another factor that I believe will play an important role in Reddit's foray into the public markets is its relations with its users and moderators. As of the writing of this post, Reddit itself is marred with posts about shorting the stock as soon as it starts trading due to its users' bearish point of view about its future. Additionally, I believe that in the near future, for the next 2-3 years, management needs to cater to its advertisers as well as trying their utmost best to attract new companies and organizations. 
• Reinvestment
• It is nearly impossible to project out reinvestment for a company that is about to go public as individual line items such as depreciation and amortization, capex and working capital could prove to be very volatile; and so to account for this uncertainty, I have calculated reinvestment in two different ways. In the first path, I try to project out company's capex, D&A, and changes in working capital, and for the second part, I look at the company's relationship between reinvestment and revenue and use that to project out reinvestment for the projected years. For the first route, I am assuming that Reddit will continue to invest in its capex in order to support its revenue growth and that D&A will be about 90% of capex by the end of the projected period in order to sustain the 3% growth in perpetuity. I am also assuming that working capital will be about 25% of revenues both by the end of stage 1 and 2. As for the second way of calculating reinvestment, I looked at Reddit's reinvestment for FY '23 which was -1.7% of revenues; I am assuming that as the company grows rapidly in the first stage, its reinvestment as a percentage of its revenues should increase to about 5%, and then start to slow down as the company grows and gains a foothold. I have added the functionality in the model that allows you to change the type of reinvestment you'd like to use.

With all of this information and assumptions, here is my valuation for Reddit. 

Based on all of my assumptions about the company, for my second approach, I get an equity value of $5.04B and a price per share of $28.08, and for reminder, the offered range was $31-$34 per share. And if I were to use the first approach where I project out individual line items for reinvestment, I get a slightly higher equity value of $5.65B and a price per share of $31.50. I understand that there are a lot of uncertainties and assumptions in my model, and to account for some of them, I also looked at the DCF derived price per share given changes in certain variables. 

Sensitivity

Image 1

Image 2

Given that WACC is pretty much the only variable that I slacked off on, I wanted to see what impact a higher or lower WACC will have on the company's valuation given different perpetuity growth rate and revenues in FY '33. Image 1 shows the impact of different WACC and perpetuity growth rate, and as you can se, If I assume the same perpetuity growth rate but a lower WACC of 8%, I get a price per share of $40.01, and if the WACC changes to 11%, the price per share goes down to $13.92. Similarly, if we assume higher revenues in FY '33 but the same WACC, we get an equity value of $9.53B, significantly higher than the proposed value of $6B-$6.5B. Sensitivity analysis for approach one (with projections for individual line items for reinvestment) can be seen below:

Image 3

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Conclusion

Based on my analysis, I believe the stock is being offered at a range that is higher than its true intrinsic value. Personally, I'd wait for at least 10 days until all the hype has dissipated and the markets correct bankers' aspirations and ambitions. Again, as I state in all of my valuations and posts, this is very much a subjective game, and so I have linked the excel file below for you to dissect and make it your own. 

Links

Reddit IPO Prospectus

Reddit Valuation- 03/20/2024