Too much enthusiasm and overvaluation

Reddit INC. (NYSE:RDDT) completed its initial public offering on March 21. The stock price was initially $34 per share. On the first day, the stock price shot up an incredible 48.40% to $50.44, valuing the company at more than $8 billion.

I think market optimism has pushed the stock price too high and Reddit is now overvalued.

Growing sales but unprofitable

Reddit can be viewed as a global digital city where people from all over the world can join different communities to connect with each other. It is one of the largest open archives of human experience where communities can exchange ideas and experiences and learn from each other. Trustworthy content drives authentic interactions and engagement on the platform. Currently, Reddit has more than 1 billion posts and more than 16 billion comments. In 2023, 1.20 million posts and 7.50 million comments were received daily. By the end of 2023, the platform attracted more than 500 million visitors.

The majority of Reddit's revenue comes from advertising on the website and mobile app. Revenue increased 20.60% year-over-year from $666.70 million in 2022 to $804 million in 2023. Losses before income taxes narrowed from $157.90 million to 87 in the same period million US dollars. The operating losses were primarily due to high research and development costs. This suggests that the company is committed to investing in innovation to improve product and service offerings to customers and improve user experience. In 2023, research and development costs accounted for 54.50% of total revenue. Despite nearly two decades of operation, it's quite surprising to me that Reddit is still making a loss and generating negative cash flow. In the last two years, operating cash flow remained negative. 2023 operating cash flow was -$75 million.

Reddit's rapid IPO: Too much excitement and overvaluation

Source: Reddit prospectus

Debt-free balance sheet

Reddit has a decent debt-free balance sheet. As of December 2023, the Company had cash and cash equivalents of $401.2 million and marketable securities of nearly $812 million, including certificates of deposit, commercial paper, U.S. and non-U.S. Treasury securities, as well Investment grade corporate and government securities. The company has no interest-bearing debt, only $19.50 million in operating lease liabilities. However, the company posted a shareholder deficit of $412.92 million, largely due to the staggering $716.56 million in losses it has accumulated over the years.

The story goes on

In addition, there are 73 million convertible preferred shares outstanding, valued at approximately $1.85 billion. The preferred shares are entitled to a non-cumulative dividend of 8% of their original issue price per year, varying from 21 cents to $4.94 per share. If these 73 million outstanding convertible preferred shares were converted into common shares at a 1:1 ratio, this would result in a 46% increase in the total number of shares, thereby resulting in significant dilution to current shareholders.

IPO with insiders selling shares

The recent IPO achieves two main goals: raising additional capital for the company and providing liquidity to existing shareholders. Of the 22 million shares available in the IPO, Reddit itself sold 15.30 million shares, while 6.70 million shares are offered by current shareholders.

In particular, important insiders took part in the offer. CEO Steven Huffman sold 500,000 shares, while Jen Wong, the chief operating officer, sold 514,000 shares. In my opinion, insiders' decision to sell shares during the IPO is a cause for concern and may make the stock less attractive as a buying opportunity.

Significantly overrated

Assuming Reddit's total revenue continues to grow at 20% annually while costs and expenses increase at 13%, the company would be profitable by 2026. By 2028, operating income is expected to reach $261 million. Using an optimistic operating income multiple of 30, Reddit's enterprise value would be about $7.83 billion.

Reddit's rapid IPO: Too much enthusiasm and overvaluation

Source: Author's calculation

At a discount rate of 7%, Reddit's enterprise value is likely to be just $5.50 billion. After accounting for net cash of $382 million, the equity value would be $5.89 billion. Assuming all convertible preferred stock is converted into common stock, the Company's total number of shares would increase to 232 million. Therefore, each Reddit share should only be worth $25.35, almost 50% less than the current share price.

The final result

The success of Reddit's IPO, which has seen its valuation rise to $8 billion, underscores investors' enthusiasm for the company. Founded in 2005, Reddit has grown into a major online community hub but still faces financial challenges, including negative cash flows and significant cumulative losses. The company's aggressive investments in research and development have not yet resulted in profitability, and its IPO has raised concerns due to insider selling. My analysis suggests that Reddit's market value may be overly optimistic, suggesting a potentially significant overvaluation of its current share price.

This article first appeared on GuruFocus.