Why IPOs Are Risky

In this episode of Market Foolery, Chris Hill chats with Motley Fool contributor Dan Kline about the latest headlines from Wall Street. They discuss a recent IPO and why they think IPOs are risky. They talk about the latest game consoles to figure out which is the better device and clarify the rationale behind their pricing. They also share a new deal in the gambling and betting space and much more.

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To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on September 17, 2020.

Chris Hill: It's Thursday, Sept. 17. Welcome to Market Foolery. I'm Chris Hill. With me today: our man in Florida. It's Dan Kline. Good to see you, my friend.

Dan Kline: Nice to see you. It's hot here, but we're going to cool things down or heat things up; [laughs] I'm not sure which way we want to go.

Hill: Yeah, let's try not to put people to sleep. Although, every once in a while, I'll hear from a listener, like, "This is the last thing I listen to at the end of the day as I drift off to sleep." It's like, well, as long as you're listening.

We've got video game news. We have news about the other type of gaming. But we're going to start with the biggest software IPO ever. Snowflake (SNOW -0.28%), the cloud software business, went public on Wednesday at $120 a share and finished the day at $255 a share. It has come down a bit from that.

Doubling on the opening day. You tell me, Dan. Is this madness or is this Sparta?

Kline: No, this is madness. This is people who don't know anything about how stocks work wanting to get the latest shiny new toy. And I'm not saying Snowflake is not a good company, but they priced it where they felt the value was; that's how these things work. And people, look, you see it all over Facebook: How do I get in, how can I get in? I want to buy shares. And they don't know what they're buying. None of these people sat down and read the S-1 and went, oh, hey, I think this is worth the $240 a share I got it at. And, look, there are Fools that bought shares, that bought shares at high prices that believed in this. I know of at least one who did that.

That being said, most people are just chasing dreams, and that is not an investing strategy. Buying IPOs I never think is a good idea. Here's the reality: The insiders have an advantage. They're getting shares at the strike price; you're getting shares at whatever the market bids it up as.

So here's what you can do. Sit back a couple of quarters, sit back a year, read the quarterly earnings reports, watch the investor call. Get a sense of the CEO. Is this a truthful person, is it someone who says, here's what's wrong in quarter one and here's the progress we've made in quarter two? Look, if you bought Amazon three quarters in, you'd still be really rich today, like, it's not that important to get in on the day out. Fear of missing out is really powerful; I get it. Just tell everyone you own a share of Snowflake, you don't actually have to buy one.

Hill: It's really going to be interesting to see where this goes, because among the thoughts I had yesterday, when this thing was shooting to the moon, was a point that's been made on this podcast over the years that when a company is preparing to go public, it is absolutely in their interest to make the S-1, the official filing to the SEC, to make that look as good as possible. And why wouldn't they? And that's not to begrudge any company that does that; that's a smart strategy.

Kline: It's your profile on a dating page. You're not going to list your bad habits.

Hill: Right. [laughs] Let the date find that out over time. But another thing I thought, as you made the point about the insiders, they've got the knowledge. They, apparently, didn't have all the knowledge, because they priced this thing [laughs] way too low. I mean, Snowflake may end up being a great company with brilliant management, but I guarantee you there were loud meetings involving profanity yesterday and probably again today with investment banks because they left so much money on the table.

Kline: Chris, it's a really tough one. Because JFrog also went public yesterday, and I don't know the exact numbers, but it was up something like 60%, and people were like, oh, that's a disappointing IPO. No, it isn't. [laughs]

Here's the reality. People don't know anything about these companies. And Snowflake has a name that caught on more than JFrog. That's really what happened here. And again, a lot of Fools believe in Snowflake and think it's going to be a good company, but is it really worth 5 times more than Slack is worth right now? It probably isn't. Could it get there? Absolutely. But this is going to be a really volatile stock for probably years, because it was very, very highly priced. And if they come out and their quarter, you know, "Hey, we were up 2% in revenue," people are going to panic, because they don't really understand.

There's also, when you're being traded rather than invested, a lot of short-term sentiment is going to cause a lot of movement, and that's not great. If I was the management of this company, I would literally say, we're not thinking about our stock price, we're not talking about our stock price, we're going to build long-term value and take, kind of, the Amazon approach. Because these numbers are just going to be really hard to explain on anything logical, like, price to earnings for a very long time.

Hill: Yeah, folks are definitely going to have to buckle up for this one.

Last holiday season all we heard on the topic of game consoles was, "Wait until 2020. We're keeping our powder dry. Come back to us holiday season 2020." Well, guess what, we're creeping up on the holiday season. Sony announced today that it is selling two versions of the PlayStation 5. They're going to be available starting Nov. 12. And this, Dan, this matches the playbook we saw out of Microsoft (MSFT -0.92%), coming out with two versions of their next-generation Xbox.

Kline: Yeah, except Microsoft, I think, has kind of lapped Sony on this. So the two Microsoft prices are $499 for the top-tier device. The top-tier device has better graphics; so, if you have a 4K television, it will matter, if you don't, it probably won't. And it has an optical drive, meaning, you could put a physical CD in. It has more memory. It has a few other bells and whistles. It's physically bigger.

The S, which is $299 -- remember that number, $299 -- doesn't have a CD drive, meaning you have to download everything. Frankly, it makes sense to download everything anyway, because when you go buy a physical disk, you spend about four hours on a decent internet, downloading all the updates anyway, so it's not really saving you a lot of time. And it's physically smaller, which is nice.

The Sony lower-end device, which has sort of the same downgrades -- the graphics aren't as good, there's no optical drive -- that one costs $399. That, to me, that $100 is going to be an awful lot of families at Christmas going, "Yeah, I'm going to buy the Microsoft one."

Both are backwards compatible, so they largely will be selling to existing customer bases. But that said, if I already own a PlayStation 4, maybe that's when I get into Microsoft and say, well, "I can still play all my games, and the new games are going to come out on both platforms for a couple of years." I think Sony is making a mistake.

And it goes further when you look at that Microsoft is also offering a financing deal that's bundled with its game subscription service, that does end up costing you more, but a lot of players were subscribing to Xbox Gold anyway, so they're spending the same amount of money, they're getting the hardware they want as a monthly subscription price, and it's a pretty palatable number, it's $24.99 for the S Series a month for two years. And at the end of that two years you have the right to opt-out completely, you don't automatically rollover into a cheaper game-only subscription. So I actually think that Microsoft has a much better strategy here than Sony does, which is probably because Microsoft has a lot more money than Sony does.

Hill: I was just going to say, it really does seem like yet another example of a large, highly profitable [laughs] tech company having that as an option, having that as a lever they can pull. Obviously, the folks at Microsoft's Xbox division, they want to do the best job they can within the company. They want to be as profitable as they can within the company. But to your point, it really wouldn't surprise me if someone in some [laughs] other part of the business just, sort of, you know, pulled someone aside and said, "Look, just get people in. Just get people in, bundle it, we don't have to make higher margins on the lower-end price."

Kline: Sony's business is selling you software and selling you devices. Microsoft's business is moving to the subscription business. So I think they're much more interested in getting people into their subscription program. And look, their subscription program gives you access to all of their new games. So anything Microsoft puts out. It also gives you access to about 100 EA Sports titles, including the latest games.

Chris, I buy Madden every year and then never play it. I buy a hockey game every other year, and also, maybe play for once or twice. Getting those things I'm not going to use, bundled in for less money, actually has some value in a very bizarre way.

Hill: Before we get to our final story, a couple quick notes. First, for those who listen on Spotify and have emailed and tweeted at us, I think we have the tech issue with Spotify fixed, so hopefully that's been fixed.

But if it's not, good news, Amazon Music now has podcasts. [laughs] One more platform where you can find The Motley Fool's podcast. So you know, again, I made this joke before we started recording. I'm not going to say the A-L-E-X-A word, lest I set off devices, but you can now find the Motley Fool podcasts on the Amazon Music platform.

And secondly, on Motley Fool Money this weekend, Laura Adams is going to be our guest. If you listen to other financial podcasts, you know her as the host of the highly popular Money Girl podcast. Laura Adams -- had her on Market Foolery last year. She has a new book coming out next week. We're talking about that book. So check that out on Motley Fool Money this weekend.

Dan, let's get into the other type of gaming. Shares of Penn National Gaming (PENN 3.04%) up around 10% today after Penn National got an upgrade from one Wall Street firm. This is by the way, the 10% today, this is on top of the 25% rise that the stock has had over the past month. And this comes on the heels of just a couple of days ago, when ESPN signed agreements with both DraftKings and Caesars Entertainment. DraftKings is going to be the exclusive provider of daily fantasy sports; both DraftKings and Caesars are going to partner on gambling link-outs. Both of those stocks up more than 10% on those announcements. So there's a lot cooking in the world of casinos and sports betting.

When you look across the industry, how is it looking to you right now?

Kline: It's interesting. So Penn has done something that's going to help their business, has helped their business, but is also going to limit their business. So they've taken a major stake in Barstool Sports. And if you don't know Barstool Sports, it's a polarizing brand. It is a brand that some people think is the most important thing in their lives and some people are very off-put by. David Portnoy, the founder, goes by El Presidente, is someone who gets attention any way necessary, not always positive ways. That's going to deliver a lot of customers to the co-branded Barstool Sports-Penn National betting parlors or sportsbooks or whatever you want to call them, but that's also going to steer away some people.

So basically, like I know, I'm not setting foot in a Barstool Sports gambling establishment. It's just not a brand I relate to. And I'll point out, I grew up with David; he's one of my brother's best friends. So there is nothing personal there. It's just not a brand I relate to. That being said, it is a good move to have a distinctive sportsbook when most sportsbooks -- you know, is the Fox sportsbook all that distinctive? It really isn't. So this is a brand people know, they will seek out.

The Caesars and DraftKings move is more interesting to me. I've been wondering why Caesars and MGM have largely been sitting on the sidelines, because they own a very powerful thing, and that's, they have physical casinos. So if I have to choose where I'm going to do my online gambling, should Florida ever decide to make that legal, I would almost certainly do it at Caesars or MGM, because they'll give me loyalty rewards points that turn into things like tangible meals and hotel rooms. And if you move up the chain and you get a higher level, you get access to lounges and you can cut in line and you get tickets sooner. That's something that I don't think DraftKings can equal, so I am pleased to see Caesars get off the sideline. And ESPN is going fully into gaming, so there's going to be a lot of partnership to be had, a lot of deals to be made, but a lot of this is going to depend on state legislation as to how quickly it can move.

Hill: I think there are a couple of interesting things here. One is, as you mentioned at the end there, ESPN, which really has a tremendous opportunity. It's taking advantage of it, obviously, with these two agreements, but it'll be interesting to see what more agreements come down the line. Because, look, ESPN is sort of the top brand in sports programming. And to the extent that they can find additional ways to monetize through legalized sports betting, more power to them, and more power to the Disney Corporation as a result of that.

Kline: Yeah. And, Chris, these are essentially ad deals. And we're not going to see the breakout of it from ESPN, because ESPN is such a small part of Disney. What makes Penn and DraftKings interesting is we're going to see how much they're paying out and sort of how these percentages work. And, look, ESPN is a slowly stalling product. You know, people are cutting the cord. It's harder to get ESPN. This is going to be another piece of the puzzle that keeps sports fans loyal.

And, Chris, you know we've seen this major shift. Since it became theoretically federally legal to bet on sports -- though each state has to approve how it's going to be done -- when you watch a telecast now, they talk about betting in a way that they used to hint at. When you're seeing that late garbage touchdown that changes the line, they used to, sort of, wink-wink it, and now they're very open about it. So we're in like the second inning of a very long game.

Hill: I'm wondering, when you look at these stocks moving up, obviously, these are meaningful deals. I don't mean to detract from -- you know, I'm not looking at DraftKings and Caesars shooting up on the ESPN announcement and thinking, "Well, that's just crazy" in the same way at the beginning of the show [laughs] we were talking about at least some portion of the rise of Snowflake.

I do wonder though, if at least a little bit of the enthusiasm, maybe extra enthusiasm, is this slowly getting back to "normal professional sports?" The NFL season has started. The Big Ten just announced they're going to have a shortened football season, so there's optimism around that. You know, the NBA playoffs are going on, same for the NHL. That's got to be a little bit of what's happening here, doesn't it?

Kline: That's some of it. And some of it is also, look, people can't go to regular casinos. So in places where it's legal to bet, they're more likely to do that. Heck, it's hard to socially distance, bet with your bookie, if you have a bookie. I'm not sure how that works anymore; it's probably all done online. But the market here is taking the illegal gambling market and moving it into legal gambling. Even things like an office pool eventually might be something done through legal channels. And that's billions and billions of dollars.

But I have no idea how to invest in this space. This is one where, you know, if you tell me that DraftKings is going to be a winner, that's possible. You tell me Penn is going to be a winner, possible. Caesars and MGM have been, kind of, dicey stocks for a long time, even though they should be in the business of printing money. There's also heavy, heavy investments there. So this is a space I love to talk about -- I love to gamble -- but I don't actually like to invest in.

Hill: We'll leave it there. Dan Kline, always good talking to you. Thanks for being here.

Kline: Thanks for having me.

Hill: As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear.

That's going to do it for this edition of Market Foolery. The show is mixed by Dan Boyd. I'm Chris Hill. Thanks for listening. We'll see you on Monday.