Should You Invest in These 2 Hot IPO Stocks?

Investing in initial public offerings (IPOs) might seem like an exciting opportunity as you will be one of the first people to own a stock when it hits the capital markets. But like other types of investments, IPO stocks can carry significant risk. For example, some companies that were unicorns during their days of being private may be hyped up before their IPO. Subsequently, when the stock goes public, investors buy the hype story and pour into the stock, propelling it upward. 

But momentum traders eventually exit their positions and book a quick profit. As the stock begins to crater, those who bought into the story, and not the business, are left holding the bag.  

Over the last couple of weeks two big-name tech companies hit the public exchanges: semiconductor company Arm Holdings (ARM -4.19%) and grocery delivery platform Instacart (CART -1.71%). Although both of these companies present interesting investment opportunities, there is a lot each needs to prove in order to earn a spot in your portfolio. Let's dig into why.

1. Arm Holdings

If Arm Holdings sounds familiar, it's likely because the company was nearly acquired by its semiconductor counterpart Nvidia a couple of years ago. However, the acquisition deal eventually fell apart due to antitrust concerns. 

Before going public, Arm was primarily owned by Japanese investment firm SoftBank Group. At first glance, Arm might look really appealing. After all, it garnered the attention of Nvidia, which is dominating the intersection of artificial intelligence (AI) and semiconductors. Moreover, the company's position in SoftBank's legendary portfolio may seem like the ultimate stamp of approval. 

But Arm is having some noticeable struggles growing its top and bottom lines. Revenue is shrinking while expenses are getting bloated. This is a classic recipe for cash-flow and profit constraints. Given the lack of growth, it raises the question why Arm would go public right now at all.

Despite its long track record of success, SoftBank has unfortunately had a number of busts in recent history -- including WeWork. Given some of these sour investments, it could be the case that SoftBank needs to raise some cash. And what better way to do that than cashing in on AI mania with its own semiconductor company? As I recently argued, my suspicion is that SoftBank is looking to take advantage of the current tailwinds in the tech sector driven by AI. But keen investors should be able to see through the mirage and shy away from Arm for now.  

Image source: Getty Images.

2. Instacart

I view Instacart -- whose formal business name is Maplebear -- as a convenience option. In other words, having the ability to use an app to order groceries and have them delivered to your home is a nice luxury. But with that said, my fear is that some investors may fall for Instacart's marketing and buzzwords, and view the operation as more than what it really is. The investment community saw this exact dynamic with Sweetgreen a couple of years ago. Sweetgreen makes delicious salads and I personally am a happy customer. However, the healthy food chain is not a technology company and should not be treated as such.

Tough Instacart operates around a sophisticated order management platform, the actual business consists of physically lugging goods from Point A to Point B. According to the company's regulatory filings, Instacart generates revenue from transaction fees and advertising. The transaction revenue stems from fees paid by customers and retailers, while advertising hails from brand partners. Some of the biggest risks that I can think of facing a model like this revolves around the transaction fees.

For instance, grocery stores tend to operate on razor-thin margins as it is since some items need to be changed almost daily, which makes for a lot of wasted inventory. Given this dynamic, paying a fee to a service such as Instacart may not be sustainable in the long term for some grocery chains. On top of that, Instacart charges customers delivery and service fees, similar to when you order food through the platforms run by Uber Technologies or DoorDash. If you're more of a power user, then paying for the company's recurring subscription service, Instacart+, might be a more suitable economic choice. Nonetheless, as I mentioned above, Instacart's service is a luxury of convenience. And during times of high inflation or rising borrowing costs, people will generally look for cost savings. In my opinion, services such as Instacart are some of the easiest to cut out in an effort to augment your monthly budget. 

The table below reflects Instacart's financial profile on a generally accepted accounting principles (GAAP) basis since year-end 2020:

Data source: company S-1 filing.

At first glance, this financial profile looks pretty incredible. The company grew revenue by 24% between 2020 and 2021, and an additional 39% in 2022. Moreover, Instacart's gross margin has expanded at an impressive rate as the company posted a profit in 2022. However, Instacart's profile through the first six months of 2023 may shed some light on the risk factors I laid out above.

Through June 30, Instacart has completed 133 million orders. Per its S-1 filing, this is virtually flat when compared to the first six months of 2022, and assumes only nominal growth above last year's total order volume on an annualized basis. Furthermore, through June the company has generated about $1.5 billion in revenue. Assuming this run rate, Instacart is on pace for $3 billion in 2023 revenue, or roughly 16% revenue growth. What is going on?

I think it's safe to say the company can attribute some of the pronounced growth in 2021 and 2022 to the COVID-19 pandemic. During the times of lockdowns and stay-at-home protocols, demand surged for online services. However, the dynamics have changed. The impact that inflation has on consumer discretionary products and services such as Instacart make it even more obvious that the business model is getting exposed. While the company offers a convenient service, I question if it's entirely investable. I suggest looking elsewhere and passing on the digital transformation of grocery delivery.