Reddit: Sell The IPO Pop (NYSE:RDDT)

One of the biggest market headlines on Thursday was the IPO of Reddit (NYSE:RDDT). The online community company saw its shares surge almost 50% for the session, even after pricing at $34 a share, the high end of its expected range. While there was plenty of green to celebrate on its first day, the valuation of this name is not something I’d get involved in currently.

Reddit is a different type of social media site, where users come together to ask questions and discuss a variety of topics. The business really started to take off back in August 2005, and has been growing ever since. As the graphic below shows, the company saw strong growth in weekly active unique users in the back half of 2023, showing almost 30% year over year growth for Q4 2023. The majority of that growth came in the United States.

Reddit generates a majority of its revenue from advertising on its website and mobile platform. After reporting around $485 million in revenues during 2021, the top line surged to nearly $667 million in 2022 and to more than $804 million last year. There is a chance that the company could pass the billion dollar mark this year, but unless there’s some major negative event, that milestone should be crossed in 2025 at the latest. Reddit is among numerous companies currently talking about its large sums of data and the huge potential in artificial intelligence, as stated on page 125 in its recently filed prospectus:

Over time, Reddit has evolved to become one of the internet’s largest corpuses of information, with over one billion posts and over 16 billion comments through December 31, 2023, and an average of 1.2 million posts daily and 7.5 million comments daily in 2023. Reddit was also among the top ten most-visited sites in the United States in December 2023, according to Similarweb. Our content is particularly important for artificial intelligence (“AI”) – it is a foundational part of how many of the leading large language models (“LLMs”) have been trained. Furthermore, we use internally built and trained models to improve many aspects of Reddit, including user onboarding, content translation, and moderation and safety. Our massive corpus of conversational data and knowledge is what makes us unique, and we believe its value will continue to grow over time as our user-generated data continues to grow.

The problem for Reddit currently is scaling its operations in a profitable manner. The company did reduce its operating loss last year by about $32 million over 2022 levels, but that still meant it lost over $140 million or more than 17.4% of revenues. Net losses were a bit less, coming in at around $91 million. Like most companies, Reddit saw a surge in interest income last year thanks to the rise in interest rates, driving a healthy reduction in losses over prior year periods.

Reddit has a very healthy balance sheet currently. The company finished 2023 with over $1.2 billion in cash and investments, with no debt, and had over $10 of assets for every dollar of liabilities. The only negative here was that free cash flow for the year was negative $84 million, although that was a more than 15% improvement over 2022’s result. With the large cash balance plus another half a billion plus coming in from the IPO, this is one area where I am not worried. For now, the company will generate some decent interest income, but it can also use that cash for either internal growth or some acquisitions.

The biggest problem for Reddit in my opinion currently is its valuation. After going public, there will be about 159 million shares outstanding between Class A, B, and C shares. Class A is the trading class, and underwriters have the option to purchase another 3.3 million shares. Assuming that option goes through, the company’s valuation works out to nearly $8.2 billion as of Thursday’s closing price. If we project that $1 billion revenue figure for this year, that gives the name a price to sales figure of about 8.19.

That prices to sales number comes in a little bit above that of Facebook and Instagram parent Meta Platforms (META). However, Meta is also showing some pretty good growth currently, along with producing tremendous profits and cash flow. Meta also has a sizable share repurchase program. If we compare Reddit to other social media names like Snap (SNAP) and Pinterest (PINS) that are growing but not profitable, the bear argument increases. The chart below shows how these four names look based on currently expected 2024 revenues (analyst average), again assuming $1 billion for Reddit.

The valuation argument for Reddit gets even worse if the name doesn’t hit that billion dollar mark, or when you consider significant potential dilution in the near term. As seen on pages 15 and 16 of the company’s prospectus linked above, there are tens of millions of additional shares not counted in the above outstanding share count. These are shares tied to employee options and other stock based compensation items, which if they were all converted today, would push the price to sales figure into the low to mid double digits.

Even assuming a minimal number of those shares are added to the count today, you would be looking at a price to sales number of around 9, whereas the two closest comps above average just about 5 times. Because of this significant valuation premium, I am initiating Reddit shares at a sell today. While the company does have a good growth story behind it, it has not yet been able to achieve this profitably. Even assuming a nearly 25% increase in revenues this year along with minimal dilution, you’re looking at a company trading at a roughly 80% premium to its closest comps.

To get to a hold rating on the stock, I need to see a couple of items. First, I want to see a quarter of two of results as a publicly traded company, to see if the revenue growth story is changing at all. While the company is pounding its chest regarding artificial intelligence, it’s unclear at this point how well that bet will pay off. I want to see if management can continue to reduce losses and cash burn, potentially swinging to profitability and positive free cash flow in the next year or two. Finally, I need to see the valuation come down quite a bit, presumably a lot closer to names like Pinterest and Snap which average a mid single digit price to sales figure.

In the end, Reddit shares surged more than 48% on their IPO day, closing the session above $50 a share. The company is currently growing its user base and revenues at a decent clip, but it hasn’t yet achieved profitability or positive cash flow. Thursday’s rally saddles the name with a very high valuation on a price to sales basis, especially when compared to its closest two industry peers that are also losing money currently, so I would sell shares today.