Hot IPOs, M&As, and More

Investment pro Tom Taulli says the recent action can't be an anomaly. It's a sign of strength in the whole market

The stellar debut of Baidu.com (BIDU ) on Aug. 5 has put sizzle back into the IPO market. Other new issues that recently lured investors include BabyUniverse (BUN ) and Golf Galaxy (GGXY ), and plenty more will follow in the coming weeks. Says author and venture capitalist Tom Taulli: "This can't be an anomaly. It's a sign of strength in the whole market. It bodes well for everyone."

Taulli, who's currently an analyst for San Francisco investment bank Instream Partners, also thinks the brisk merger activity will continue. He sees more deals brewing in the banking and credit-card sectors, as well as among Internet outfits.

For his portfolio, Taulli tends to gravitate to small-cap stocks, given that they offer the most potential rewards. Stocks that he picked up recently include Blackboard (BBBB ), a developer of software for universities and other types of learning institutions, and Bankrate (RATE ), a provider of rates for mortgages and CDs. He also likes Motorola (MOT ), the well-known cell-phone maker.

These were a few highlights of an investing chat with Taulli presented Aug. 4 by BusinessWeek Online on America Online, in response to questions from the audience and from Karyn McCormack of BW Online. Edited excerpts from this chat follow. AOL subscribers can find a full transcript at aol.businessweek.com/chat.

Q: Tom, the stock market struggled today, but for the most part it has been climbing on cheery earnings news. What's your outlook?

A:

I've been bullish this year and continue to be so on the equities market for the rest of the year. It's to be expected to see down days in the indexes, especially in light of the big rally we've had lately. But the investors I've spoken to give me hope that the rally will continue.

Something else that's interesting is that the IPO market is really picking up steam and will have a strong August. It's rare to see a strong IPO market in August, because investors usually go out of town for vacation. So when you start to see strength in the IPO market, it does show lots of bullishness from investors. Unless there is some terrible event that occurs, and it could, the rest of the year looks good for equities.

Q: Earlier in the summer, the IPO market was still rather drab. Why has it picked up now?

A:

The irony is that being drab has helped it out, going into the second part of the year. There are a lot of weak pricings for the second part of 2005, which meant investors got great deals on IPOs. As the equity market started to improve, so did the valuations on IPOs.

The market returns on IPOs have actually also been very, very good this year, one of the strongest in the equities sector in 2005. The time to play IPOs is when the area is drab, and investors are negative. You get attractive valuations and solid companies with solid financials and prospects. They're the only ones who can go public in such an environment.

Going forward, I'd be more selective about IPOs, since more companies will be out there. But I don't see a multiyear rally in the market. What I do see is IPOs going cold, going warm, going cold, etc. The way to play this market is when everyone doesn't want these things, think about buying.

Q: What IPOs look good to you in the next few weeks?

A:

The one that will grab a lot of attention is Baidu (BIDU ). The company is based in China and is the largest search engine there.

Interestingly enough, about a year ago Google (GOOG ) purchased an equity stake in Baidu. At the same time Google is pushing hard into China and what should be a high-growth market for the search-engine industry. In 2004, Baidu did $13.4 million, and revenues are ramping. In 2004, they were good, but this year, they will likely rise to over $35 million.

The Chinese search market is still in the early stages, but it's growing at a staggering rate. From one report I've seen, search queries are expected to grow 49.8%, compounded per year, between 2005 and 2007. Conducting searches in China is no easy feat, because of the complexities of the language.

Also, Baidu uses a business model similar to Google, in that it charges advertisers for search words. The problem in China is that many businesses don't even have credit cards. There are thousands of third-party providers that help businesses with these search words.

There is also the foreign risk of investing in a Chinese company, but given that the IPO market is doing quite well right now, and given the surge in Google's stock, I believe Baidu will be an excellent position this year.

Q: Are there any new issues coming that investors should avoid?

A:

That's a good question. There's nothing that jumps out at me as being a company to stay away from. I think the quality of IPOs is still strong, but as we go into the rest of the year, that may change as investment banks see an opportunity to take out more companies. The August bunch looks solid in terms of quality, but you'll probably pay a premium price for them.

However, if you do get the opportunity to invest in these at a premium price, this is a great way to make money. But it's not always easy for the individual investor to get IPOs at the offering price.

I did, however, talk to somebody today who was able to get two IPOs and make 30% on each of them. So it's possible, but this will get more difficult as brokers realize these are hot commodities again and will start giving the opportunities to those who have more money.

The other thing I've noticed in the IPO market is that small-cap IPOs are making more of a comeback. This week, BabyUniverse (BUN ) had its IPO, and it has done quite well. Actually, I think in the last few days it's up 30%. So that company has done well, and it's a small company with a small underwriter.

There was another small IPO, Golf Galaxy (GGXY ), that's up over 30% this week. So I wouldn't be surprised to see more small-cap IPOs come into the market. As an individual investor, be careful with these small offerings. They tend to be of lesser quality (though not always), and as the market turns they can be extremely volatile.

Q: How can the average investor find information on the next IPOs and get in on the ground floor?

A:

There are different sites on the Internet that have IPO filings. One of the more common sites is called IPOhome.com. There are lists of recent filings, there are lists of recent pricings, and other such data that are extremely helpful for IPO investors.

There's another site called IPOmonitor.com, but they charge for the information. So from IPOhome, you can find out what the upcoming IPOs are and get some summaries of those.

But if you want to get much more in-depth information, you can download the company's prospectus, which means you get the financials, the business plan, the bios, an incredible amount of information to help make an investment decision. It can be intimidating to read these documents, because they're written by attorneys and CPAs, but there are resources, including IPOhome.com, that can help you read these.

If the company makes sense in terms of an investment, the hard part is trying to get shares of the IPO. It would be extremely difficult to get shares for a company like Baidu at the opening price. But the smaller companies are easier in this respect.

My friend who got two initial IPOs got them because they were small. Find out who the underwriters are, which you can find in the first few pages of a prospectus, and find out from them if there are available shares of the IPO. If there are, you'd have to open an account with them.

You have to keep in mind the unwritten rules, however. An underwriter doesn't typically want anybody to flip an IPO -- that is, sell it on the first day. If you do, that's likely the last IPO you'll get at offering price. So it does take a lot of work, and a lot of calling around, but you may get lucky and get some shares.

Q: Last week we saw 13 IPOs, the strongest presence since February, and surprisingly high for the summer. Is this an indication of a positive upswing in the market and the economy, or simply a coincidence?

A:

My opinion is that the IPO market is a follower, not a leader. When liquidity comes into the equity market, it spills over into the IPO market, and that usually means a rally has legs.

We're in the early stages of a comeback in the IPO market, and what is very encouraging is that the rally is occurring in August. I can't even remember the last time we had a solid August, and I've followed the IPO market a long time. This can't be an anomaly, it's a sign of strength in the whole market. It bodes well for everyone.

I think there's a bit of irony, too. Ten years ago, in August, we had the Netscape IPO, which inaugurated a huge bull market in the NASDAQ and meant five years of strength in the IPO market. I'm not saying this will happen again; I doubt it, but I do think investors are willing to take more risk and are looking for growth-oriented companies which you see in the IPO market.

The long drought for growth companies should be ending, though. In the last few days I even see Microsoft (MSFT ) doing well in the market. You'll see more investors looking at new ideas and sparking further growth in the market.

Q: Why has there been a spate of mergers lately? And do you see more deals on the horizon?

A:

I think the U.S -- the world -- is in the midst of a major consolidation wave. We'll see deals of all sizes, including these megadeals. That's something that will be a big positive in the equities market. Companies sell at a premium when they are bought out.

Why this big consolidation wave? Part of it is that equity markets have been lackluster for a long time, and there have been good values in the marketplace for buyers. Next, I think companies are having a harder time generating organic growth. Over the last three or four years, there has been the big move to cut costs, but you can only cut so much before you reach the bone. So companies are buying growth.

Another trend is the money in private equity, about $120 billion at the moment. Private equity firms are willing to do certain types of deals that they wouldn't in the past. These firms are buying technology companies -- one deal was $10 billion deal for Sunguard.

Another trend is that, these days, being a small public company is not easy. The liabilities are hefty, and the costs are significant. There has also been a lack of analyst research for small and midsize companies to get valuations. You have a lot of willing sellers who might not want to be public anymore and join forces with a bigger company.

Hedge funds are also making an impact in this market. They want to make a quick buck, and a good way to do this is by having a company be bought out by a private equity firm. Hedge funds themselves are also becoming buyers. We saw this with Kmart and Sears (SHLD ), backed by Edward Lampert. There are a lot of key trends that I think will make M&A a multiyear trend around the world.

Q: Which sectors do you think are still ripe for mergers?

A:

I think there are certain sectors in the market that will see a lot of consolidation. The banking sector will see quite a bit. We also saw, recently, a lot of activity in the credit-card market. A lot of banks are getting into credit cards. A lot of big banks may then try to diversify by buying into other areas. We saw the acquisition of E-Loan (EELN ) recently.

On that track, we'll see a lot of consolidation in the Internet space. One that will be bought out is Fastclick (FSTC ). They went public, but the stock has been lackluster. Competition is tough, but they have some solid assets. I could see a few others looking to expand into search snapping them up.

IVillage (IVIL ) is another that has built up a thriving business with online advertising. They're attracting traditional advertisers like Pfizer (PFE ). IVillage is a unique business with a desirable demographic. At some point a bigger company may swoop in and buy it.

I would never recommend buying a company solely on the basis that it might be bought out, however. I think having a buyout scenario as a plus makes sense, but you want to have a company that will be around for a while, and ensure it has solid fundamentals. IVillage has been around for a while and is a very solid company, and therefore the buyout possibility only adds to its intrinsic value.

Q: Can individual investors participate in private equity?

A:

Typically an individual investor cannot participate in private equity. Private equity is high-risk, it's illiquid. Takes a while to get your money back -- it can take five to 10 years. As a result, these investments are mostly for high-net-worth individuals, also known as accredited investors, and institutional investors like pension funds.

But there is a unique way to play private equity. A few years ago, there were some private equity firms that did IPOs. They contacted individual investors to lend their money to buy IPOs. Apollo Investment (AINV ) is one that does this now.

Apollo Investment is a private equity group that has been around since the early '90s. They're one of the best in the world today. They know how to structure these investments. The stock has moved up lately, but it's still an effective way for investors to play private equity over the next few years.

Q: Have you bought any stocks lately?

A:

Yes, I have. I've bought Motorola (MOT ) a couple of weeks ago. I like what the current CEO has done in terms of turning around the operation. The company has come out with a new line of exciting products and is gaining market share in the mobile-phone arena. It's a marquee name, a great brand, and a company with a lot of momentum.

Another company I like is Blackboard (BBBB ). They develop software for universities and other types of learning institutions. Essentially it streamlines the process for teaching both regular and online courses. It has become a dominant brand and solution in the U.S. market, and it's expanding overseas. The management team is top-notch, and it's one of the few software companies doing markedly well in the sector. I would not be surprised to see an acquisition here.

Bankrate (RATE ) is another I like. It has been around for a long time; it's a leader in providing rates for such things as mortgages and CDs. The company has a thriving online business. The CEO came on a year ago and has done an excellent job streamlining its assets.

The company is also changing its business model in a serious way, from a flat fee to a charge per click for its advertisers (similar to Google). The stock has had a good run already, but I can see it go past $30 in the next six months.

Q: Are small caps still the place to be even after the long runup?

A:

I've always played small caps, and one or two small caps can make all the difference in the world for your portfolio. But it does require a lot of homework. Even if the small-cap arena is lagging, you can make a lot of money. I'm still finding good values in the small-cap area; I mentioned Bankrate as an example.

As a company starts going up in market cap, it attracts newer investors and investors with more money. You can see a small-cap stock gap up once the momentum starts coming in.

It's hard to predict whether small caps will continue running or not, but that would not be enough for me not to participate in small caps. Even if a slowdown in the area were the case, I would continue to search for individual prospects there.

Edited by Jack Dierdorff

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