Think You've Found The Next Microsoft?Jeffrey Laderman
Getting in on the ground floor of a new company is part of every investor's dream. Who wouldn't want to participate in an initial public offering and buy a few hundred shares in the next Microsoft or Wal-Mart Stores? For many investors, though, IPOs have been a nightmare. It's common for new issues to sell below their initial offering price within 6 months to 12 months and stay that way for some time.
That's a sober bit of advice now, as investment bankers furiously crank out new issues. So far this year, Wall Street has brought out 60 of them, raising nearly $4 billion. And an additional 132 are in the pipeline, looking to raise some $4.5 billion, according to IDD Information Services, a New York firm that collects data on deals. "When you get to a rate of 35 deals a month, it's a frenzy," says Robert Natale, who writes the Emerging & Special Situations newsletter at Standard & Poor's.
ON A TEAR. The IPO market comes to life every time the bulls stampede down Wall Street. Hopeful companies and eager investment bankers try to capitalize on the insatiable appetite of investors. As a result, the first wave of deals--in this case, those done in January and February--are usually considered best for investors, since they were on the drawing board before the bull market took hold. Later deals are pricier--and riskier.
Stocks that go public are often in industries that are already popular in the market. Health care stocks have been on a tear for several years now--so the new-issues calendar is heavy with health maintenance organizations, home care providers, and biotechnology companies. There are plenty of high-technology companies, too, from next-generation semiconductor manufacturers to software developers.
Not all the companies raising money in this year's IPO market are young outfits, either. Duracell International, which was expected to go public May 2, has nearly $2 billion in sales worldwide and traces its lineage back to 1935. The battery manufacturer, which planned to sell 25 million shares to the public, was part of Kraft before the investment firm of Kohlberg Kravis Roberts took the company private in a 1988 leveraged buyout.
The Duracell deal--like those of RJR Nabisco, Caldor, and the upcoming AnnTaylor Stores and Filene's--is a reverse LBO that takes a private company public again. Given the billions in LBOs launched over the past decade, such deals will dominate the new-issues market.
SLIM PROFITS. Playing the IPO market is daunting. The preliminary prospectus, or red herring, is often a jumble of legalese and financial jargon, and you're largely on your own when it comes to deciphering it. That's very different from investing in General Motors or IBM, where there's no shortage of advice. Newsletters such as New Issues, published by the Institute for Econometric Research in Fort Lauderdale, Fla., and S&P's Emerging & Special Situations offer IPO analyses, but not for every deal.
With many new offerings, such as those in biotechnology, conventional analysis won't be much help. Forget about profits, too. Most of these companies don't have revenues, and it could be years before they have any salable products. Such a company is Cephalon, which on Apr. 25 sold 3.3 million of its 7.5 million shares to the public at $18 a share. That gave the company, which hopes to develop drugs for treating disorders such as Alzheimer's disease, a total market value of $135 million.
Some indicators suggest that investors are having second thoughts about the lofty levels at which biotech companies come public--a healthy sign. By Apr. 30, the Cephalon stock was down to 15 1/4. And Regeneron Pharmaceuticals, which came out at 22 on Apr. 2, is now 12 5/8.
BUYER BEWARE. Given the huge risks in IPOs, investors can follow certain rules to improve their prospects. First, stick to what S&P's Natale calls "investment grade IPOs"--those underwritten by major New York investment banks or regionals such as Alex. Brown & Sons, Cowen & Co., Hambrecht & Quist, Montgomery Securities, or Robertson, Stephens & Co. These firms are more likely to pitch high-quality IPOs, because they cater to major institutional clients.
Along the same lines, buy IPOs in which the price is at least $5 per share. Below that threshold, the IPO is a penny stock. And keep away from "unit" offerings--new stocks packaged with warrants to buy more shares. Quality deals don't need such warrants as sweeteners.
Next, compare the IPO's financials with those of similar companies already public. Pay attention to price-earnings ratios. If an IPO has a p-e of 40 and comparable public companies are 20, the deal could be overpriced. Look at the earnings growth rate. "I want a minimum 30% growth rate in earnings and revenues," says Jim Oberweis of the Oberweis Emerging Growth Fund. And the earnings growth rate should be well above the p-e.
Find out who benefits from the offering. The best deals are those in which the proceeds go to the company for working capital or to reduce debt. In small, entrepreneurial companies, founders might put shares on the block to boost the size of the offering. If existing shareholders are selling, they should still own a large proportion of the company's stock after the sale.
Finally, pay attention to management's pedigree. What are the executives' track records? One reason for the success of the IPO for Medical Marketing Group is the superb reputation of its parent, Medco Containment Services, and of Medco CEO Martin Wygod, who also chairs MMG. With research companies, look at the scientific advisory board.
Ask yourself, too, whether the company's business plan makes sense. Ross Systems, which went public on Apr. 26, sells software that, in effect, retrofits Digital Equipment computers from technical to commercial applications. "You can make money doing that," says Roger McNamee, manager of the T. Rowe Price Science & Technology Fund. "But the market is limited." Also, Ross's prospects may depend more on DEC than on itself.
PATIENCE PAYS. Your homework on IPOs may be futile if you can't actually buy shares at the offering. But that's where the individual is at a disadvantage: Most shares are allocated to the pros.
If you're the best customer of the best broker in a large branch office of the lead underwriter, you might get a couple hundred shares allocated to you. Bob Mescal, an analyst at New Issues, says individuals frozen out by underwriters might call the chief financial officer of the company going public and ask to buy some shares. Says Mescal: "These companies want a diversified group of shareholders--especially individuals."
Finally, if you don't get a piece of the offering, don't chase the stock in the aftermarket. Instead, keep track of its price, earnings, and other developments. Indeed, history suggests the best time to buy IPOs is long after they come public. By that time, "flippers"--traders who look to take advantage of a stock's short-lived hot streak--have sold and moved on. That's the time for long-term investors to move in.
WHEN INVESTING IN IPOs... -- Stick to offerings from major investment banks or well-regarded regionals -- Buy stocks with an initial offering price of at least $5 per share -- Compare financials with those of like companies that are already public -- Be sure most of the proceeds go to the company, not to other shareholders