Just How Juicy Is That Ipo?Robert Barker
Manhattan attorney David Solomon is hitting pay dirt in IPOs. In recent weeks, he has grabbed several initial public offerings from Fidelity Investments, including data-storage maker Box Hill Systems and Qwest Communications International. In Qwest, a telecom company, Solomon snapped up 500 shares at $22 and saw them surge as high as $53. "Obscene," he says.
Don't we all get the urge to make such a killing? So far this year, the volume of new issues is down 27% from 1996, to $23.8 billion. But with discount brokers such as Charles Schwab and Fidelity taking bigger roles in selling new issues, small investors now are getting more chances to get in at the start.
Yet for every Qwest, there are many more IPOs such as Pixar Animation Studios, which went public in 1995 on the strength of its dazzling work for the Walt Disney film Toy Story. Pixar briefly soared to $49.50 but soon sank to near $12, and it is only now back around its initial $22 price. "For every success story in the IPO market," says Nancy Smith, the Securities & Exchange Commission's investor education director, "there are many, many more examples of failure."
So how can you protect yourself if you're a buy-and-hold investor looking for an IPO that may pay off over the long haul? While there are no sure bets, your best defense is to pay meticulous attention to an issue's prospectus. Every company aiming to sell stock to the public must by law make one available, but the document can run to more than 100 reader-cruel pages of legalese and financial tables. "It's overkill," says Jeff Calloway, a Lake City (Tenn.) minister and former accountant who runs his own $165,000 portfolio via Schwab.
KEY NAMES. The more you read and digest in a prospectus, the better--but who has the patience or the time? Here's how, then, to get a quick fix. Each of the key sections, which are mandated by the SEC, are listed in a table of contents, usually on page 3. But check the cover first. Ignore all that small type (it's boilerplate) and look at the bottom to see which Wall Street firm is responsible for selling the stock. Ever heard of it?
Marc Baylin, a T. Rowe Price Associates growth stock analyst, scours prospectuses for a living and pays close attention to the underwriters' names. He allows that even the top firms, including Goldman Sachs, Morgan Stanley, Dean Witter, Discover, and Merrill Lynch, sometimes sponsor shares that later collapse. Robertson, Stephens, a well-regarded firm, led the Pixar offering. Still, those firms or well-known boutiques, such as San Francisco-based high-tech specialists Montgomery Securities or Hambrecht & Quist, "have more business than they can handle," Baylin says, so they can pick the best deals.
To check an underwriter's record, ask a broker for a list of recent IPOs it has led, or use such Web sites as IPO Maven (www.ipomaven.com), which keep score. An even better indicator is the number of Wall Street firms joining in the sales effort. The more names on the cover, the more firms are likely to trade the stock once it's public. That supports its price. More co-sponsors also means coverage by more research analysts, another key to investor interest.
Your next stop in the prospectus should be a section called "Selected consolidated financial data." It's a page or two of small numerals--sort of the greatest hits of the company's financial statements. (For more serious number crunching, the statements are presented in full in the back.) But don't go cross-eyed. Focus instead on the basics.
How large is the company's shareholder's equity? That's all assets minus all liabilities. If it's negative, you'll want to know why and when it will turn positive. A full-service broker may be able to provide some answers. Otherwise, you must dig deeper into the prospectus. Look to see if revenues are increasing. And if net income isn't growing or is nonexistent, that's a worry. Also, check cash flow from operations. Because of accounting rules, companies can post higher earnings yet see operations drain the company of cash. Cash flow is net earnings plus all noncash expenses, such as depreciation and amortization.
Conversely, year after year of red ink on the bottom line may divert your attention from steady cash-generation by the business. A recent securities filing for Friendly Ice Cream, the Northeastern restaurant chain that aims to go public later this year, shows just that: Friendly has run losses at least since 1992, which is as far back as the prospectus goes. But because it has had many noncash expenses such as depreciation, it has always generated cash enough to maintain the business.
The answer to the Friendly enigma lies in a section called "Management's discussion and analysis of financial condition and results of operation." Rather than look to the general overview of a business and its strategy that always can be found at the front of a prospectus, Hambrecht & Quist Managing Director Abby Adlerman suggests heading straight here. "It's a little drier, but it does absolutely discuss the actual trends and what's causing them," she says.
In Friendly's case, you can find out that its $176 million negative net worth is a legacy of a 1988 leveraged buyout that left the chain heavily burdened by debt. Also, the $373 million it has paid in interest on that debt is the chief reason why operating income is positive, while net income (a figure reckoned after payment of interest) has been steadily negative. The upshot? Friendly might post an actual profit if, after raising cash in the IPO to retire much of its debt, it has a lower ongoing interest bill.
Here you'll also find a table, "Results of operations," that breaks the income statement down as a percentage of total revenues. Look for the operating profit margin, which is the ratio of operating income to total revenues. Is it growing? Is it wider or narrower than rivals'? Friendly's has bounced around, running as high as 5.8% in 1994 and more recently at 4.7%.
IN A HURRY? As with anything you buy, you might wonder who's selling shares. Learn that by turning to the "Ownership of common stock" section, which lists all owners of 5% or more of the company. If stockholders are bailing out, it should give you pause. "They know a lot more about the business than I know," Baylin says. Professional investors will tolerate an insider giving up 10% to 15% of his or her holdings, Adlerman says, but they grow wary if the figure goes higher.
To understand why an insider might want to sell, turn to the section toward the front of the prospectus called "Risk factors." Not all the items stuffed into this section are worth your attention. For example, Friendly lists such obvious worries as "Exposure to commodity pricing"--that's the concern that, say, the price of coffee or cream will rise and cut into profits. Another category is "Regulation," a generalized concern over all manner of government regulations. "You're going to get your best insight if you focus on risks unique to a company," Smith says. More worrisome about Friendly is the high debt the chain will owe even after the IPO. The prospectus concedes that this means Friendly "is more leveraged than certain of its principal competitors, which may place the Company at a competitive disadvantage."
None of this is exactly light reading. However, if you're intent on investing in IPOs, cut first to the quick of a prospectus and protect yourself.