IPOs: How to Kick the Tires
It's been less than a week since the Blackstone Group's (BX) much-vaunted initial public offering, and other private equity firms are eyeing a foray into the public market, starting with the Carlyle Group. Should investors respond to this trend with eagerness or wariness?
While an IPO allows investors to participate in what's usually a hot sector, a healthy dose of skepticism is always advisable when considering buying a newly issued stock. First of all, there's nothing accidental about the timing of an IPO. As investment guru Burton Malkiel says in A Random Walk Down Wall Street, an IPO is usually scheduled by a company's managers to coincide with a prosperity peak for the company, or with the height of investor enthusiasm for a current fad.
Some experts recommend that you wait until after the so-called lockup period, or the first six months of trading, has passed. This allows you to see how well the stock holds up to additional selling pressure, or to take advantage of a price decline.
The Blackstone IPO, which was valued at $33.6 billion, was touted as the biggest IPO of the past five years. Ten times oversubscribed, the shares opened at $31 last Friday and had risen 13% by the market close that day. By Tuesday, however, the price was down to $30.75.
It isn't hard to see why private equity firms have become the talk of the market when you consider the rise in demand for financial services and the economic strength that industry has demonstrated in recent years. Private equity accounted for 48% of merger-and-acquisition value and 20% of volume during the first five months of 2007, vs. 32% and 17%, respectively, for all of 2006, according to Thomson Financial. But not everyone is buying the hype, with skeptics citing inflated prices and the absence of a track record of trading publicly.
If IPOs are pricing fairly strongly lately, it's because the IPO market takes its cue from the broader market, where valuations have increased over the past year. Given the greater cyclicality of the IPO market vs. the broader market, it's likely that if there's a slowdown in the broader market, we'll see a more dramatic drop in IPO issuance, says Michael Hoder, a stock analyst at Morningstar Funds (MORN).
And investors would be missing some good opportunities if they think it's wiser to stay away from IPOs in a weak market cycle, according to Paul Bard, vice-president of research at Renaissance Capital in Greenwich, Conn. When the overall market is weak, only companies that have strong fundamentals get pushed through, often at very attractive prices.
Conversely, when the IPO market gets hectic, deal quality tends to diminish, as at the height of the tech bubble in 1999. Seeing the market's willingness to absorb IPOs, banks are happy to oblige by pushing even lower-quality stocks into the public sphere, says Bard.
In any market, investors looking to buy shares of newly public companies should do their homework. This week, Five for the Money takes a look at five things investors should look for when considering an IPO.
1. Company Fundamentals
Don't let the lack of transparency and hype around hot sectors cloud your vision. As with any company, its financial track record, competitive position in its industry, business model, and earnings power will tell you most of what is worth knowing.
After the quality of a company's management team, its market opportunity and products are the key factors to look at, according to Bob Davis, managing general partner at Highland Capital Partners, a venture capital firm.
"We like to see a market we believe is expanding and a market we believe is huge with a capital H," Davis says. He'd rather pick a company with a small share of a $5 billion market than one that has the dominant position in a $50 million market.
For Bard at Renaissance, it's not only how ample the market opportunity is but whether a company is able to grow faster than the market.
"If you can find both those things, those are the two key ingredients for driving strong earnings growth," he says.
Davis, who was the first CEO of Lycos and now specializes in digital media and Internet companies, says it's important to thoroughly analyze the subsegments within such a broadly defined industry as digital media so as to fully appreciate what a company actually does and who its competitors are.
He asks lots of questions. For example, if a company is the dominant player in a market, what are the barriers to entry for newcomers? If there's another entrenched competitor, does that company have more capital, more time, more resources, more relationships, more intellectual property, or a better team that will put your company at a disadvantage?
In looking at products, he asks "What is the satisfaction that I'm delivering to a customer, that says either 'I'm going to solve your problem or make you feel pretty good about something'?" Having products that give a customer a reason to want to do business with or switch to a provider is critical, he says.
Renaissance Capital, which does extensive research on IPOs, says its analysts use a variety of metrics to compare newly public firms with the most comparable publicly traded peers. These metrics include price-to-sales, price-to-earnings, and enterprise value-to-cash flow, using the midpoint of the proposed offer's price range. Similarly, Renaissance measures the trading performance of the new company's peers relative to the market, using it as a proxy for the expected trading of the new company's stock.
In weighing the potential value of a company, Morningstar doesn't believe in relying on comparable multiples within the same industry, as many analysts do. Instead, "we build a discounted-cash-flow model based on what we think its competitive position is," says Hodel. "We don't take a favorable view of an IPO just because it's in a hot sector. We take a look at it for its own merits."
In the absence of public filings of financial results and analysts' coverage, investors' best bet is to check the S-1, the registration statement companies are required to file with the Securities & Exchange Commission prior to an IPO. An S-1 typically includes a preliminary prospectus, income statement, and balance sheet, plus various sections that highlight potential risks and intended use of proceeds from an IPO.
3. Corporate Governance
In looking at how closely the interests of the company's managers and the board of directors are aligned with the interests of new public shareholders, Renaissance considers insiders' stock holdings, any conflicts of interests, and the number of independent directors on the board.
An insider on a board often gets paid an exorbitant fee. If a board member has "a relationship with the company through affiliates, then they're not independent and we're not certain they're going to do what's best for investors," says Bard at Renaissance. Insider transactions with an affiliate that may not have been done on an arm's-length basis, such as with a supplier, also set off alarms.
How eager insiders are to sell their shares may also send a warning. If the preliminary prospectus says that founders and officers are selling 30% or more of the number of shares being offered, it could signal a rush for the exits, says author Tom Taulli in his book, Investing in IPOs, Version 2.0.
Hodel says he likes to see a company with a motivation to do an IPO for reasons other than the strength of recent valuations. "If it's just a cash-out for insiders, that's a bad sign."
A good example is MasterCard (MA), which went public in May, 2006. Some of the banks that owned MasterCard saw a public offering as a way to take some of the litigation risk associated with antitrust lawsuits off themselves.
"Our analyst looked at the company and determined that the litigation risk was more a matter of perception, that it wasn't as big a deal, as some people thought," says Hodel.
The MasterCard example also highlights the need to peer below the surface of typical market concerns. For example, any mention of litigation risk in a company's S-1 is generally treated as a red flag that shouts "Beware" to would-be investors. Stated risks should be weighed in the context of how big an impediment to growth they may be. If the worries that a risk gives rise to aren't warranted, it can just as easily be an opportunity.
Investors would be wise to scrutinize not only the company offering the shares but also the financial institution underwriting the deal. The first question is how confident the underwriter is that there's enough demand for all the shares being offered. If a bank offers shares on a firm commitment basis, it's a sign of confidence in the quality of the stock, while offering to sell shares on a best-efforts basis shows some trepidation.
The size and reputation of the underwriter can also send a signal to investors: "The general rule of thumb is either to stay away from or take a closer look at companies being underwritten by third-tier underwriters that don't typically do IPOs," says Bard. "They don't have as long a track record, but also the companies they're taking public are less-seasoned companies."
One trait that distinguishes the so-called top-tier banks from others is their relationships with the largest institutional investors, such as major mutual fund companies. By using a top-tier underwriter, a company has a better chance of placing its shares with the most reputable institutional investors. But even the best-regarded underwriters do their share of less-than-stellar deals, Bard warns.
Certain underwriters have more expertise in particular sectors, perhaps because they have a trustworthy analyst covering a given industry. Morgan Stanley (MS) and Goldman Sachs (GS) are known for their skill with technology companies, which can serve as a kind of stamp of approval, Bard says.
An IPO may look good on the surface, but the involvement of a second- or third-tier underwriter can make investors suspicious and can cause some of the top institutional investors to hold off and question why a more respected bank isn't managing the IPO, he says.
But a less-well-known underwriter doesn't always mean there's reason for concern. A small shop may have specific knowledge of an industry that makes it more qualified to handle the IPO than a bigger firm.
Morningstar is beginning to take a closer look at the shareholders behind IPOs as another way of gauging a company's underlying value, Hodel explains.
"This is going to be especially important as more private equity firms come public," he predicts. "We're getting a sense of who the better private equity or venture capital firms are [in terms of] how well they pick their investments, how they value them, how disciplined they are in what they pay for them, how well they operate them after taking control of them."
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