Evaluating IPOs in Today's Saner Market Environment
by Robert Bridges and John Huber
Many investors “swore off” initial public stock offerings after so many IPOs collapsed in the 2000–02 bear market.
But 2004 saw a resurgence of interest in IPOs (initial public offerings). Renaissance Capital’s IPOHome.com reported a total of 216 IPOs, the highest since 2000, raising $43 billion (see Table 1).
The most recent resurgence appeared to be along more traditional lines. Investment bank standards for IPOs had declined over 30 years from a minimum of four years of corporate profitability to little more than a good business model—if that—by the late 1990s. In 1999 and 2000, only a quarter of IPOs were by profitable firms. In contrast, 63% of IPOs in 2004 were from companies generating a profit. Another healthy contrast with the 1990s is that recent IPOs have been diversified across industries instead of concentrated in technology.
The IPO resurgence has lost only a little steam in 2005. IPOHome.com reported a total of 146 IPOs through mid-October, down from 151 over the same period in 2004, raising $27 billion.
Yet many individual investors are still leery of IPOs—they don’t know how to evaluate them, and they fear being played for suckers by insiders.
How can you take a sober look at IPOs in today’s saner environment?
As with all investing, the axiom “caveat emptor” rules, and especially so in the case of IPOs. While most IPOs turn out to be losers, some of the best-performing stocks are recent IPOs. By definition, IPOs have no trading history as a public company, and with limited financial information available, investors are forced to make a decision with more unknowns than when assessing a more seasoned public company. Despite such limitations, IPO investing can be profitable. In this article, we’ll show you how to evaluate IPOs using an investment decision process that is substantially identical to that of any equity investment decision.
The Investment Decision
The first step involves an assessment of the investment’s merits and risks.
We feel long-term investors are best served by focusing on high-quality companies that exhibit strong sustainable growth prospects and have reasonable valuations—these firms offer the greatest potential for long-term share price appreciation.
Identifying high-quality companies can be daunting, but focusing on the common characteristics that define a “high-quality” company helps identify the outperformers. These characteristics include:
- Strong competitive positions,
- Highly visible future growth prospects,
- Excellent profitability,
- Superior management teams, and
- Reasonable valuations.
These characteristics, while extremely important, apply to all stocks, not just IPOs. For that reason, we include a summary of what to look for in the accompanying sidebar on pages 12 and 13. In this article, we will focus more specifically on IPO analysis, which has additional considerations.
Road Shows: The IPO Process
First of all, what exactly is an IPO?
An IPO is the first sale of stock to the public by a company or existing shareholders. IPOs are undertaken for a variety of reasons and can occur at different points in company life cycles. Since an IPO is first and foremost a financing mechanism, companies in growth phases are more likely to undertake IPOs than those in mature steady-state phases. However, assuming willing investors, there is nothing that precludes a company at any stage in its life cycle from completing an IPO.
The IPO process begins when a registration statement, called the S-1 or red herring, is filed with the Securities and Exchange Commission (SEC).
After an iterative review process, the SEC declares the filing effective. From the time of initial filing until 25 calendar days post pricing, the company is in the “quiet period,” which is an SEC- imposed ban on all written or verbal promotional publication. An exception to the quiet period occurs after the S-1 has been declared effective, but prior to pricing, and it is known as the “road show.”
During the road show, top company executives and underwriters’ sales forces meet with prospective investors to communicate the company’s story. Individual investors can gain access to road show materials through a company’s underwriters.
Traditionally, IPOs have been sold on a fully underwritten or a best efforts basis. In a fully underwritten deal the underwriters guarantee a price (to the company) for all of the shares being offered. Best efforts deals are those where underwriters do not guarantee a price, but will use their “best efforts” to sell the shares being offered. The underwriters’ target pricing range typically values the IPO at a slight discount to its comparable public peers. Ultimately, IPO pricing is a function of demand.
As the road show culminates, the underwriters aggregate their order books and determine the market clearing price at which the IPO can be offered. Given the market clearing price, the company and its board will determine whether or not to proceed with the offering.
More recently, the IPOs of Google and Morningstar witnessed the emergence of a Dutch auction pricing mechanism. A Dutch auction uses a bidding process to find the price at which an issuing company can sell all its available shares, diminishing the underwriters’ pricing role to auction facilitator. From the seller’s perspective, the price determined in a Dutch auction should be optimal, as it is set purely by the supply-demand balance. While new to equity markets, Dutch auctions continue to be the method used for U.S. Treasury auctions. The future use of Dutch auctions to price IPOs is uncertain.
The S-1: Understanding the Firm
Even more important than understanding the IPO process is reviewing and understanding the information provided in the S-1 statement. Although voluminous, the S-1 is a must read for any IPO investor. These documents will provide you with your most basic understanding of the company.
The S-1 of any IPO is available on the SEC’s Web site (www.sec.gov). When retrieving an S-1, make sure that the most recent amendment is selected.
Although the S-1 is your most valuable source of information, recognize that the company, its underwriters and lawyers craft the S-1 to properly communicate the company’s story from their perspective. Also recognize that the SEC review process is focused on the company’s compliance with filing requirements and not a review of the facts.
Start reviewing the S-1 by identifying the underwriters. Are the underwriters marquee bulge bracket firms or are they unknowns? If you do not recognize the underwriters, a Web search is warranted, as there are a number of lesser-known, reputable regional and boutique underwriters.
Next, review the prospectus summary, which contains an executive overview of the business, key risk factors, summary financial information, information on the offering and other key data. This high-level overview determines if the IPO fits a specific investment strategy or if it should be investigated further. It also should allow you to evaluate how well the company meets the characteristics of a high-quality company with sustainable growth prospects.
Here are some IPO-specific issues you should evaluate.
Focus on the company’s operating history. Reviewing the financial statements and business sections will provide detail and allow you to answer some important questions:
- How long has the company been in existence?
- Is the company seasoned or is it a private-equity-sponsored roll-up that has been financially engineered? In an effort to create value, private-equity sponsors will “roll-up” industry segments by purchasing a platform company and making multiple acquisitions. Here the concept is that the sum of the parts is more valuable than the individual parts. Such roll-ups are not necessarily bad, but they carry additional risk.
- Should the company even be a public company? The late 1990s were a time when venture capitalists and private-equity sponsors took nascent companies public, shifting traditional private-company early-stage risk to public-market investors. Generally, this strategy turned out to be extremely profitable for the equity sponsors and particularly unprofitable for individual investors.
Management Ownership and Selling Shareholders
Pay attention to management ownership and selling shareholders.
Are the IPO shares primary or secondary? IPO primary shares are shares offered for sale by the company and secondary shares are those offered for sale by existing shareholders. If the shares are primary, how does the company plan to spend the money and what does the capitalization look like post-offering?
If the shares are secondary, who is cashing out? Is management cashing out? Are members of management subject to lock-up agreements prohibiting them from selling shares for a period of time?
Use of Proceeds
Underwriters reserve the right to issue an over-allotment of up to 15% of the offering. Where might the proceeds from the over-allotment be headed? Companies go public for a variety of reasons including capital needs, liquidity needs or a desire to have a publicly traded stock to use as acquisition currency. What is the reason in this instance?
Other Sections to Note
There are no right or wrong answers to these questions, but the combination of answers should be considered in the context of the overall opportunity.
The other sections in the S-1 merit a superficial review, including the risk factors. However, the risk factors are filled with legal-ese and written to cover any conceivable risk short of an ice age. [For a summary of what to look for in a prospectus, see "The IPO Prospectus" in this issue.]
One difficulty all investors face is the issue of valuation. Obviously, you do not want to overpay for any stock. But how do you put a value on a stock that is new?
Of course, value is a relative and subjective concept—after all, the value of anything is what someone is willing to pay for it.
There are many common valuation techniques for stocks, including multiples of various ratios, discounted cash flows and dividend-discount models.
Investment bankers set IPO pricing ranges using comparable company valuations. This is the best place to start assessing value. Understanding how Wall Street analysts value comparable companies should provide insight as to how the market will value a specific IPO. The valuation techniques utilized by analysts provide the most insight, regardless of whether they are the most theoretically sound or appropriate. The best place to find this information is in sell-side analyst research reports.
Determining the value of a company is difficult and comes with experience. IPO or not, we find it helpful to look at the implied valuation and ask: Does this value make sense given the opportunity? How realistic is the valuation given the company’s growth prospects?
Try to avoid unsustainable values driven by momentum investors—the drivers behind “hot” markets and “hot” issues.
The IPO Market Environment
Generally, when equity markets are strong they are more receptive to new offerings, even those with non-traditional business models.
In hot IPO markets, more poor-quality issues will be completed than would have otherwise under normal conditions. Going public in a hot IPO market says little about a particular issue, but successfully pricing in a difficult IPO market lends credibility to the company.
Similar to hot IPO markets, there are hot IPOs. Deciding whether to invest in a hot IPO can be particularly precarious.
Hot IPOs are notoriously volatile and have a unique element of uncertainty driving the hype. Determine why an issue is particularly hot and what may be fueling the speculative demand. Paying a premium for a hot IPO may be a good investment decision, if the decision is based on fundamental facts, not hype.
How do you identify hot IPOs and hot IPO markets? This is really a subjective determination. Hot IPOs are those that generate considerable “buzz” in the investment community and are generally, in retrospect, characterized by too much demand relative to supply. Similarly, hot IPO markets are those where there is considerable demand for IPO issues and more marginal-quality issues get completed. A high level of IPO activity can be an indicator of a hot market.
Different Timelines for Success
When in doubt, err on the side of caution and wait to see how the company performs before investing. Waiting will flush out short-term holders and allow a trading history to develop.
Many investors fall into the trap of feeling like they need to invest on the day an IPO starts trading or they will miss the opportunity. This is not necessarily the case—IPO investing can follow several different timelines.
A good example is Alcon Inc. (ACL), a market leader in the ophthalmology industry. Demographic trends and a promising drug pipeline positioned the company to execute its growth strategy, and the company has a long history of growth and profitability. The IPO came out in March 2002. Our firm waited and established a position in May 2002, several months after the company’s IPO. Since then, the stock price for Alcon has appreciated over 200%.
Successful IPO investing, like all investing, involves committing significant time and resources to investment analysis and portfolio monitoring. [For sources of information on IPOs, check out the box on this page and the Hot Links article in this issue.]
The additional uncertainties associated with IPO investing make it more treacherous than traditional investing and, accordingly, it is more difficult, especially for part-time investors. If you are daring enough to test the IPO market, remember to do your homework and consider all the facts and circumstances when making investment decisions.
Focus on making sound decisions and don’t get caught up in market hype and timing. While it is frustrating to miss part of the price appreciation, that frustration pales in comparison to the pain of buying an overvalued, hyped-up, poor-quality stock.
Sources of Information on IPOs
There are many sources of information on IPOs. Most are now Web-based, and for a listing of these you can turn to the Hot Links article.
Those without Web access can check out the latest offerings in the Market Laboratory section of Barron’s, which each week lists expected IPOs and new initial offerings filed.
In addition, daily periodicals such as the Wall Street Journal and Investor’s Business Daily provide IPO pipeline information.
5 Steps to Identifying High-Quality Companies With Sustainable Growth Prospects
1) Strong Competitive Position
Understanding the company’s position within its industry context is critical. High-quality companies have dominating market leadership resulting from unique businesses that cannot easily be replicated. Such businesses enjoy competitively advantageous positions fortified by high barriers to entry. Technology, patents, brands, intellectual property, capital investments, low cost advantages, regulations, and contractual relationships are among the types of barriers that create defensible competitive positions.
Identifying how a company competes can provide insight:
- Is the company a low cost producer like Dell?
- Does the company differentiate itself through branding like Starbucks?
- Does the company have a regulatory advantage like Moody’s?
- Would the company’s business model be extremely difficult to replicate like eBay’s?
Focusing on the key competitive advantages and assessing the defensibility of those advantages provides insight about performance sustainability.
Often market leaders are first movers, creating new industries with their products and services. Being the first to market is often important in establishing dominant market share. However, first movers without defensible competitive positions will fall victim to competition. Try to avoid “me-too” competitors. The people who benefit from investing in “me too” firms are the private-equity sponsors who identify the opportunities early, fund these companies and shortly thereafter sell them to public investors.
2) Highly Visible Future Growth
Earnings increases propel stock prices, and the market values visible growth at a premium. Identifying companies poised to deliver growth involves assessing the company’s business model and the underlying drivers for the company’s product or services.
Industry trends and dynamics deserve attention. Is the industry new and growing or is it mature and declining? How does the industry benefit from demographics, new technology, globalization, outsourcing or other trends? Is there pricing pressure or power at the supplier and customer levels? Assess how these macro influences impact the company. What is the company’s growth strategy? Is the company gaining or losing market share?
Visible growth is a by-product of high-quality business models. Understanding a company’s business model provides insight about visibility and tells the investor how the company generates cash. This is made easier by following Warren Buffett’s suggestion: Invest in those businesses that you understand.
The most visible business models are those with high percentages of recurring revenue. The nature of the product or service and the manner in which it is sold impacts visibility. Products and services that require repeat purchases, updating or maintenance enhance visibility. Long-term contracts and subscription-based pricing also enhance visibility. Companies such as the newly public Morningstar provide significant visibility, as over 70% of its revenue is generated from existing contracts and contract renewals.
On the other end of the spectrum are emerging biotech companies that may never generate revenue. While successfully identifying the next biotech blockbuster will provide a windfall, the chances of such an occurrence are extremely remote.
3) Excellent Profitability
High-quality companies have excellent profitability (which we define in terms of a company’s ability to generate free cash flow, which is the cash available after satisfying all other obligations including debt).
While profitability is industry relative, the highest-quality companies are also the most profitable. During the Internet boom, the concept of profitability was forgotten as companies were valued on multiples of projected revenues or such metrics as “eyeballs per click.” When the bottom fell out, many investors were reminded about the importance of profitability.
Profitability is a function of many variables ranging from price elasticity for products and services to a company’s cost structure. Understanding a company’s cost structure is useful, as it provides guidance on future profitability. Is the company a high-fixed-cost, low-variable-cost business, or vice versa? High-fixed-cost, low-variable-cost businesses experience operating leverage when they grow.
The Chicago Mercantile Exchange, which had an extremely successful IPO in December 2002, is a great example of strong operating leverage. The company has made massive infrastructure investments to establish its exchanges, yet the variable cost of additional volume is essentially zero. As the firm grows it becomes more profitable.
Traditional ratio analysis focusing on margins and return on invested capital provides insight into profitability. Pay attention to changes in profitability over time and look for the catalysts. What is driving the change and is it a temporary phenomenon or a permanent shift?
4) Superior Management
The more you know about a management team, the better. It is difficult to assess competency from a carefully crafted executive biography. Yet, more often than not, a successful management team will have a history of success. Look for industry knowledge and leadership experiences. Is the management team deep or dependent on an individual?
Also review management’s ownership and quantify how much they have at stake. Take advantage of opportunities, such as webcasts or conference calls, to hear management tell the company’s story.
5) Reasonable Valuation
The last significant consideration is what price to pay for a high-quality company. Typically, high-quality companies have premium valuations. This also means that when the company stumbles, negatively surprising the market, its valuation will be punished in the short term. However, while nobody wants to overpay, investors should not be afraid to pay a premium for a high-quality business. Focus on high-quality companies at reasonable valuations.
John Huber is a principal of Geneva Investment Management of Chicago, LLC, an independent investment management firm located in Chicago and owned by its professionals. Geneva provides fee-based customized portfolio management services to individuals and institutional clients throughout the U.S. Geneva can be reached at 800/505-1720 or through its Web site at www.gimllc.com.