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[qi:053] The floodgates are back open for tech IPOs. Since August – a seasonally sluggish month compounded this year with market turmoil – VMWare (VMW), MercadoLibre (MELI) and athenahealth (ATHN) went out with ecstatic receptions. The pipeline could start getting crowded.
There have been notable fizzles as well: HireRight (HIRE) and Orbitz (OWW) are below their offering prices. So this seems as good a time as any to trot out the old lectures about doing homework and reading prospectuses.
Okay, I’ll spare the lecturing, and instead offer five tricks I’ve found that can speed up the evaluation of IPO candidates and shorten the slog through hundreds of pages of legalese. These have worked for me, but are far from definitive. If you have others please share them below.
- Pick your key stats. The first thing I always look at is in the financial table up high: Does the company have an operating profit and, if not, are the losses growing dramatically? Some companies go public with losses and do just fine; but more often they don’t. Then I check revenue growth rates. Then, a bit further down, I look at operating cash flow, and whether that’s growing.
- Compare new filings with old ones. The “risk factors”, “legal proceedings” and “management’s discussion of financials” are all important sections, but can go on for pages. Comparing the most recent S-1 filing with the original will highlight changes that were made in the interim – often at the request of lawyers or the insistence of the SEC.You’d be surprised what can come out in the highlighted text. I use Microsoft Word’s “compare and merge documents” command, which is kludgey but does the trick. If anyone has a better alternative, please speak up.
- Examine the margins. Once a company goes public, investors will be scrutinizing whether profit margins are rising or falling, so you might as well get a head start. There is often a table listing expenses as a percentage of revenue, letting you see in a few seconds whether costs are falling, and whether margins are rising.If margins are falling, it’s not necessarily bad. R&D or marketing costs might be up to plant seeds of revenue growth. Look in the management’s discussion to see if you buy the reason why. If all costs are up as a percent of revenue, that’s not good.
- Follow the money being raised. This can be found in the “use of proceeds” section. It’s like the “how I will change the world” speeches at beauty pageants. Normally a company will say the funds will go to possible acquisitions and general purposes like hiring and R& D. The more detail there, the better the chances that there’s a focused strategy in place.Recently, some companies have used most if not all proceeds from their IPOs to pay existing investors a big fat dividend. That’s not necessarily a sign of a bad company (VMWare did it) but if it happens with a company that has a lot of other red flags in its S-1, it’s a clear warning.
- Check out the bosses’ pay. Steve Jobs may draw a $1 salary and Larry and Sergey may insist on no salary, but they are exceptions. Top executives at companies trying to go public often draw between $200,000 and $350,000. Salaries above $500,000 – and especially $1 million – can be a warning that managers are only in it for the money. Look at the compensation tables in the S-1.Another bad sign can be insiders selling the majority of their pre-IPO shares, or insiders selling more aggregate shares than the company itself is. Still another bad sign is an eleventh-hour plan to issue millions of shares to board members and executives right before the offering. These can be harder to spot.
And finally, a rough idea of potential valuation: Often the company will put something like a “proposed maximum aggregate offering price” on its first page to estimate its registration fees. Divide that by the most recent 12-month revenue figure. If it’s more than 8-10 times revenue, that’s not great. These help give me coarse picture in a few minutes. Your mileage may vary.
Financial prospectuses are often written to appear as intimidating to the layman as possible. But with a little common sense and a few shortcuts like the ones I suggest, you should be able to get a decent, initial picture of whether an IPO is worth your money.