Tips on how to find a hot IPO

By Helen Burnett
Globe Investor Magazine Online, May 7, 2008

Visa Inc.’s recent $19-billion (U.S.) initial public offering was a record breaker – the largest in U.S. history, coming at a time when the U.S. IPO market has been slow.

The stock was offered at $44 and rose 28 per cent on the first day. It has now more than doubled to almost $90. What made it so successful?

Bob Gorman, chief portfolio strategist at TD Waterhouse, says the IPO was a “close to unique” situation. Investors have been gravitating towards the safest investments and the IPO found a ready market because of the success of competitor Mastercard’s IPO, Visa’s brand recognition and the nature of its business, he said. There aren’t that many similar operations out there, he added.

So there might not be another Visa IPO coming soon for investors to jump on, but here are some practical tips on how to spot the next one.

Look at history and future prospects.

Mr. Gorman says investors are buying partial ownership of a business, not simply a stock certificate. They should ask themselves if they really want to be part owner of the business.

“If you look at it that way, you may come up with a different answer than whether or not you think it happens to be an interesting idea,” he says. “You have to make a clear distinction between the concept, which you may really like, and the desirability as an investment,” he adds.

Look closely at the track record for sales and earnings growth and future prospects. If the business is new, investors should consider the realistic prospects for sales and earnings, the basis for the projections and industry figures. Investors should also look at how speculative the industry is, what other firms are in the industry and their track records of success, or whether it is something unproven.
What is the reason for the IPO?

For long-established businesses, Mr. Gorman says one of the questions should be, why are they going public now? Are the owners cashing out, and if so, why and why now? If the owners are selling their full stakes in the company, it may be a red flag. Is the business at its peak and are they selling at the highest possible price? If the owners intend to retire, what is the succession plan?
Understanding the history of the financing.

Brian Pow, vice-president research and equity analyst at Acumen Capital Partners in Calgary, says investors need to look at investors in the company prior to the IPO. Understanding the lockup agreements is key. The lockup is the period after the IPO when company insiders are not allowed to sell shares. Sometimes the lockups are time-based and sometimes they are cash-flow generation based, he says. There may be longer-term investors who have a cost base that is significantly lower than the IPO level, he notes. Stocks can often fall after a lockup has expired when insiders with cheap shares are selling heavily.
Use of proceeds.

Investors need to understand what the company plans to use the proceeds of the IPO for, Mr. Pow says. A company may show some good growth numbers but the use of proceeds may be to try to go into another market or try another product. When that’s the case, the market may penalize them, as the year-over-year growth may not be as good as it was in the past, he says.

He cites December’s Bridgewater Systems IPO as an example. The Ottawa-based high-tech company provides subscriber-centric policy management software for IP-based service providers. It completed its IPO last year at $5.50 (Canadian), but has fallen to $2.69 as the market anticipates that the equity already raised will be needed to try to get into new markets, and may cost even more, he says.

A business that is going public to fund growth, such as one where the existing owners are willing to dilute their interest to bring in more cash to finance growth, is generally a good sign, says Mr. Gorman. A recent example of this, he says, was the Lululemon Athletica Inc. IPO in July, which offered 18.2 million shares to the public, or a 30-per-cent equity stake. Of those shares, 2.3 million came principally from the company founder and 15.9 per cent from private equity investors. The IPO raised roughly $250-million, which was largely earmarked for the opening of a number of stores.

For a new business, investors need to ask whether the IPO is being used to finance losses. “That’s not always bad, but you should ask yourself, what is the burn rate?” he says, or the rate at which they’re going to burn through cash. Investors should try to determine the prospects for reaching profitability before the company has to raise more money and sell more shares.
Understand the timing.

The market timing of an IPO should also be understood, says Mr. Pow, and in a tough market, the quality should be better, such as with the recent Visa IPO. “If you’re in a bull market, in a momentum market…then that’s the time to be more careful,” he says.