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EXIT STRATEGIES

No Tech, No Takers
 

Various Inc. writers examine eight myths about going public that the 1996 market shatters.
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Eight myths about going public that this year's market shatters

Thinking about taking your company public? This may not be the year to depend on conventional wisdom about the initial-public-offering market. We present eight myths to ponder.

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1. In this market, high tech is the name of the game.
In recent years IPO dockets have been crammed with companies in sexy growth areas -- medical technology, software, anything for the Internet. With the stunning valuations racked up by the likes of Netscape, Pixar, and other hot technology outfits, one might wonder, Can a company in a more mundane business also hit a bonanza?

In a word, yes -- particularly if it looks as if it can be a dominant player in its industry. There have been more than 2,300 IPOs in the past four years, and portfolio managers at the biggest investors -- mutual funds -- look for industry winners, no matter the industry.

A few examples:

( Baby Superstore Inc., based in Duncan, S.C. Founded in 1971, this retailer went public in September 1994, pricing its stock at $18. By the time the offering closed, however, the price had jumped to $34.75, raising some $40 million. "It was one of the most successful retailing IPOs over the last couple of years," says Marcia Aaron, a retail analyst with Alex. Brown & Sons in San Francisco, who covers the company. Now it boasts a market value of around $700 million. We're talking diapers here, along with clothing, furniture, toys, shoes, and other baby needs -- a category killer for tykes. Baby Superstore is the first superstore in its sector and expects to add 20-odd stores this year, bringing its total to 80. "They are exploiting a very large market, $23 billion and growing," says Aaron, "and they'll hopefully do in this sector what Home Depot did in home improvement."

( Sunglass Hut International, based in Coral Gables, Fla. Public since 1993, Sunglass Hut developed sunglasses as a separate retail category and then claimed it. Its IPO brought in $64 million. As the company has tightened its grip on the category, investors have opened their wallets wider. Its stock price has shot from $5 at the IPO to about $31 recently, adjusted for stock splits. Multiplied by the 55 million shares outstanding, that works out to a market capitalization of more than $1.7 billion -- for a company with earnings last year of $28 million on sales of $418 million. "Sunglass Hut's valuation is basically the size of the premium sunglass market, so the valuation is as large as the sector it's in, and it owns only one-third of it," says David Buchsbaum, who tracks the company for Southeast Research Partners, in Boca Raton, Fla.

Borders Group, based in Ann Arbor, Mich. In 1994 Kmart spun off its Borders Books and Waldenbooks divisions. The two joined forces as an independent entity and went public in May 1995, raising $500 million. Waldenbooks has been stable at about 1,000 stores and $1 billion in sales. But Borders Books superstores have grown explosively in the 1990s. Chris Vroom, senior retail analyst at Alex. Brown in Baltimore, says, "From a growth standpoint, Borders is one of the best-?positioned companies in all of retail." There were 75 Borders Group superstores in 1994, doing $12 million; by the end of last year, with the company at 116 stores, sales hit $700 million. Another 40 are opening this year.

The stock is up nearly a third since the IPO, from $14.50 to $26.75, bringing the market value to more than $1 billion. On revenues last year of about $1.7 billion (for Waldenbooks and Borders), earnings hit 85¢ a share, which makes the price-earnings multiple an above-average 31.

-- Jay Finegan

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2. If you're doing OK, don't worry about the aftermarket.
The first 9 or 12 months after an IPO are especially critical, according to Boston securities lawyer John Piccione, a former investment banker. "Believe me," he says, "the analysts will kill you if you're wrong about those early quarters."

Even a tiny disappointment can savage a stock, as Diamond Multimedia learned the hard way. A computer-products outfit based in San Jose, Calif., Diamond went public in April 1995 on the heels of its best year: revenues had jumped from $130 million in 1993 to $203 million in 1994 (and then to $467 million in 1995). The company had been consistently profitable for four years.

In January analysts were looking for fourth-quarter earnings of 42¢ to 45¢ per share for Diamond. "We would have hit the high end of that range," says chief executive officer Bill Schroeder, "but we had an unexpected inventory variance, so we reported 40¢. They didn't like that."

Indeed not. When Diamond announced its results, on January 18, its stock plunged from $26 to $16 in two hours. Schroeder isn't na—ve about Wall Street -- Diamond is the third company he's taken public -- but he was startled by the "panic reaction." He addressed his workforce that very afternoon. "I wanted the employees to know what was going on, so they wouldn't be distracted," he says. "I told them that Wall Street is driven by people who have a phone in each ear and a cup of coffee in one hand and a cigarette in the other, and they trade stocks like commodities." -- J.F.

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3. The analysts will follow you through thick and thin.
The burgeoning IPO market makes it tough for analysts to follow every deal. And when analysts abandon coverage, a company can fade into stock-market oblivion, becoming, in Wall Street lingo, an orphan.

"There's a limit to the number of good analysts," says Kevin Landry, CEO and managing director at TA Associates, an investment firm in Boston. "With so many deals coming through, at some point analysts have to pick and choose, and they're going to choose the companies with great long-term prospects -- that's how their firms make money."

Bob Cook, senior editor at Going Public: The IPO Reporter, agrees. "There are so many small deals out there that nobody has time to look at all of them," he says. "Therefore, when they do come out, there's not the interest that there would be otherwise. It's happening already, where companies drop 10% or so because nobody has had time to read their prospectuses."

"Analysts are key to building a market for a stock," Landry adds, "so when you slip off their charts, it's brutal. All you can do is hunker down. Once you get a decent track record, you can try to get people interested again, but it's not easy."

Fortunately, it's not impossible. Quarterdeck Corp., a software company in Marina Del Rey, Calif., is one former orphan that has escaped the NASDAQ catacombs. Public since 1991, Quarterdeck saw its stock reach $26 and then tank in 1992. "Two years ago this company was considered dead," one analyst says. "People thought Microsoft was incorporating the same technology into its software. They wondered, 'Who needs Quarterdeck?"

For more than two years, Quarterdeck stock limped along in the $2 range. It began ticking back up in early 1995, when new CEO Gaston Bastiaens began making acquisitions and broadening the company's line, bringing in a number of products in the white-hot Internet sector. Revenues rose briskly as those deals kicked in, hitting $70 million last year, up from $38 million in 1994, while net income turned positive by $4 million after a $19-million loss a year earlier. As the turnaround gathered momentum and analysts reactivated coverage, investors began to take an interest, and the stock reached $39 last year.

Most orphans aren't as fortunate or as flexible, and entrepreneurs contemplating an IPO during the current frenzy should think twice. "When the market is this receptive, it tempts companies to go public even though they'd be better off waiting," says Jim Scopa, a San FranciscoÑbased managing director for Alex. Brown. "Bad things can happen if they have unexpected setbacks and investors lose interest. Being public is not necessarily nirvana for every company." Bob Keefe, a partner at the Boston office of Coopers & Lybrand, points out that outside forces can wreak havoc as well. "If the economics of this market shift" -- for example, if interest rates change, the money dries up, newly public companies show poor results, or your company's concept falls out of favor -- "the weaker companies will become orphans."

-- J.F. and Jerry Useem

* * *

4. The young entrepreneurial companies will continue to be in the spotlight this year.
Not necessarily. Spin-offs from major corporations are currently the hottest segment of the IPO market. Offerings like the split-up of AT&T and H&R Block's spin-off of CompuServe "are going to take a lot of attention away from the smaller companies that we saw last year," says M. William Benedetto, who heads the investment bank Benedetto, Gartland & Greene in New York City. "People are going to be focused on big companies, big deals. The analyst, for example, who might have had time to study a fast-growing company in the telecommunications business is going to be told by his boss to look at the AT&T spin-off."

But all is not lost for smaller companies. High-tech companies will enjoy another warm reception this year, although IPO analysts say that their altitudinous price run-ups will come back down to earth. As investors become more discerning about Internet stocks, don't expect to see so many triplings and quadruplings right out of the block. A few areas in the Internet sphere are just starting to heat up. Creators of search engines should be hot. Companies that provide secure on-line financial transactions will be in vogue. And waiting in the wings are content providers, such as University Online, that might plunge in if the first wave secures a stable beachhead.

Most analysts, furthermore, agree that a broader variety of companies will go public in 1996 as businesses from less glamorous industries try to capitalize on the technology-led IPO frenzy stirred up last year. Specialty retailers, health-care-management companies, and theme restaurants (headed up by Planet Hollywood) are all in the running to have a banner year. -- J.U.

* * *

5. You need to be profitable to get a high valuation in this market.
That's less true today than ever. The prodigious sums pouring into stock mutual funds -- $129 billion last year -- are fueling a huge demand for and a high valuation of new stock issues, even for companies running in the red. "These high valuations we've been seeing are a function not so much of companies' numbers as of their future projections," says Keefe of Coopers & Lybrand. "People are buying stock based on a company's story or concept rather than its financials."

The most dazzling example of 1995 is Netscape Communications, maker of the Netscape Navigator for the World Wide Web. The California software phenomenon went public last August, with operating losses of $4.6 million in the two quarters before the IPO. But companies of more modest scope are getting attractive valuations in today's market even when they haven't yet turned a dime -- and might not for some time.

In 1993, when Focus Enhancements, of Woburn, Mass., went public, it had been in business just over a year. Founder Thomas Massie was only 31. And the company that year reported losses of $3.8 million on sales of $3 million. But Focus held a few aces. Demand for its graphics software was building. Its board of directors included former top brass at Apple Computer and Atari. And Massie himself had already started and cashed out of another public high-tech company. The offering raised $6 million, giving Focus a market value of $17 million. Aided by that capital infusion, the company turned profitable by $1.2 million last year as sales hit $18 million.

For the Italian Oven, with headquarters in Latrobe, Pa., IPO success hinged on a business opportunity. Investors liked the chain's market positioning -- moderately priced dining on suburban fringes. Despite steady growth to $16 million in revenues, the company hadn't turned a profit by last November, when it went public. It had reported operating losses of $1.8 million in 1993 and of $2.8 million in 1994. And the IPO's timing was bad, right before Thanksgiving, the tail end of a banner year for investors. "They had made a lot of money in high-tech stocks over the last year, and we came along with a little meatball-and-spaghetti deal. It didn't have much sizzle," says CEO Jim Frye, who launched the company in 1989. But when the IPO dust cleared, the company was $14.5 million richer. It didn't turn a profit until January 1996. -- J.F.

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6. Of course, you want to be the next Netscape.
So lavish has been the attention bestowed on the Web-navigating software company that many have canonized its story as the new model for taking a company public.

But it is simply wrongheaded, say many analysts, for the average company builder to emulate the Netscape formula. "I would tell entrepreneurs to pray they're not a Netscape," warns Benedetto of Benedetto, Gartland & Greene. "It's not a model to adopt. In fact, it's one to run from." Huh? Why wouldn't you want to wow Wall Street before showing any profits, go public after just a year and a half of existence, and see your stock price jump fivefold in four months?

Benedetto explains, "It looks awfully good to your net-worth statement for a short period of time, but if your stock zooms up well beyond its intrinsic value, it ends up chomping you in the butt later on." Shareholders, he says -- especially those who buy in near the peak -- start to expect the superhuman growth to continue. When the share price drops from its towering crest, they get acrimonious, insisting that management resuscitate the price with damaging short-term solutions. "The best that companies can hope for is a fairly valued stock, with increases in price representing improvements in the company, not just a hot market or speculation."

All of which will leave many Netscape wanna-bes undeterred. Predicts Rolf Selvig of VentureOne, in San Francisco, "No doubt there will be business plans flooding into people's offices, saying they're going to do it exactly the way Netscape did -- 'Eighteen months, and we're straight to the market!" -- J.U.

* * *

7. During your IPO, you're the center of attention.
Just the opposite is true. To get a sense of your standing in the pecking order, picture an inverted pyramid. At the top, put the institutional investors -- mutual funds, pension trusts, and the like. They control the money pot you want to tap, so they hold maximum leverage. Right below them, slot in the underwriters, the investment bankers who organize and sponsor the deals. In the descending strata, you've got venture capitalists, whose interest is protecting their investments, along with lawyers, accountants, and stock analysts, the foot soldiers of the campaign.

And way at the bottom? That's you. "A lot of people mistakenly think the company is the real client, because it's paying the fee," says Landry of TA Associates. "But the mutual funds keep the game going. The company is just a bit player, a blip on one particular day. It's one deal this year out of 600, and it might not be back in the market for a long time." -- J.F.

* * *

8. Somebody knows where the IPO market is headed.
Investors who regarded last year's IPO market as too chancy have their own blindness to blame for missing the most no-brainer payoff in a decade. On January 29, 1995, a trio of extraordinary signs virtually guaranteed a 12-month advance in stocks -- and, even more profitably, in initial offerings. (Gains in old-line issues boost the volatile IPO aftermarket all the more.) That promise was not seen in such shaky indicators as the CPI or the GDP, but came from a reliable source -- the NFL. What investor wouldn't have rushed to his or her broker, realizing that stocks had risen in 12 of the 16 years that a team from the National Football Conference won the Super Bowl, as the 49ers had that Sunday? Not to mention that the market had closed higher in the third year of presidential tenure 13 straight times and that not once in 110 years had stocks declined in a year ending in 5.

Sunspots and gamma rays also foretell markets, but not so starkly as when, on October 6, 1987, an eclipse darkened the moon, and eight business days later, Black Monday spread darkness across Wall Street. On August 24, Venus, Mercury, Mars, the moon, and the sun had converged in a tiny two-and-one-quarter-degree wedge of sky. That date fingered the top of the 1987 stock market, which soon dipped by half a trillion dollars. It also signaled the coming three-year swoon in IPOs.

It's no surprise, then, that Crawford Perspectives, an investment newsletter based on astronomical activity, boasts a demonstrably better record than the balance-sheet crowd. As for 1995, publisher Arch Crawford urged clients on December 3, 1994, to "cover any shorts and go back to the long position immediately!" For 1996, however, the astral indicators are quiet. "Usually, I have strong opinions," Crawford says, puzzled, "but I just don't see any big deal ahead for this year." -- Robert A. Mamis

Last updated: May 1, 1996




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