Tech IPOs Are Back… But Don’t Buy This One

The IPO buzz is building… In a span of one month, the number of IPOs in 2009 doubled. Half have been tech IPOs.

Sure the tally stands at a pathetic six. But with over 100 deals waiting in the pipeline, the uptick is being closely watched.

Even more so, considering that last week’s debut of Digital Globe (DGI) - a provider of satellite imagery used in Google Maps and Microsoft Virtual Earth - garnered interest reminiscent of the IPO heydays in the late 1990s.

Heck, it broke into Google’s Hot Trends list, meaning it was one of the fastest-rising search terms in the world. (That’s no small feat considering it meant beating out pop culture search mainstays Britney Spears, Ashton Kutcher’s twitter record and Desperate Housewives spoilers to name a few).

However, I’ve learned hype seldom translates into profits in the IPO space. In fact, I revealed that I was skeptical about the Digital Globe IPO from the outset.

Sure enough, the aftermarket performance only confirmed my suspicions. Despite pricing above the projected range at $19, and rallying in the first few moments of trading, the stock is now in negative territory.

Nevertheless, the buzz is building about another tech IPO this week. But it, too, should be avoided. Let’s take a look at why. Then I’ll share my proven formula for sifting through the IPO hype to find sure-fire winners.

Tech IPOs: Cancel Your Reservations at OpenTable

On Thursday, the tech IPO, OpenTable (OPEN) a provider of online reservation services for restaurants, will begin trading.

As a frequent user, I’ll concede it’s a convenient service. In a few keystrokes I can guarantee a table at my favorite sushi restaurant, instead of waiting on hold forever or getting an answering machine. And it’s free.

Don’t worry. This isn’t some dot-com company with a clever idea and no revenue stream. It makes money by charging restaurants one-time installation fees (avg. $1,200), monthly service fees (roughly $260) and $1 for every reservation.

A novel concept, for sure. That’s probably why so many investors want a piece of the deal.

Yesterday morning, underwriters increased the pricing range by 31% to $16 to $18. Such a big bump only happens when a deal is oversubscribed.

Why The OpenTable Tech IPO Will Be A Dud

Don’t be so quick to book a seat at this tech IPO, though…

• We all know the restaurant industry relies on the consumer to thrive. In such an abysmal spending environment, OpenTable’s growth initiatives will certainly be hampered.
• Speaking of growth, it’s limited. OpenTable already counts 9,500 of the 30,000 reservation-taking restaurants in North America as customers.
• The best IPO returns come from companies with endless growth potential… Think Starbucks (SBUX), Chipotle Mexican Grill (CMG), or Wal-Mart (WMT) in their infancy.
• Plus, barriers to entry for new competitors are low. And consumers can switch allegiance with a click of the mouse, meaning market share can erode before any efforts to combat it can be concocted.
• Making matters worse, the company’s struggled with profitability, reporting operating losses in four out of the last five years.
• If that wasn’t enough, the valuation is completely out of whack. At the midpoint of the proposed pricing range, shares would be valued at 6.4 times 2008 sales. The average company in the S&P 500 only trades at 1.8 times sales. Even more glaring, OpenTable’s initial price-to-earnings ratio would be a whopping 106!

Even the village idiot knows that’s frothy.

Don’t overlook what insiders are doing either. They’re cashing out 1.4 million shares, equal to almost 50% of the total offering. On average, insiders cash out less than 30%. Seems like they’re tipping their hand about the company’s shaky growth prospects.

We’ll be getting our answers regarding OpenTable shortly. Regardless of whether it soars or dives, the fact that it successfully debuts will usher in more IPOs in coming months.

Three Steps to IPO Success in Any Market

Here are three key steps that I would insist on before buying IPOs in any market:

• Profitability. Sounds obvious, but most companies that flop in the aftermarket lack earnings. Insist on at least two years of profitable operations.
• Long-Term Growth Potential. The reason IPOs can be so darn profitable is because they represent the opportunity to invest in the infancy of a company’s growth cycle. Accordingly, focus on companies with verifiable long-term growth potential. Stick to companies with a market potential that points to a decade or more of heady growth.
• $50 Million or More in Annual Revenues. Research out of the University of Florida confirms revenues are a good predictor of stock performance. The key threshold is $50 million for the 12 months prior to an IPO. Companies below that level underperformed the stock market by a margin of 15% for the next three years. Those above it outperformed.

One more thing, IPOs are just like any other investment. Ultimately, fundamentals win out in determining share prices. So, after confirming the three characteristics above, take some time to dig into the underlying business. The stronger the fundamentals, the greater the profit potential.

Today’s Investment U Crib Sheet

Many new investors hear the term IPO thrown around without ever knowing that it stands for: Initial Public Offering.

IPOs occur when a company wants to list and have its stock traded on the public markets. These can be younger, new companies looking for capital to fund expansion and operations, or it can be older, private companies whose investors are looking to cash out.

Either way, they need to find an investment bank to underwrite the offering. The bank will help determine how many shares will be sold and the price they will be sold at. It will also work at placing the shares with its institutional and individual customers.

Many times they do not know exactly how much interest and what kind of market is available for the offering, so they will quote a price range - Like for OPEN above.

When an offer is oversubscribed, it means they have commitments for more shares than they were authorized to sell. By raising the offering price, they can reduce the number of buyers.

IPOs can mean huge windfalls for early investors. But it should be noted that, soon after the excitement dies down, these stocks become like any other. They become judged like every other stock and can rise and fall just as quickly.

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