Second Quarter's IPO Market: Slower, But Quality Reigns In

By Jeffrey R. Hirschkorn, Senior IPO Analyst

Certainly, one can't dispute that the markets during the second quarter went on several different patterns. Some good while some were bad! First and foremost, President Bush led a coalition of forces to finally rid the world of Saddam Hussein. Albeit, the war, according to defense analysts, was concluded in record fashion and despite some late casualties a new government seems to be taking shape in Iraq and liberating the citizens of that country with democratic values.

Has stability actually returned to the marketplace? We can only hope that last week's Federal Open Market Committee action on interest rates could help. In its June meeting, the FOMC lowered interest rates by 25-basis points in an effort to help jumpstart a sagging economy. Economists interviewed by IPO Monitor foresee that better growth could be just a blip on the radar. Why?

Consumer Spending Could Encounter Resistance

Once the effects of the tax cut and the money the FOMC is sending sloshing into the economy wane – employment will be a key. Consumer spending could run into complications if the labor market continues to deteriorate. June's employment report, due out on Thursday, is likely to show a rise to 6.2% with an additional 5,000 jobs eliminated during the month.

For the stock market the problem is much simpler: Valuation. With the big run in share prices, the market's beginning to look rather expensive. That is extremely true with so many issues, including some of our year-ago IPO highlights which will be discussed later in the review. The market will be tested over the short-term with confession season beginning to pick up over the next couple of weeks. Pundits feel that the market could take a hit as more companies issues forecasts for the quarter ended June 30.

Strong Quarters for Major Indexes

The quarter managed to see strong return for the major market indexes and better days could lie ahead if the markets run the course predicted by strategists. In the three months ended June 30, the Dow Jones Industrial Average rose 12.4% while the S&P 500 ascended 14.9% and the tech-laden Nasdaq Composite jumped an impeccable 21%.

Research done by IPO Monitor indicates that the second quarter performance by the S&P 500 and Dow were the best three-month period since the final months of 1998 when the S&P 500 returned 20.9% and the Dow rose 17.1%. The Composite posted its best quarter since early 2001 when it skyrocketed 30.1%.

Fast Facts on Q2 IPOs

There's no quarrel that deal flow remains at levels not seen in over 30 years. For the quarter, there were five deals, with one pricing below $5 to debut. Average deal size: $312 million with $1.6 billion raised for the period, of which the majority came from two-late quarter real-estate-investment-trust IPOs. Performance of the quarter's IPOs was also a key measurement to the breed of companies introduced by the Street's underwriting force. By June 30, the average return for deals that debuted in the second quarter was 19.2% and no deal finished on the negative side.

As stated in numerous analyses on this site, profitability and attractive valuations are now in high demand by the investing public. Can you blame them? After all, these investors lost billions of dollars in failed dot-com entities and violation of ethics by bankers such as Frank Quattrone and Jack Grubman, an analyst of the former Salomon Smith Barney. Just to call him an investment professional gets me sick to the stomach. Luckily enough, he's banned from the securities industry.

With deal flow at record lows, we have continued to see investment banks partner up and share book allocation roles. Such duties are classified as joint book running positions. The benefits to an issuer include a more in-depth distribution of shares throughout the investment community. This was especially true in the quarter's REIT offerings.

Second Quarter Deals

• iPayment (ticker: IPMT), an online payment processing firm finished the quarter up 49% from its offering price of $16. The company priced five million shares on May 12 through Bear Stearns. The offering, with high expectations, priced at the high-end of range price talk.
• FormFactor (ticker: FORM), a firm involved in semiconductor measuring and testing, ended the quarter up 26%. Morgan Stanley led the underwriting syndicate to price six million shares at $14. Such terms were above amended talk of $11-$13. Initial structure for the deal called for the sale of 5.1 million shares at $9-$11, but owing to overwhelming demand from the institutional investment community, the underwriters raised the bracketing for the transaction.
• American Financial Realty Trust (ticker: AFR), a REIT involved in acquiring and operating properties leased to regulated financial institutions, finished the quarter up 20% from its late-June offering price of $12.50. The IPO managed to price at the high-end of its range. After several revisions, the deal priced at an increased level of 55.95 million shares. Underwriters were co-led by Banc of America Securities and Friedman Billings Ramsey.
• Maguire Properties (ticker: MPG), a REIT that is the largest owner and operator of office properties in Los Angeles ended the quarter up marginally. Offered at $19, the company sold 36.5 million shares through joint lead managers Credit Suisse First Boston and Citigroup Global Markets. The IPO priced 36.5 million shares, up from an earlier target of 33.4 million shares. Typically, REIT deals are of good interest to the public because of the tax environment that mandates REITs pay out 90% of their net income in the form of a dividend to shareholders.

Even though, we mentioned the fifth deal in our statistical rankings of the quarter, it should have been excluded because it priced below $5. Redline Performance Products (ticker: RED), a firm that designs and develops snowmobiles, priced its IPO below talk of $5-$6 at $4.50 [while selling 2.2 million shares] through GunnAllen Financial. This company listed shares on the American Stock Exchange.

Compared to a Year-Ago

Obviously, deal flow for the second quarter of 2003 is way behind the comparable period in 2002 when 33 IPOs totaling $4.1 billion priced. In today's environment, issuers are more selective in structuring IPOs. Quality of deals has vastly increased. Selective nature stemming from criminal violation activity of bankers has led to more scrutiny of deals seeking release from various regulators before they can publish pricing terminology.

Underwriters have eliminated highly risky offerings and rather obscure deals from even filing with regulators. Although, the effect from weaker deals filing in other time periods did cause eight companies to withdraw respective IPOs. One deal that may encounter investor resistance is online retailer RED Envelope: (ticker: REDE), a $41 million transaction, with widening losses that filed recently to sell stock via the OpenIPO process at W.R. Hambrecht + Co. Although, Overstock.com (ticker: OSTK), another online retailer that debuted through the Dutch auction system in 2002, has done well after falling on hard times early on. But that was then and this is now!

Effects from ethics violations have increased pace to separate research and banking initiatives. As such, many upper tier firms have created entities to do just that. Look at Citigroup. It formed Citigroup Global Markets to house all investment banking activities and resurrected Smith Barney to manage all research functions. It eliminated the Salomon name all together.

Q2/02 Stars: Are They Still Around?

A quick review of our historical database reveals some interesting action amongst last year's second quarter IPO darlings. Two of the quarter's biggest stars: Netflix.com (ticker: NFLX) and JetBlue Airways (ticker: JBLU) have continued to reward shareholders with strong returns in the marketplace.

Netflix.com, an online DVD subscription service based in Los Gatos, Calif., is up 70% from its May 23, 2002 offering price of $15. IPO was led by Merrill Lynch. Shares still rose despite increased competition from Wal-Mart. Wal-Mart rolled out a new DVD rental plan for $15.54 a month during the quarter. Still, the company upwardly revised guidance in June for its second quarter profit outlook. Netflix.com now foresees second quarter net of $3-$4 million, up from a prior indication that it would post a loss of $600,000. It also raised expectations for second quarter revenues to $62-$64 million, up from earlier projections of $60-$64 million.

JetBlue Airways, a Kew Gardens, New York-based airline has certainly had a lot to smile about since going public in April 2002 through Morgan Stanley. Profitability continues to be the main thrust to robust financial growth, and it has rewarded shareholders accordingly. Adjusting for a stock-split in December 2002, the stock is up 135% since its IPO. But, some banks, while maintaining bullish stances on a long-term basis, are concerned with the firm's lofty valuation. This has prompted actions to alert the public about near-term concerns on JetBlue. We mentioned this earlier in the review as a major concern of market pundits.

"The largest fundamental risk to JetBlue is execution failure (especially cost) due to rapid growth, although the company's track record to date is excellent," said Lehman Brothers analyst Gary Chase in a report on JetBlue. "Competitive retaliation from incumbent network airlines, including matching some of JetBlue's product attributes, dumping large volumes of capacity in major JetBlue markets, and developing separate low-cost subsidiaries, is also a risk."

Furthermore, the report, which maintains a neutral rating on the stock, added: "Given the enormous cost advantage that JetBlue enjoys, however, any retaliation would likely be short-lived. As for low-fare subsidiaries, these operations historically have failed. Lastly, a crash or operational blunder could undermine JetBlue's performance."

"We downgrade JetBlue to a peer perform from outperform solely due to valuation," said David Strine, an airline analyst at Bear Stearns in a June 20 report. "This change does not mean that we have found a problem with the JetBlue business model or earnings growth prospects. In fact, we are not changing our estimates. We continue to believe that JetBlue is demonstrating excellent execution of a sound business model. Near-term, however the valuation has become rich given our earnings forecasts (which are at the high-end of the Street range)."

Winners: 2003 Year-to-Date

The year might not have witnessed a large roster of debutants, but as we discussed above, a flight to quality initiative has been implored by investment bankers. In this market, financial-services companies, such as ones involved in providing mortgages, are good candidates for upward momentum. As such, the success of Accredited Home Lenders (ticker: LEND), a San Diego-based mortgage provider that caters to clients with credit concerns, is no surprise to market pundits. Offered at $8, the low-end of price talk, through Friedman Billings Ramsey, the company and selling shareholders sold 9.65 million shares on Feb. 14. By quarter's end, shares of Accredited Home closed at $19.21, generating an aftermarket jump of 140%.

Stock momentum has been powered by increased financial guidance by company management. On June 9, the company raised guidance for its second quarter and full-year expectations, citing record-low interest rates fueling a boom in home loans. The company now anticipates profits of $1.20-$1.25 for the second quarter, up from a prior expectation of $0.80-$0.90. For the year, it foresees profits of $3.50-$3.75 a share. Analysts polled by Thomson Financial First Call previously handicapped second quarter results at $0.90 per share and $2.97 for the full-year.

"The mortgage market has remained strong for the first five months of the year, and it now appears that we will show continued strength into the latter half of 2003," said James Konrath, the firm's CEO in a statement. Mortgage rates have fallen to their lowest levels on record in the past few weeks.

Furthermore, "based on the rapid accretion to book value and on the ability to sustain earnings power by building an on-balance-sheet portfolio, we are raising our price target to $23.00 from $18.00 on the shares of Accredited Home," said Todd A. Pitsinger, an analyst with Friedman Billings Ramsey in a report released the same day as the upgrade in projections by the company.

"We are also reiterating our outperform recommendation. Notwithstanding the 137% move year to date, we believe that Accredited Home shares will continue to outperform those of the company's peer group in the slow-growth/low-interest-rate environment that is expected to persist throughout the remainder of 2003," concluded Pitsinger, whose firm led the 2003 IPO for Accredited Home.

By the way, the Accredited Home IPO was the only venture capital funded deal to debut in the first quarter, reports Thomson Financial Venture Economics and The National Venture Capital Association. Analysis from the group points out that there's "a decline from the fourth quarter of 2002 when four U.S.-based venture-backed companies went public. Venture-backed companies were not alone in feeling the impact by the continued struggling economy."

Second Half Outlook – Will Google Finally Go Public?

The outlook for deal flow activity in the second half of the year looks quite intriguing, considering some of the occupants in registration with the Securities and Exchange Commission. According to our research, there are 50 candidates in planning respective market entrances, of which analysts interviewed by IPO Monitor, anticipate strong reception for a myriad of transactions that include Crystal Decisions (ticker: CRSX) and NetGear (ticker: NTGR).

There's also much ado about the prospects for a headlining and market grabbing offering from Internet search engine Google. Although, company executives are backing away from prior indications that an offering may occur sometime this year, market pundits foresee a deal on the horizon. Google has certainly attracted its share of funds from the venture capital community. According to various sources, Google has raised $40 million since 1999. That funding came from venture capital specialists Sequoia Capital and Kleiner Perkins Caufield & Byers, two mainstay investment engines that benefited handsomely from the surge of IPOs in the 'Net heyday.

"While Google has become one of the world's most popular Web sites, its most vocal fans of the moment are the underwriters, venture capitalists, and stock junkies who think a Google initial public offering--perhaps valuing the company at a whopping $2 billion--could revive the comatose tech IPO market," said in an article still appearing on the now-defunct Red Herring Magazine. "For Google boosters, the four-year-old Palo Alto-based company is a standard-bearer for technology, and, more precisely, an example of a pure-play Internet startup that can make money."

Moreover, private companies such as Google aren't required to release financial reports, but industry professionals, estimate that the company has already achieved a break-even standpoint and moved into profitable waters. Market observers estimate that Google's 2003 revenue base could be $400 million, with gross margins of 70-80%.

"A Google IPO, some believe, would be followed by other IPOs from companies like Salesforce.com and Crystal Decisions," added Red Herring Magazine. "These tech standouts could juice the market and bolster the technology sector in the process." By the way, following the end of Red Herring, Crystal Decisions filed for its IPO seeking to raise $173 million through Goldman Sachs, Morgan Stanley Citigroup and Thomas Weisel Partners.

Crystal Decisions, which filed its IPO on May 23, sells software that organizes and analyzes financial and operational data, is expected to debut during the third quarter, analysts say. Red Herring Magazine predicted that the company would go public in the near future; "claiming profitability and year-over-year revenue growth of about 30% in its past two quarters" would prompt the controlling shareholders to proceed with an IPO.

"It wouldn't be surprising if its owners, Silver Lake Partners, Texas Pacific Group, and management from the disk drive maker Seagate Technology (ticker: STX), were eager to see the company go public like its sibling Seagate did in December (although Seagate's IPO was met with a share-price drop). But it wouldn't be surprising, either, if they too saw fit to wait for a healthier stock market," concluded the Red Herring article.

By the way, Seagate Technology, subject of an article appearing on the main portion of the IPO Monitor web site, is involved in another round of equity financing. Now, Seagate's controlling shareholders [New SAC] are planning to offer more stock to the public in a registration statement filed with regulators June 27. This time, the deal (filed at $18.38) expects to sell 60 million shares through sole book runner Morgan Stanley. JP Morgan Securities is acting as a joint lead manager; co-managers for the deal include Citigroup and Goldman Sachs. If successful, the deal will reward shareholders with another hefty payday of $1.1 billion. Following the offering, the New SAC's holding in Seagate Technology will drop to 67.6% from 82.1%.

NetGear Prepares for Market Debut

One deal that will certainly generate its share of media attention is NetGear of Santa Clara, Calif. Pequot Capital Management, a money management firm run in part by Art Samberg, a member of the Barron's roundtable, owns a pre-offering stake of 34.4% in NetGear. The early line is that investment bankers led by Lehman Brothers, Merrill Lynch and UBS Investment Bank expect to price NetGear during the week of July 21. However, that could change as there are no specific pricing terms for the $115 million transaction.

Founded in 1996, NetGear designs, develops and markets technologically advanced, branded networking products that address specific needs of small business and home users. One of the firm's signature products: an Internet sharing hub is almost in every office that I've been at or worked in. The company notes in its red herring that, "as a result of our brand name, the implementation of our operating strategy and the growth in demand for networking products within small businesses and homes, we have achieved net revenue growth in each year since our inception."

Taiwan Comes to Wall Street

Other deals to keep tabs on include Chunghwa Telecom (ticker: CHT), a Taiwanese-based telecommunications provider. In fact, the company claims to be the largest telecom entity in Taiwan and based upon revenues, "it believes that it is one of the largest in Asia based on revenues," added the firm's F-1 prospectus on file with U.S. regulators. This type of transaction can be classified as a "quasi IPO" because shares of Chunghwa already trade overseas, so some in the IPO analytical community may consider this to be a secondary stock offering.

Profits, as you know, are a premium demand for investors in today's marketplace. This company is no exception, as it reported revenues of $5.2 billion with net income of $1.3 billion for the year ended Dec. 31, 2002. The offering is structured in an American Depositary Share format, with one ADS equivalent to ten overseas shares in the company.

With the assistance of lead managers Goldman Sachs, Merrill Lynch and UBS Investment Bank, Chunghwa plans on offering 75 million ADS at a range of $13.33-$15.32 per share. Co-managers on the deal include Credit Suisse First Boston, Daiwa Securities SMBC Hong Kong, Deutsche Bank Securities, CLSA Asia-Pacific Markets and HSBC Bank anticipates pricing during the week of July 14.

A handicap to the firm's future growth potential lies within its ownership structure. Founded in 1996, the company is and will continue to be majority owned by The Ministry of Transportation and Communications. Following this deal, that government agency will own 72% of the company. "For so long as the government continues to own a majority of our common shares, our autonomy will continue to be limited by regulations governing state owned enterprises," concluded the firm's offering statement.

Digital Theater IPO: Profits Abound

Keep your eyes tuned because money managers we've spoke with are also high on the prospects for Digital Theater Systems (ticker: DTSI), a provider of high-quality digital multi-channel audio technology, products and services for entertainment markets worldwide. Founded in 1990, Digital Theater received key investments from investors in 1993 from Universal City Studios.

It also produced the first DTS audio soundtrack for Steven Spielberg's Jurassic Park in that same year. Deal seeks to price 3.4 million shares at $14-$16 through underwriters SG Cowen Securities, William Blair and Thomas Weisel Partners. Officials tell IPO Monitor that the deal is scheduled to price on July 7. And, by the way, the company has been profitable since 2001 and is on a perennial climb to higher levels.

As you can see, there are quite a few interesting concepts in registration with the Securities and Exchange Commission that are likely to debut over the coming days and weeks. All we need is a stable marketplace for investment bankers to parade these IPOs to the corners of Broad and Wall Streets.

Jeffrey R. Hirschkorn is Senior IPO Analyst for IPO Monitor. Send comments or press inquiries to jeffh@ipomonitor.com.