Third Quarter Review: A New Beginning Has Started to Take Place for IPOs

By Jeffrey R. Hirschkorn, Senior IPO Analyst

Wow! That can actually sum up the festivities of the third quarter's initial public offering market. There's no getting around that deal flow is at multi-year lows, but with investment bankers now preaching a flight to quality over the 'Net days where quantity ruled, we're in for some good days ahead. The days of seeing money losing operations debut are over for the most part. To provide evidence that there are makings of a solid future in the new issues marketplace, one needs to look at the increased path of profitable new deal filings that took place during the three months ended Sept. 30.

Our in-house data has tabulated 20 new deal filings for the third quarter, of which 6 commenced proceedings in September. Three have actually gone public and others are on the IPO launching pad. One deal: Crystal Decisions (ticker: CRSX) was snatched off the calendar in an acquisition by Business Objects (ticker: BOBJ). It was to raise $172.5 million in an IPO led by Goldman Sachs.

Is Now the Right Time?

Analysts we've spoken with now believe that the timing is ripe for a dedicated focus in new issues because of the success in the general marketplace. Those returns, and some concerns about economic growth and the government reforms needed at the major exchanges in light of the firing of NYSE Chairman and CEO Richard Grasso over his compensation package. Word of regulatory problems at the AMEX has come about. A complicating factor, sources say, is the pending sale of the exchange to a group of private investors.

One can't forget that the IPO market is follower, not a leader. As such, over the past few years, issuance has struggled in the new issues arena because of depressed returns posted by the major averages. That's not to say we've lacked deal flow. Deal flow took place, but on a more conservative pitch. That conservative nature enabled strong returns in the past few years for IPOs. For the quarter, the Dow Industrials ended up 3.2% while the tech-laden Composite finished 10.1% higher.

A conservative path to deal flow was implored by the Street's underwriters following a timeframe where ethics violations were breached and a bond between investors and bankers became strained. Now is a perfect time to dissect how investors were deceived. One can start by viewing the obstruction of justice trial of investment banking kingpin Frank Quattrone in New York.

Third Quarter Overview

The third quarter certainly presented a unique opportunity for issuers and bankers to test public interest in initial public offerings. And, believe me they did. Not only did we see an increased pace of new deal filings, a total of 20 IPOs, totaling $3.1 billion in proceeds, were brought to Wall Street. Tech deals resurfaced in the third quarter and were anchored by strong results from Digital Theater Systems (ticker: DTSI), interVideo (ticker: IVII), iPass (ticker: IPAS) and SigmaTel (ticker: SGTL).

For the quarter, albeit nearly all of the activity for the year, the average return over offering stood at 20.73%, with iPass winning praise for the best performance -- up nearly 67.5%. The quarter's laggard: a semiconductor concern and late quarter entrant AMIS Holdings (ticker: AMIS). This one is a bit mind boggling because the size of the deal was increased prior to pricing, thus giving the impression that the company would succeed in the market.

Still, analysts tell IPO Monitor that a slow start isnt a death sentence. Just look at the early trading history for Seagate Technology (ticker: STX) and how it has powered in the market lately. On the first day of trading, the stock declined 4.6%. By Sept. 30, Seagate was hovering around $27.20, generating a sizeable pop in the aftermarket of 127%.

While Morgan Stanley remains cautious on the systems and PC hardware marketplace, analyst Rebecca Runkle, in a report published on Sept. 29, concluded that, "we believe that the combination of continued HDD market stability and incremental evidence of strong end-demand through the end of the calendar year should accrue a market multiple to Seagate shares." As such, Ms. Runkle raised her price target on the stock to $30, from $26, on the belief that Seagate could exceed her third and fourth quarter expectations for overall units at 17.9 million, revenues of $1.64 billion and earnings per share of $0.35.

Better Than a Year Ago

Deal flow may be at record lows, but that isn't the case when you compare the third quarter of 2003 to the third quarter of 2002. In Q3 of 2002, there were only seven companies willing to brave the rough seas of the new issue marketplace. A paltry $541 million was raised; performance over offering showed a decline of 3.7%. Of the group, three of the companies have gone on to continued success in the market: LeapFrog Enterprises (ticker: LF), Pacific Energy Partners (ticker: PPX) and Red Robin Gourmet Burgers (ticker: RRGB).

That return was skewed by the dismal inception by CIT Group (ticker: CIT) and HealtheTech (ticker: HETC). CIT Group had an ill-fated inception anticipated because of ties to scandal plagued Tyco International (ticker: TYC), of whose former CEO and CFO are on trial in New York for allegedly looting $600 million from the company's coffers.

Increase in Quality at the SEC

As I alluded to earlier, there's been a movement towards quality in the current and future state of the initial public offering market. Bankers have learned that catching the eye of an investor is a one shot deal. In today's market, institutional investors still dominate the offering circuit, but individuals still chip in monies with retirement accounts at brokerage firms. That brings us to the valuation frenzy.

An example of the underwriting community prowess to bringing profitable companies public can be best illustrated in the recent filing of Conn's (ticker: CONN), a Beaumont, Texas-based home appliance and consumer electronics retailer with fiscal 2003 revenues of $450 million and profits of $18.5 million. The company, with 42 stores in the southwestern portion of the United States, has retained Stephens and SunTrust Robinson Humphrey to jointly manage its $68 million transaction. Affiliates of Stephens Group, the parent to one of the IPO underwriters, own a majority stake in Conn's.

Valuations are keys to an offering's success, analysts say. It is essential that investment bankers create situations of leverage. These situations, in today's market, need to include attractive valuations. Investors, after having been burned in previous instances with money losing gambles, are now demanding profitability (or imminent) at time of offering. During the quarter, there were 20 IPOs, of which 11 were profitable, one hit break-even, one had no operating history and the remaining seven were still booking losses. This definitely illustrates that a flight to quality remains the front mission of the Street's investment banking community.

OpenIPO = New Wave

One method of underwriting that is starting to win its share of praise doesn't follow traditional means. The OpenIPO or Dutch auction method has been implemented by W.R. Hambrecht + Co. Just recently, W.R. Hambrecht and Pacific Crest Securities conducted an OpenIPO for redEnvelope (ticker: REDE), an online retailer that specializes in the sale of upscale gifts. Pricing structure doesn't follow normal ideals. Final terms: 2.2 million shares at $14; stock finished the quarter unchanged.

The price talk set for the deal gives prospective bidders a range to utilize when placing a bid in the auction method. Minimum share bid is 100. An investor must open an account at W.R. Hambrecht with $2,000 for participation. Aftermarket demand will generally be lighter than a normal underwriting because the OpenIPO takes into account what investors are willing to pay for a share.

As indicated in a previous analysis of redEnvelope, "the clearing price may not be the offering price. This price is calculated as a result of all participants of the OpenIPO. The final offering price cannot be higher than the clearing price." There have been some success stories from companies that have used this method to go public. They include: Overstock.com (ticker: OSTK) and Peet's Coffee & Tea (ticker: PEET). To build on the strong IPOs and need for further expansion capital, both companies revisited the marketplace with secondary stock offerings where W.R. Hambrecht had a big involvement.

This method of underwriting will be further tested in the fourth quarter when the IPO of Genitope (ticker: GTOP) is completed. Terms: 4.6 million shares at $9-$13. Pricing, according to sources, may occur in October. Punk Ziegel & Company is a co-manager in the offering.

Underwriting Tier

With no product out there, underwriters have been locking horns in getting the most fees from deals. There's no secret that investment banks have been jockeying for increased revenues. During the quarter, we had 20 deals, of which 12 featured joint book runners. Joint book running allows for a much broader distribution network amongst the investing community. In more prosperous times for underwriters [such as the 'Net hey-days], the billion dollar plus transactions were the most common deals to utilize this type of relationship.

SG Cowen Securities has continued to build a position for itself with a niche area of underwriting. In previous years, SG Cowen made its bread and butter with biotech and healthcare stock underwriting. Those sectors have started to make a comeback as evidenced in the number of recent filings. Still, the firm had to find a way to prosper and it did: lead manage technology companies to the marketplace.

Not only did it tackle a new area of underwriting, its two deals are ranked number one and three in the quarter, as measured by performance in the aftermarket. Digital Theater and interVideo, which also featured SoundView Technology Group as a joint book runner, were led by SG Cowen to Wall Street. Both deals came in mid-July. By quarter's end, shares of Digital Theater, which priced at $17, finished up 67.3%. The success story can be easily attributed to the profitability found on Digital's income statement. Like Digital, shares of interVideo, which withdrew its first attempt at an IPO due to market conditions earlier this year, have received premier treatment in the aftermarket, having generated a rise of 53.2%.

A trend that has continued to develop since the fallout from the conflict of interest is the movement towards utilizing the regional investment bankers. This process was used three times during the quarter for the IPOs of Direct General (ticker: DRCT), Gladstone Commercial (ticker: GOOD) and Providence Service (ticker: PRSC). Direct General was led by Keefe Bruyette & Woods. Gladstone utilized Ferris Baker Watts while Providence Service retained SunTrust Robinson Humphrey and Jefferies & Co.

Outlook on Q4

Outlook on the fourth quarter looks quite promising considering the impressive roster of new filings. We can certainly expect to see some headlining news from the biotech and healthcare sector since there has been a bevy of transactions filed from that particular area of the marketplace. Of course, profits in this area are highly unusual and only occur if a company sees a drug or treatment receive approval from the FDA. In most cases, these types of companies utilize enormous funding from private investors (and public capital if they complete an IPO) for R&D activities.

Moreover, Irv DeGraw, a veteran IPO expert and professor of finance at Washington College added that, "I wouldn't be surprised to see a late second half surge in biotech deals." He pointed to the increased path of new deal filings by biotech concerns, but voiced concern that biotechnology IPOs have a tradition or a history of being extremely volatile and cyclical. You'll get a wave of them and then nothing and then a few years later, the process begins over again.

One intriguing stock sale that may come to fruition is a float from Internet search engine Google. Company executives have shot down the theory repeatedly, but sources around Wall Street are indicating that a filing could happen soon. Sources tell CBS MarketWatch that Google's private market valuation is worth roughly $18 billion. Furthermore, there's some movement on Wall Street that thinks Google may utilize the OpenIPO process by Hambrecht because it could keep a tight reign on share allocation. But, again that's speculation. You know what speculation gets you.

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