Picking Gems Out of the IPO Junk Pile

by Aaron Pressman

Browse Issues

Browse the BusinessWeek Archive

Alex Robbins

Story Tools

• post a comment
• e-mail this story
• print this story
• order a reprint
• digg this
• save to del.icio.us

Illustrations by Alex Robbins

After churning out nearly 500 offerings over two years, the market for initial public stock offerings has ground to an almost complete halt. The stock market's sharp decline has been particularly unkind to these IPOs, and many recent ones trade below the price at which they went public, making them what Wall Street calls "busted IPOs." That's bad news for hot-growth investors who bought IPOs right out of the gate. But it's great news for value-fund investors such as First Eagle's Jean-Marie Eveillard and Whitney Tilson, who consider busted IPOs happy hunting grounds. "It's a fertile area to find bargains," says Tilson, co-manager of the Tilson Focus Fund (TILFX). Once the IPO price is breached, "These stocks can get much cheaper than they should be."

Of the 219 IPOs that launched in 2007, 149 are busted already, according to Thomson Financial. Renaissance Capital's IPO Index, which includes every deal from the preceding 24 months, has lost 16% so far this year, almost triple the decline in the Standard & Poor's 500-stock index. The selling of busted IPOs tends to get overdone as the initial hype that commonly sends shares jumping 20% or more on their first day of trading later turns to disappointment when a company's performance fails to meet expectations. Growth investors dump the stocks and don't look back.

Finding the best prospects among the rubble means looking for substantial revenue and actual profitability, says Brian Hamilton, CEO of Sageworks, a Raleigh (N.C.) firm that researches companies going public. Trends in cash flow from operations should match the trend in net income, he says.

At Renaissance Capital, which runs The IPO Plus Aftermarket Fund, managers also look for signs that the share price of busted IPOs may be ready to turn around. That means that the price not only appears to have bottomed but that trading volume is increasing. "You don't want to buy a busted IPO when no one else is interested," says Kathy Smith, a principal at the firm.

A typical busted IPO that some value managers like is Phillipines-based outsourcer eTelecare Global Solutions (ETEL), which went public last March at 13.50 a share. The company provides warranty support and customer service for U.S. companies including American Express (AXP) and Intuit (INTU). ETelecare stumbled in August when it announced revenue and income wouldn't meet analysts' forecasts. Investors dumped the stock and, more recently, sinking Asian markets depressed shares further to almost 5. Still, revenue jumped 33%, to $260 million, for the year, and net income nearly doubled, to 79 cents a share.

Financial companies that went public last year have, not surprisingly, been among the hardest hit in 2008. HFF (HF), which helps companies line up loans, went public in January, 2007, at 18 a share. But last summer's credit crunch, and fears that HFF's business would dry up, sent investors fleeing, and shares dropped below 5 in March. HFF's results were solid, though, as revenue rose 11%, to $256 million, and net income totaled $12.5 million, or 84 cents per share, in 2007. Operating income did fall 11%, to $48 million, as HFF spent more to expand post-IPO just as lending markets slowed. Sageworks' Hamilton likes HFF's low price-earnings ratio of 6.7 and says it is still quite profitable.

Some investors also see value in the shares of two private equity and hedge fund managers that went public last year, Blackstone Group (BX) and Fortress Investment Group (FIG). Both companies were hit with a double whammy. The credit market turmoil makes it hard to borrow money to do new deals, and the IPO market shutdown means the firms can't cash out of existing holdings.