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How The IPO Market Got Its Buzz Back


Chipotle Mexican Grill Inc. (CMG) is used to seeing customers line up for its burritos, but at the end of January the McDonald's Corp. (MCD)-owned chain experienced an even bigger rush. In an initial public offering, Chipotle's shares jumped from 22 to 44 in one day, the first time since 2000 that a U.S. IPO of more than $10 million had doubled so quickly.

Investors' appetite for IPOs isn't limited to Chipotle. With 32 offerings priced since Jan. 1, up 14% from the same time last year, 2006 is shaping up to be the busiest year for new issues since before the tech crash.

And IPOs are performing well in the aftermarket. They returned an average of 18% in 2005 and 10% so far this year, according to Renaissance Capital in Greenwich, Conn., vs. returns of just 5% and 1%, respectively, for the Standard & Poor's 500-stock index.

How warm are things getting? Eight of this year's deals have been priced higher than underwriters had anticipated, vs. three to this point last year. "The market is off to a very healthy start," says Craig Farr, co-head of U.S. equity capital markets at Citigroup (C).

NO MOOD TO QUIBBLE

Perhaps too healthy, say some observers. The downside to a strong IPO market is dumb deals -- and they're here. The offering of shoemaker Crocs Inc. (CROX) on Feb. 8 showed investors turning a blind eye to glaring problems. Another upcoming IPO, that of Internet telephony provider Vonage, seems shaky, too.

But investors, grappling with the sideways stock market of the past 27 months, aren't in a mood to quibble just yet. It's not only the number of offerings that's grabbing their attention but also the kinds of companies going public. Many are so-called reverse leveraged buyouts -- former poor performers that were bought up by private equity firms betting they could fix them up and sell them back to the public for a profit. The top performers recently have been fast-growing upstarts such as Chipotle, Baltimore-based clothier Under Armour (UARM), and Latin American steel company Ternium (TX), all of which are seeing rapid sales and earnings increases. There has been a "return to the traditional growth IPOs," says Citigroup's Farr. That's good news, of course, for corporations looking to raise money. And when promising companies have an easier time forming capital, the economy as a whole benefits.

It was a long winter, though. When the bear market began, unprofitable startups with shaky business plans fell out of favor. Instead, well-established companies generating lots of cash, such as Kraft Foods Inc. (KFT) and Genworth Financial Inc. (GNW), stole the spotlight. The percentage of profitless IPO companies fell from 80% during the tech boom to 40% during the bust, and has stayed there. The average age of companies going public shot up from four years in 1999 to 15 in 2002, according to research by University of Florida finance professor Jay Ritter. Investors, in other words, gave money only to companies already demonstrating that they deserve it.

The reverse leveraged buyouts were received particularly well, making up about 40% of all IPOs in 2003 and 2004. Most of those companies were in good standing and had been managed smartly while in private hands. Now, with growth companies back in vogue, reverse LBOs are making up a smaller percentage of deals. The average age of companies going public slipped to 11 in 2005, and it's heading lower.

WORRISOME DEBUTS

But that'll likely be only a temporary phenomenon. The private-equity market has been booming, with huge investment inflows fueling more and bigger LBOs. Assuming the IPO market stays strong, the reverse LBO pipeline should soon be gushing.

Observers worry, however, about the Feb. 8 offering of Niwot (Colo.)-based shoemaker Crocs. Yes, the company's financial outlook seems strong, with a 2004 net loss of $1 million turning into a $13 million profit for the first nine months of 2005. But Crocs went off for almost 10 times its revenues, a staggeringly high multiple. And material in its filings with the Securities & Exchange Commission gives reason for pause. The company found "material weakness" in its internal controls during its most recent audit, according to the filing. The filing also showed that Crocs has instituted takeover defenses to protect management. And it has a history of consulting deals with companies controlled by officers. Crocs declined to comment.

Also on Feb. 8, Internet telephony provider Vonage Holdings Corp. filed to go public, despite posting a net loss of $190 million in the first nine months of 2005. The company said it wants to raise $250 million, but it hasn't disclosed how many shares it will sell or what the company's total value will be after the deal. Its business plan emphasizes market share growth over profits and cash flow. Skeptics point out that what's really growing are Vonage's expenses and customer acquisition costs, which are rising faster than revenue. Vonage declined to comment, as did Citigroup's Farr, whose firm is underwriting the offering. "Investors need to take some responsibility for due diligence," says Lynn Turner, managing director of research at independent research firm Glass Lewis & Co. and the former chief accountant of the SEC.

For the most part, however, the business models of successful IPOs have been decidedly 21st century. Energy and health-care issues have been plentiful. But the hottest niche by far has been consumer-oriented companies, especially restaurants. Despite fears that Americans are tapped out, retailers and restaurant operators have been thriving. Chipotle's net loss of $17 million in 2002 swung to net income of $33 million in the first nine months of 2005. Clothier Under Armour, meanwhile, posted revenues of $194 million in the first nine months of 2005, triple the 2002 level, and a net income of $14 million, five times the 2002 amount.

Investors paid a premium for those brands, and their success has encouraged followers. Steakhouse chain Morton's Restaurant Group Inc. (MRT) raised $161 million on Feb. 9, while Ian Schrager's hip hotel chain, Morgans Hotel Group Co. (MHGC), garnered $360 million on Valentine's Day. Among the hotly anticipated issues are MasterCard, Wendy's (WEN) doughnut-chain spin-off Tim Hortons, Mexican airport operator Pacific Airport Group, and retailer J. Crew Group, all expected to offer shares in the next few months. Burger King Corp. has said it will file soon, and Levi Strauss & Co. might file this year.

"The consumer confidence and spending numbers have been so good," says Chad Abraham, head of equity capital markets at Piper Jaffray Cos. (PJC) in Minneapolis. "Investors are looking for ways to play that." The trend shows no sign of slowing: The Commerce Dept. reported on Feb. 14 that January retail sales increased 2.3%, the biggest monthly gain in almost two years.

With saner practices and mostly sane offerings, the IPO market seems to be on solid ground. Activity could slow if the broader stock market tumbles; falling equity prices last March and April hurt new issues, as did Hurricane Katrina later in the year. But for now, the business is healthy. Finally, there's some real demand out there for growth stories, especially for companies selling burritos or T-shirts.

By Aaron Pressman, with Michael Arndt in Chicago


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