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The Three-Step Formula To Successful IPO Investing

|Includes: CMG, DigitalGlobe, Inc. (DGI), OPEN, SBUX, WMT

Guest Editorial by Louis Basenese, Associate Investment Director, The Oxford Club

Editor’s Note: Today, we welcome good friend and colleague Louis Basenese. Lou is Senior Analyst for The Oxford Club and Chief Investment Strategist of The White Cap Report, as well as a contributing editor to Investment U. In today’s article, Lou examines the stock market debut of online restaurant reservation company OpenTable - separating the hype from the reality - and gives three foolproof ways to successfully invest in IPOs. Have a pleasant and restful Memorial Day weekend.
Martin Denholm, Managing Editor, Smart Profits Report

A Classic Case Of “Overhype… Underdeliver”

The IPO buzz is building…

The number of IPOs in 2009 more than doubled in the span of one month. Half of them were technology IPOs.

Okay, so the tally now stands at a pathetic seven. But with over 100 deals waiting in the pipeline, we’re watching the market closely.

Even more so, considering that last week’s debut of Digital Globe (NYSE: DGI) garnered interest reminiscent of the IPO heyday of the late 1990s.

Digital Globe provides satellite imagery used in Google Maps and Microsoft Virtual Earth. Its rampant popularity saw it break into Google’s “Hot Trends” list as one of the fastest-rising search terms in the world (no small feat considering it meant beating out pop culture search mainstays like Britney Spears, Ashton Kutcher’s twitter record and Desperate Housewives spoilers).

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

Sure enough, the after-market performance confirmed my suspicions. Despite pricing above the projected range at $19, and rallying at first, DGI is now in negative territory.

We just saw another overhyped IPO, too…

From The Restaurant To The Stock Market

On Thursday, OpenTable (Nasdaq: OPEN) a provider of online reservation services for restaurants, ­began 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.

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

A novel concept, for sure. That’s probably why so many investors wanted a piece of the deal. On Tuesday morning, underwriters increased the pricing range by 31% to $16 to $18. Such a big bump only happens when a deal is oversubscribed.

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

Cancel Your Reservations At Open Table

We all know the restaurant industry relies on the consumer to thrive. And in such an abysmal spending environment, OpenTable’s growth initiatives will certainly be hampered.

Growth is limited, too. 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 - firms like Starbucks (Nasdaq: SBUX), Chipotle Mexican Grill (NYSE: CMG), or Wal-Mart (NYSE: WMT) in their infancy.

Plus, barriers to entry for new competitors are low. Consumers can switch their allegiance with a click of the mouse, meaning market share can erode before any efforts to combat it can be concocted.

Making matters worse, OpenTable has struggled with profitability, reporting operating losses in four of the last five years.

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.

So how did the IPO launch go?

Open Table: A Great Launch Or The Greater Fool?

Warren Buffett once said: “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”

And after pricing shares 54% above its initial range and tacking on another 59% in the first day of trading, you’d think OpenTable was a smashing success.

Alas not. As of yesterday afternoon, three million shares had traded hands. But a quick check of the SEC filing reveals only three million shares were offered. That means roughly every single share that the company sold to well-heeled investors (i.e. - not you or me) got flipped for mega profits to investors like you and me.

Talk about the greater fool theory in full effect!

Insiders made out like bandits again.

Haven’t we been scammed enough to know we need to do our own research and not rely on institutional hype?

I mean how can you rationally expect this stock to head higher for an extended period of time? It came to market at an ungodly valuation - more than 180 times earnings. (That’s not a typo).

And that’s if we’re charitable. The company was profitable in the first quarter, earning 4 cents per share. But there’s no guarantee it will continue to make money for the rest of the year. It does have a history of losing money for four out of the last five years.

And bets are off if it relapses. After all, you can’t have a P/E ratio without the E (earnings).

Of course, the valuation isn’t my only concern, although it’s sufficient.

Forget The Hype… Profitability Is The Key

Remember, the stock is intimately tied to consumer spending, which is hanging out in the gutter. Even if spending miraculously rebounds and we all start eating at Morton’s and Ruth’s Chris’s again, the company’s not going to suddenly dominate the world.

Don’t get me wrong… the fact that OpenTable bagged one-third of the market for reservation-taking restaurants in 10 years is impressive. But it still hasn’t figured out how to be consistently profitable. Increasing market share won’t magically make this fundamental business flaw go away.

Bottom line, if you bought into the IPO, I’d consider selling immediately. Pray there’s a greater fool out there to take shares off your hands. Then maybe establish a short position because the fall promises to be historic.

Here’s the foolproof way to invest in IPOs…

Three Steps To IPO Success In Any Market

Here’s my proven, three-step formula for sifting through the IPO hype to find sure-fire, long-term winners…

1. Profitability: Sounds obvious, but most companies that flop in the after-market lack earnings. Insist on at least two years of profitable operations.

2. 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, stick to companies with a market potential that points to a decade or more of heady growth.

3. $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.

Good investing,

Louis Basenese

Editorial Endnote: The term IPO stands for Initial Public Offering.

IPOs occur when a company wants to trade on the stock market. They can be younger, new companies looking for capital to fund expansion and operations, or older, private companies whose investors are looking to cash out.

Either way, the big step to launching an IPO is 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, the underwriter doesn’t know exactly how much interest and what kind of market is available for the offering, so they will quote a price range.

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

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

Guest Editorial by Louis Basenese

Disclosure: No positions