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spacer July 2006
Commentary

As readers know, Contra's modus operandi is to search for companies that have been ignored by the market and can be picked up on the cheap. On occasion, readers have asked about recent IPOs; but our rule that a company must be public for at least ten years before we'll consider it means that these young 'uns do not register on the Contra radar.

Therefore, we asked a colleague of ours who has spent time in the world of early-stage investing to provide some thoughts about how to look at those freshly-minted public companies. His name is Keith Lue, and he is a former venture capital fund manager who is now a private individual investor.

Ever notice that when stock markets are hot, new stock issues -- known as initial public offerings (IPOs) -- proliferate? The past year has seen a number of high-profile American IPOs, among them, Chipotle Mexican Grill, Google, Mastercard and Vonage. Meanwhile, Canadian IPOs have also been sprouting like weeds; these include Miranda Technologies, Workbrain and Tim Hortons.

Investing in new issues is somewhat different from finding ignored or undervalued stocks. By their very nature, IPOs have a built-in elevated level of interest -- this enthusiasm is, in fact, a prime motive for bringing a new issue to market. Here are some guidelines as to how to view these animals and perhaps avoid the pitfalls.

First off, to understand how the game is played, you need to recognize who is selling you that "hot" stock. While a buyer may be excited about purchasing a potential high flyer, there is someone on the other side of the transaction who is no less motivated to sell, thereby monetizing their investment.

This gaggle of people who got in on the ground floor takes in everyone from "angel" investors who provided the seed capital to get the private business going, to venture capitalists, to participants in the private placement, to merchant bankers and corporate management.

Potential buyers should consider why the enterprise is on the block and why it is being offered at a particular price. There are many questions that ought to be asked, and the following list is by no means exhaustive:

  • What is the state of the underlying business? Are estimates of the company's current and expected growth rate and profit margins realistic? What is the enterprise's competitive position? How secure is its market share?

  • What is the valuation of the business? Is it reasonable in the context of the industry, or is it excessive, driven by the public's pent-up desire to buy the issue -- and the seller's desire to achieve a top price?

  • How good are management and the board of directors? Are there gaps in the top brass? How will they be filled? Are these people highly motivated and significant shareholders in the business?

  • Who is selling you shares in the new issue? Recognize that shares out of treasury have a different intent than shares being sold to you from the holdings of management insiders and earlier-stage investors such as venture capitalists.

  • Have you stepped back from the company-specific hype to look at the big picture? Is the economy headed up or down? What is the state of the market in general: overbought, oversold, or simply lethargic? IPOs often take advantage of a buoyant market; a downturn in the market or economy will likely mean the price will suffer.

  • Studies indicate that most IPOs are down in value a year after they are issued. Therefore, would it be better to wait to invest? What will make this one defy the odds in the short term?

  • During the technology bubble of the late 1990s, it was not unusual to be able to buy in the morning and, after a couple of coffees and a few smokes, sell in the afternoon and collect a huge profit. These days, most IPOs do not see significant quick appreciation, and a few months later many sell well below their initial price.

    Heck, you can even skate into shares of Tims now for well less than what it cost on the first day of public trading! So the suggestion is to hurry up -- and do your analysis -- and wait. Here, we might borrow an investment adage from Contra: the longer you look at a stock, the better the investment decision.

    A company that offers the combination of strong fundamentals and a post-IPO stock price that has had some of the exuberance wrung out of it can make for an attractive buy candidate. But what are those fundamentals exactly? Let's examine them by looking at a company that I haven't bought to this point, but which is worthy of consideration.

    Vancouver-based Xantrex Technology develops, manufactures and markets all sorts of gear designed to deliver electrical power: battery chargers, power packs, portable and backup power supplies, and converters and inverters for wind and solar power.

    The enterprise has a blue-chip customer base that includes Applied Materials, BP Solar, Cisco, GE Wind and Kyocera.

    Xantrex was started about ten years ago by Mossadiq Umedaly. Sales growth in the early years was rapid; in recent years, however, revenue has flattened at around $140 million. It went public in March 2004 at about $18, and since then the stock toppled to the $5 range before climbing back to $8 and change at press time, representing a market capitalization of $250 million.

    IPOs are normally unleashed in sectors that are growing at an annual rate between 10 and 30 percent. These companies need capital to fuel their rapid development. Demand for wind and solar equipment like Xantrex's is estimated to grow at 20-40 percent per year.

    Amid rising oil prices and the possibility that world oil production may peak (if it hasn't already), there is reason to expect that the growth of markets for alternative energy will accelerate over time.

    Ideal IPO candidates are able to increase both market share and total sales, as well as deliver a profit. As a rule of thumb, high-growth companies without profits are valued at between three and five times revenues. If profits are reported, the growth rate should equal the P/E -- for instance, when sales are growing at a rate of 30 percent, the P/E should be around 30.

    The Xantrex IPO may have been overpriced on misplaced expectations that the company could maintain the vitality of its early years. It didn't hurt that it was offered in the wake of an IPO dry spell that came after the high-tech bubble burst in 2000. The company was also heavily backed by venture capitalists, who were eager to obtain liquidity after the long drought.

    The near-stagnant sales figures are a major factor in the share price's slide. More alarming to investors is the fact that profits shrunk from $5.7 million in 2002 to just better than break-even in the year ended December 2005.

    In the most recent quarter, sales remained flat at $34.7 million; the company did return to profitability after three losing segments, but the 2 cents per share was less than half the 5 cents earned in same period in 2005.

    There's a pretty good reason for the deteriorating bottom line: spending on research and development has risen 20 percent since two years ago. Earnings estimates for 2006 are in the neighbourhood of 25 cents per share, which would put the P/E ratio in the 30s.

    That's high, considering Xantrex's limited progress, but if shares can be picked up somewhat below the current price, any subsequent revival in sales would reward the buyer.

    The probability of such a resurgence depends heavily on the company's ability to compete. Xantrex contends with divisions of much larger companies such as Sharp and Siemens in the solar energy market and Agilent Technologies in the DC programmable power supply market.

    But these alternative power products are a small part of these giants' overall operations; the fact that Xantrex specializes in the field appears to be its competitive advantage.

    Initial public offerings tend to be issued by relatively young businesses whose founders are still at the helm. It is therefore crucial to take the senior management into consideration. If the visionaries who established the operation are not seasoned managers, it is essential that such talent be in evidence.

    A recent example of such a powerful combination would be Google, whose senior management consists of the founders, Sergey Brin and Larry Page, complemented by an experienced manager, Eric Schmidt, who earned his stripes at Sun Microsystems and Novell.

    Xantrex appears to have capable management headed by chairman and founder Umedaly, who acquired early-stage corporate experience while at Ballard Power Systems. John Wallace, who was recently appointed CEO, worked at Ford.

    Superior management alone is not enough; a public corporation also needs a good board of directors. In young companies, the board is crucial: it can act as a coach to management, encourage executives, set challenges and, when needed, enforce penalties.

    If necessary, it can also provide a counterbalance to the management. A good working relationship between these two parties is one of the keys to the success of a fledgling public enterprise.

    Xantrex's board includes several experienced executives and appears to be adequate for the company at this stage of its development. Also represented on the board are several venture capital firms, including Canada's Growthworks, Britain's RIT Capital and U.S.-based Oaktree Capital. The latter is the largest shareholder, with about 24 percent of the outstanding shares.

    Should the share price drop further, Xantrex might be a worthwhile buy. One would hope that the company has matured and that the increased R&D spending will pay off. If the new product cycle can bear some fruit and oil prices remain high -- and the new CEO can make operations more efficient -- this is more likely.

    Xantrex is an example of the potential and the pitfalls that one encounters in young, emerging firms. Typically, these types of companies are in novel industries, often with a compelling technology or concept that enables rapid growth in the early years.

    They go public to continue to stimulate the growth and to provide liquidity to their early investors. Those high growth rates accord the firm a higher multiple and thereby allow it to command an increased valuation -- which is good for the insiders, because it enables them to raise a significant chunk of cash without overdiluting their own stakes.

    But those who are thinking about buying would do well to be skeptical as to whether the company has what it takes to sustain that rapid growth.

    In a nutshell, don't rely on the word of those selling the IPO; instead, be prepared to ask questions and take the time to practise due diligence.


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