The Good, Bad, & Ugly of IPOs

Brian is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The Bad

We all remember the infamous Facebook (NASDAQ: FB) IPO. It was heralded as a can’t miss offering -- the most anticipated IPO in decades, perhaps ever. Yet, instead of a 30% pop on its IPO, the stock closed flat, and even temporarily traded lower.

Facebook is the quintessential example of a bad IPO. Not only is the stock currently trading at half of its IPO high, but trading was delayed by more than 30 minutes by the NASDAQ and there were millions of shares that were never confirmed. In the end, the Facebook IPO not only hurt investors and the reputation of the NASDAQ, but also damaged the lead underwriter Morgan Stanley; as they had to maintain an opening price that they inflated from $24 to $38.

The Ugly

Facebook’s IPO was without question “bad” in every facet of the word. Looking back, if it would have maintained its $100 billion market cap, it would have been a company with decelerating growth trading at 25 times sales. Yet, because the stock did fall and never maintained such a lofty valuation, it’s not considered ugly.

An IPO might be ugly when the opening price leads to a large one-day gain in a company that is seeing decelerating growth and is not worthy of the premium. Workday (NYSE: WDAY) was an ugly IPO!

Technology produces the most highly anticipated IPOs, and in technology it is big data and cloud computing that garners the most outrageous valuations of all. Workday fits in the cloud computing space.

It was expected to price between $24 and $26 per share, but instead priced at $28, and then opened at $48.05. Workday has since doubled its IPO price – which many might call a good IPO – although, the company’s less than flattering fundamentals paint an ugly picture.

When Workday became a public company, back in October, it was producing revenue growth of 100%. Now, growth has slowed to 61% and is expected to decelerate to 40% year-over-year. The stock trades at a mindboggling 34.6 times sales with an operating margin of negative (38.65%). As a result, with growth being its only driver of valuation, the stock becomes a trap to retail investors due to the fact that growth is slowing. When it’s all said and done, this presents dangerous situations for retail investors.

The Good

The quintessential example of a good IPO can be seen more recently, on Wednesday as a matter of fact, with Gigamon (NYSE: GIMO). Gigamon is considered a play on “big data,” a rapidly growing space that is expected to triple in size over the next two years.

Gigamon helps companies manage the flow of data within their networks, including both performance and security. For this particular function, Gigamon provides the service of choice, as more than 60 of the 100 largest U.S. companies are clients of Gigamon. Considering the company has 13 issued patents on its technology covering them between 2027 and 2030 – and 23 pending – I’d say its services are pretty well protected.

So what makes Gigamon’s IPO good? For one, it was priced attractively as seen with its 49.84% rally – also closing at intraday highs. But also, this is simply a fabulous company even after considerable gains, still presents value for shareholders; which is rarely seen in this momentum-based IPO market.

After its large IPO gains, Gigamon is trading with a market cap of nearly $850 million. But more importantly, this market cap represents a price to its last 12 month’s sales ratio of approximately 8.0; which is about half (to one-third) of what we’ve seen in the big data/cloud IPO markets.

With that said, you’d think there has to be a reason for its attractive valuation relative to sales: Perhaps it is due to slow growth or significant operational inefficiencies. However, Gigamon has three years of profitability (which is exceedingly rare for tech IPOs of this size), gross margins of 79% (better than competitors Cisco, Juniper, or Brocade), and is growing by 50% year-over-year (almost identical to Workday).

When you consider all of the above facts, you can’t help but to realize that Gigamon was certainly a good IPO. This is a company that is still relatively inexpensive even after large IPO gains, indicating that management was fair when the stock was being priced. To me, good IPOs such as this suggest much larger gains ahead. Thus, I would watch Gigamon closely as it’s one of the better IPOs I’ve seen in a while.

Final Thoughts

“Yes, it is possible to find value in the IPO market, but you must be willing to use common sense! If a company is trading at 30 times sales, it better have the cure for cancer or expect 200% growth for the next decade. Other than that, companies in this range should be avoided. These are overvalued companies with greedy directors and underwriters who have baked in all future gains and are being valued on speculative madness and not fundamentals. These situations rarely end pretty for the little people.” Taking Charge With Value Investing (McGraw-Hill, 2013)

The quote above is a bit lengthy, but is exactly how I feel when referring to good, bad, and ugly IPOs. Facebook had everything go wrong during its IPO – and although Workday’s IPO was good, its lack of upside makes it ugly for retail investors.

Gigamon is the perfect balance of value, growth, and excitement all rolled into one stock – such opportunities are far and few between – I’d cherish this one, and the opportunity it presents. 

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Brian Nichols is long GIMO. The Motley Fool recommends Facebook. The Motley Fool owns shares of Facebook. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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