Investors Are Making This Classic Mistake Again

StreetAuthority Network

When the financial news website MarketWatch.com went public in January 1999, it registered one of the largest one-day gains ever.

Within a few quarters, TheStreet.com (Nasdaq: TST) came public, as did Edgar Online, while a host of already-public rivals (including my then-employer, Individual Investor) also raised large news sums of money in the secondary market. 

And it all ended quite badly.

All of these firms, flush with cash, cranked out massive amounts of content, spent millions marketing their brands, and built up expensive executive teams. And this happened as they all crested on the wave of the dot-com boom, when they were collectively worth several billion dollars. 

These days, TheStreet.com is the lone surviving public company, and its market value is less than $40 million when cash is excluded.

The obvious lesson in this and other dot-com debacles is that valuations got out of hand. Yet the less obvious but more important lesson is that a flood of IPO money can lead to all kinds of distortions in an industry. And it's happening again. The IPO market has been so strong in recent quarters that the fourth, fifth or even sixth-best operator in a given industry is gearing up to go public. And their IPO proceeds could well spoil the party for everyone.

Let's use the recent IPO of Paylocity (Nasdaq: PCTY) as an example. The provider of cloud-based payroll services just raised $120 million, and will likely use those funds to add to its sales force, flesh out its products, poach well-regarded software developers and boost its brand through extensive marketing.

[More from StreetAuthority.com: The U.S. Consumer Rebound Is Coming -- Here's How To Profit]

That's bad news for already-public rivals such as Workday (NYSE: WDAY) and CornerstoneOndemand (Nasdaq: CSOD). Those firms are also going after the same customers, using their cash to build up similarly robust business models. 

Frankly, existing players need a break from competition. Workday, for example, generated roughly $130 million in sales in the most recent quarter, but also had a net loss of $47 million. Spending less money fending off rivals would surely help. And though it's too soon to know how Paylocity's financial will play out, it's a safe bet that the intense competition will mean heavy spending for talent, branding and direct sales staff. 

It's not just the recently-public companies that will feel the effects of this competition. You can bet that many clients of Paychex (Nasdaq: PAYX) and ADP (Nasdaq: ADP) are getting a sales pitch from their younger rivals. 

Often times in such scenarios, these companies engage in a war of attrition that is bad for all concerned, until the industry begins a phase of inevitable consolidation. And few winners emerge. On its first day of trading in 1999, MarketWatch was valued at $1 billion. By the time it was acquired by Dow Jones in 2004, it was worth half as much, and if TheStreet.com's current valuation is any guide, MarketWatch would be worth a lot less than what Dow Jones paid if it still stood alone today.

The Cloud Is Going Crazy
Much of the current wave of IPOs is capturing the frenzy for "cloud" based business models. These firms are simply traditional software vendors, with the twist that transactions are completed and stored on the internet, and contracts are for monthly subscriptions, rather than the historical method of upfront expensive seat licenses and long-term maintenance contracts.

Here's a quick look at companies that have come public in just the past few months:

[More from StreetAuthority.com: 3 Unloved Gems From The Bargain Bin]

View photo

.

Companies Soon To Go Public

It may seem unfair to single out the cloud-based companies, but there are an awful lot of me-too business models, and as long as the IPO market remains solidly open, look for more of these cloud-based businesses to step up to the IPO gate as well.

Similar concerns have arisen in biotechnology, which has also been a huge beneficiary of the frothy IPO market. Dozens of these firms have come public in the past two quarters, and though every biotechnology firm is presumably distinct in terms of its drug development process, very few of these companies are likely to make it all the way through the FDA clinical testing process. 

Just because their bankers were able to raise them money doesn't mean that their drug development platforms are any better than those companies that have not yet sought to go public. It would be nice if investment bankers vetted these companies for us, bringing public the best in class operator in each biotech niche. But that's not how it works. Any company that wants to raise money can do so, at least while the IPO spigot is wide open.

[More from StreetAuthority.com: Are These Energy Stocks In A Bubble? ]

As a final concern, the IPO market will eventually shut down, perhaps due to the end of the bull market, or a period of stagnant IPO returns that dampens enthusiasm. That would be a problem for many of these cloud-based tech firms, and the many biotech firms that have recently gone public. Almost all of these firms remain unprofitable and likely plan to raise more cash as needed through a secondary offering. If they don't line up those funds, some of these companies may not even be around on a standalone basis in five years. 

Risks to Consider: These newly-public companies face many risks beyond crowded competitive environments. Insiders will be free to unload stock 180 days after the IPO, and their lack of established track records makes them strong sell candidates when fund managers need to trim their portfolios. 

Action to Take --> These issues are surely a concern when assessing the merits of any new or recent IPO. But investors need to also think about the impact on existing established incumbents that once shared their market with just a few well-funded rivals. The IPO surge has created a number of fields where five or six firms now have deep pockets, and all that cash being deployed may end up simply stealing key customers from one another.

Related Articles

View Comments (4)