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The Ugly Truth About IPOs: Yes, there were winners like Cisco
and Broadcom, but the primary legacy of the recent IPO madness
was busted stocks and disappointed investors. Who got rich? The
investment banks that churned out the deals, of course. Just ask
Merrill Lynch.
Nelson D. Schwartz Reporter Associate Len A. Costa
11/23/98
Fortune Magazine
Time Inc.
Page 190+
(Copyright Time Inc. 1998)
It never made the newspaper or the evening news, but Oct. 5 of this year
marked the end of a remarkable era on Wall Street. That was the day Boston
Chicken, whose initial public offering five autumns ago dazzled investors and
made headlines across the country, filed for bankruptcy. In itself, the filing
was hardly significant. The stock, down from over $35 in early 1997 to
under a dollar, had disappeared from the Street's radar long ago. Its final
collapse, though, provided the perfect bookend to one of the bull market's
more costly delusions--the dream of getting rich on a hot IPO.
The fact is, the typical IPO of the last decade proved to be at best a mediocre
investment--and at worst an outright wealth destroyer. Not every company
that came public in the 1990s went under like Boston Chicken, of course, but
that stock's trajectory is echoed in the charts of dozens of other once-hot new
issues. Some are well- known, like Discovery Zone, which went bankrupt
back in 1996. Others, like the more obscure Intelligent Medical Imaging or
Morrow Snowboards, still cling to life at the bottom of the Wall Street
barrel, having lost over 90% of their original value.
To be sure, Cisco and Microsoft and AOL were all IPOs at one time too. But
picking the next Cisco out of a crowd of unproven companies at their initial
offerings is an extremely low percentage bet. The typical IPO of 1993 had
returned just one-third as much as the S&P 500 by mid-October of this year,
according to CommScan, an investment-banking research firm. What's more,
of the nearly 3,500 companies that have gone public over the past five years,
more than half are below their offering price. One in three is down over
50%.
How could things have gone so wrong? To figure it out, we chose to focus on
a highly successful promoter--and beneficiary--of the decade's IPO
addiction, Merrill Lynch. The monster brokerage was among the most
prolific underwriters of new equity offerings of the past five years, along
with Goldman Sachs and Morgan Stanley Dean Witter. And with the
nation's largest army of retail brokers, Merrill was in a unique position to
accommodate individual investors eager for IPO shares.
In the process Merrill did its customers few favors. Not only have Merrill's
offerings largely underperformed the market, they've also badly trailed the
average IPO led by other bulge-bracket dealmakers (though they've beaten
those of smaller Wall Street firms). For example, while the typical 1993
Merrill Lynch IPO has risen an annualized 6% to date, the average Morgan
Stanley deal of that year has climbed 12% a year, and the average Goldman
issue has risen 11%. (See the chart later in the story.) Boston Chicken,
fittingly enough, was a Merrill deal. So were a wide range of other major
and minor flops, from telecom company HighwayMaster Communications
(off 95% from its 1995 IPO) to sports outfitter Starter Corp. (off 93% from
its offering in 1993).
To be fair, Merrill has also had some very big winners: Eckerd, first traded
in 1993, returned 400%; and Teleport, a local phone company that AT&T
bought in 1998, gained more than 250%. Brian Hehir, co-head of Merrill's
equity capital markets division, says the firm would never lead an offering it
didn't think would be successful. Merrill spokesman Timothy Gilles adds,
"For 1997, Merrill Lynch's IPOs have outperformed those of other
bulge-bracket firms by a factor of four, and their outperformance continues
in 1998." In addition, Gilles notes that more than half of Merrill's deals over
the past five years are trading above their offering price. As for the Boston
Chickens? Every investment bank, he points out, has its share.
That's true. Indeed, as far as we could tell, Merrill's practices are not
appreciably worse than the competition's, although the firm has sometimes
been less choosy than other bulge-bracket underwriters. For example,
Morgan Stanley wasn't interested in leading two telecom
offerings--HighwayMaster and USN Communications--that Merrill
ultimately took public (with disastrous results for investors). Morgan even
tried to dissuade HighwayMaster from doing an IPO. Gilles denies that
Merrill is any less discriminating: "We apply a rigorous review process to
every deal we do."
Instead the real problem at Merrill is one it shares with many smaller IPO
underwriters: At each step in the process, what matters most is volume, not
quality. Investment bankers have every incentive to get deals done,
regardless of the company's real prospects. Research analysts are likewise
rewarded for helping to rope in IPOs; that tends to impart a certain rosy
glow to the analysis of potential clients' business prospects. For brokers, too,
the imperative is crystal clear: Move the merchandise. If the stock fails to
live up to overwrought expectations and crashes after the opening, well,
there are more where it came from.
In recent months the IPO market has grown cold, another victim of
worldwide stock market weakness. Merrill and other underwriters have had
to postpone scores of new issues. But the relative calm is a perfect chance to
come to grips with what the IPO craze of the past few years really meant for
investors--and why.
To understand the IPO market from an investment banker's point of view,
you must grasp this: It's all about the spread. That's the 5% to 7% share of
the IPO proceeds that underwriters typically keep, and it's what makes taking
companies public an irresistible proposition on Wall Street. Roughly half the
spread goes to the "lead" underwriter, the firm that arranges the deal, prices
the stock, and sells the largest percentage of shares. In the 1998 IPO of USN
Communications, for example, the company raised $128 million, of which
Merrill likely kept about $4 million.
The profits don't end at the IPO, either. Most rapidly growing firms need
new capital to fuel their expansion, so secondary offerings can generate
underwriting revenues for years to come. The underwriter can also collect
brokerage commissions when founders cash out, and its financial consultants
can bid to run the portfolios of executives made rich by the IPO. Says a
well-known money manager: "Brokerages want to get everything out of the
pig but the squeal."
What's pork for the bankers, though, isn't always so pleasant for their
customers. "I think 95% of companies go public too soon," says Henry
Nicholas, president and CEO of Broadcom, a newly public chipmaker.
Nicholas points out that recruiting managers is tougher following an IPO,
since many experienced execs want to get in when a company is still private
and amass a big equity stake. At the same time, dealing with Wall Street and
institutional investors can be a dangerous distraction for managers whose
time would be better spent guiding the company's first steps.
But then, that's not the investment banker's problem. His compensation is
linked to the revenues from the deals he brings in, not to the number of bad
deals he heads off. Besides, investment bankers know that if they turn down a
deal, it will almost certainly end up with a rival across the street. "It's a
systemic problem in the industry," notes Richard Kauffman, the head of
global equity capital markets at Morgan Stanley . "At many banks it's very
hard for a banker to say no to a deal."
It can be hard for a startup company to say no, as well. "It's all very
tempting because you can become a millionaire overnight," says Broadcom's
Nicholas, who fended off investment bankers for three years before finally
taking the company public through Morgan Stanley this spring. (The stock
soared a record 123% on the first day and, unlike most other IPOs, has since
risen even higher.) More commonly, however, a company willingly gives in.
For example, despite being turned down by Morgan Stanley ,
HighwayMaster interviewed several prominent investment banks, including
Smith Barney and Credit Suisse First Boston, before settling on Merrill as its
lead underwriter. Merrill's bankers pointed to the firm's global franchise, its
experience in the telecommunications sector, and especially Merrill's huge
retail network. One telecom banker, who recently left Merrill for a
competing firm, knows the routine perfectly. "Retail is seen as the fallback
on a deal," he says. "We would tell clients, 'Our retail customers are less
discerning. We can push this through the retail system.'" Merrill, however,
denies that its bankers would ever make such a promise.
If reciting the firm's virtues still fails to sway a potential client, a banker
always has one more tactic: to promise a higher offering price than the other
guys. It's a win-win proposition. "The company wants to raise as much as
possible, and the bankers know that the higher the valuation, the bigger the
fee," says Salomon Smith Barney restaurant analyst Stacy Jamar. Win-win,
that is, as long as you're not an investor. To justify a jumbo offering price,
earnings expectations have to be stretched. And that sets the stage for the
kind of earnings disappointment that can quickly devastate the shares of a
young company.
In one spectacular recent example, Merrill analyst Mark Kastan was forced
to lower his revenue estimates for USN Communications five times in the six
months following the company's February 1998 IPO. The stock, issued at
$16, now trades for less than $1. How do bankers feel when that happens?
"Investment bankers don't like to look back a lot," says the former Merrill
banker. "They've already moved on to the next deal."
If the investment banker's job is to sell the company on the idea of going
public, it's the research analyst's job to sell the company to investors. In
recent years that role has expanded: Now analysts aren't judged merely by
how well they follow an industry but also by how many deals they bring in
the door. For analysts, then, the challenge is to strike a balance between the
desire to attract big- dollar deals and the need to make accurate earnings
forecasts. But as with bankers, so with analysts: Doing the deal can tip the
scale.
HighwayMaster is an instructive example. Just four months after Merrill
brought the company public in June 1995, Merrill telecom analyst Linda
Runyon Mutschler, a strong supporter of the IPO, lowered her earnings
projections while keeping her "long-term buy" rating on the stock. She
brought her numbers down further in February 1996 and downgraded the
stock to "neutral." By then Wall Street wags had nicknamed the stock
"Highway Disaster." Its stock was trading below $9, vs. its initial offer of
$19.75. Nevertheless, Merrill says its analysts would never sacrifice their
credibility for a deal.
Strangely, though, that awful call didn't stop Mutschler from taking top
honors for her sector in Institutional Investor's closely watched analyst
survey in 1995 and 1996. Last month she won the top spot again in the 1998
poll. "Wall Street can forget things as quickly as anything I've ever seen,"
says George Novello, manager of the Salomon Smith Barney Special Equity
fund and a frequent investor in IPOs. "And because the basic premise of the
place is greed, everything is forgiven if the analyst can come up with one
home run. People say to themselves, 'Sure, he's had three bad IPOs in a row.
But this new one really looks hot.'"
As the final stop on the assembly line, the individual broker would seem to
be the participant most likely to feel accountable for the investors'
experience with the IPO. Guess again. At Merrill, as at many other firms,
brokers stand to earn considerably more by moving several hundred shares
of an IPO than by selling the same amount of a stock on the secondary
market.
Richard Urbealis knows all about that. A broker for Merrill in Midtown
Manhattan for three years, Urbealis recalls, "There was a lot of pressure to
place IPOs. The commissions were bigger, and it was a good way to work
your way up. So a lot of younger brokers encouraged mom-and-pop
investors to buy."
Urbealis, however, ran up against one of the dirty little secrets of the IPO
game. At Merrill and many other firms, brokers are punished if IPO
customers immediately sell, or "flip" their shares. Offending brokers can
lose their commissions on the earlier trade, and they can expect to have a
much harder time getting IPOs in the future. So brokers tell clients to hold
on, adding that if they do sell, the client could also forfeit a shot at future
new issues. Institutions, however, are generally exempt from these rules.
"Institutions would bail out right away," says the 36-year-old Urbealis. "But
retail customers would be left holding the bag."
Ultimately he grew tired of keeping investors in IPOs that seemed bound to
fail, and in the summer of 1992, after months of violating Merrill's policies
on flipping, Urbealis was forced out. "You could tell customers that the
analyst still liked it," he says. "But I didn't have the stomach for it. It just
killed me to keep people in those positions."
Merrill's Gilles says that Urbealis is wrong. "Merrill Lynch's policies are
designed to place shares in the hands of bona fide long- term investors," he
says. As for Merrill's rules on flipping, Gilles adds, "We do not permit
financial consultants to prevent or discourage clients from ever selling." He
also denies that institutional clients get special treatment.
Tom Davidson, who worked in Merrill's Cleveland office from 1992 to
1994, still remembers Starter Corp., a 1993 Merrill IPO. The company
makes uniforms for many pro athletic teams, as well as other apparel
emblazoned with team logos. "It really appealed to individual investors
because they knew the teams," says Davidson. "We hyped the hell out of the
stock after the IPO. The managers liked it when we could buoy a new IPO in
the aftermarket."
Months later, however, the stock got sacked. Offered at $21.50, i now trades
for about $1.50. For brokers, if not clients, such blowups became a source of
humor. "We'd say, 'Here comes Mr. Starter,'" Davidson recalls. "People
teased me quite a bit about it." But there was no backlash from Davidson's
bosses, who he says looked at disasters like Starter as "the breaks of the
game."
It would be unfair to end this tirade against lack of accountability on Wall
Street without noting where the buck really stops: with investors. After all,
bankers grind out deal after deal only because they know investors will buy.
Even Gilles notes, "The truth is, client demand for IPOs far exceeds
available shares."
It's not only the uninitiated who get burned. Stacie Cowell manages the $250
million Invesco Small Company Growth fund, but she was surprised when
software seller Versatility plunged just three months after Merrill took the
company public in late 1996. "You assume the bankers have done their due
diligence and that the first few quarters out of the gate will be okay," she
says. "But you have to realize they get paid on volume, not on how stocks
perform afterwards."
That's something to remember, with the market stabilized (for now) and
Wall Street eager to crank up the IPO machinery again. The fact is, investing
in IPOs was a sucker's game even in the great bull market of the 1990s. It's
hard to imagine that it will be any less so next time--for Merrill customers
or anyone else.
COLOR PHOTO: PHOTOGRAPHS BY SCOTT GOLDSMITH {Sign
announcing closure on Boston Market store} COLOR CHART: FORTUNE
CHART Boston Chicken, parent of the Boston Market chain, was the original
hot IPO. But huge earnings shortfalls made the stock a turkey. {Chart not
available--line graph showing end-of-quarter stock price for Boston Chicken
from November 8, 1993 through October 23, 1998} COLOR PHOTO:
PHOTOGRAPHS BY SCOTT GOLDSMITH {See caption above--Road barrier
with defunct Boston Market store in background} COLOR PHOTO: PABLO
ALFARO For Urbealis' IPO clients, the ship never came in. {Richard Urbealis
beside yacht} FIVE COLOR CHARTS: FORTUNE CHART/SOURCES:
COMMSCAN, S&P How Not to Get Rich in a Bull Market The average Merrill
Lynch IPO has lagged badly behind new issues from chief competitors Morgan
Stanley and Goldman Sachs, let alone the S&P. One exception: stocks that went
public in 1997. {Charts not available--bar graphs comparing average cumulative
return through October 22, 1998 on IPOs issued by Merrill Lynch, Morgan
Stanley and Goldman Sachs for 1993; 1994; 1995; 1996; 1997} COLOR
CHART: FORTUNE CHART HighwayMaster's communications systems for
truckers seemed like a promising business. But three years after its IPO, the
company is profitless, and the stock is road kill {Chart not available--line graph
showing end-of quarter stock price for HighwayMaster Communications from
June 22, 1995 through October 23, 1998} COLOR PHOTO: PHOTOGRAPHS
BY SCOTT GOLDSMITH {See caption above--dashboard of truck} COLOR
CHART: FORTUNE CHART The Vikings are winning, but you can't say the
same for Starter Corp., which makes their uniforms. It's off 93% since its 1993
IPO. {Chart not available--line graph showing end-of quarter stock price for
Starter Corporation from April 8, 1993 through October 23, 1998} COLOR
PHOTO: PETE KUHNS {See caption above--Minnesota Vikings players at
practice} |
