Before You Buy Into That I.P.O., Search 'Lemmings'

[David Farber <dave () farber net>]

Before You Buy Into That I.P.O., Search 'Lemmings'

August 1, 2004
 By GARY RIVLIN





STEVEN A. BALLMER, the chief executive of Microsoft,
recently sent a sly but unmistakable message to the
executives at Google. Think of it as a sobering peek into
the future, written by the leader of a longtime Wall Street
star for the benefit of its latest boy wonder.

There are "soon-to-be-public companies," Mr. Ballmer wrote
last month in his annual e-mail message taking measure of
his company and the technology industry, "that will deal,
as we have, with flat stock price for a number of years
while they build adequate profits" to justify their stock
price.

Take it from a behemoth now suffering from middle-age aches
and pains. The inflated expectations of Wall Street might
seem a validation of your hard work and potential,
Microsoft's chief executive seemed to be saying, but over
time it will also be a burden - maybe even a curse.

Mr. Ballmer's message might well have been directed, too,
at all those investors now contemplating whether they
should pay an extraordinarily high premium to own a small
piece of Google, the world's most popular Internet search
engine, when it finally goes public, probably in the middle
of this month. According to a document it filed last Monday
with the Securities and Exchange Commission, Google expects
to be worth $29 billion to $36 billion the day it goes
public. That would instantly give this company, hatched in
the late 1990's, a market value greater than that of Ford
Motor, Starbucks, Federal Express or Lockheed Martin,
though Google generates a small fraction of the revenues
these brand-name giants do.

"If an investor asked me, 'Should I bid on this stock?' "
said David Menlow, the president of the IPO Financial
Network, an independent research firm, "I would respond
with an unqualified 'no.' "

Yet one man's "financial train wreck," to borrow Mr.
Menlow's phrase, is another's rare chance to magically
transform a modest stash of cash into a single-stock
retirement fund. "Google might look ridiculously
expensive," said Michael Moe, the chief executive of
ThinkEquity Partners, a research-oriented investment bank
specializing in growth industries. "But Microsoft, Cisco,
Qualcomm - take your pick. All came out with a lot of
fanfare and people said they were ridiculously expensive -
and all of them proved a great investment.

"This is like making a bet on a thoroughbred," he said.
"You're paying a premium."

Investing in a newly minted stock is always risky. More
than 5,000 companies went public between 1989 and 2000,
according to Richard J. Peterson, chief market strategist
for Thomson First Call. Nearly one-third of those companies
are down 50 percent or more since their stock market debut,
Mr. Peterson said - if they are even still in business.
Only one-fifth are worth at least twice their opening day
price.

Moreover, this year has been a terrible one for technology
companies new to the stock market. Two dozen
technology-related companies have gone public in 2004, Mr.
Peterson said; collectively they were down more than 10
percent as of Friday's stock market close. That compares
with a gain of about 1 percent in the share price for the
nontechnology companies that have gone public this year

Google is hardly just another company seeking to sell
shares on the stock market. But, then, that is already
reflected in the share price, which is expected to be the
highest ever for an initial public offering.

In Monday's filing, Google said it expected its shares to
sell for $108 to $135 each. Even assuming that Google sells
initially for $108 per share, that would make the company
worth 150 times its last four quarters of earnings. By
contrast, its Internet rival, Yahoo, is valued at 105 times
earnings, and Microsoft 39 times earnings.

Still, Barry Randall, a mutual fund manager, is among those
thinking about taking the plunge. The company's balance
sheets, at least at quick glance, he said, are compelling.
According to Google's most recent filing, it has a gross
profit margin "in the high 80 percent range," said Mr.
Randall, who runs the First American Technology Fund, which
specializes in technology stocks.

"Your average tech stock," he said, "has gross margins of
40 percent."

Still, it seems legitimate to ask if any company, no matter
how extraordinary, should trade at such sky-high multiples.
As even Google acknowledges in its S.E.C. filings,
competitors threaten its dominance in search, from Yahoo
and Microsoft to any number of lesser-known rivals.

Moreover, Google can maintain its torrid rate of growth -
which it must do to justify so extravagant a stock market
valuation - only if it increases traffic on its site. That
is no easy task given that it's already the default search
engine for much of the world. (That explains recent
initiatives like Gmail, a free e-mail service from Google
that challenges offerings by Yahoo and Microsoft.)

"The company's valuation is clearly based more on the hype
factor than business fundamentals," said Ashok Kumar, a
technology analyst at Raymond James & Company. Unlike many
of the Internet companies that came to life at the end of
the last decade, Google turns a sizable profit ($79 million
in the second quarter of 2004, up 147 percent from a year
earlier). But Mr. Kumar nonetheless concluded that its
pricing "harkens back to the late 90's boom."

As many people learned the hard way after the bubble burst
in 2000, the stock market value of a technology company is
not based as much on its intrinsic worth as on an
assessment of its future earning power. How one answers
when asked to consider the wisdom of investing in Google,
then, seems to say as much about that individual's faith in
the technology sector generally as about his or her view of
Google.

"Basically we're looking at your classic bull versus bear
tussle over Google for a long time to come," Mr. Moe said.

Mr. Moe is among those who say they believe the technology
sector is undervalued. Then there is Fred Hickey, editor of
The High-Tech Strategist in Nashua, N.H., and a longtime
technology stock analyst who stands out as perhaps the most
bearish of them all. To him, the steep price Google has
assigned itself is proof that the stock market has not
shaken off the excesses of the bubble.

"Look at history," Mr. Hickey said. "There's never been
valuations of 100 times revenues, except during this
bubble."

Mr. Hickey concedes that there is a certain logic to
Google's price. The pricing of a stock on Wall Street is
not unlike that of the real estate market, where the worth
of a property is set largely by recent sales prices of like
properties, or "comps." Yahoo, the other large company that
sells advertising tied to Internet searches, seems to be
everyone's favorite comp to justify Google's valuation.
"Everyone is playing the 'relative-to' game," Mr. Hickey
said. "Google has a reasonable valuation if you assume its
fellow Internet stocks, like Yahoo, are reasonably priced.
The problem is, as we saw in March 2000, that game works -
but only for a while."

Mr. Kumar is not nearly as dour in his assessment of
technology's future as Mr. Hickey, but he, too, says he is
inclined to believe that technology sector valuations are
generally too high. And he is hardly alone in that
assessment, he said.

"Most portfolio managers are underweighting technology,"
Mr. Kumar said, "because they don't feel the reward of the
upside is commensurate with the downside risk." Technology
companies account for roughly 16 percent of the Standard &
Poor's 500-stock index, yet by his calculations, technology
stocks account for between 13 and 14 percent of the overall
basket of stocks held by portfolio managers.

Apparently, Wade Slome, co-manager of the American Century
Ultra Fund, a $22 billion growth stock mutual fund, is
braver than much of his cohort. He's bullish on Internet
stocks, and generally optimistic about the broader
technology market.

I THINK people are a little too pessimistic, given all the
uncertainties," Mr. Slome said. "Whether you're talking the
election, Iraq, inflation or interest rates, there's so
many things for people to worry about."

It's no surprise, then, that Mr. Slome plans to take a hard
look at Google. Whether he will actually make a bid,
though, is unclear. Typically, institutional money mangers
like him set a stock's opening price in the rarefied world
of I.P.O.'s. Google, however, is selling shares to the
public in an unconventional Internet-based auction that
puts the public on equal footing with the professionals.

Given all the hype, Mr. Slome said, "You could really have
retail investors take this to levels that are silly."

That is what worries Mr. Menlow of the IPO Financial
Network. He is convinced that institutional investors will
largely shun the Google offering, allowing the wider public
to price the deal.

"That's dangerous on a hot deal," Mr. Menlow said. "You
have to price a deal based on some kind of financial model,
not the highest price people are willing to pay in a
supercharged environment." He emphasized that he was a big
fan of the company, but said he believed that an Internet
auction would inevitably mean a lot of average people
holding overpriced shares of Google.

"I don't want make any disparaging remarks about the
individual investors," he said, "but when you entrust the
pricing of a company to amateurs, people end up getting
hurt."

http://www.nytimes.com/2004/08/01/business/yourmoney/01tech.html? 
ex=1092307596&ei=1&en=a92ffc67c57205ba


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