Pardon the flames, but the IPO market has been on fire this year. According a report from IPOHome.com, Wall Street has seen 131 offerings that have averaged a staggering 28%.
But while this is obviously good news — especially considering the IPO market has seen big periods of shakiness since the financial crisis — investors should be alert to a growing minefield.
The thing is, the buy-buy-buy nature of the recent IPO market could lead to a decline in the quality of deals coming at us.
When the IPO market rebounds, it’s usually the top-notch companies that test the market first. A public offering is expensive and takes a lot of time for senior management — that’s why it’s so important that, before pulling the trigger on a filing, a company knows there’s a good chance the deal will be successful.
However, as investors continue to eat up IPOs left and right, Wall Street will start to run out of quality companies. So do you turn off the faucet … or just lower your standards?
Answer: It’s the latter, and we’re already seeing indications of this.
As I pointed out in a post for the IPOPlaybook.com, Violin has already lost one of its biggest customers — Hewlett-Packard (HPQ) — and it faces a hypercompetitive environment that includes well-funded giants like IBM (IBM), Oracle (ORCL) and Fusion-io (FIO), as well as a host of startups.
But perhaps the scariest part of the deal is the financials. Violin’s independent auditor has issued a “going concern” opinion — this means the company will likely go bust if it cannot raise more capital. Heck, Violin’s losses are greater than its revenues!
This is not the only recent dicey filing. Another one comes from textbook rental service Chegg. Even though its revenues ($213.3 million in 2012) are significant, losses (of $49 million) remain an issue.
But the biggest challenge could be structural — that is, the emergence of e-textbooks. It is a market that already is feeling competitive pressures, such as from heavyweights like Amazon.com (AMZN), Apple (AAPL) and Google (GOOG). Then there is this (from the S-1):
“Publishers have significant flexibility in pricing eTextbooks due to their low production costs and may change their pricing strategies in the future, especially in light of increasing competition in the print textbook market and the rising costs of education. If the retail price of eTextbooks were to be significantly lower than print textbooks, consumers may purchase eTextbooks directly from the publisher or other retailers rather than use our print textbook or eTextbook services.”
It’s still very well possible that these deals could end up performing strongly, but if nothing else, that’d be even further evidence of how bubbly the IPO market is getting.
Investors need to exercise extreme caution for the next few months. Dig into the S-1 filings and get a good sense of the competitive advantages and risks.
Because if the IPO market does blow up — and it will at some point — you’ll at least have the advantage of holding solid companies.
Tom Taulli runs the InvestorPlace blog IPO Playbook. He is also the author of High-Profit IPO Strategies, All About Commodities and All About Short Selling. Follow him on Twitter at @ttaulli. As of this writing, he did not hold a position in any of the aforementioned securities.