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Look Out for Bad IPOs!

Written By Briton Ryle

Posted March 28, 2014

Hold on to your purses, investors — it finally happened.

For the first time in a long time, a hotly anticipated IPO closed its first day of trading in the red. King Digital Entertainment (NYSE: KING) — maker of the popular Candy Crush online video game — got crushed itself on its first day of trading this week.

From its initial offering price of $22.50, the stock started its public life at $20.50, down 8.88%. It was like watching Miss America trip down the stairs on her very first step onstage. Though the stock managed to climb to $21.39 within minutes, an hour later it was at $19.75, on its way to a $19.00 close where it ended its first day down 15.56%. The stock never even came close to its offering price.

For IPO enthusiasts, it was like watching Mohammed Ali or Mike Tyson losing a fight, or standing at Superman’s side and watching helplessly as he collapses to the ground with a fragment of Kryptonite chained around his neck.

  1. An IPO has failed. You didn’t think it could happen, did you? At least not now; not with all the supercharged IPO hype and fervor we’ve been witnessing lately. Could this be a sign that the IPO hysteria has finally run its course? Are investors finally taking careful consideration before tossing their money at a new stock?
    Perhaps we should too.

Instead of being bedazzled by balloons, marching bands, and cute mascots, we would do well to pop open the hood and take a closer look at the investment vehicle we’re buying. Make sure you’re not getting a lemon with a glossy shine.

Keep Me Interested

When sizing up an IPO as a potential investment, investors need ask one very important question… Will interest in the company’s products and services continue for years? Or is it transitory, like a fad that’s here today and gone tomorrow?

Ultimately, investor interest in a stock lasts only as long as customer interest in the company. As soon as its customers lose interest, you can bet its investors will too — and fast.

In King Digital’s case, the company’s books paint a beautiful picture. The gaming company has a catalogue of over 180 games which 128 million users play 1.2 billion times each day. And it generated $568 million of net income from $1.8 billion in revenues in 2013 — a 7,100% increase from 2012’s $8 million of profit from $164 million in revenues.

But will this debutante keep her slender figure? Or is she just dieting now to snag a rich husband?

Even before this week’s outing, analysts were sounding the alarm.

78% of King’s gross sales come from just one game — Candy Crush — while 95% come from just three games. The company’s staying power depends on lightning striking over and over again, an expectation which other gaming companies have been unable to fulfill.

Such as Zynga (NASDAQ: ZNGA), for instance. On the overwhelming popularity of its FarmVille and CityVille games playable on Facebook, the company’s stock debuted in late 2011 with an offering price of $10, and quickly soared to nearly $16 within three months.

Where is it today? $4.64 — down some 53.6% of its IPO price in just over two years.

Why? Because Zynga has been unable to recreate the magic that drew in the crowds not so long ago. It is a problem common to entertainment providers from movie studios to record labels to gaming companies. There are only so many times that fans will watch the same movie or listen to the same song or play the same game.

Entertainment companies need to produce hit after hit after hit, or they won’t last.

Investors showed they have not forgotten Zynga, issuing a warning to King Digital that they want to be wined, dined, and swooned repeatedly, or the love affair will be over as fast as it started.

Beware of Opportunists

This leads us to a very cautionary word: opportunism. Companies selling products that do not have staying power are like fruit and vegetable vendors peddling their foods before they rot away. Time is of the essence, and the sale is best made when their products are their freshest.

So, too, with some IPOs, especially companies enjoying an exceptional moment of popularity — the flavor of the month.

Is calling them “opportunists” a little harsh? Not if they are trying to offer their companies to the public while still unprofitable. It’s like selling bread that isn’t baked yet. Here are two such half-baked offerings to avoid sinking your teeth into:

•, a cloud computing company, seems to have run out of venture capital offers. The company is aiming to raise $250 million on revenues of $124 million and net losses of $168 million. That represents expenditures of $292 million — or 235% of its revenues. The company is moving three steps forward and seven steps back.

Why is it considering an IPO? Because it has only $108 million left in cash, barely enough to see it through the next eight months. If it had a viable operation, venture capital funding would be more than willing to keep feeding it. But where VC money needs to be paid back usually within a certain time frame and with profit, money raised in the public markets do not need to be paid back at all.

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They aren’t thieves; let’s not get carried away. But companies leaking money have no business offering themselves to the public. They seem to be striking while the IPO metal is hot.

• TubeMogul may likely be another half-baked offering in the making. The video ad company allows advertisers to “buy video inventory in real-time across all devices, in multiple formats on one platform with ad serving, targeting, optimization, and brand measurement,” the company outlines its services at its website.

Aiming to raise $75 million through its IPO, the company hopes its growing revenues of $57.2 million in 2013 — up from $34.2 million in 2012 — will be enough to entice investors. It would have to be, really, since there isn’t much else that’s enticing. Not when you consider that its net losses have also increased over the past year to 7.4 million, more than double 2012’s losses of $3.6 million.

TubeMogul’s expenditures in 2013 reached $64.6 million, or 113% of revenues. While that’s better than, it still has TubeMogul moving eight steps forward and nine steps back.

Show Me The Money

Investors need to be more demanding of the companies they invest in. If they can’t show you the money now through impressive profits, they should at the very least be able to give you some solid expectation of profits in the not too distant future.

One thing about going public — it gives companies access to cash which they don’t have to pay back if they don’t want to — or worse, if they can’t. If a company is clearly showing that it is not in a position to pay its investors back, there are hundreds, even thousands of others that are already proving they can.

With all the hype surrounding IPOs lately, you can bet there will be dozens of companies trying to squeeze in through the gate before investor interest cools, offering unbaked pies and unripe fruit to hysteric investors who are caught up in the IPO frenzy.

Are we sure we can tell them apart? Are we confident we can identify an unbaked pie when it is being offered to us? If we have any doubt at all in our ability to distinguish, we’d be better off taking a bite out of the tried and tested thousands of other stocks available to choose from.

As always, it’s investor beware.

Joseph Cafariello