Burnham's Beat

Dutch Auctions and Democracy: Two Things That Don’t Make Sense For IPOs

Almost all post mortem accounts of Google’s now infamous IPO almost reflexively refer to the event as Google’s “Dutch Auction” IPO. Indeed many proponents of Dutch Auctions are now holding out Google’s IPO as supposedly some kind of validating watershed that will lead to increasing use of Dutch Auctions for IPOs (just take a look at the article on WR Hambrecht today in the San Francisco Chronicle). There’s even a new start-up trying to build an entire underwriting business around conducting Dutch Auctions on the American Stock Exchange. The only problem with this hubbub is that, no matter how you look at it, Google’s IPO was clearly not a Dutch Auction. The most egregious violations of Dutch Auction etiquette perpetrated by Google include:

1. Google didn’t fill 100% of the orders. In Dutch auctions, almost all the bidders above the clearing price receive 100% of the shares they bid on. Typically, the only people that don’t receive 100% of their orders are those that “tie” for the lowest bid. It has been widely reported that investors only got about 75% of the shares they bid for, regardless of what bid they made. This is a clear violation of the principles of a Dutch Auction.

2. Google changed the number of shares offered. In what is perhaps the most egregious violation of Dutch Auction principles, Google substantially reduced the amount of shares offered after the auction had already started. Dutch Auctions are supposed to have fixed inventories. Fixing the inventory assures investors that the issuer won’t be able to manipulate the clearing price by simply reducing inventory. This is of course exactly what Google did. They started the auction, didn’t like the way the winds were blowing and promptly cut the size of the offering by 24%. This may be good deal management by the underwriters, but it’s clearly not consistent with a Dutch Auction.

Despite being faced with the obvious fiction of Google’s “Dutch Auction” IPO, many pundits and policy wonks still insist calling the IPO a “Dutch Auction” solely because it used a “democratic” means of allocating shares. From this perspective, it doesn’t matter that Google bent a few rules, it just matters that the process was more “democratic” with the supposition being that a democratic distribution of shares is much better than one in which the underwriters and issuers hand pick which investors get shares.

Tyranny of Idiocy
The problem with this argument is that Dutch Auctions are not democratic, they are more like the “Tyranny of The Biggest Idiot” in that any idiot can get shares if they are willing to pay a high enough price. While having such an allocation process will clearly maximize short term pricing, it does not guarantee a strong syndicate of stable, long-term shareholders which should be one of the primary goals, if not the primary goal, of any IPO.

The painful truth for all the academics and Wall Street critics is that democracy isn’t necessarily a good thing when it comes to IPOs. The fact is that the old-fashioned method of allocating IPO’s is a far more reasoned and reliable way of allocating shares than Dutch Auctions because it gives issuers the discretion to allocate shares to specific investors. This flexibility allows the issuer to avoid giving shares to obvious flippers and to give more shares to investors that clearly want to be long-term shareholders.

It’s true that many banks take advantage of this discretion to reward prized clients preferred access to under-priced shares but in the grand scheme of things such “payoffs” are really just a franchise tax that issuers must pay to an underwriter in return for renting their brand. For every issuer that gets screwed by having a portion of its deal allocated to settle old-debts or curry new favors, there’s another issuer that get a huge benefit when an underwriter calls in its chits and gets a few big investors to step up to the plate and help them move a soft deal.

Issuer Beware
The ultimate solution to the problem of under-priced IPOs and underwriter pay-offs is not to blindly adopt Dutch Auctions as some kind of saving grace, but to better educate Issuers about their rights and responsibilities when it comes to determining the issue price and allocating shares. Issuers need to make sure that they stay on top of their order book and that they develop an opinion on which investors they’d really like to have at their annual meetings.

One potential solution that may bridge the gap between traditional syndicate book building and Dutch Auctions may be to simply use the Dutch Auction process as a non-binding way to improve the price discovery process that syndicate desks already do today. Rather than simply taking share orders, syndicate desks should just ask investors explicitly about pricing levels and then make this data available to issuers. The reality is this is basically what Morgan Stanley ended up doing in the Google IPO.

In the past underwriters have been reluctant to do this kind of research as such “price discovery” chit-chat could potentially be construed as an attempt to “ladder the deal”, which has been a major “No! No!” since 1934. Given that the SEC seems to be a big supporter of Dutch Auctions I don’t see why they would object to providing Wall Street with a safe harbor letter that would allow them to solicit such variable pricing data prior to going effective.

However things evolve, the mindless championing of Dutch Auctions and “democratic” allocations is not doing anything to improve the IPO process. Rather it is simply lulling issuers into believing that the only thing that matters about an IPO is getting the highest price possible. Getting a high price is important, but it’s also important to get a stable core of long-term shareholders and to avoid allocating shares to flippers that might needlessly destabilize a stock’s trading early on. Issuers and underwriters have to balance both of these needs and as result retaining the flexibility to allocate shares remains incredibly important no matter what the academics say.

Software Stock Update: 8-04

August was another poor month for software stocks with the average stock down 3.7% vs. a 2.6% decline for the NASDAQ in general. Small caps actually did slightly better than large caps this month, but that’s probably because small caps got killed in July and there just weren’t a lot of sellers left.

In terms of my hand picked virtual software stock portfolio, the portfolio had a great month with the average stock up 6.0% vs. the NASDAQ’s 2.6% decline and the software sector’s 3.7% decline. 7 out of the 10 stocks in the portfolio had a positive month with the short side more than making up for losses on the long side. On an overall market weighted basis, the portfolio is now up 15.2% YTD (it’s up over 17% on a cost weighted basis) vs. a 14.7% decline on the NASDAQ, so it is now outperforming the market by almost 30% despite having been strongly net long for the first 7 months of the year.

While several of my shorts seem to have performed about as well as they can in the short term, I don’t have a lot of new ideas so I will leave them in place for this month. I expect September to be more of a mixed month, as investors concentrate on adjusting their portfolios ahead of the Q3 reports (which in general should be light).

Details on the specific stocks in the portfolio:

Long Picks
Company: Actuate Ticker: ACTU
Sub-sector: Business Intelligence
Investment Thesis: I continue to like the turn around story here and their Q2 report suggests that are making good progress at becoming solidly profitable again. It will probably take another quarter for this story to play out.
Performance: Since 1/26/04: -11%, Jul vs. Aug: -13%
Comments: Another bad month on very weak volume. BI continues to be strong and the company continues to make product progress, so I won’t sell for now.

Company: SumTotal Ticker: SUMT
Sub-sector: E-Learning
Investment Thesis: SumTotal was formed by the merger of Docent and Click2Learn which closed in mid-March. I liked Docent before the merger because as it was relatively cheap, had good products, and was in a space still seeing good corporate spending (E-Learning). The combined companies promise to be solidly profitable after the debris from the merger clears which should help the overall valuation as they cement their leadership position in the e-learning space.
Performance: Since 1/26/04: -37.3%, Jul vs. Aug: -3.6%
Comments: Didn’t have the disasterous month that it had in July and seems to have bottomed out a bit. Worst performing stock in the portfolio right now. I will give it another quarter to see if they make progress on clearing up the debris from the merger.

Company: SPSS Ticker: SPSS
Sub-sector: Business Intelligence
Investment Thesis: SPSS is another player in the business intelligence space with a particular emphasis on predictive analytics, something that is particularly hot right now. The stock has been battered by a restructuring that the company went through last year as well as an accounting restatement. My thesis is that the new product set is strong and the accounting trouble is overblown.
Performance: Since 4/30/04: -3.0% Jul vs. Aug: -6.8%
Comments: Had a poor earnings report in August when it missed license revenues by $2M. Stock would have been hurt more, but the NASDAQ decided to relist them to the NMS, so that helped somewhat. Still like the BI space and the relative valuation of this company. Stock is very jumpy on light volume though.

Company: Stellent Ticker: STEL
Sub-sector: Content Management
Investment Thesis: Stellent is a relatively sleepy, but well established, content management company that is attractively priced. Q1 was the first quarter of positive cash flow in awhile and Q2 saw pro forma, but not GAAP positive, EPS. With $20-25M/quarter in revenues, Stellent has a lot of room to work on expenses and should be able to return the company to solid GAAP profitability at which point the stock should recover from its current 1.3X ev/sales to something much closer to 2X.
Performance: Since 6/30/04: -19% Jul vs. Aug: 0%
Comments: After a poor July, STEL calmed down a bit in August. Seems like it will range trade a bit here until Q3 report.

Company: Neteller Plc. Ticker: NLR.L
Sub-sector: Internet Payments
Investment Thesis: Every portfolio needs a flyer and this sure counts as one. Neteller is Europe/Canada’s answer to PayPal and it has been making a killing by servicing markets, particularly online gambling, that PayPal has been pressured into exiting by the US Justice Department. I know, I know, this is not a software stock, but I still follow online financial services quite closely and I feel compelled to point out this stock because it is such an attractive buy. After going public in London on 4/14, the stock is now trading at about 15X estimated 2004 EPS and yet is growing like an absolute weed.
Performance: Since 6/30/04: +28% Jul vs. Aug: +12.1%
Comments: Best performing long pick two months in a row now. Will announce it’s 1st half 2004 results mid-September (they move slowly over there in the UK). Stock ended the month just above its IPO price and at a 52-week high. Guess it is getting discovered now. Still a decent bargain at 15X this year’s EPS and less than 10X next year’s given its growth rates.

Short Picks
Company: Autonomy Ticker: AUTN
Sub-sector: Content Management
Investment Thesis: Autonomy is a UK based purveyor of advanced enterprise search software a space I know well based on my VC investment in Stratify. The enterprise search space is crowded and getting even more competitive with the entry of folks like Google. Autonomy’s secret sauce, its categorization software, is increasingly being duplicated by it competitors. Autonomy continues to trade at a premium to the market at 3.6X enterprise value to sales however its decline has brought it to a more reasonable level. This premium appears to be largely an artifact of the fact that autonomy is a bit of a cult stock in its home country of the United Kingdom as well as the small float due to its meager cross listing on NASDAQ.
Performance: Since 1/26/04: +46.1% Jul vs. Aug: 1.9%
Comments: Seems to have bottomed out a bit after last month’s 36% drop. Still don’t like the space, but I am worried that the downside might be limited from here on, but the stock continues to have a premium valuation and its Q3 should be weak as it gets the majority of its sales from Europe.

Company: Commerce One Ticker: CMRC
Sub-sector: Supply Chain
Investment Thesis: I know CommerceOne well as I was the analyst on their IPO in the summer of 1999. CMRC has lost over $3BN in the last 3 years and while it has reduced the size of the losses, it looks like it will be too little too late. I have watched a number of high flyers implode under the weight of the infrastructures that they built and I think CMRC will succumb to that same fate. With all the institutions long gone, it looks like a bunch of clueless retail investors are currently holding the bag unaware that it contains a ticking bomb. With $12.5M in preferred stock and another $5M in bank lines ahead of the common there’s a good chance that the common stock will get nothing if this company is even sold.
Performance: Since 1/26/04: +72.2% Jul vs. Aug: +20.5%
Comments: CMRC remains the overall top performer in the portfolio for the 5th month in a row. The Q2 earnings report was not encouraging with just $350K in license revenues and cash burn of $4.8M. That’s a lot considering that the company had a grand total of $4.3M in cash at the end of Q2 and $4M of short term debt. With a current ratio of 0.84 the only way this puppy survives is with a massive (read $10-$15M) equity infusion which would have to come on top of the $12.5M in existing preferred. In-lieu of a financing, it’s Chapter City for CMRC. Either way the common holders are looking at a zero shot. Needless to say, this pick remains firmly in the portfolio.

Company: Redhat Software Ticker: RHAT
Sub-sector: Operating Systems
Investment Thesis: Redhat is the Linux poster child and has the largest independent distribution of open source Linux-OS. As the poster child for all things Open-Source, Redhat has been the recipient of tremendous investor interest and its valuation reflects it. Investors apparently are expecting RedHat to take over the world, despite the fact that Redhat sells just one of several Linux distributions and faces competition from IBM, NOVL, and possible folks like SUNW and HP. From what I hear Redhat’s move into the App Server business went over like a lead brick at Big Blue. That combined with continued customer grousing over price changes has made RHAT vulnerable.
Performance: Since 7/1/04: +46.5% Jul vs. Aug: +28.4%
Comments: Another terrible month for RHAT. No real news moving the stock other than folks digesting last month’s accounting restatements. Stock has almost been cut in half in just two months. The company has an earnings report this month and I gotta believe they’ll do everything in their power to put a positive spin on things so I’d be surprised if the stock didn’t trade up this month.

Company: RSA Security Ticker: RSAS
Sub-sector: Security
Investment Thesis: I have always wanted to short RSAS. I covered the security sector when I was an analyst and basically came to hate the sector due to the fact that almost every company blows up once every 12-18 months and does so with no warning whatsoever. RSA used to be called Security Dynamics and its main product remains a "hard token" called Secure ID which they already have sold to just about everyone on the planet that is going to buy one. The stock's last major blow up was on it's Q3 report last year. I am thinking it's due for a repeat. Even if it doesn't, the stock tends to trade along with the boarder tech market and I need some shorts that more closely follow the market, so this will have to do.
Performance: Since 8/1/04: 20% Jul vs. Aug: 20%
Comments: RSAS had a nice debut in the portfolio as it traded down throughout the month apparently mostly on general market weakness rather than anything specific. Management has an aggressive set of investor presentations planned for September which may help the stock in the near term, but I like the fact that the stock trades well and correlates nicely with the market so it’s a good short to have in the portfolio.

Company: Salesforce.com Ticker: CRM
Sub-sector: Vertical Applications
Investment Thesis: Salesforce.com is a, mostly, hosted sales force management application. It's a good product, most of my start-up companies used it, but it is expensive the longer you use and the larger your company gets. CRM is 2nd most highly valued stock in the software space despite the fact that it is facing increased competition from the big boys of enterprise software and that its very hard to rapidly grow subscription-based revenues. Any mis-step and this stock will down 25% in a heartbeat.
Performance: Since 1/26/04: 0% Jul vs. Aug: 0%
Comments: I added this stock a month too late to the portfolio. CRM was down strong beginning of the month but recovered on a decent earnings report and outlook. That said, it still trades at 7.2X EV/Sales and 93X 2005 EPS (which are sandbagged). At these levels, there’s little if any room for error which gives me confidence to keep this in portfolio even though it will trade up in a positive tape.