A Really Cheap IPO

Small investors rarely have the opportunity to get into lucrative IPO deals. Wall Street investment banks reserve the juiciest ones for the big boys.

You know the routine: IPO price is $40, stock shoots up to $50, little guys buy in as big guys sell with their 25% short-term gains ... then the stock does nothing or, worse still, slides back down to the IPO price. Naturally, there are huge exceptions that seem to defy the laws of nature -- Google (Nasdaq: GOOG  ) is a clear example -- but what about regular companies?

Last year, one such regular company presented the average investor with a juicy value opportunity.

Mastering MasterCard
Early last summer, MasterCard (NYSE: MA  ) announced that it would IPO about half of its shares at $39. The financial press was mostly negative and warned investors to stay clear because, the story went, MasterCard's owners -- the big banks -- wanted to go public to wash their hands of the company's mounting legal challenges and potential liabilities.

To be sure, these concerns could not be taken lightly. Challenges to Visa and MasterCard from merchants of partner banks, as well as suits from rivals American Express (NYSE: AXP  ) and Morgan Stanley's (NYSE: MS  ) Discover card, could lead to settlements of more than $1 billion, perhaps even $2 billion. Against this backdrop, and with a share price up almost 20% since the IPO, why would anyone invest?

In a word: cash
IPOs carry a great deal of uncertainty because the previously private company typically files pro forma financial statements as if it had already been a public company. These filings often don't include additional debt, cash, and other measures that will end up on the balance sheet.

Early last summer, MasterCard already had $1.2 billion in cash and investments, and the banks were going to leave $650 million of the IPO cash with the company.

The focus on the legal challenges was masking the truly remarkable nature of MasterCard's business model -- a true toll business that extracts a small fee per transaction (the issuing banks get the big fees) and a dollar-volume percentage from bank customers for using MasterCard. Additionally, plastic cards are gradually displacing cash, and worldwide electronic forms of transfer are expected to grow by 12.9% through 2009, according to GlobalInsight.

I recommended shares to subscribers of my Motley Fool Inside Value newsletter service. That was in June 2006, when the stock was close to $45.

Global growth
You might think that developed countries are saturated with cards, yet there is tremendous growth in debit cards and further inroads in credit card usage in making bill payments, submitting government fees, and even purchasing your meal at a fast-food restaurant. In emerging countries, MasterCard is making major investments in advertising and branding with its "Priceless" campaign and its sponsorship of soccer's FIFA World Cup. These investments should aid growth well into the future.

Establishing a value range for MasterCard required that I estimate likely outcomes of very large future legal settlements. I estimated roughly $6 per share per $1 billion in future settlements, but still my very conservative estimates came out at $66 for a roughly $46 share in an exceptional business.

Was I wrong!

In the past two quarters, the company has really shown the power of its business model and blown all of my estimates out of the water. Much of this is a result of a one-time change from significant price increases and some IPO-related issues, but a substantial amount is a result of the fabulous business model.

The Foolish bottom line
When I added MasterCard to our Inside Value scorecard, it was already up 20% since its IPO. But by focusing on the long-term strength of the business, I found true value even after that 20% pop. Today, the shares are up more than 120%, making them -- unfortunately -- close to fairly valued. Consequently, they're a "hold" in my book.

Where else could we look for value? Start by checking MasterCard's rivals. Visa has already announced that it intends to IPO, perhaps later this year; and Morgan Stanley has said that it will spin off its Discover Card unit. Perhaps these companies learned from the MasterCard IPO experience -- and perhaps Wall Street did as well, so they may not be as cheap. Nevertheless, I'll be eagerly awaiting the IPO details.

Philip Durell, advisor/analyst of Motley Fool Inside Value, does not own shares of any company mentioned. You can view Philip's favorite stocks for new money, as well as their fair value and buy-below prices, with a free 30-day trial to Inside Value. The Fool has a disclosure policy.


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