A Rule Maker IPO?

By Rob Landley (TMF Oak)

AUSTIN, TX (August 10, 1999) -- United Parcel Service has announced its intentions to hold an initial public offering (IPO). Unlike most IPOs, UPS is a multi-billion dollar company that has already been in business for years. Like all other IPOs, the sound and fury does NOT signal the creation of a new company, merely a registration with the Securities and Exchange Commission so that an existing company may be publicly traded.

In UPS' case, the company is a bit more "existing" than usual. Whether or not UPS actually qualifies as a Rule Maker is currently being discussed on the Rule Maker Strategy board, but this is the first IPO with Rule Maker potential to catch my attention since this portfolio started. And before I go any farther I'd like to tell a little story that shows how IPOs are set up to put small investors at a disadvantage.

Tomorrow, Linux distributor Red Hat will hold its IPO, and trade under the symbol RHAT. Red Hat's business is distributing Linux, a software product created and continuously enhanced by thousands of part-time programmers collaborating through the Internet. This army of volunteers acts as the supplier of the product Red Hat polishes, packages, and distributes; and keeping its suppliers happy is important to any distributor.

So Red Hat sent out letters to many of the people who have contributed to Linux over the years, informing them that it had reserved shares of its stock on E*Trade so they could buy in at the IPO asking price. That's where it all started to go wrong. The letter's instructions sent people to an E*Trade "IPO Qualification" questionnaire, which asked about things like net worth and trading experience, and rejected most of the applicants that Red Hat had sent letters to. They weren't rich enough to participate. Needless to say, it was not a public relations coup.

Read all about it here: Rules undercut Red Hat IPO goodwill

Why would a brokerage care about an investor's net worth before letting them buy a stock, when they can buy that same stock on the open market a few hours later? Because brokerages use IPOs as a kickback to their largest customers. The shares of an IPO stock are sold in blocks at the IPO price to the big fish, as a way of saying "thank you for doing business with us." When small investors like you or me who want to buy shares of these stocks put in our orders on the open market, we're buying these shares from the big fish who have them all, and we have no chance of getting them at the IPO price. They let demand drive up the price, and only sell once it's gone up. This is also why an IPO issue's stock price tends to go down again after the first week or so, as supply catches up with demand and after the big fish have sold their hoards and lost interest in the stock.

So coming back to UPS, we're not standing in line to buy shares just yet, even if it does turn out to be a Rule Maker. There's never any rush to get into Rule Makers; they keep their dominant position for years. Since we wouldn't get the IPO price even if we stood in line for it, there's really no rush. I'd rather make darn sure it's really a good stock to hold for 10 years than try to cash in on its first month anyway.

So why would an established company like UPS want to go public? Not for the money. Although the traditional view of IPOs is that they're a means of providing funding for a company, that's often more of a side effect than a motivation. Potentially profitable start-up companies can get funding from venture capitalists, often hundreds of millions of dollars at a time, without the bureaucracy, uncertainty, or inefficiency of an IPO. Companies also have the option of taking out loans, and as unpleasant as debt is, it's a lot less drastic than selling off part of the company.

Certainly, UPS doesn't need the cash its IPO will generate. They made billions last year. Our previous example, Red Hat, isn't exactly short of cash either. Red Hat has received a dozen equity investments from IBM, Intel, Oracle, Netscape, and also from venture capital funds. There's plenty more where that came from, and Red Hat's business is fairly lightweight anyway, with a healthy stream of revenue from operations.

Add in the fact that the IPO company gets the IPO price for its shares, which is almost guaranteed to be incredibly low due to the collusion between brokerages and their largest customers, and an IPO doesn't make much sense as a funding tool. Most companies can find a good use for the extra cash, but by itself that's not a good reason for an IPO.

So what do IPOs accomplish? One thing: they make a company publicly traded. This can make the original owners of the company, who usually keep a whole lot of the stock for themselves, suddenly rich. For a lot of small companies, the IPO is the founders' way of selling out, at least partially.

For a larger company like UPS, being publicly traded allows them to use their stock as currency. They can buy other companies with it in a stock swap acquisition. Or they can give stock options to their employees and management as compensation instead of cold hard cash. Both can be excellent additions to a company's arsenal, if used correctly.

Used incorrectly, issuing new shares dilutes the value of existing shares. If the company doesn't get bigger, more shares means each one is a smaller piece of the whole. Acquiring a company with stock isn't much different from acquiring a company with cash. The acquisition target should still be worth at least the purchase price or you lose money on the deal. Stock options are a trickier matter, as the only way to counter their dilutive effect on everyone else's shares is to buy back an equal number of shares on the open market. But the fun part is that the buyback can occur after the shares are issued, and in the meantime the company has effectively borrowed money from itself, interest free, by printing extra stock it will "pay off" by buying it back.

Finally, in the case of UPS, an IPO can "unlock hidden value." To be blunt, high tech companies can reach hysterical valuations in the current market, and owners want in on that action so they can spend overinflated stock while it's whipped into such a froth that a tiny fraction of their company can buy another company outright.

Like everybody else, UPS wants to be an Internet stock, and they have a better argument than most. Every time an Internet high flyer like Amazon, Dell, or eBay sells something, who ships it? Maybe UPS. Maybe FedEx. Maybe the United States Postal Service. But it's far harder for UPS to miss out on the surge of shipping than for eBay to suddenly lose all of its business to Amazon's or Yahoo's auctions.

So, as far as I can tell, UPS wants to become a "safe" Internet stock, and use its potentially overinflated stock price to buy other companies. Will this make it a good investment? Maybe. We're still trying to figure that part out.

Related Links:

After the bell today, Rule Maker Cisco Systems (Nasdaq: CSCO) reported fiscal fourth quarter earnings of $0.21 per diluted share, a penny ahead of estimates and up 31% from the year-ago quarter. We're grateful for the fact that Cisco provides full access for all investors to participate in the earnings conference call, available live and by replay at the Cisco investor relations website. Tomorrow, Phil will be back to report on the networking giant's results.

- Oak

08/10/99 Close

Stock Change    Bid
AXP   -  1/2    124.50
CHV   +  3/16    96.81
CSCO  -1 1/16    58.75
DPH   -  1/4     17.56
EK    -1 1/16    71.56
GM    -1 11/16   60.81
GPS     ---      37.75
INTC  -1 11/16   71.75
KO    +  1/16    59.81
MSFT  -  7/8     82.94
PFE   -  7/8     32.69
SGP   -1 1/16    47.00
TROW  -  1/8     33.38
XON   +  13/16   81.19
YHOO  +6 5/16   127.50

                  Day     Month  Year    History
        R-MAKER  -0.77%  -4.03%   7.35%  35.18%
        S&P:     -1.26%  -3.56%   4.83%  29.71%
        NASDAQ:  -1.15%  -5.62%  13.56%  50.65%

Rule Maker Stocks

    Rec'd    #  Security     In At       Now    Change
   6/23/98   68 Cisco Syst    29.21     58.75   101.16%
    2/3/98   54 Microsoft     45.13     82.94    83.76%
    5/1/98   82 Gap Inc.      23.05     37.75    63.75%
   2/13/98   52 Intel         46.93     71.75    52.89%
   5/26/98   18 AmExpress    104.07    124.50    19.63%
    2/3/98   66 Pfizer        27.43     32.69    19.15%
    6/3/99   11 *Delphi Au    17.19     17.56     2.17%
    2/6/98   56 T. Rowe Pr    33.67     33.38    -0.89%
   8/21/98   44 Schering-P    47.99     47.00    -2.07%
   2/27/98   27 Coca-Cola     69.11     59.81   -13.45%
   2/17/99   16 Yahoo Inc.   126.31    127.50     0.94%

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   20 Exxon         64.34     81.19    26.19%
   3/12/98   15 Chevron       83.34     96.81    16.16%
   3/12/98   20 Eastman Ko    63.15     71.56    13.33%
   3/12/98   17 *General M    61.28     60.81    -0.77%

Rule Maker Stocks

    Rec'd    #  Security     In At     Value    Change
    2/3/98   54 Microsoft   2437.28   4478.63  $2041.35
   6/23/98   68 Cisco Syst  1985.95   3995.00  $2009.05
   2/13/98   52 Intel       2440.28   3731.00  $1290.72
    5/1/98   82 Gap Inc.    1890.33   3095.50  $1205.17
   5/26/98   18 AmExpress   1873.20   2241.00   $367.80
    2/3/98   66 Pfizer      1810.58   2157.38   $346.80
    6/3/99   11 *Delphi Au   189.09    193.19     $4.10
   8/21/98   44 Schering-P   2111.7   2068.00   -$43.70
   2/27/98   27 Coca-Cola   1865.89   1614.94  -$250.95
    2/6/98   56 T. Rowe Pr  1885.70   1869.00   -$16.70
   2/17/99   16 Yahoo Inc.  2020.95   2040.00    $19.05

Foolish Four Stocks
    Rec'd    #  Security     In At     Value    Change
   3/12/98   15 Chevron     1250.14   1452.19   $202.05
   3/12/98   20 Eastman Ko  1262.95   1431.25   $168.30
   3/12/98   20 Exxon       1286.70   1623.75   $337.05
   3/12/98   17 *General M  1041.80   1033.81    -$7.99

                              CASH    $255.59
                             TOTAL  $33280.22

Notes: The Rule Maker Portfolio began with $20,000 on February 2, 1998, and it added $2,000 in August 1998 and February 1999. Beginning in July 1999, $500 in cash (which is soon invested in stocks) is added every month.

*Although DPH is not a Foolish Four stock, it was spun-off from GM on June 3, 1999

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