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Why Wall Street wants Google to fail
The most anticipated initial public offering in years threatens to derail a cherished gravy train, where underpriced shares are handed out to favored investors and grateful CEOs.
By Jim Jubak
Wall Street is rooting for Googles anticipated initial public stock offering . . . to fail miserably.
Investment bankers fear the "Dutch auction" IPO, if successful, could severely diminish their power and influence, and that has a lot of people on Wall Street worried and more than a little angry. In just about every interview they give, Wall Street sources are actively campaigning to undercut the IPO, warning the public that the stock will be overpriced, and instead of appreciating in value after the offering, will actually retreat.
Investment bankers have a lot to be unhappy about.
To start with, Googles underwriters have been told not to expect the typical 7% commission they generally pocket for acting as the middleman between the company and the stock-buying public. Instead, the underwriters, led by Morgan Stanley and Credit Suisse First Boston, will get 3%. If the offering generates $3.4 billion as expected, that means the underwriters will earn $103 million -- not bad, but still far less than the $241 million they would net with the normal commission fee.
But Wall Street has survived low commissions on high-profile IPOs before. What really bothers the investment bankers is the worry that this deal might spell the end of the very lucrative IPO game.
Take their word for it
Heres how the game works: A company seeking to go public lines up an underwriting team that promises to get the best price it can for the piece of the company that will be sold to the public. The underwriting team gauges that price by holding a road show, where institutional investors hear the companys pitch and tell the underwriters how interested they are and how many shares theyd be inclined to buy at what price. Using time-honored formulas, the underwriters report back to the company with a price and a size for the offering.
Its difficult for the company to judge demand itself, and there is no formal mechanism for setting a price that would clear the market for all shares to be offered. In practice, most companies take the underwriters word. The company is, after all, paying the underwriters for their expertise.
Anyone who remembers the post-bubble scandals and lawsuits, however, knows that this system is extremely vulnerable to abuses.
The most innocent abuse is that underwriters are tempted to leave too much money on the table. That is they set the price too low so that companies going public dont receive the maximum amount of the capital they need from their share offering. Of course, the underwriter wants to make its client, the company offering shares, happy by raising a good amount of capital at a decent price. But the underwriter also needs to make the investors who bought shares in this offering happy, too, since it will have to go back to those same investors to raise money on its next initial public offering deal.
The worst thing that can happen to an underwriter is to burn those investors by having the price of an IPO sink rapidly in the days, weeks and months that follow the initial sale of shares. So the tendency is to underprice the deal to guarantee that the shares will go up after the initial public offering.
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Spinning their way to riches
In the buildup to the 2000 market top, underpricing of IPOs spiraled out of control. Investment banks discovered that if they underpriced IPOs and carefully limited supply they could guarantee not just a modest climb in share price after the IPO, but a rocketlike takeoff.
And some Wall Street firms also figured out that they could use the massive profits that investors could make on an IPO to increase the volume of investment banking business that came to the firm.
These underwriters could reward influential company managers and CEOs with shares in hot IPOs that would pump hundreds of thousands, if not millions, of dollars into the CEOs portfolios. A CEO so rewarded, the investment banks figured, would be likely to send company business the investment banking firms way. Creating hot IPOs by restricting supply and underpricing new issues became a major tool in the sales efforts of Wall Street investment banks.
That led to Friends of Frank, a group of 300 CEOs and company executives named after Frank Quattrone, head of Credit Suisses high technology investment banking group. Friends of Frank received IPO allocations in exchange for company investment banking business, a practice called spinning. The Financial Times has calculated that spinning generated $200 million to $400 million in IPO profits for the members of the Friends of Frank list.
But Quattrone and Credit Suisse werent the only spinners. Salomon Smith Barney allocated IPO shares to former WorldCom CEO Bernie Ebbers. Goldman Sachs allocated IPO shares to eBay (EBAY, news, msgs) CEO Meg Whitman. And the list goes on.
Wall Street did it because it worked. Phone.Com, now known as Openwave Systems (OPWV, news, msgs), counted 12 company executives on the Friends of Frank list. The company sent investment banking business worth $76 million to Credit Suisse First Boston. (In one of those delicious ironies that Wall Street manufactures over and over again, Quattrones former employers Credit Suisse and Morgan Stanley are the lead underwriters in the Google IPO.)
No middleman, no lottery ticket
The burst of post-bubble financial reform has put a spotlight on spinning that has certainly slowed the game. And the sluggish IPO market has meant that theres not much in the way of IPO profits to pass around. But Wall Street, with its eye on the eventual return of the hot IPO, certainly doesnt want to see anything put an end to its power to play some version of the pricing and allocation game in the future.| How a Dutch auction works | Investors register and can submit a bid for as few as five shares. The underwriters will tally all the bids. They'll start at the top --150, $200, whatever -- and work their way down until all the shares are spoken for.
That price then becomes the clearing price, which Google intends to use as the IPO price. There's no penalty for bidding high. If the clearing price is $140 and you bid $200 you'll pay $140. Those who bid under the clearing price get nothing. |
But thats exactly what Googles IPO threatens. By moving to an auction format with Google executives guaranteed, by the terms of the offer, access to the books so they can judge demand for themselves, the Google IPO shifts the balance of power toward the company and away from the underwriter. The auction format is designed to get Google the best price for its shares and to leave as little money as possible on the table. There will be no guaranteed post-IPO appreciation for investment bankers to pass on to favored clients. The auction process indeed goes a long way to eliminate the very idea of favored clients since the deal will be dominated by individual investors who set their own price and demand on the Internet. And as if thats not enough to kill any prospects at a post-IPO bounce, if Google sees evidence of more demand than expected, the company has reserved the right to increase the number of shares in the offering.
If Googles offering works for the company -- that is, if it raises money at a good price and at a low commission to boot -- then this IPO would legitimize an alternative to the traditional IPO that will diminish the power of Wall Street investment banks. Other companies, companies with lower profiles than Google, will have a new alternative for raising money. Wall Street doesnt even like to think about that possibility.
If, on the other hand, Googles IPO fails -- if not enough investors bid, or if the price is too low, or if the IPO sinks, leaving hordes of angry individual investors and the company with egg on its face -- then the auction model will go back on the shelf and Wall Street investment banking will go back to business as usual.
Tell me how much to bid
Thats why I dont think you can trust anything Wall Street says about the Google IPO: The investment banking establishment has too much at stake and too many institutional conflicts of interest to make them credible on this offering.
Of course, just because Wall Street hates this deal doesnt mean you should jump at the chance to invest. For entirely different issues, those that count for you as an investor and have nothing to do with Wall Streets concerns, the Google IPO might be a bad deal. On the other hand, it could be that Wall Streets naysaying has turned the Google IPO into a great investment opportunity.
In my next column, Ill take my best shot at valuing the Google IPO. Ill also give you a chance to vote yes or no on putting some of my money into Google shares. Ive already registered on the IPO site (www.ipo.google.com). And Ill give you a chance to vote on how much I should bid for my shares.
Your opinions and my money. Cant get a better deal than that, on or off Wall Street.
New developments on past columns
5 stocks that could soar if rates stay low
In the current market, it doesnt take much to put a ding in a stock. And thats whats happened to shares of Engineered Support Systems (EASI, news, msgs) in the last few weeks. The stock was down 17% from July 5 through Aug. 5, including an 11% drop on Aug. 5. The catalyst that day was a downgrade to peer perform from Thomas Weisel Partners.
That research report cited valuation and worries that organic growth (that part of growth that isnt a result of acquisitions) would slow and margins decline because two of the companys highest margin programs are winding down, and a competitor won a $23 million armor contract. The research note admits that the growth slowdown is well-known, and it doesnt quantify the effect of the $23 million competitive win. The report goes on to note that Engineered Support Systems should still have no difficulty in making its 20% earnings per share growth target for fiscal 2005. More of that growth, the research report worries, would have to come from acquisitions instead of organic growth of existing businesses.
Certainly nothing in the companys May 25 report on earnings for the quarter that ended on April 30 flagged any problems with growth: Order backlog increased to $1.47 billion from $1.45 billion at the end of the previous quarter, for example. And even if the worst problems raised by this research note are true, I think the stocks price now amply discounts them. The company is next scheduled to report earnings on Aug. 24 before the stock market opens. Wall Street currently expects earnings of 72 cents a share, according to Zacks Investment Research. As of Aug. 6, Im keeping my target price at $68 by December 2004. (Full disclosure: I own shares of Engineered Support Systems.)
Editor's Note: A new Jubaks Journal is posted every Tuesday and Friday.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Engineered Support Systems. He does not own short positions in any stock mentioned in this column.
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