Which Internet IPOs Should You Invest In?

News that online real estate broker Zillow plans to file for an initial public offering is a reminder of how long it has been since tech IPOs attracted much public attention. Back in 1995, a maker of Web browsers, Netscape Communications, sold shares to the public and kicked off a boom in Internet stocks. That led to a wave of hundreds of IPOs and a NASDAQ that peaked 11 years ago at 5,048 on March 8, 2000.

By that point, of course, the market was at the apex of the tech bubble: Companies like Noosh, an online printing company, were filing for IPOs with no revenues and no legitimate claim on investors' cash. Then the bubble burst, wiping out $4 trillion in market value. (By way of comparison, that was about 17% of the $23 trillion wiped out by 2008's financial crisis.)

Like all market corrections, it was painful. Still, the effect of that bubble bursting has led to a higher quality of technology companies being offered to the public by Wall Street now.

Today, with NASDAQ still trading at just 53% of its peak value, a new and better crop of IPOs is being presented to investors, among them vacation rental website HomeAway, Internet radio site Pandora -- whose founder, Tim Westergren, I interviewed two years ago -- and LinkedIn, the business networking site. Of these, LinkedIn looks like it might be the best investment. Read on for the reasons why, and for a method you can use to evaluate other IPOs so you can decide which to buy and which to shun.

What strikes me about the latest crop of technology IPOs is that none of these companies is creating a vast new ecosystem, as the Web did back in the 1990s. However, a look at their financial statements reveals that they're generating substantial revenues and, in one case, even a little profit. If they are successful, they could help pave the way for blockbuster offerings from Facebook and Groupon.

Four Tests For an Internet IPO

To evaluate IPOs, it helps to have a scorecard: I developed one in my book, e-Stocks. Here are the four questions to ask before plunking down your cash on an IPO:

  1. Is there an attractive market for the company's products? It should go without saying, but it helps if there are a large number of potential customers willing to pay a good price for the company's services.
  2. Does the company have a significant share of that market? If so, it means that the company has solved an important problem for customers, and that the money raised in the IPO should go toward maintaining its lead.
  3. Is the company's management team experienced? As an investor in a public company, you'll be best served by a management team that has experience handling quarterly reporting duties and the challenges of boosting a company's growth.
  4. Is the company growing and profitable? This is the test that usually delivers a knock-out punch to most IPOs. Most are growing, which suggests that they may have the potential to be profitable. But few are profitable when they file to go public. Those rare gems that are have a pretty good chance of staying that way as long as the numbers are reported conservatively.
Applying these four tests to the three companies mentioned above, yields a ranking with Linked In at the top and Pandora at the bottom. Here's how:
  • LinkedIn. The company doesn't clearly define the size of its market for helping professionals network, but it claims 90 million members and generates revenues from three balanced sources. Its management team has good executive experience in public companies. Its revenues doubled to $161 million for the nine months ending September 2010, and it earned a nearly $2 million profit during the period. And its cash balance sits at nearly $90 million.
  • HomeAway. It's aiming to be the No. 1 intermediary in an $85 billion market for vacation rentals, and it already leads the online portion of the listing industry with 9.5 million unique visitors and 500,000 listings, according to its prospectus. Its management team has strong executive experience in public companies, and compelling consulting and academic pedigrees. Its revenues grew at nearly 40% to almost $168 million in 2010, but it lost $18 million that year and its cash balance fell 30% to $60 million.
  • Pandora. The company is going after markets for online display and rich media ($8.5 billion), mobile ($743 million) and broadcast radio ($15.7 billion). Pandora controls 50% of one segment of one of those markets -- the online radio listening segment for top 20 stations, according to its prospectus. Its management team has good executive experience in public companies and a strong academic pedigree. Its revenues grew by 178% to $50 million in 2010, but it lost almost $18 million last year. Still, its cash balance for the most recent nine months was up 152% to over $40 million.
IPOs can be a great way to make money if you invest in the right ones. When LinkedIn goes public, it may be worth placing a bet.
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