EF5052(A) INVESTMENT CASE 2

Netscape’s IPO

Group 7
JU Fei LIU Yao LIU Yini WU Tianyi ZHANG Xuehui ZHANG Yiyun

52752084 52815259 52750804 52748187 52700026 52738944

Netscape’s IPO

Brief Introduction
Netscape Communication Corporation is going to issue its initial public offering in August 9, 1995. It is a young but rapidly growing company which is founded in April 1994 and only operates for 15 months. Netscape is also going through losses and never gain profits. But in the time of rapidly developing of the Internet, Netscape now had succeeded in capturing 75% of the Web browser market by using its most popular product, Netscape Navigator. Netscape has set the industry standard and is the indisputable leader of its kind. Netscape Navigator begun to ship in December 1994. Until then, Netscape did not earn significant product revenues. And Netscape Navigator generated more than half of total revenues for the company in the first two quarters in 1995. The other main source of revenues is generated by Netscape’s server and integrated applications products. In terms of the market share, we can say that Netscape has a promising future by using its excellent Web browser, Netscape Navigator. Another reason for its promising future is the industry background that Internet is in a rapidly developing position. However, Netscape is also facing kinds of competition in every market. Its main competitors are Spyglass, America Online and Microsoft. Microsoft, the powerful PC software company was going to release its long‐awaited Windows 95 operating system, which included a rival browser in weeks. This could be a big challenge and threaten to Netscape. In response to its growing capital needs, Netscape decided to initiate an initial offering of its stock. Companies find it desirable to “go public” when their equity capital needs increase to the point where the opportunity cost of remaining private and compensating investors for the lack of liquidity become too great relative to the lower cost of capital derived from liquid public markets. The principal reasons for Netscape going public were to fund expected future growth, to stockpile cash reserves for potential acquisitions, and to gain visibility and credibility within the industry. And in 1995, the IPO market is characterized as a “hot issue” market. In the first half of 1995, IPO stock prices increase on the first day of trading by an average of 20% and this outstanding momentum was largely attributable to venture‐backed high‐technology stock offerings, particularly those related to the Internet. Netscape’s initial capital is from Clark. In the fall of 1994, Clark invested additional $1.1 million and the Silicon Valley venture capital firm of Kleiner, Perkins, Caufield & Byers invested $5 million. The third round of financing in April 1995 is private placement of stock totaled $18 million. On July 17, 1995, the investment bankers suggested offering 3.5 million Netscape shares priced at $12‐$14 per share. But after the “road show”, the response was overwhelmingly favorable. On August 8, 1995, the lead underwriters proposed to increase the original offering price from $14 to $28 per share and the number of shares to be offered from 3.5 million to 5 million. Before answering the related questions, I will do the valuation of the company first.
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DCF Valuation of Netscape’s IPO
Assumptions (Hint Sheet and Template):
1. In terms of annual basis, the data (including Revenues, Cost of goods sold, R&D expenses and Other operating expenses) of year1995 in the Excel template is the double amount of data in the income statement for six months ended June 30, 1995 (Exhibit 1). 2. Total cost of revenues remains at 12.50% of total revenues. 3. R&D remains at 36.8% of total revenues. 36.8% is derived by dividing Revenues by R&D in the income statement of half year of 1995. 36.8%=6,115,152/16,625,391 (Exhibit 1) 4. Other operating expenses (which already includes depreciation) decline on a straight‐line basis from 80.9% of revenues in 1996 to 20.9% of revenues in 2001 (this would give Netscape a ratio of operating income to revenues close to Microsoft's, which is about 34%). 80.9% is derived by dividing Revenues by other operating expenses (total operating expenses – R&D) in the income statement of half year of 1995. 80.9%=(19,564,223 – 6.115.152)/16,625,391 (Exhibit 1) 5. Capital expenditures decline straight‐line from 45.8% of revenues in 1996 to 10.8% of revenues by 2001 (again, close to Microsoft's experience). 45.8% is derived by dividing Revenues of half year of 1995 (Exhibit 1) by capital expenditures of the year ended June 30, 1995 (Exhibit 3). 45.8%=7,618,000/16,625,391 6. Depreciation is held constant at 5.5% of revenues. 5.5% is derived by dividing Revenues of half year of 1995 (Exhibit 1) by Depreciation of the year ended June 30, 1995 (Exhibit 3). 5.5%=918,000/16,625,391 7. Change in net working capital is essentially zero. 8. Long term steady growth of 4% annually after 2005 can be used to compute terminal value. 9. Long term riskless rate of 6.75%. 10. You can take Netscape's equity beta to be 1.5. 11. You can take the market risk premium to be 7.5%. 12. Consider Netscape as an all‐equity company (ignore interest income expense). However, in 1995, Netscape has debt capital in its balance sheet (Exhibit 2). So after IPO, Netscape would repay its debt to turn to an all‐equity company. After calculating the NPV of FCF, we should minus debt to get the value of equity which is used to calculate stock price. Debt = Current portion of long‐term obligations + installment notes payable + long‐term obligation = 725,000+551,449+725,000+1,511,331 = 3,512,780 (Exhibit 2) 13. Tax rate of 34% is applicable when the company has positive taxable income; if income is negative, no tax is paid in that year and the negative income is carried forward to offset future positive income. 14. Now Netscape’s Cash and short‐term investment is used to calculate capital needs as a start point and then minus future free cash outflow. Cash and short‐term investments = 25,436,000 (Exhibit 3).
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Calculations
1. Calculate the ratios of other operating expenses and Capital expenditure for 10 years, after 2001, the ratio remains unchanged. 2. Using the respective ratio to revenues, calculate cost of goods sold R&D expenses, depreciation, other operating expenses and capital expenditures. 3. Profit before taxes = Revenues – Cost of goods sold – R&D expenses – Other operating expenses 4. Carryforwards is the accumulated losses of former years. 5. Taxable income is the positive amount of profits before taxes after deducting carryforwards. 6. Taxes = Taxable income * 34% 7. Net income = Profit before taxes – Taxes 8. Free cash flow = Net income + Depreciation – Capital expenditure – Change in NWC 9. Capital Needs = Cash & short‐term investments – FCF Next year’s cash & short‐term investments is the negative of former year’s capital needs. 10. WACC is weighted average cost of capital. But in this case, Netscape is an all‐equity company, so WACC = cost of equity. Using CAPM: Cost of equity = Riskless rate + Beta*Market risk premium = 6.75% + 1.5*7.5% = 18% 11. PV = FCF(t)/(1+WACC)^(t‐1995) t=1996‐2005 12. Terminal value = FCF(2005)*(1+terminal growth rate)/(WACC – terminal growth rate) 13. PV(Terminal value) = Terminal value/(1+WACC)^10 14. Value of equity = Total PV – Debt 15. Price = Value of equity/Total shares outstanding
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Assumptions in my opinion:
However, I suppose that some of the assumptions given in the Hint Sheet and Template are not reasonable and supported. So according to the case statement and the Exhibits, I would like to give some different assumptions which I think are more reasonable. 1. Total cost of revenues ratio to the revenues. In the income statement of first half year of 1995, the ratio of cost of revenues to revenues is 1,735,812/16,625,391=10.44 %.( Exhibit 1) I would apply this ratio in calculation. 2. Capital expenditures. Original assumption applies 7,618,000 (Exhibit 3) to calculate the ratio, but it is based on the whole period Netscape operates, from April 1994 to June 30, 1995. However, in the case’s page 2, it states that the company expected total capital expenditures for 1995 of approximately $12 million. So I recalculate the ratio of capital expenditures to revenues by 12,000,000/ (16,625,391*2) =36.09%. 3. The decline in straight‐line basis is from 1996 to 2001. But I think 1995‐1996 could also achieve a decline in other operating expenses and capital expenditures. So I apply decline in straight‐line basis from 1995 to 2001. 4. Depreciation. Original assumption applies 918,000 (Exhibit 3) to calculate the ratio, but it is based on the whole period Netscape operates, from April 1994 to June 30, 1995. So I recalculate the ratio of depreciation to revenues by 918,000/ (695,871+16,625,391) =5.3% 695871+16625391 is total revenues from the same period from April 1994 to June 30, 1995. After these re‐assumptions, calculate the related results following the same procedure as the former one. The results under original assumptions are shown in Sheet 1, 2 & 3. The results under new assumptions are shown in Sheet 4, 5 & 6.
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Comparable Method
Another method to obtain estimated value of Netscape is comparable method. The comparables are provided by companies that share similar characteristics. Generally, common comparables include: The company's share price divided by the Earnings per share (the P‐E ratio) The company's share price divided by the Cash Flow per share The company's share price divided by the EBITDA per share The company's share price divided by the Revenues per share Netscape is compared with its potential competitors AOL, Microsoft and Spyglass in exhibit 3, and Internet companies like Netcom Online, Performance System International, UUnet Technologies and Spyglass in exhibit 6. So we can use comparables data from those companies and calculate the average value and use it to value Netscape. In this case, as the earnings per share, net cash flow and EBITDA of Netscape are all negative number, it is obvious we should choose revenues per share as the comparable value. In the following, the company's stock prices divided by the revenues per share is further investigated. And the result is shown in the following table: Competitors Net Revenues Net Revenues per share Current Stock Price P/R ratio Average P/R ratio Predicted Price based on average P/R ratio Internet‐related Net Revenues Net Revenues per share Current Stock Price P/R ratio Average P/R ratio Predicted Price based on average P/R ratio Netcom Online 2,411,600 0.38 36.38 95.72 61.64 Performance Systems 15,214,000 0.75 22.00 29.33 Uunet 12,413,863 0.62 46.25 74.60 Spyglass 3,629,392 1.05 49.25 46.90 Netscape 17,321 0.46 American Online 394,290 11.60 22.00 1.90 5.74 Microsoft Crop 5,937,000 9.48 90.38 9.53 Spyglass 9,084 2.47 14.31 5.79

2.64

28.35

As can be seen in this table the price/revenue per shares ratio ranges from 1.9 to 95.72 so we should consider differently based on whether it is a mature or a young internet company. If we use the average P/R ratios of the three possible competitors, the predicted price of Netscape would be 2.64. But if we use the average P/R ratios of the four Internet companies that recently underwent IPOs, the predicted price of Netscape would be 28.35. For the Internet companies
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that recently underwent IPOs. We think the comparables for the companies with the Internet‐related IPO serve as a better estimate of the actual value of Netscape, because these values better reflect starting companies who will likely experience strong sales growth over the next decade. The competitors, on the other hand, are companies that are well established and therefore the resulting ratios are much smaller. As said before, the share prices of the companies that recently underwent IPOs performed very well after the IPO: Netcom Online's share price tripled in six months, Performance Systems' share price almost doubled in three months, Spyglass' price increased by over 150% in 2 months and UUNet's price tripled in less than three months (see cases, Exhibit 8, p. 12). Taking this as a likely future route of Netscape's shares after an IPO, an offering price of $28.00 is consistent with the value determined through the Comparables Method.
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Q & A
 Does Netscape need to go public to satisfy its capital needs? What would you estimate might be the magnitude of its capital needs over the next 3 to 5 years? What sources other than the public equity market could be tapped to satisfy these needs? Going public is not the only way to satisfy its capital needs. So Netscape did not necessarily go public. It can raise capital by other ways. We can analyze the advantages and disadvantages of going public. Companies go public when their equity capital needs increase to the point where the opportunity cost of remaining private and compensating investors for the lack of liquidity become too great relative to the lower cost of capital derived from liquid public markets. By going public, the firms increase their overall liquidity at a reduced cost of capital which results in enormous monetary benefits. It can obtain additional capitals and use then for expansion and future growth. Another advantage of going public is that it gains an increased public profile and prestige. Going public helps firms to improve the familiarity and concern degree in public. The corresponding publicity of various mediums will make firms more familiar with the public, which results in greater brand recognition. It can also facilitate future access by the company to go public equity markets. However, going public has disadvantages as well. It spends time and considerable costs. And company needs to report timely information to investors and regulators. Firms face the increased risk of liability if any SEC reports found to be false or misleading. Hence, going public is an important but not the only way for Netscape. However, combined with the forecast and position of Netscape, it needs a considerable amount of capital, captures great share of market and has the overwhelming favorable response of “road show”, despite of its limited operating history, deficit and competition, going public is a good choice for Netscape. As shown in Sheet 3 & 6. We expected 50% growth rate of revenues in the future ten years. In terms of Netscape current leader position in the market, the great success of Netscape Navigator and Internet’s development, we believe it has shown its creativity and advantage in its industry and 50% growth rate is achievable. This will generate free cash outflow in the future 4 years. So these outflows make capital needs of the company. Under different assumptions, the amount of capital needs is different due to different capital expenditures ratio and other reasons. Under original assumptions, the capital needs is around $130 million. Under new assumptions, the capital needs is around $60 million. The capital needs is for many reasons. Netscape is in an industry with a lot of existed and potential competitions. To keep in the advanced position, Netscape will have to invest in a significant amount of money in research and development by hiring top‐notch software experts in order to develop innovative products. Sales and marketing also need increasing amount of money. There would need great amounts of expenditures for advertising as well as increasing the level of staffing within the sales and marketing department. In addition, Netscape’s capital expenditures are another source of needs of capital. Netscape will need to spend to acquire more computers and other necessary equipment. Netscape will also need capital to repay its existed debt.
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Netscape’s IPO

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There are many ways to raise equity capital. One way is through a private equity transaction. A private transaction involves direct negotiations with various financial or nonfinancial institutions. In such a case, a company raises money from these various entities, which then own a portion of that company in the form of its privately held shares of stock or other securities convertible into stock. Another option to raise equity capital is to get a loan from the bank. It can also raise equity by venture capital transaction or leveraged buyout transaction. Among them, private equity transaction and public offering of stock are the two broadest ways. The case points out that the IPO market is sometimes characterized as a “hot issues” market and that in retrospect many IPOs are viewed as underpriced? What might explain these phenomena? Should the Netscape board be concerned about the underpricing? Why or why not? “Hot issues” is called because of the high returns earned by initial buyers of the shares. It also refers to a period over which a large number of firms undertake an initial public offering. Whether demand or supply driven, the IPO underpricing trend persists. As we know, in the “firm commitment contract”, the underwriters first commit to bear the risk of the issue by purchasing the shares offered, less an underwriting discount. This provides incentive for underwriters to underprice IPOs to ensure that all of the shares can be sold without much effort. Underpricing can reduce the risk of being undersubscribed. Moreover, some firms go public with the intent of placing a larger offering at some point in the future. So underpricing the IPS can make investors more likely to buy a firm’s second offering after making favorable risk‐adjusted returns from the IPO. Another reason of underpricing is that underwriters avoid the loss of reputation because of failed issue. One explanation is “winners curse”. Since hot issues are underpriced on average, excess demand for IPOs typically exists. If new issues are not underpriced, informed investors will not put in an order for an IPO. Consequently, uninformed investors will obtain their full allotment of shares, and will on average lose money. Investment bankers, wanting to broaden the appeal of their IPO shares, may therefore systematically underprice the issue to induce uninformed investors to buy them Overpricing, at the same time, from investment banks prospective is profitable as well. They earns percentage of gross proceed generated by the IPOs. So it seems attractive to investment banks. But it is not the case actually because this could break the relationship between the investment bank and its clients. So the underwriters don’t want to risk of losing their valued client. Underpricing could make investors gain profits and make their relationship better. Netscape’s board should be concerned about the underpricing because given the history cases, not all companies have the good fortune of offering their stocks to the public during
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hot issue markets as indicated by such disparate outcomes. According to the article, the different results of Boston Chicken, Snapple and PixTech indicate the high degree of uncertainty over whether underpricing will produce desired results earned by initial buyers of shares. As Netscape’s board, it is better to evaluate Netscape's future business prospectus and the internet industry in general, analysis the stock‐price related data and predict the response of potential investors. At the same time, to oversee the investment banking's IPO process. Can the recommended offering prices ($14 or $28) be justified? How fast must Netscape's revenue grow on an annual basis over the next ten years to justify a $28 share value? What growth rate would justify the $14 price? Discuss your findings. As an executive of Netscape, what would you recommend with respect to the proposed offering price? As an investor in Netscape, would you be willing to buy and hold Netscape's stock at $14 or $28 per share? As shown in Sheet 1, 2, 3 & 4, under original assumptions, the growth rate for $28 is 61.29% and for $14 is 51.63%. Under new assumptions, the growth rate for $28 is 59.80% and for $14 is 49.18%. We assume that the number of new shares to be issued for both prices is 5 million all the same. The two groups of results are not very different. We can estimate that about 60% growth rate of Netscape’s revenue over the next ten years can justify a $28 share value and about 50% growth rate can justify a $14 share value. We firstly analyze the strength and risks of Netscape. Netscape’s biggest strength is that it is a market leader in Web browser market and has 75% such high market share. And it has innovative operating mode. In the future, as a market leader, it can bundle its other products and services as addition to Netscape Browser and charge for them. And Netscape also faces many risks. It has limited operating history and deficit. The Internet market is also an extremely unpredictable industry. Now it expands very fast, but we cannot guarantee that it will keep on. Moreover, Netscape has faced much competition. Microsoft has intensified competition to Netscape. There will also be many new entrants to this industry. As an executive of Netscape, though we have uncertainty and risks as stated above, I still have confidence to issue the stocks at $28 offering price. We now own the most popular product and the Internet is expanding at a very fast rate. In near future, we are pretty sure to gain a growth rate as high as 60%. Of course, to maintain our competitive position, we have to come up with innovative products in long run. We must maintain the leader position by effective marketing and excellent product innovation. Facing the competition, we have to make efficient adjustment and keep sensitive to the change of industry. And the response to the “road show” is very favorable. Due to the comparable method of valuating stock, we can see that the price is $28.35 compared to Internet‐related IPOs. The market is confident about the Internet industry. There is high possibility to go through underpricing and get capital gain. So we have reasons to set the offering price at $28.
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Netscape’s IPO

As an investor, I would buy the stock at both $14 and $28 in short run because of the “hot issue”. But in long run, Internet IPO’s that had recently taken place before Netscape’s IPO ranged between $12.00 and $17.00. Certainly, I would not be comfortable with a price at, near or above $28.00. So I would buy and hold the stock at $14 but I would not hold the stock at $28. Because the competition exists and the industry is unpredictable, the position of Netscape would not keep as good as $28.

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