Investors Still Love Those Money-Burning IPOs

Network-security firm Sourcefire (FIRE), with $39 million in accumulated deficit, went public valued at 7.5 times revenue. It's since rallied 19%.

Next up is Aruba Networks, a wireless LAN company with a lot of buzz but also accumulated losses of $89 million ($15 million in the year ended Jan. 21, 2007). Also this week, the debut of SenoRX is expected. Its devices can diagnose breast cancer, but it also lost $15 million last year on $26 million in revenue.

Some of these companies have a lot going for them. Glu is in a burgeoning market for mobile-phone games. And Aruba, despite taking on formidable rivals such as Cisco and Symbol Tech (bought in 2005 by Motorola (MOT)), is more than tripling its revenue.

Aruba is a good example of a company with a history of losses that nevertheless offers plenty to entice investors. Its secure wireless networks allow users to roam around a building or campus without losing access. Many companies offer similar services, but Aruba's software has received strong reviews for its quality.

Aruba has built up 2,000 customers in 18 months, including companies such as SAP and Google as well as government entities such as the U.S. Air Force and schools such as the University of Washington and Ohio State, where Aruba set up the world's largest wireless LAN network.

Like Aruba, many of the recent offerings offer narrow exposure to an area of an emerging technology. Investors seem desperate to get into these hot new sectors -- after all, if these young companies are bound for big capital gains, it's much better to get in now.

Such thinking would justify paying a substantial premium on a company that loses money but hints that profit is just a year or two away.

The risk in that logic is that companies usually take the money they raise and invest it to compete against bigger companies -- so Glu spends to compete against Electronic Arts , and Aruba spends to take on Cisco and Motorola. That spending can set back moving into the black. And once investors grow impatient, it pushes the stock below the offering price.

That's why the high price-to-sales ratios are so important. (Because most of the companies mentioned here are losing money, normal P/E ratios don't apply.) They inject more risk into what are otherwise smart, well-run, promising companies.

Again, take Aruba, which is set to be priced between $8 and $10. At the middle of that range, the stock will be valued at seven times revenue. If it's priced as the top of the range -- as the more promising IPOs have been this spring -- it will be eight times revenue.

That's not as high as some recent IPOs, but it's high compared with Cisco's price-to-sales ratio of 5 -- even after that stock's huge tear. And it's several times bigger than the price-to-sales ratio that Symbol had (2.2) when Motorola bought it.

These new stocks are going public at such valuations thanks in large part to the aging bull market. In its waning years, the bull has sired a calf. And that calf, once properly fatted, may be sacrificed for the return of the prodigal IPO.

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