An Odd Couple Goes Public

The way the tech-stock naysayers see it, the supply of stock from initial public offerings eventually will exceed demand and the whole shaky structure will come tumbling down. This simplistic approach doesn't cut it.

What with newbie mutual fund investors, greater overall investor appetite and even non-U.S. interests clamoring for a piece of the IPO pie (coupled with rapid-fire mergers shrinking said pie), it seems plausible that demand will continue to soak up the generous supply for some time.

Actually, the real fear is that despite obvious shifts in the appetite of tech-stock investors away from slim-margined, consumer-oriented companies and in favor of fast-growing infrastructure and service companies, the steady supply of the former continues. The reason is simple: Venture capitalists funded all these consumer-oriented companies when times were good. Now they must have a "liquidity event," the most attractive of which is an IPO.

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With that in mind, here's a look at two IPOs expected this week, one a likely keeper from the infrastructure world and another that looks like it would have been a good idea in 1998, but not 2000. Both have considerable buzz, and they even share two sets of venture capital backers. But if the zeitgeist is right, WebMethods will keep making public investors money for some time, while VarsityBooks.com will be lucky to get bought out sooner rather than later.

By the way, first-day or even first-month performance of these companies isn't particularly relevant. From an institutional perspective, the selling of IPOs is a game of hardball. Investment bankers sell certain issues by promising buyers shares on hotter deals down the road. As such, these deals will get done. Period. All bets are off later when the IPO luster has faded and the media and retail investors are focused on the next fad.

With the IPOs expected this week, let's start with the old-school consumer play, one that induces a good deal of head-scratching: Washington, D.C.-based VarsityBooks.com, a sort of Amazon.com (AMZN) for college campuses. Robertson Stephens hopes to sell slightly more than 4 million shares between $12 and $14 a share in a deal expected to be priced Thursday night. If all goes according to plan, VarsityBooks.com will begin trading Friday.

VarsityBooks.com has many of the nasty attributes of the dot-coms we've grown to know and love: Its accumulated deficit through Sept. 30 is $21.8 million, its 29-year-old co-founders each are selling 37,500 shares in the IPO (never a good sign, despite the fact that the stake they're selling is small relative to their holdings) and the company has been selling books only since August 1998. And depending on whether investors view this as a positive or a negative, VarsityBooks signed a three-year, $9 million deal with America Online's (AOL) ICQ unit, meaning VarsityBooks pays AOL for the exclusive marketing tie-in. The amount is more than the young company's revenue through the first three quarters of 1999, and it's not with AOL but one of its units. But hooking up with AOL's ICQ instant-messaging service no doubt is cool, and on campus, cool matters.

What's troubling about the VarsityBooks business is how very retro it is in relation to earlier Net IPOs. The company is spending heavily to build its brand. That's to be expected, considering it competes against venture-funded start-up bigwords.com as well as Wallace's Bookstores' ecampus.com, Follett's efollett.com and Barnes & Noble's (BKS) textbooks.com. (Story idea for another journalist: Is Barnes & Noble getting Amazoned a second time in a second market, but by VarsityBooks?) Losses from operations through Sept. 30 were $19.8 million on sales of $8.9 million.

What makes no sense at all are the bookseller's gross margins of 5.6%. That's gross margins, meaning that after buying and shipping books, VarsityBooks is left with less than 6 cents for every dollar of sales. That's before pesky expenses like marketing and paying the salaries of its 200 employees. By the way, the company spends 34% more to ship books than it collects from customers for shipping expenses.

The company's federal filings suggest that VarsityBooks hopes to boost revenue by selling advertising and eventually other stuff. But it currently relies exclusively on one book distributor for its entire supply. That's why its margins are so thin. The company's existing backers are Silicon Valley's Mayfield Fund, Tribune Ventures (the investment arm of TV and paper conglomerate Tribune (TRB)) and a venture arm of brokerage Friedman Billings Ramsey (FBR), also one of the VarsityBooks underwriters.

A VarsityBooks spokesman declined to comment, citing the quiet period surrounding the expected offering.

More alluring is the story of WebMethods, a Fairfax, Va., company that is set to position itself smack in the middle of the mania for business-to-business, or B2B, stocks. Morgan Stanley Dean Witter will sell 4.1 million shares of WebMethods, also on Thursday, in a deal currently expected to be priced at between $11 and $13 per share. Expect that to rise. There are no selling shareholders, the company had almost $18 million in cash at the end of the year and its customer list includes SAP (SAP), Ariba (ARBA) and W.W. Grainger(GWW).

There's more. Investors Goldman Sachs (GS) (not an underwriter) and Dell (DELL) are buying shares in the IPO, as is customer Eastman Chemical (EMN). Other backers include Mayfield and the same venture unit of FBR that's backing VarsityBooks. It should be an interesting day at those two venture firms.

WebMethods makes software that aids in integrating B2B software applications for other vendors. Think of WebMethods as a subsystem for Ariba in the same way last week's hot IPO, Avanex(AVNX), is a subsystem for equipment-maker Sycamore Networks (SCMR). Revenue through the first nine months of 1999 was $12.6 million, up sixfold from the year-earlier period, and gross margins were 67%. Never mind the net losses of $20.2 million for the same period -- this is going to be a very profitable company.

Yes, there are risks. SAP alone accounted for 31% of WebMethods' revenue through the first three quarters of last year. WebMethods almost certainly will win an inflated multiple due to its full-on embrace of the B2B craze. This will fade when the craze does.

Until then, the bias toward companies that at least show the way toward profitability and away from those only hinting at it will continue.

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