Thacker: Demand the Same from IPOs as Any Other Stock

Ryan Leggio: Hi, I'm Ryan Leggio. I'm a mutual fund analyst at Morningstar, and with me today is Allison Thacker. She's a co-portfolio manager at RS Investments based in San Francisco. Allison and her team run large, mid, and small-cap growth funds.

Allison, thanks so much for being with us today.

Allison Thacker: Thanks for having me.

Leggio: Well, it's perfect that you're in our offices right about now. We've seen the IPO market, especially the social media stocks like Pandora, in the news, and that's right in your wheelhouse being based San Francisco. You get to meet with a lot of these companies, and you've really kind of seen them grow up.

Can you talk a little bit about, if you're seeing opportunities in these companies, which either have launched or are getting ready to launch, and what you think generally about valuations for these stocks?

Thacker: Sure. Well, we're very interested to see the new crop of IPOs coming out. Social media has been something that our team has looked a lot at over the last few years. As you mentioned, having a big presence in the Bay Area can be an advantage, because during the time periods when the companies are actually private, you can go over and meet with them, and to some extent they are often more open with information because they're not regulated when they're private companies.

So, I know we've talked about it before, but "anchor point investing" is a key part of our process, where we're trying to understand where does this company want to go over a three to five-year timeframe and what kind of quantitative metrics do they use to think about where they can take their business. And at lot of the time, private companies think more of that way, so you can get a good read on what they want to do with their business and you can get a feel for how their business is developing before they go public.

So, it's interesting that you mentioned Pandora. That's one of companies that I've met a couple of times around the Bay Area and visited their original offices, and it's very insightful to get to go see them in place. One of the big advantages of their technology, as they say it, is that they analyze a musical track on over 400 characteristics, anywhere from the lyrics to the melody to what type of percussion instruments you hear on the piece, and you may not, as a listener to music, know why you like something, but there is often these little characteristics that are what you like about it, and so when you tell Pandora that you like a certain song or a certain type of jazz, they can find out their music for you, and so that discovery and that DNA of it is very special, and when you go to their offices, you see this huge workstation area where musicians come in and put in a few hours, listening to tracks and categorizing it, and it's really interesting to see it physically at work as opposed to just reading it in a document, and not necessarily understanding the DNA of the company.

Now Pandora is very interesting. You asked about valuations, and I think this one's a real challenge. They are currently not profitable from either a cash flow or EPS perspective, and they likely won't be for several years, and so from a valuation perspective, the investment banks want you to look at a price-to-sales multiple, which has shadows of the last dot-com time period to it. I mean, at least we're not pricing it on users, which is what was happening in 1998 and 1999. But price-to-sales is also a relatively earlier-stage company metric to use, and so we're wary of that, looking at companies solely on price-to-sales. But I think, Pandora has a lot of very interesting things that make us as growth investors intrigued with it. So I ... could tell you about a couple of those.

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One of them is that that they're currently running less than one minute of ads per hour, and typical terrestrial radio runs 13 minutes. So you can see that they are very much under-advertising on their streams. They also have a lot of room to continue to possibly improve their content costs, so they are at a very disadvantaged position today and paying quite a lot for their access to music compared to terrestrial radio. This has to do with the great debate that went on about whether Internet radio should be allowed to have any music or not. So that's a long-term wildcard about Pandora and their ability to control costs.

Leggio: So it sounds like you're intently focused on these companies, when they are IPOing and as they come out, and that you're really focused on valuations, and just because you may not be buying it now, if the stock price were to fall 25% or 50% over the next few months, given the great long-term growth characteristics you look for, you may be interested at cheaper prices?

Thacker: It's absolutely true. I mean, I think there are arguments that Pandora is interesting at the current price. If you believe the bull case scenario it. If you believe it can get to 20% margins. If you believe that they'll grow a 100% year-over-year this year possibly on the user side, or certainly in terms of listener hours.

So, if you were a venture capitalist, I think that's something you can get your arms around, and we sit in between the two worlds--maybe the world of investors that are much more on the large-cap, slower-growing company space, and the world of venture capital. And we try to sit in the middle and look for IPOs that have the growth characteristics we look for from a sustainability standpoint. But we do require IPOs to have the same valuation upside as any other name in our fund. So, we're going to look for 70 to 90 names that are sustainable, secular growers, that can grow regardless of the GDP growth environment, and that offer us $2 of upside for every $1 of downside. And so we hold IPOs to those same standards, absolutely.

Leggio: Another area, which is related to social media, which you have been doing some work on, is the technology area. Can you give us a little history on where you were with a lot of these stocks, and if you're finding more opportunities in that sector more recently?

Thacker: So, we were very successful at buying brand name technology companies during the 2008 downturn. I know you and I talked about it at the time: Akamai Technologies, for example, dipped down extremely low to about $10 a share, and then subsequently went up towards $50 during the recovery because of their great positioning providing content delivery networks for the Internet.

And we had quite a few of examples like that, but they powered 2008, 2009, and 2010 results for us and became quite expensive. So late last year, we sold off a lot of our technology names in the funds, believing that they'd become too expensive, that the upside to downside ratio wasn't good for the names.

So what we continue to do, like I was telling you about some of the social networking names, we continued to do intensive amounts of work. We meet with the companies, we develop our anchor point, so that we have a buy price, and within the team several of us are getting excited on the technology front believing that names that we've had to sit out this last rally on may be getting down this summer towards prices that we're more excited about.