Netscape's Ipo

Executive Summary

Netscape Communications Corporation is often credited with launching the dot-com era and technology boom of the late 1990's and making the Internet and World Wide Web (WWW) common household terms and services. This era is coined the "Information Revolution", since the Internet and WWW was integrated into our modern culture and society during that time. In 1995, Netscape, an early leader and innovator in the Internet and WWW software and web browser market, had been going through the initial public offering (IPO) process. Specifically, on August 8, 1995, Netscape's lead IPO underwriters recommended to the Netscape board to increase the initial offering price to $28 per share from $14 per share, a 100% increase. At this new offering price, the firm's value would be $1 billion, raising many eyebrows since their 1995 revenues to date were only $16 million, the firm was only 16 months old, and they had not yet shown a profit. The question remained: what was the required yearly revenue growth rate to support a firm value of $1 billion and the IPO price of $28 per share?

A net present value analysis was performed for the time period 1995-2005 using current 1995 income statement and balance sheet data for Netscape. Pro forma cash flow projections were made through 2005, and a terminal growth rate of 4% was used for 2005+. A discount rate of 12% was employed to discount the future cash flows to present day. Other assumptions were made on capital expenditures, depreciation, operating expenses, research and development (R&D) expenses, and cost of revenues to be similar to Microsoft as a proxy. The net result was that a yearly revenue growth rate of 50.89% was required to support the firm value of $1 billion and the IPO price of $28 per share.

Significant concerns for Netscape moving forward are the sustainability of their business model and competition. Microsoft has plans to release the new Windows 95 operating system with an integrated web browser in 1995 and a line of web server software applications in 1996. A web-browser seamlessly integrated with the operating system and other application software would be more attractive to most non-technical business or individual users. Netscape has a very narrow product line, whereas Microsoft has a more diversified software product line. Market share of the web-browser market would be gained or lost based on what the emerging Internet Service Providers (ISPs) used as their default web browser.

As a Netscape executive or Netscape investor, I would likely recommend to accept the new $28 per share IPO price, knowing even at that price, the shares are still probably underpriced, but particularly knowing they are oversubscribed. Oversubscribed new issues in high demand but short supply should develop a premium on price per share when trading opens. The rapid adoption of Netscape Navigator and other Internet related software applications has created an optimistic outlook for rapid growth and future development of the Internet. Given the hype surrounding the IPO and this very optimistic market, I would enjoy a run-up in share price to profit from the underpriced new issue. As a fund manager, I would still recommend a buy and hold strategy even at $28 per share for the same reasons: to take advantage of underpricing and profit from the run-up in market price after trading opens.

The Problem

In August 1995, Netscape Communications Corporation was in the final stages of an initial public offering (IPO). On August 8, the lead underwriters for Netscape's IPO, Morgan Stanley and Hambrecht & Quist (H&Q), proposed to Netscape's board a 100% increase in the initial offering price from $14 to $28 per share. The problem in this case is to determine how to value Netscape Communications Corporation as a company, since the company had only existed for 16 months and had yet to be profitable. There is limited financial data for the firm for a useful evaluation with a limited number of proxy firms for comparisons. Furthermore, the average age of a company before an IPO has been 6-7 years during the past five years.

Background

Netscape Communications Corporation was started in 1994 to provide a line of client, server and application software products for communicating and commerce on the Internet and private networks. Netscape's success to date has been based on its business model by making their basic client product, Netscape Navigator, available for free up front and generating revenue on the back end by selling a line of server and integrated application software products to enable businesses (and consumers) to communicate and conduct commerce over the Internet and over private Internet Protocol (IP) networks.

Netscape Navigator was a client-based web browser software application that allowed users to navigate the Internet and the new World Wide Web (WWW) using a graphical point-and-click interface with text and images, similar to the Windows or Mac operating systems for personal computers. Navigator combined many of the text-based Internet commands (such as telnet, ftp, news, etc.) into an easy to use graphical interface and it gave rise to the term "Internet surfing". Navigator's functions included web browsing, file transfers, news group communications and e-mail. By making Navigator freely available, Netscape's strategy was to gain a substantial market share of the web browser market, and build brand loyalty and brand recognition, which would stimulate upsell demand for its revenue producing line of server application software.

For Netscape to be successful as a long-term going concern, it had two primary challenges: to set a new industry standard for the web browser market, and to be profitable. As of August 1995, Netscape was not yet profitable. However, with the release of Netscape Navigator, the company did set a new industry standard for web browsing. To be successful in the long run, Netscape must continue to offer new innovations in the web browsing market. Netscape's current competitive position as the web browser market leader is at significant risk due to competitor's entrance into the market. The firm's primary competitor is Microsoft.

In 1995, Microsoft rolled out its new Windows 95 operating system for the personal computer, which came bundled with their free web browser: Internet Explorer (IE) 1.0. Microsoft also offered a suite of software applications for common business and office tasks such as word processing, financial spreadsheet analysis, E-mail and databases. IE would be a problem for Netscape, since