In initial public stock offering (IPO) by a company’s rival can have significant impact on the profits of other public stocks in the sector, points out a new research report from two Yale University professors.

IPO is bad news for rivals

The paper points out that competitors can see long term profit drop of between 10 and 25 percent. “Overall, the model indicates that an IPO is generally bad news for rivals’ future profits per unit of market share,” wrote Yale University finance professors Matthew Spiegel and Heather Tookes.

What happens is that when a rival company launches their IPO product competition increases, lowering profits. “If forced to provide a broad characterization of what happens, the hypothesis that the information released from an IPO leads firms to a more homogeneous form of product competition (and thus lower profits per unit sold) appears to dominate,” Spiegel and Hookes wrote.

IPO firm market share

IPO: Poaching competitor’s customers

One key finding in the report is the increased ease with which an IPO company has in poaching customers from established competition.  Noting examples in the cell phone industry, the study indicates that post-IPO it becomes 3 to 4 times easier to lure away a rival’s customers.  Using cell phones as an example, as companies became public unit sales grew but profits were down.

The study says that the generally accepted reason for this profit decline is that, as time passes; the product offerings become more homogeneous. Without significant product differentiation, price pressure increases, dropping profit margins.  This relates to IPOs in a unique sense, the report notes.

When firms go public, they are generally small, with less than 1 percent market share. For the subsequent three years after the IPO they remain relatively small, the study notes, with “industry value changes in our sample ranges from -4% to +3% over the long run post-IPO.”

The report notes the causality of an IPO relative to an industry and then challenges conventional wisdom.

The study considers common logic that if going public makes a firm stronger, its forecasted profits per unit of market share should increase and its rivals’ profitability should decrease. “Alternatively, if the IPO leads to the transmission of formerly private information useful to the firm’s rivals, then the opposite should be true.

IPO firm growth

This is not the case. The IPO should be viewed as a warning to more established firms in an industry, an event that doesn’t cause change but rather foretell larger market environment changes.  The paper finds that estimated parameter changes pre- and post-IPO look similar for both the newly public firm and its rivals, indicating the IPO is best described as a “canary in the coal mine” rather than a causal competitive event.

Read the full paper here.

H/T HLS Forum on Corporate Governance and Financial Regulation