I confess. I love a good IPO (initial public offering).

As part of the research for my Fast-Track Millionaire newsletter, I pore over every prospectus filed each month to take a look at who might be on to The Next Big Thing — companies that aren’t only engaged in interesting businesses, but that could deliver triple-digit gains (or more) for my subscribers.

I’ve found some winners. I was among the first to see the promise in Digital Globe (NYSE: DGI), a satellite imagery company that sells pictures to the U.S. government. It went public in May 2009. I later added it to my portfolio; now my subscribers and I are sitting on a 74% gain.

That’s not bad — for a start. My focus is on long-term, sustained returns. I’m shooting for the type of gains that will enable my subscribers not to have to work another day in their lives. Digital Globe may well be one of the stocks that get us to that point.

For every big winner I find, I come across dozens of stocks I wouldn’t touch with a 10-foot pole. And a few are worth shorting six ways from Sunday.

Take Epocrates (Nasdaq: EPOC), a recent IPO. Epocrates sells a smartphone app for medical professionals that offers a suite of reference tools. The market value of the company, which reminds me of the dot-com days, is already an astounding $490 million. Some publications — the normally brilliant Fast Company, to name one — have lauded Epocrates as an innovator. I think it’s a loser with a dot-bomb-style business model.

What does that $490 million market cap buy you?

• A series of smartphone apps and
• The app’s user base.

That’s it. So now the trick is to decide what — if anything — that’s really worth.

Epocrates has more than a million users of its apps. So the question is whether each user is worth $490. It’s not. It might not be worth anything.

Here are six reasons for that:

1. Most users don’t pay. The basic app is free and has some functionality. To upgrade to the premium version is $199 a year. At present, the company says, only 9% of the user base has bought a subscription. To put it another way, 91% of users have decided the app isn’t worth anything. Not only do few users upgrade, but the percentage of those who do is shrinking. In 2007, 32% of users paid. That fell to 16% in 2008 and to 12% in 2009, then to 9% in the first nine months of 2010. I expect this trend to continue. A million users is a nice figure, but the reality is the paid base is far less than that.

2. Most paying users don’t renew. In a subscription-based business, the higher renewal rate you can get, the greater the value of each individual subscriber. If one can show that a new subscriber will renew for four years — paying $800 — then one can reasonably accept a value per user that’s a multiple of the annual subscription price. As it stands, that’s clearly not the case. The data show the company’s subscriber base shrinks each year. That means users are not renewing, so paying a premium for them seems foolish.

3. The target market is too small. There are 2.7 million nurses and 661,400 doctors in the United States, the Department of Labor says. Right now, only 9% of Epocrates’ users pay. If that were to expand to the entire market, Epocrates would have 302,526 paid users. If each pays $199 a year, that’s $60.2 million in revenue. A 25% margin puts annual earnings at $15 million. At the average earnings multiple of the S&P 500, which is 16, Epocrates is worth $225 million, or less than half its current valuation.

But this is an extremely rosy picture. Let’s not forget that this (1.) assumes Epocrates captures a paid subscriber base three times the size of what it has captured to date. It assumes (2.) all subscribers will renew at $199 a year indefinitely, when, in reality, the subscriber base shrinks by half almost every year. And it also (3.) assumes a 25% net profit margin, which is more than 10 times what the company is actually able to execute.

4. The marketing is self-defeating. To staunch its dramatic customer bleed, Epocrates says it will give more content away. But the more it gives away, the fewer the users who will subscribe. After all, if the free version meets one’s needs, there’s no reason to upgrade.

A company worth a half-billion dollars ought to have a stellar marketing plan. But Epocrates relies on word of mouth. That approach can deliver, but it has to be part of a larger strategy. Here, because the company faces no other competition from similar apps, it presumes it doesn’t have to bother with users accessing other sources of information. But that ignorance of the marketplace can be a fatal mistake…

5. That’s because upcoming changes in health care will render the application obsolete. The government is transitioning the country to digital medical records. These systems will put PCs or tablets, into caregivers’ hands and allow the sharing of patient information, test results, logistical management and more, including checklists for hundreds of tasks and medical reference. Not only will every hospital have its own system, but you can bet it will, out of liability concerns, forbid the use of any other systems. Next-generation health care information technology will make the Epocrates app redundant and use restrictions likely will render it anathema. 

6. With all this in mind, the Epocrates “channel” isn’t worth anything significant. Say you have a base of customers who are willing to pay a subscription fee to obtain a product. That is, you’ll recall, one of the things we get if we theoretically buy the whole company. Now, access to that body of consumers is worth something to advertisers if you can demonstrate a high level of penetration within a certain demographic. If I can show that 80% of men age 25 to 40 are watching the Super Bowl, then I can charge a king’s ransom for a 30-second spot. In the same way, Epocrates says it can market access to its users to companies that want to deliver information and advertising to physicians and nurses.

Nonsense. If only 9% of your customers are using the app to the degree that they are willing to pay for it, then it’s a stretch to deem the Epocrates app a meaningful channel. And were it to add marketing messages to the critical functions of its apps, users would complain and cancel. Presumably one of the reason users upgrade in the first place is so that they do NOT have to see commercials. Advertisers can find more effective ways to reach medical professionals.

Action to Take–> Epocrates was a good idea for a smartphone app, but that doesn’t means it’s a reasonable basis for a $490 million company. My prediction is that Epocrates will see its user base continue to shrink, its revenue and earnings will continue to disappoint and its usefulness as a marketing channel will fail to deliver any meaningful results. These factors will push the share price down until the company is sold off piecemeal, or goes the way of Pets.com.

I hate to spend all this time doing due diligence on a company that I think will end up tanking. But investors who see as dismal a future as I do for these shares should consider a short position. As for me, I’ll have to move on and find a better candidate for my Fast-Track subscribers.

[Note: I was excited to share some of my latest promising IPO finds in an exclusive audio chat with my Fast-Track Millionaire subscribers. For more information, including how to get access to my research, go here.]