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Shop 'broken' IPOs for comeback bargains
When a new stock falls below its initial public offering price, investors may have a chance to buy at a bargain price. But be careful; some broken IPOs never get fixed.
By Michael Brush
While rapid-fire traders scramble for shares of initial public offerings hoping for a profitable bounce, another type of investor sits back patiently and does just the opposite with new issues.
These scratch-and-dent speculators watch for so-called broken IPOs, the ones that sink below, or break, their offering prices. Then they swoop in to buy the bargains.
Many of these broken IPOs are bargains for a simple reason, says John LaForge, a money manager with SRQ Capital in Sarasota, Fla. They still have the cash they took in from the IPO. The cash can act as firepower to promote growth and provide some protection from the stock's slide because it's uncommon for stocks to trade below their cash-per-share level.
Often with a broken IPO, the problem is the bruised credibility of a management team that disappoints by missing earnings expectations or some other blunder soon after bursting on to the public stage.
"On Wall Street, it does not take much to lose credibility," says Tom Taulli, who tracks the latest IPO news at his Web site, CurrentOfferings. "After the analysts and investors put their trust in you and you have a bad quarter, you are done. You've just ruined your relationships, and to rebuild them will take a long time."
But not forever.
This is what makes the following broken IPOs buys for long-term investors ready to wait patiently for these companies to regroup and prove their worth.
| Broken stocks | | Name | Recent price | 2005 estimates | Price-earnings ratio | Cash per share | Price-to-sales ratio | Sector | Comments | | Affordable Residential Com. (ARC, news, msgs) | $13.20 | $1.25 | 10.56 | $0.87 | 2.59 | Residential trailer parks | Pays 9.4% dividend | | Cherokee Inter. (CHRK, news, msgs) | $8.90 | $0.67 | 13.2836 | $0.86 | 1.11 | Power supplies | Insider buying recently | | Collegiate Funding Serv. (CFSI, news, msgs) | $14.70 | $1.16 | 12.6724 | $0.08 | 3.84 | Student loans | Solid demographic trends | | iPass (IPAS, news, msgs) | $6.30 | $0.37 | 17.027 | $2.59 | 2.48 | Remote Internet access | Shifting to broadband | | Integrated Silicon Sol. (ISSI, news, msgs) | $7.10 | -$0.56 | n/a | $6.10 * | 1.44 | Communications chips | Down but not out |
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*includes $2.30 per share in long-term investments
Source for earnings estimates: Thomson Financial
Many missteps
Anyone still holding shares of trailer-park operator Affordable Residential Communities (ARC, news, msgs), which went public in February 2004, surely feels burned. The company came out at about $19. It recently traded near $13, thanks to a series of earnings mishaps, a management shakeup and a decision to stop offering earnings guidance.
But with its stock at these levels, this real-estate investment trust pays an attractive dividend yield of over 9% per year. Yes, there are questions about whether the board will have to trim that dividend. But the company still has $27 million on hand from the IPO to postpone that day of reckoning. Besides, speculates Wachovia analyst Stephen Swett, a 25% dividend cut may already be priced into the stock.
Will Affordable Residential ever post strong enough results to regain investor confidence? It certainly has a few underlying trends going for it, says LaForge, who owns the stock. First off, demand remains robust for mobile-home parks in Florida, where the company operates. Second, while rising interest rates typically hurt dividend plays like bonds and REITS, they may help this company. Higher rates make home mortgages more expensive, so many people who planned to buy a brick-and-mortar home may have to turn to a cheaper trailer home instead.
Alienating investors
If top managers at Cherokee International (CHRK, news, msgs) are fed up with Nortel Networks (NT, news, msgs), they have every right to be.
Shortly after Cherokee, which makes power supplies used on devices like telecom switches and medical equipment, came public in February 2004, Nortel started cutting orders. As Cherokee's biggest customer, Nortel's decision caused earnings misses, which alienated investors and drove Cherokee stock down below $7 from above $16 where it came public.
Now, managers must rebuild investor confidence. But it may not be as hard as it looks, says LaForge. For starters, the cuts in Nortel's business are probably over. And the rest of the business is solid. Sales to other customers grew by about 5% in the third quarter, compared to the year before.
Sales could pick up even more if a Y2K echo effect kicks in, says LaForge. A lot of technology-based devices have a natural life cycle of roughly five years, he says. Much of the new gear put in during 1999 Y2K scare is now getting replaced, which should help Cherokee since many of these devices use the built-in power supplies and adapters that Cherokee makes.
Another plus: The stock is cheap. Cherokee trades for 1.1 times sales, well below the 2.5 times investors pay for competitor Power-One (PWER, news, msgs). This probably explains why insiders have bought around $290,000 worth of stock in the $7-to-$8 range since November.
A government guarantee
Collegiate Funding Services (CFSI, news, msgs) gets the lion's share of its revenue by offering "consolidated" student loans. Recent grads turn to this company to combine several adjustable-rate loans into one fixed-rate loan and extend payback times beyond the normal 10 years for student loans. These tricks reduce onerous monthly payments.
Why is Collegiate Funding a broken IPO? For starters, it was probably priced too high, because the stock came out when student-loan companies where hot. Next, growth has been slow for some of the kinds of loans it offers, and marketing expenses were higher than expected.
Problems like these have the stock trading about $1 below its July 2004 IPO price of $15.75. Even more weakness may lie ahead. Insiders will be free to dump shares as of Jan. 15, when lockup constraints are lifted. Lockups force insiders to hold shares for a certain time after an offering.
But several trends will probably help fix this broken IPO, which Taulli at CurrentOfferings thinks is a buy. First, a recent Harris Poll (paid for by Collegiate Funding) found that only 41% of new graduates from four-year college programs are aware they could consolidate loans. Just 35% have done this. Conclusion: Better marketing should help.
What's more, many recent graduates have more than $20,000 in debt, so they may welcome a tactic that cuts monthly payments. Meanwhile, tuition keeps rising, and so will the number of college students. The Education Department predicts the college-age population will grow 11% by 2013. Taulli also likes Collegiate Funding because its loan book is safe since it's guaranteed by the government.
Expanding services
iPass (IPAS, news, msgs) has spent most of its stint as a public company as a truly broken IPO. The company came public at $19 in July 2003. It quickly traded below those levels and never looked back. The stock recently traded for $6.30.
Thanks in part to proceeds from that IPO, however, iPass has a huge cash hoard totaling $161 million. The cash, which works out to around $2.60 per share, offers comfort to value investors recently picking up the stock, like John Buckingham, manager of Al Frank Fund (VALUX) and publisher of The Prudent Speculator newsletter.
IPass offers services and software that give employees secure Internet access to their corporate networks from remote locations. Last year, iPass shares weakened after it lost business because it alienated customers in a clumsy transition to broadband access from dial-up. But that problem may be behind it, says Vik Grover, an analyst at Needham & Co. The company will continue to build new broadband hotspots. And it'll offer other services like messaging, voice-over-Internet protocol phone service and e-commerce transaction processing. Grover thinks these changes could push iPass shares to $9 in a year.
Sticking it out
Besides busted IPOs, Buckingham likes to look for broken follow-on offers, or stocks trading well below levels where a company issued new shares to raise funds. A great example: memory chip designer Integrated Silicon Solution (ISSI, news, msgs). At $7.10, its stock is well below the $16.50 level at which it issued 6.1 million shares in January 2004 to raise $93.5 million. You can blame it on the downward spiral in pricing for its random access memory chips used in consumer electronics products and communications devices.
But the ugly phase of the boom-and-bust cycle in this commodity chip market won't last forever. And thanks to that offering, the company has a big enough cash hoard to stick it out until things improve. The company has around $3.80 per share in cash, or $6.10 if you throw in long-term investments. That's why Buckingham tells long-term investors to buy shares up to around $7.90.
The risks
About 14% of IPO companies go bust within five years, according to Craig Lewis, a professor of finance at Vanderbilt University's Owen Graduate School of Management. So you have to be cautious with broken IPOs. They may be headed in that direction.
Be careful with companies that come public using what academics describe as "low-quality" underwriters. These are the smaller investment banks that typically take the most subordinate role in an offering.
Also be wary of deals that don't use the full number of shares set aside for unexpected demand, often called the over-allotment or the green shoe.
"If they have these two characteristics, they are likely to fail," says Lewis.
And if you shop among broken IPOs, be wary of those in the biotech sector for now, warns LaForge at SRQ Capital. News flow is too sporadic at biotech companies. "So for broken biotech IPOs to recover, you need a speculative market," says LaForge. "I don't think we are in a speculative market at all right now."
Finally, if the overall market fails to recover from the funk of early January, be careful with broken IPOs. "They don't do well in a weak market," says LaForge. "If the market gets weaker, get out of them."
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