Express IPO Looks Good for a Bounce

Express IPO Looks Good for a Bounce

Express Inc. (EXPR)The last few weeks have been difficult for many retail stocks – and particularly challenging for investors in the recent IPO of Express Inc. (EXPR).  After being offered to the public at $17.00 per share, the stock has lost about 15% of its value and hit a new low in light trading this morning.  Express is a specialty apparel chain with 573 retail locations spread across the United States.  Originally a part of Limited Brands (LTD), the majority of the company was purchased by Golden Gate Private Equity Inc. in 2007.  The IPO is the first step for the private equity company to cash in on its 3-year investment.


The IPO was managed by Merrill Lynch / Bank of America (BAC) and Goldman Sachs (GS). With such a diverse retail and institutional platform, one would have expected the shares to be placed in the hands of long-term investors and priced at a discount to allow for an initial increase in the share price.  But the environment for retail stocks has been extremely difficult and institutional investors have been offloading risk at a steady pace this month.  At this point it seems that the selling shareholders got the better end of the deal – liquidating part of their position at $17.00 per share.

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According to the terms of the prospectus, there were roughly 16 million shares sold to the public of which 10.5 million were primary (sold by the company to raise  capital) and 5.5 million were sold by private shareholders.  However, when looking more carefully at the deal, this statistic is a little misleading…

Express essentially DID receive $170 million in proceeds from the deal which it used to reduce outstanding debt.  However, it should be noted that the outstanding debt is actually owed to several subsidiaries of the private equity firm that purchased the brand in 2007.  So after passing briefly through Express’s balance sheet, the funds will then be distributed to the selling shareholders in the form of a debt repayment.  Express will be left with $368 million in long-term debt and roughly $67 million in cash.  The pro-forma balance sheet has stockholders equity at $89 million – which implies a 413% debt to equity ratio – not exactly a solid balance sheet.

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But despite the shaky circumstances with which this stock began its publicly traded days, I expect EXPR to find a floor near $14 and begin to trade higher.  One of the primary reasons is because only a small portion of the stock was actually liquidated in the IPO transaction.  Sixteen million shares were sold to the public, but the number of shares outstanding is closer to 89 million.   That means Limited Brands and Golden Gate Private Equity still hold the majority of the stock and will see the market value of their investment rise and fall with the fortunes of the stock.

Once a private equity firm has begun to liquidate its position, they usually don’t wait too long to follow up by selling the remaining shares.  With the negative reaction to EXPR’s stock there is even more of an incentive for the company to find a “graceful” way of exiting this position.  So it may sound counter intuitive, but one of the best ways for Golden Gate to liquidate the rest of its position is for the company to step in and support the price of EXPR – and if they are going to take this action they need to act quickly!

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Supporting the stock at this time when the market is attempting to rebound will be key.  If EXPR begins to trade back towards the $17.00 IPO price and holds a stable pattern, then Golden Gate stands a better chance of selling its remaining shares in a secondary offering.  But if the stock is allowed to fall from here, there will likely be no market for quite some time.  So the stakes are high and the amount of capital at risk is not trivial.

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It may be a little too cute on the trading side, but with retail names showing some relative strength over the past few days, I expect EXPR to be good for a trade higher.  The potential return is somewhere in the neighborhood of 10% to 12%.  But this can be painted against a relatively low-risk backdrop.  If I were to enter the trade later this week, I would place a stop just below $14.75 or so – exiting the trade if the rebound in EXPR doesn’t take place immediately.  Setting up a short-term trade in an improving market with capped risk is one of the better ways to play a short-term rebound and I think the general negative sentiment in the retail area could be temporarily lifted as the illusion of financial stability comes back into this market.

Express Inc. (EXPR)

FD: Author does not have a position in any stocks mentioned in this article.

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Posted in Featured, IPO, Long IdeasComments (5)

Metals USA Primed for a Bounce

Metals USA Primed for a Bounce

Metals USA Holdings Corp. (MUSA)Just over a month ago, we took a look at Metals USA Holdings Corp (MUSA) after it’s IPO.  The private equity firm Apollo Group was the primary beneficiary with a convoluted transaction where MUSA would issue primary shares (with the capital proceeds paid to the company) but would then be required to make a payment to Apollo Group which basically represented the capital from the IPO price.


This transaction seemed bound to be a poor deal for investors who were really just funding Apollo’s exit.  And sure enough, the stock dropped from the offering price of $21 down to Wednesday’s closing price of $14.80.  That means investors in the actual IPO lost nearly a third of their capital over just about six weeks.  Of course, the economic weakness and concern in Europe has helped to speed up the decline.


At this point, MUSA may be at a level low enough to consider buying.  Forward earnings expectations are robust as the company has cut costs and is now operating more efficiently.  The first quarter earnings report showed the company eking out a small gain which was better than management’s previous guidance for modest losses.  According to the press release, management appears relatively upbeat about future prospects:

Lourenco Goncalves, CEO, Metals USA Holdings Corp. (MUSA)Market conditions continue to improve, as we see increases in customer inquiries and order volumes.  Raw material prices continue to rise and metal prices are following.  ~Lourenco Goncalves, CEO

Analysts are expecting the company to earn $1.16 per share this year compared to a loss of 52 cents last year.  In 2011, the expectations are for earnings of $1.94.  So at the current price below $15.00, investors can pick the stock up for 13 times this year’s earnings and less than 8 times next year’s expectations.  Of course those estimates aren’t a given, but at this point the risks seem more contained with the stock trading at such a discount to the IPO price.

The prospect for the company to be acquired shouldn’t be overlooked.  With MUSA’s market cap now approaching a half billion (from above) the company is well within the reach of larger metal conglomerates wishing to increase their business lines.  Heck, Apollo Group could step in and buy the company again pocketing about $250 million and still owning the same company it started with before the transaction.

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Fears of deflation and weak demand cannot be simply overlooked.  But traders who bought on the IPO have likely pressured this stock down to a place where it makes fundamental sense to own.  Investors will have to be patient, but could see a significant return if they weather volatility and hold the stock for 6 to 12 months.

High debt levels may continue to cause concern, but this is standard operating procedure for the capital intensive metal industry.  The company has a healthy level of inventories, productive property and equipment, and has reduced costs to allow for healthy cahs flow into the business.  So despite the macro headwinds, I would cover shorts at this point and consider picking a few spots to add exposure cautiously.

Metals USA Holdings Corp. (MUSA)

FD: Author does not have a position in MUSA

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Posted in Featured, IPO, Long IdeasComments (3)

Harsh Winds Blow for Solarwinds

Harsh Winds Blow for Solarwinds

SolarWinds Inc. (SWI)Shares of Solarwinds Inc. (SWI) are off sharply today after the company announced first quarter earnings.  While the headlines beat the published consensus expectations, the devil was in the details.  As I write, the stock is off close to 15% as growth assumptions are being challenged, and speculative investors are getting punished.


Despite the “alternative energy” name, Solarwinds is actually a network company which seeks to identify and solve network performance issues.  The company has a broad client base – boasting 93,000 customers at the end of the first quarter and offers a wide assortment of solutions:

  • Network Monitoring
  • Newsletter AdConfiguration Management
  • Network Traffic Monitoring
  • App & Server Monitoring
  • IP Address Management
  • IP SLA Monitoring
  • Virtualization Monitoring
  • Wireless Monitoring
  • Network Mapping

I’m not a tech guy by any means, but I can tell you that investors were excited about this relatively new stock because of the broad number of services the company offers, and the potential to cross- sell these services to existing clients.  The idea is for the company to get their foot in the door by selling one service, and then quickly explain why the customer needs a full bundle of services to operate efficiently.

Up to this point, it looks like the company has been very effective in growing its revenue base.  The first quarter showed a revenue increase of 43% over the same quarter last year.  The business was nearly evenly split between license revenue and maintenance revenue.  The maintenance business is a bit more valuable to investors because this is largely recurring revenue with stability quarter after quarter.

But looking at management’s projections, it appears the growth rate is likely to contract considerably – which is a major concern for investors.  For the second quarter, management is guiding revenue of $36 to $37.8 million which is at best a 40% increase over the second quarter of 2009.  For the full year, revenue is expected to be $159-165 million.  This indicates that management is expecting a significant pickup in revenue for the third and fourth quarters in what is known as a “back end weighted” year.

Essentially, management is asking investors to take a “leap of faith” stating that revenues will be in the mid 30 million level for the first two quarters – and then the high 40 million range for the third and fourth quarter.  Unless there is a particular contract that management expects to land – and the timing is very specific, it would seem that the back-end weighted guidance is sketchy at best.

Despite the 15% drop in Tuesday trading, the stock still appears to be over-valued based on earnings expectations.  Management is guiding analysts to expect 72 to 75 cents per share this year which only represents an increase of 15%.  But at $20.50, the stock is trading at 27 times the high end of guidance.  This multiple might be reasonable for a stock in the middle of a strong growth period, but with heavy competition, disappointing growth projections, an extended and vulnerable market, and a technically broken stock chart; the risks seem to far outweigh the potential benefits of owning the stock.

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Shorting SWI today may be a bit premature.  With the market likely to at least stage a rebound attempt from the sharply negative trade today, I wouldn’t be surprised to see SWI consolidate or even trade back to the $22-23 range.  But with the technical breakdown we have seen today and the potential for more selling as managers become less confident in the recovery, the stock will remain on my short list and could potentially trade back down to the IPO price of $13.

SolarWinds Inc. (SWI)

FD: Author does not have a position in SWI

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Posted in Featured, IPO, Short IdeasComments (2)

Apollo Cashes Out with Metals USA

Apollo Cashes Out with Metals USA

Metals USA Holdings Corp (MUSA)Late last week Metals USA Holdings Corp (MUSA) made it’s stock debut being offered to the public at $21.00 per share.  The deal was relatively small with just 11.4 million shares being offered and a broad assortment of underwriters took the lead in distributing the shares to the public.  Recently, new issues have performed well in the after-market but MUSA was an exception.  It may be that the underwriters reached too far on this one, setting the bar a bit too high with the $21 offer price.

Newsletter AdWhile at first blush the prospectus states that the shares are primary (with the shares being distributed to the company) further reading highlights the fact that private equity holders will actually retain the majority of funds from this transaction.  In no more than 60 days, the company is required to make an offer to purchase Payment In Kind (or PIK) notes which are held by the asset manager Apollo Group and some of its subsidiaries.  So while all the information is public, it appears this is a bit of a stealth deal to allow Apollo to cash out.

At this point there is still significant incentive for Apollo Group to support the stock and also provide MUSA with the necessary support to grow its business.  While 11.4 million shares were offered to the public, a full 37 million shares are outstanding with Apollo Group still owning a majority position.  I wouldn’t be surprised to see these additional shares hit the market later in the year – especially if equities markets continue to price in a recovery scenario.

Metals USA is an industrial company which is heavily dependent on sustained economic growth.  In the prospectus, management indicated that they expect demand for steel products to increase alongside improving general economic conditions.  The company believes that its customers are continuing to operate with low inventory levels which could bolster demand if these inventories are rebuilt.

To show how economic conditions affect this company, consider the wide swings of the last three years.  In 2007, the company collected $1.8 billion in revenues and produced 55 cents in earnings per share.  2008 was an even better year with revenues of $2.2 billion and earnings of $2.87 per share.  But 2009 was quite a challenge – revenues were cut in half to $1.1 billion and through cost cutting and managing expenses MUSA was able to generate just 14 cents per share.

Improving trends this year should push earnings higher but we are unlikely to see returns similar to 2008.  It is very difficult to forecast future growth because manufacturing and broad economic conditions are so unpredictable.  But lately the price of steel has been rising and competitors like US Steel (X) are expecting strength in 2010 and a much more profitable year in 2011.


MUSA operates three primary business segments

  • Plates and Shapes accounted for 47% of 2009 sales
  • Flat Rolled and Non-Ferrous commanded 45% of revenue
  • Building Products is much smaller with 8% of revenues.
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Looking through the prospectus materials, it is clear that the company has been slowly working both its inventory and its debt level lower.  This should provide a more stable fiscal foundation which is encouraging for shareholders.  But the failure of the IPO deal and the overhead resistance from Apollo’s shares which could eventually be dumped on the market will likely keep this stock lower.

As I write Thursday, the stock is trying to rally a bit and very well make a run back towards the IPO price.  If it reaches $20.50 or even $21, I will be interested in setting up a short position.  The position would not be entered until the stock began to fall again, but using a sell stop to get short and a tight stop above the IPO price, there is a good chance that traders could capture $2 to $3 in profits quickly, while only risking about $1.00.  Timing is critical and it might take more than one trade to get it right, but busted IPOs are some of my favorite short opportunities to pursue.

Metals USA Holdings Corp (MUSA)

FD: Author does not have a position in MUSA

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Posted in Featured, IPO, Short IdeasComments (4)

Calix Networks – When Valuation Doesn’t Matter

Calix Networks – When Valuation Doesn’t Matter

Calix Networks Inc. (CALX)It’s 1999 all over again!  In late March Calix Networks Inc. (CALX) completed its IPO, selling 6.3 million shares to the public at $13.00 per share.  The deal helped the company to raise roughly $50 million dollars and also allowed private investors to cash in on a portion of their holdings and receive a $26 million dollar payday.  Best of all, the stock was in high demand on opening day with a quick gap higher to $18.00 and an eventual close near $15 for a 16% return on the day.

Newsletter AdCalix Networks is a provider of communications equipment to what the company calls CSPs or “Communication Service Providers.”  The equipment helps telecom companies make better use of their networks, be they copper or fiber.  In the offering prospectus, the company laid out several issues that the products are meant to assist with.

  • Service Offerings – Calix products are able to help telecom companies offer a broader array of services to their customers.  Many networks were originally designed to only provide voice or limited data to customers.  The products offered by Calix helps to increase the number of services telecom companies can provide.
  • Capacity and Efficiency – With the demand for data increasing an exponential rate (think streaming media, video conferencing and other feature rich applications) telecom companies are seeing their networks strain to handle the traffic.  Calix products can help with this – allowing customers to upgrade networks at a moderate pace when capital is available.
  • Technology Flexibility – There are many different protocols and technological means by which voice and data flow.  Calix products allow networks to efficiently communicate with each other even when different or conflicting technologies are being utilized.
  • Customer Value – The end goal is to provide a value for CSPs technology that will allow for flexibility, lower costs and better returns on their capital expenditures.

While the business model certainly sounds respectable (and the company has already shipped 6 million “ports” to roughly 500 customers) investors are being asked to take a leap of faith.  The fact that the company has yet to post a profitable year has raised concern and will likely be discussed more as CALX continues to trade above its offering price.


Typically, I would agree with this discussion except for the fact that CALX appears to have a good shot of generating strong earnings in the next two years – if management can grow its business responsibly.  On top of the potential for fundamental improvement, we are currently in a very speculative market where traders are looking past fundamental barriers.  So when speculative issues rise, expect CALX to be one of the go-to names for generating higher returns.

The Fundamental Picture

Looking at the financial data from 2009, the company generated a gross margin of 33%.  So before covering expenses like R&D, Sales and Marketing and the catch-all General and Administration category, CALX actually turned a $77 million dollar profit.

Why gold will not make new highs or lows this year

Why gold will not make new highs or lows this year

Now assuming the company is able to generate 30-35% annualized revenue growth over the next two years, maintain a 33% gross margin, and keep operating expenses at a stable level, the company could come very close to reporting $1.00 per share in EPS for 2011.  If this were the case, CALX would likely see its stock trade at a multiple north of $20 – good for a 50% increase from today’s price.

I understand that this scenario may not play out perfectly.  Sales growth could be much higher or much lower.  Management will almost certainly increase operating expenses as the company grows.  But the company is at a very dynamic point where earnings are just beginning to turn positive (forth quarter EPS was positive $0.08 per share) and the actual dollar earnings per share could ramp up significantly in the next few years.

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The stock is now trading just above the $13.00 IPO price and the reputations of Goldman Sachs (GS) and Morgan Stanley (MS) are on the line.  Trades could be initiated here with a tight stop below the IPO price as the brokerages will likely step in to support the deal if the stock gets close to this level.  Initiating a trade with a relatively small amount of risk and potentially large returns is a good way to initiate small trades at this time, and one could quickly increase position size as the trade moves into positive territory.

Calix Networks Inc. (CALX)

FD: Author does not have a position in CALX

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Posted in Featured, IPO, Long IdeasComments (8)

Citigroup Taps a Liquid Market

Citigroup Taps a Liquid Market

Primerica Inc. (PRI)The current market is flush with liquidity as speculative traders search for opportunity.  Growth and speculative companies are especially attractive due to the potential high returns if the economy really is on track for a full recovery.  Faithful readers of ZachStocks know that I am hesitant to buy into the “full recovery” argument, but that doesn’t mean we can’t make money trading this speculative environment.

The ample liquidity has allowed new companies to raise capital to build their businesses, and has also allowed private equity investors to unload positions at a profit as the public market snaps up shares.  Last week Citigroup (C) took the position of a private equity player by selling a large portion of its position in Primerica Inc. (PRI).  The stock was issued to the public at a price of $15.00 and quickly began trading near $20.


Investors are likely very happy with their 30% plus gain in a single day and it looks like Citi may have sold itself short, as it could easily have collected $17 or $18 for the stock and still made investors very happy.  Fortunately for the company, it still owns roughly 40% of the company so it should be able to write up the value of its holdings.

Newsletter Ad

The transaction has certainly benefited Citi as the company was able to raise roughly $300 million.  That number is actually very conservative because as part of the convoluted transaction, Citi issued warrants to Warburg Pincus LLC, and also was the lead underwriter for  the stock – meaning Citi was able to keep a large portion of the underwriting discount usually paid to brokers who place IPO stock.

Primerica could be considered a “low-tier” financial services company whose primary business is selling life insurance.  The target client includes middle income families with $30,000 to $100,000 in annual income.  The prospectus lists these client as:

  • Having inadequate or no life insurance coverage
  • Needing help saving for retirement
  • Needing to reduce consumer debt
  • Preferring face-to-face meetings for financial decisions.

While this target market covers a large percentage of households (Citi estimates the demographic at 50% of US households), the margins on this segment of customers is usually relatively low.  That is why Primerica was considered the perfect solution for Citi – allowing middle income households to be served by Primerica while the Citi financial professionals focused on the bigger and more profitable clients.

Why gold will not make new highs or lows this year

Why gold will not make new highs or lows this year

The problem that I have with the Primerica business model is that the representatives often take a multi-level marketing approach to building their client base.  In the prospectus, Primerica speaks of “independent entrepreneurs” who are responsible for building and operating their own businesses.  These representatives are classified as independent contractors and are not official employees of Primerica.  Many of these “financial representatives” are part-time workers and Primerica actually encourages this aspect in order to attract more representatives.

The end result is that many of these representatives have little experience, a deficient knowledge base, and may not be giving the best advice to clients who need financial information.  While there are of course exceptions, Primerica has become known as the “Amway” of financial services – a reputation Citi would like to distance itself from.

I must say that I am a bit surprised at how well the IPO has been accepted by the market.  Financials are still a bit sketchy as it is difficult to understand the pro-forma numbers presented in the prospectus and account for the adjustments.  Below is a flowchart of the organizational structure which shows the convoluted state of the offering.

Primerica Org Chart

With this much complexity, I would avoid buying the IPO at this point as the market hates uncertainty and once the hype of the IPO wears off the stock could drop quickly.  Farther down the road, I expect Citi to unload the rest of its  shares and Warburg will likely exercise its warrants and liquidate the shares as well.

Aggressive traders might consider shorting below $19.60 but don’t get too greedy.  Citi will defend this stock vigorously as they still have a vested interest in the deal working.  So the stock could drop to $17 or even $16, but the IPO price is important for Citi to defend so I would expect them to start buying aggressively at the $16 level.

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Typically an IPO that trades well out of the gate is likely to continue its positive trend.  But Primerica is a different animal and I wouldn’t put too much confidence in the positive initial reaction.

Primerica Inc. (PRI)

FD: Author does not have a position in PRI

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Posted in Featured, IPO, Short IdeasComments (18)

MaxLinear Off to a Positive Start

MaxLinear Off to a Positive Start

MaxLinear Inc. (MXL)Last week two telecom IPOs were offered to the market – each showing strong gains out of the gate.  The transactions were indicative of a healthy IPO market with plenty of liquidity, and while that can change in a heartbeat, for now the environment looks technically strong for these new issues.

Today, I want to take a closer look at MaxLinear Inc. (MXL) which was priced Wednesday at $14.00.  The book was jointly managed by Morgan Stanley (MS) and Deutsche Bank Securities (DB) in a deal which provided underwriting commissions of $6.3 million.  The stock was well accepted by investors who immediately sent the stock up 33% in its first day of trading to close at $18.70.  The positive traction is likely giving private equity companies such as The Blackstone Group (BX) additional confidence as they prepare additional offerings which could quickly hit the US exchanges.

Newsletter AdPart of the appeal for the MXL deal is that the majority of shares being sold to the public were primary shares.  This means that the proceeds went directly to the company which should be helpful in providing the financial ability to continue to generate growth.  According to the prospectus, MXL will use the cash for “working capital” and possibly for future acquisitions.  I would prefer to see a bit more information on how this capital could be put to work, but since the company has shown strong historical growth, I’m willing to give them the benefit of the doubt for the time being.

MaxLinear is a “fabless semiconductor company” which designs chips that allow devices to better receive wireless television signals.  The majority of the company’s sales have been in Japan where it appears that MXL has a lock on the mobile handset market.  In the last four quarters, the company has seen sales increase by 49%, 13%, 107% and 96% (using year over year comparisons).


In addition to the handset market, MXL is increasing its product offering to include chips that enable devices to receive wireless signals for more traditional television viewing.  These products are anticipated to go in cable boxes, digital televisions, PC’s and notebooks.  While the handset market continues to provide stable cash-flow, these new markets are expected to drive the growth in future quarters.

When we say that MaxLinear is “fabless” it simply means that the company does not have its own manufacturing facilities.  This can be both a business strength as well as a liability.  During the financial crisis, many firms struggled under the weight of the debt used to build large manufacturing plants.  For several solar companies, the decision to expand manufacturing capacity at the wrong time turned out to be fatal.  So MaxLinear’s decision to outsource the manufacturing process gives the company better financial flexibility to be able to focus on research and development and growing other parts of its business.

But the flip-side of this coin is that if the economy improves to the point where it becomes difficult to negotiate contracts with outside manufacturers, MXL could see its costs rise exponentially.  The laws of supply and demand can easily come back to bite the firm if it is not accurate in its long-term projections of customer demand and its need for manufacturing capacity.

After staging a positive IPO transaction, MXL has largely been biding its time and trading within a relatively close range.  This week we will begin to see some patterns developing and from a trading perspective, it will be interesting to see what opportunities set up.  Due to the success of the IPO transaction, it appears demand is in control at this point and I would recommend trading from the long side initially.  A pullback closer to the IPO price would provide a welcome entry point and risk can be carefully managed by placing a stop slightly below the $14.00 IPO price.

On the other hand, if MXL were to break higher – crossing $19.50 – a higher-risk breakout setup might be in order.  The risk is higher in this type of trade because there is less of a defined floor that would be supported by the underwriting team.  When buying above $19.50, traders should look to use a stop where they would exit the position if MXL trades back into its current range.

Fundamentally, it is very difficult to set a fair valuation for the stock.  This is because MXL is just crossing the line where its revenue overcomes fixed expenses and the company is starting to show a positive profit.  There are many variables which could cause MXL to ramp up its profitability sharply over the next two years, or possibly cause it to over-extend and lose value for investors.

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So for today, it is important to determine who is trading this vehicle and what these traders are looking at.  Currently, MXL is being largely held by growth stock investors who currently appear willing to give the global economic rebound the benefit of the doubt.  As long as these investors continue to provide liquidity and are willing to pay speculative prices for future growth, MXL should stay in a positive trend.  But when the tide turns and growth investing falls out of favor, MXL will likely be hit with distribution – and at that time it might make sense for us to set up a short position.  The stock is dynamic – positive for now – and offers swing traders ample opportunity for profits.

MaxLinear Inc. (MXL)

FD: Author does not have a position in any stocks mentioned in this article.

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Posted in Featured, IPO, Long IdeasComments (4)

Resurging IPO Market Adds Liquidity for Businesses and Owners

Resurging IPO Market Adds Liquidity for Businesses and Owners


As the market trends higher and investors gain more confidence, business owners and private equity firms are increasingly tapping into the available market liquidity.  The opportunity at this point is for businesses to raise capital through an IPO transaction, selling shares of the company to the general public.  Private equity firms which own and manage individual companies are also cashing in.  A market of willing buyers allows the private equity managers to sell portions of these companies (or the entire company) and often realize healthy profits on their initial investment.

ZachStocks NewsletterBut how exactly does this process work?  As a fund manager who focuses on new issues, I have seen hundreds and participated in dozens of these transactions.  While there are often many moving parts and more than a little “slight of hand,” the IPO transaction is a fairly simple concept to grasp.  And whether you are a business owner or an investor, you should be aware of and understand the basic building blocks of this type of transaction.

The Cast of Participants

In order for a company to start trading on the public exchanges, there are basically three parties who are instrumental in the process.  The seller is the party distributing the shares and receiving the capital.  The underwriter facilitates the transaction much like a broker would facilitate a real estate transaction.  Finally, the buyers actually pay for the newly issued shares for the company.

So let’s look at each of these parties a bit more carefully.

Sellers Seeking to Raise Capital

When I look at an IPO transaction from an investor perspective, one of the most important questions I ask is who is selling the shares?

Usually, I am most excited about participating in the IPO when the shares are primary or being sold by the company.  This means that the capital that I pay for the stock goes largely back into the company which allows for growth.  The capital can be used to expand the sales force and pay their salaries, it can be used to expand a plant or facility that allows for better production, or it can be to pay down debt to make the financial foundation more stable.

The more specific a company can be about what they are doing with the capital, the more confident I can be that the money raised will be put to good work.  Too many times a selling firm will announce that the capital will be used “for general corporate purposes.”  That simply means the management team is asking for a blank check to spend however they see fit.  Not exactly a great way to instill confidence.

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Other sellers can include the company’s founders, a private equity firm, or a wealthy individual or trust who has previously owned all or a large portion of the business.  While I understand that these parties need to sell at some point to monetize their investment, I’m instinctively uncomfortable with a current investor selling shares to the public.  Since in this case the seller knows more about the inner-workings of the company than I could hope to learn in a few weeks time, I’m curious whether he or she sees a problem and that is motivating them to liquidate.

Whether a private equity firm or an individual investor is selling shares in the transaction, there are a couple of things that can be done to make the deal a little more appealing.  If the seller retains a large portion of their investment, then I can feel confident that they still believe in the future of the business – but they just want to begin collecting capital from their success in building the company.  I understand this need and if they still stand to benefit or lose from the ongoing success or failure of the company, then I am a more willing buyer.

A second way for sellers to make the deal more appealing would be to issue a mix of primary and secondary shares.  This way the company is still receiving part of the money from the transaction and the sellers are liquidating a portion of their holdings as well.  This way there is still a reason to expect the company to benefit from my investment and the selling parties receive an opportunity to monetize their investment as well.

Underwriters Introduce Buyers and Sellers to Each Other

Underwriting firms are usually well known brokerages such as Goldman Sachs, Merrill Lynch (now a division of Bank of America), Morgan Stanley and similar firms.  In recent years, the number of top tiered underwriting firms have decreased as a result of the financial crisis.  But there are still plenty of niche boutiques which also have the ability to act as underwriters for IPO transactions.

ZachStocks NewsletterThe underwriter is responsible for putting together the prospectus which is an offering document with all of the pertinent information that investors need to make an educated decision as to whether to invest or not.  Typically, underwriters are part of a brokerage firm which will service a number of institutional and retail investment accounts – thus bringing the buyers into the picture.

After performing due diligence on the company, the underwriter will determine a “fair market” price range for the IPO.  This is based on their assessment of the profitability of the business, its risks and growth expectations, and the price at which similar investments are trading for in the open market.

Once an acceptable price range has been established, the underwriters will then turn to the buyers to place the stock with willing investors.

Usually there is more than one underwriter working on a deal.  The LEAD underwriter is usually the firm responsible for performing the due diligence and determining the acceptable price range.  Secondary underwriters are simply brought in to help place the deal.  Since it is important to have a broad number of investors in the stock, underwriters usually work in teams to distribute the stock to a wide assortment of investors.

The underwriting firms are typically paid very well for their assistance in getting the stock distributed to investors.  Typically the underwriting fees are between 6% and 10% of the stock price, so if a company is selling 30 million shares at $14.00 per share, the underwriters could split between $25 million and $38 million.  Underwriting fees can often make up a large portion of revenue for a company like Morgan Stanley.

Buyers Invest In an Unproven Vehicle

You’ve probably heard that the average investment return is highly correlated with the risk taken.  While I don’t think that’s an absolute truth, there is a certain amount of return an IPO investors should expect due to the risk he is taking.  After all, there has never been a market for this stock before and the buyer is being asked to trust the underwriter’s “fair market” valuation of the company.

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Since as a buyer, I am putting my investors capital at risk on an unproven stock, I expect the deal to be profitable immediately.  Underwriters understand this dynamic and so they are constantly trying to please both their buyers and sellers.  After all, they need both parties in order to generate their fees.

So IPO transactions are usually priced with the expectation of being a bit below the expected market price.  That way buyers are pleased with their transaction and are willing to come back the next time the underwriter has a new IPO to pitch.  But if the IPO pricing was TOO low and the stock jumps 50% or 100% from the pricing immediately, the sellers could become angry because they could have received a better price for their stock.  So there is a fine line, but the pricing of the transaction usually favors the buyer.

Buyers of IPOs are typically institutional investors, although it’s not impossible for retail accounts to participate in many of these transactions.  Underwriters typically approach the buyers with information about the stock, the expected price range, and maybe some color as to how much demand there is for the stock.  Buyers will then offer an IOI or Indication of Interest, stating how much stock they would like to buy when the transaction is completed.

When indicating for a particular stock, I am always interested to know how much stock the underwriter believes he can get for me.  There is a bit of reverse psychology at play here because if the underwriter says “this is a great stock and the best news is that I can get you all the shares you want!” then I quickly become nervous that the demand is very low.  However, if the story is “We don’t have much of this one available,” then I am much more interested because it is likely that demand will drive the price higher once the stock begins trading.

After the Process Is Complete

You might think that once the sellers have received their capital, the underwriters have collected their fees, and the buyers begin trading the stock, that the process is over.  However, just like a baby, the newly issued stock still needs some care to survive to maturity.

Underwriters have a definite incentive to make sure IPO transactions work and the stock remains a viable investment vehicle.  After all, they want to make sure that sellers look them up when they have a company to sell to the market, and the only way buyers will stay interested is if the IPO continues to trade in a positive manner.

So it’s a loosely guarded secret that many underwriting firms “support” the stock in the first few months of trading.  That simply means that when and if the stock trades back towards the offering price, the underwriter very well may place large buy orders in the market to keep the stock from falling below the IPO price.  If you look through the charts of a dozen recent IPOs, you will probably see 6 or 8 of these stocks which trade right down to the IPO price and then mysteriously find support.

Another issue is the research process.  Since many investors are hesitant to invest in a stock without receiving a few second opinions from analysts, it is important for these stocks to catch the eye of research departments in various investment firms.  Ironically, the underwriters usually know the most about these companies because of their due diligence process, and yet the underwriters are restricted from offering analysis for a period of time after the offering.

But once that “quiet period” is over, you will often see several underwriting firms issue reports on the newly issued stock.  More often than not, the analysts will have a “buy” rating on the stock which helps to attract more buying interest and once again beef up the stock.

A word of caution here:  If an IPO breaks below the offering price, the risk immediately becomes exponentially higher.  At this point every investor in the IPO transaction is now under water.  There are exceptions, but usually a break below the IPO price leads to massive distribution which can take days, weeks, or even months to run its course.  This is where the risk comes in and while it may be frustrating to sell an IPO at a loss within the first few days, there is a very real risk that the loss will get much worse.

Opportunities and Risk

So IPO transactions offer exceptional opportunities along with material risks.  As a primary buyer, it is important to have a strong relationship with an underwriting firm (or several underwriters if your account size is large enough).

There is opportunity to participate in many of the gains just by investing in IPOs after they have begun trading.  These stocks are usually very dynamic with wide swings and attractive trading opportunities.  But remember to keep your trades sized smaller than a typical established stock because of the large swings associated with unstable supply and demand dynamics.

IPO transactions can be an excellent way for traders to generate returns provided appropriate risk controls are in place.

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Talecris Bounces Off IPO Price – Strong Growth Potential

Talecris Bounces Off IPO Price – Strong Growth Potential

Talecris Biotherapeutics (TLCR)Talecris Biotherapeutics (TLCR) is one of the more recent successful IPO stories as the company raised capital and began trading on October 1.  The IPO was priced at $19.00 per share and underwritten by an all-star cast of investment bankers including Morgan Stanley (MS), Goldman Sachs (GS), Citigroup (C) and JPMorgan Chase (JPM).  On the first day of trading, investors were rewarded with an 11% return as the stock bolted out of the gate. Quarterly Sector Report Sidebar Ad

Over the next month, the stock began to cool off as is often the case with new issues.  In early December, TLCR breached the all important IPO price of $19, but within two weeks the stock began to mount a recovery.  This is a perfect example of how underwriters and IPO investors can often be counted on to support a new issue very close to the IPO price.  It’s important for the underwriters to have the issues trade above the offering price, because it makes their job easier when peddling the next IPO to investors.  So often for quality IPOs, it is a good strategy to buy additional shares when the stock tests the initial price point.

The business model for Talecris appears to be very sound, as the company is experiencing strong revenue growth and generating impressive strength in earnings.  The company is a world leader in plasma based therapies and has strong command over its niche of the medical business.  One concern could be that the company receives 70% of its revenue from its two main products (Gamunex IVIG and Prolastin A1PI).  I’m not extremely experienced when it comes to the medical industry, but it appears based on market share and revenue trends that the company is very successful in its product lines. The third quarter was a strong period for TLCR with revenue growth of 12.9% and EPS of $0.38 which represents an increase of 72.7% over last year.  It appears that the company has been able to reduce expenses through vertically integrating its supply chain which has led to stronger gross margins.  The IPO transaction allowed the company to pay down a portion of its debt leading to lower interest expense which further helps to bolster earnings.

Lawrence D. Stern, CEO, Talecris Biotherapeutics (TLCR)Our third quarter results reflect the continued demand for Gamunex, our brand of IGIV, as well our success in building a vertically integrated plasma supply chain to ensure a continual supply of Gamunex. ~Lawrence D. Stern, CEO

As far as debt is concerned, the company still has long-term liabilities north of $1 billion.  The liabilities are offset by $630 million in inventory and a healthy balance of accounts receivables, but the high level of debt could still become a concern should there be any unexpected changes in the revenue stream.  While it is still too soon after the IPO, I would not be surprised if the company issued additional equity in the first few quarters of 2010 in order to pay down debt.  This would dilute current shareholders, but would also lead to a more stable capital structure.


Analysts are expecting the company to earn $1.52 per share in 2010 which is probably reasonable given the strong management team, growing revenue base, and cost cutting initiatives.  At the current price near $21, the stock is trading at a multiple of 14 which seems a bit conservative considering the earnings growth.  Some caution is in order due to the debt level, but a multiple of 20 would not be unreasonable.  If we see medical stocks rebound in the aftermath of health care reform (as I expect we will), TLCR could ride the trend and see a much higher multiple.

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So at this point it looks like the risk/reward ratio is very good.  $19.00 remains an important level to watch as a breach of this level would cause me to stop out my position.  On the other hand, the stock has the potential to trade through $30 and yield a 40% plus return.  The next six months should be a positive period for TLCR and its investors and I look forward to seeing what kind of growth management can generate.

Talecris Biotherapeutics (TLCR)

FD: Author does not have a position in TLCR

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Posted in Featured, IPO, Long IdeasComments (1)

Fortress Investment Sees Better Times Ahead

Fortress Investment Sees Better Times Ahead

Fortress Investment Group (FIG)Shares of Fortress Investment Group (FIG) are trading higher today after comments made at the Goldman Sachs (GS) US Financial Services conference. The private equity company has benefited from the equity market rebound and the return of liquidity to the global investment universe. As I write, the stock is up more than 7% after CEO Daniel Mudd spoke at the conference this morning and told investors that they are seeing more demand for their private investment funds.

ZachStocks Free NewsletterFortress has seen its stock plummet over the past year as funds that the company managed took on losses while at the same time, investors pulled capital out due to the poor returns. This is the nature of private equity – it can often be a boom and bust business model even though funds are usually structured to be absolute return vehicles. When a fund or family of funds are performing well, the company recognizes very attractive incentive allocations (FIG gets to keep a portion of it’s investor’s profits) and at the same time, new capital comes pouring in.

However, when these funds face a few months of poor performance, investors pull capital out resulting in a smaller pool of capital available to generate gains. At the same time, the poor performance puts the funds below their “high water mark” and that level must be reached again before the fund can charge any incentive fees on investors who are simply making their money back. So even in a rebounding market environment, companies like FIG will see their profitability lag because it takes time to make up past losses on their investments.


But we are likely in the early stages of another boom in the private equity market and for Fortress particularly. There are two factors feeding this new wave of profitability which could quickly lead to a sharply higher stock price. First, the company isseeing new investment capital come in the door. Keep in mind that this capital does not have a high water mark. Gains on these new investments will immediately lead to FIG taking a portion of the returns as their own profit. In the past few months, FIG raised $500 million in a portfolio designed to invest in the Japanese real estate market. Other new fund launches will likely allow the company to substantially increase their Assets Under Management (AUM)

ZachStocks AdvertisementThe second factor is that existing funds are nearing their high water marks. So while the funds have been struggling to make up past losses, these assets have basically been adding very little to FIG’s profits. But once the magical high water mark is hit, immediately new gains will tie directly to increased profits. As expectations ramp higher, the stock price will likely get a lift and potentially run several hundred percent higher.

Currently, analysts are expecting FIG to earn 28 cents in 2009 and 45 cents in 2010. This means that the stock is currently trading below 10 times next year’s expected earnings. To be fair, these earnings estimates are not very reliable. It’s extremely difficult to handicap exactly how well the company’s funds will do and what type of incentive allocations will be generated. But I do think that the Wall-Street analysts are excessively conservative given the difficulty we have experienced over the last year.

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FIG is not an investment that you should make with your “safe” capital. In many ways, this is a risky bet that could go bust, or could pay off big. If the market experiences another decline (which I think is possible) its likely that the funds will be better prepared to handle the turbulence. But there’s no guarantee that they won’t lose money in the funds resulting in much lower revenue. However, there is a good chance that FIG will have some of its funds make wise investment decisions (short or long) which will yield significant profits and push earnings up significantly. A little confidence could go a long way and if FIG realized a multiple of 20 on earnings of 75 cents we would have a return of roughly 275%.

So consider taking a shot at FIG – buy a few speculative shares and tuck them away for 6 to 12 months. The potential is great and you are only risking roughly $4.20 per share.

FIG Chart 1

FD: Author does not have a position in FIG

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Posted in Featured, IPO, Long IdeasComments (4)

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