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Posted
2/27/2003
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The
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The
Speculator
Don't be lured
into an IPO con game
Is that hot stock an exciting new opportunity
or just a con artist with a new angle? We've found a gauge to help you
judge whether the numbers add up.
By
Victor
Niederhoffer and Laurel Kenner
The
anglerfish and the stock market have much in common vis-à-vis the use of
deception to ensnare unwary prey. Anglerfish are fish, but they are
fishermen, too. They have appendages on their foreheads that look like
fishing rods, with baitlike lures on the tips.
The
lure of a female deep-sea angler, one of more than 200 anglerfish species,
is luminescent. She lurks on the ocean floor, perhaps carrying one or more
parasitical mates of the species. When a fish approaches to take the bait,
the anglerfish opens her huge mouth and swallows it in a flash, be it twice
her size.
The
situation is so like the typical stock-market ploy in which the market
establishment dangles and highlights a desirable-looking morsel in front of
the public that one is tempted to take out Izaak Walton’s "The
Compleat Angler" for guidance. Some of the market’s more outrageous
lures are found in the initial-public-offering stream. In a continuation of
our work on cons (see last week's column, "Commission-free trades and other scams"),
we concentrate today on the deceptive techniques of some IPO species.
Managing mischief
Every
company that goes public wishes to raise as much money as possible for
itself and the selling stockholders. One way to do so is to “manage
earnings” to present the best possible financial picture to the public. Of
course, if the company and its bankers manage the earnings too hard, they
will be vulnerable to shareholder lawsuits and suffer a lack of flexibility
in managing future earnings.
A
number of studies have been performed on the subject of pre-IPO earnings
management. The most widely cited is a December 1998 Journal of Finance
article by Siew Hong Teoh, Ivo Welch and T.J. Wong, which looks at how
companies about to go public time their recognition of revenue and
expenses. Companies that were the most aggressive with adjustments --
accruals, as they say in the business -- in their first-year financial
statements underperformed the most conservative firms by 15 to 30
percentage points within six months after the close of the fiscal year.
Even
more dramatic results were reported by Larry L. DuCharme, Paul H. Malatesta
and Stephan E. Sefcik in a 2000 study. DuCharme and his colleagues
separated IPOs into quartiles based on the level of managed accruals the
year of and before the IPO. They found that companies with the
heaviest-handed accruals could be expected to underperform the broad market
by some 70 percentage points over the three years after the IPO.
Unfortunately,
after eliminating non-manufacturing companies and others that didn’t meet
the study’s parameters, the DuCharme study covered only 171 of the 6,307
companies that went public from 1982 to 1987.
The
Speculators felt that an update was in order. Moreover, the sheer
egregiousness, effrontery and enormity of the big cons we discussed last
week precluded our normal counting in last week’s column, and we are not accustomed
to maintaining a blank envelope for more than one week.
Lights, camera, financials…IPO!
We
did penance for our hiatus by seeing if the results of our old friends
Jacob Thomas and Huai Zhang would hold up with IPOs. Thomas and Zhang, as
we reported last Sept. 19 (in "Empty shelves signal a rising stock"),
found that companies with significant increases in accounts receivable as a
percentage of assets compared with their peers underperformed the market.
Would there be different post-IPO performance in companies that had
significant increases in receivables and inventories as a percentage of
assets when compared to their peers?
We
were intrigued by the results of companies such as HealtheTech (HETC, news, msgs), which markets medical and
fitness devices. In fiscal year 2001, HealtheTech reported losing $20
million on sales of $2.7 million. Not an overly good figure on the surface,
but then again, its sales went up from $500,000. Some great demand for
products is surfacing. However, we note that inventory rose from $600,000
to $2.8 million, a rounded increase of $2 million. Receivables, meanwhile,
went up from $200,000 to $1.3 million -- a rounded $1 million increase.
Without
those increased accruals, HealtheTech’s loss would have been a rounded $23
million, instead of $20 million. Now, this is a very broad-brush analysis.
We didn’t consider liabilities or other accruals, and we didn’t normalize
by assets. (HealtheTech’s accounts and notes receivable in 2001 as a
percentage of assets went up from 2% to 5%, and its inventories as a
percentage of assets rose from 5% to 11%.)
For
a more accurate picture, we used changes in accounts receivable as a
percentage of assets as the raw material for our study. We took all 160
U.S. companies that had initial public offerings last year. For each one,
we calculated the change in accounts receivables, normalized by assets, for
the fiscal year before the IPO. Our hypothesis was that companies with a
big decline in receivables would perform well and that companies with a big
increase in receivables would perform badly.
In
bowling terms, we hit a strike. It turns out that for the 56 companies for
which data was available, the correlation between receivables change in
2001 and return in 2002 was -0.26. This correlation is about a 1-in-10 shot
by chance alone.
Receivables pre-IPO
Here
is a list of companies with large increases in receivables relative to
assets that performed abysmally after their 2002 IPOs.
|
Companies with large increases in receivables
|
|
Company
|
%
chg in receivables, normalized to assets, '01
|
Ret.
Since IPO
|
|
Kyphon (KYPH,
news,
msgs)
|
149%
|
-29%
|
|
HealtheTech (HETC,
news,
msgs)
|
146%
|
-67%
|
|
PrintCafe Software (PCAF,
news,
msgs)
|
101%
|
-76%
|
|
Ribapharm (RNA,
news,
msgs)
|
67%
|
54%
|
|
Synaptics (SYNA,
news,
msgs)
|
40%
|
36%
|
|
The
following companies reported a very large decrease in receivables and
showed excellent returns after their 2002 IPO.
|
Companies with large decreases in receivables
|
|
Company
|
%
chg in receivables, normalized to assets, '01
|
Ret.
Since IPO
|
|
Chicago Mercantile Exchange (CME,
news,
msgs)
|
-74%
|
30%
|
|
JetBlue Airways (JBLU,
news,
msgs)
|
-51%
|
48%
|
|
Sunoco Logistics (SXL,
news,
msgs)
|
-36%
|
37%
|
|
EON Labs (ELAB,
news,
msgs)
|
-17%
|
49%
|
|
CTI Molecular (CTMI,
news,
msgs)
|
-15%
|
33%
|
|
We
also looked at the top 20 largest decreases in accounts receivable and
found an average return of 2%, compared with -13% for the companies with
the largest receivables increases. The difference, while of practical
interest, is only about a 1-in-20 shot by chance alone.
Five to watch
The
whole subject of IPOs is such a big one that we will not be able to refrain
from considering their merits, demerits and trends in a future column. For
now, we’ll note some recent and pending IPOs that may be of interest.
During
the last three months, just eight companies went public. Only five had 2001
data on accounts receivable. We ranked them in terms of expected return,
with the biggest decline in accounts receivable at the top of the list.
|
Companies ranked by expected return
|
|
Company
|
Sym.
|
%
chg in A/R (2000-2001)
|
|
Chicago Mercantile Exchange (CME,
news,
msgs)
|
CME
|
-74%
|
|
Accredited Home Lenders (LEND,
news,
msgs)
|
LEND
|
-42%
|
|
VistaCare (VSTA,
news,
msgs)
|
VSTA
|
-11%
|
|
Infinity Property & Casualty (IPCC,
news,
msgs)
|
IPCC
|
-9%
|
|
Chicago Bridge & Iron (CBI,
news,
msgs)
|
CBI
|
-4%
|
|
Among
pending issues, two stand out:
Molina Healthcare (expected ticker: MOH) had a
56% reduction in accounts receivable in 2001, from 32% of assets to 14%.
Athletic
shoe maker Converse (expected ticker: CNVS) reported that accounts
and notes receivable went from 21% of assets to 28% in its last fiscal
year.
|
Converse: Selected annual financial results ($
millions)
|
|
|
2002*
|
2001
|
2000
|
|
Sales
|
160
|
149
|
225
|
|
Net income
|
17
|
5.1
|
-27
|
|
Accts. rec.
|
32
|
14
|
30
|
|
Receivables as % of assets
|
28%
|
21%
|
31%
|
|
|
|
|
|
|
* Through September 30. Sources:
Bloomberg, SEC filings.
It
will be interesting to see if 2003 results continue the negative
correlation between receivables changes and stock returns that we observed
for 2002 IPOs and that was predicted by the academic studies.
Endless elaborations
Variations
on IPO lures are probably endless. We do not wish in any way to denigrate
the basic entrepreneurial urge to raise money for expansion. However,
anyone who reads the history of the big con is struck by the endless
creativity and elaborative power of successful practitioners. As Jacob
Thomas, a Columbia University accounting professor who knows as much about
the subject as anyone, told us:
I think there
is more texture to the earnings management story than 'Manage earnings
upward in the IPO year, get a huge IPO pop and then the price deflates as
the truth comes out.'
"There may be an earlier period where earnings are actually managed
down (say in year -3 or year -2, where year 0 is the IPO year). Then
earnings are managed to show growth leading up to the IPO; i.e., it is not
the level of earnings in that year but the earnings growth leading up to
that year that has a bigger impact on IPO pricing.
"I also think there is evidence of the analyst from the lead
underwriter talking up the stock really optimistically for the 180-day
period after the IPO.” (Owners agree not to sell their shares for 180 or
more days after the IPO, a respite referred to as the lockup period.)
Is the Buffett bond a free lunch? Maybe for Warren
Last
week, we wrote that there are no free lunches, but now we’ve heard
otherwise. James Altucher of Subway Capital writes:
"Actually,
I think a free lunch was served in the stock market this past year. But it
was served by investors and was eaten by Warren Buffett when he offered
investors the opportunity to lend him money and pay him for the
opportunity. According to the May 22, 2002, press release from Berkshire,
'(the SQUARZ bonds are) believed to be the first security to carry a
negative coupon.' The $400 million worth of bonds carry a coupon of 3% but
a warrant that the bondholders have to pay 3.75% installments on, resulting
in a negative coupon of 0.75%. The warrants are in the money if between now
and 2007 Berkshire returns an annual 8.3% (note that Buffett thinks stock market
returns are only going to be in the 7% range). In addition, because of the
way the warrants are structured, Berkshire Hathaway actually gets a tax
deduction along with the coupon payment.
"Sounds complicated? Well, as Charlie Munger has said, 'To say that
derivative accounting is a sewer is an insult to sewage.' Needless to say,
the offering was oversubscribed. Three million a year in payments plus
warrants that are likely to expire worthless can buy many lunches for
Buffett and Munger over the next four years, once and for all proving that
a free lunch is possible in the stock market. Just to add, I'll be heading
to Omaha in May to try and meet some of the SQUARZ holders. If there is a
reason, I will find it."
Have you been taken for a ride by an IPO or an accrual?
E-mail us at gbuch@bloomberg.net. A full workout of all the
receivables data for the IPOs of 2002 is available on our Web
site, along with important information on a highly recommended
book -- our own -- that is guaranteed to get the worst reviews of any
financial book in history when it comes out next month.
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