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Posted 2/27/2003


The Speculator

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• Commission-free trades and other scams, 2/20/2003
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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


% chg in receivables, normalized to assets, '01

Ret. Since IPO

Kyphon (KYPH, news, msgs)



HealtheTech (HETC, news, msgs)



PrintCafe Software (PCAF, news, msgs)



Ribapharm (RNA, news, msgs)



Synaptics (SYNA, news, msgs)



The following companies reported a very large decrease in receivables and showed excellent returns after their 2002 IPO.

 Companies with large decreases in receivables


% chg in receivables, normalized to assets, '01

Ret. Since IPO

Chicago Mercantile Exchange (CME, news, msgs)



JetBlue Airways (JBLU, news, msgs)



Sunoco Logistics (SXL, news, msgs)



EON Labs (ELAB, news, msgs)



CTI Molecular (CTMI, news, msgs)



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



% chg in A/R (2000-2001)

Chicago Mercantile Exchange (CME, news, msgs)



Accredited Home Lenders (LEND, news, msgs)



VistaCare (VSTA, news, msgs)



Infinity Property & Casualty (IPCC, news, msgs)



Chicago Bridge & Iron (CBI, news, msgs)



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)









Net income




Accts. rec.




Receivables as % of assets








* 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 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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