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Digital subscriber line (xDSL) company Amati Communications (Nasdaq: AMTX) jumped $4 9/16 to $19 3/4 after Texas Instruments (NYSE: TXN) offered $20 per share in cash for the company, scuttling the planned merger between Amati and Westell Technologies (Nasdaq: WSTL). Texas Instruments doesn't get much of an operating business of out of the deal, but rather a set of intellectual property assets and human assets in the form of engineers working on multiple flavors of xDSL digital modulation schemes. ADSL, or asymmetric DSL, is used to modulate high-bandwidth signals over twisted pair copper telephone wires. Consumers hope that ADSL service, which is more secure and provides more reliable bandwidth than high-speed cable modem service, will be made available from local phone companies. Amati is also developing VDSL, or very high speed DSL, which will connect a home to a fiber optic line passing by at the curb. TI says this is a $6 billion market opportunity, for which it looks like TI will be supplying software solutions, chips, and other know-how rather than the actual modems themselves. Westell gained $13/16 to $18 9/16 on announcing a strategic alliance with TI in return for the breakup of the deal.
Tax preparation service Jackson Hewitt Inc. (Nasdaq: JTAX) exploded $15 7/16 higher to $66 15/16 after agreeing to be acquired by hotel and real estate brokerage franchisor HFS Inc. (NYSE: HFS). The $68 per share cash deal values Jackson Hewitt at a pretty heady 14.7 times trailing twelve month revenues but a more reasonable-looking price multiple of 41 times trailing earnings (before extraordinary items). The combination of HFS and CUC International (NYSE: CU) will relieve Jackson Hewitt of one of its larger capital expenditure items, which is the purchase of customer lists. Large corporations using HFS's services for relocation, auto leasing, condo time shares, and lodging will become a nice fat target for Jackson Hewitt, which along with H&R Block (NYSE: HRB) is the only national tax preparation service in a widely fragmented market. In addition to the cross marketing of HFS services and Jackson Hewitt, CUC's convenience-driven customer base will also prove to be a gold mine for tax preparation marketing.
After being dumped for a loss of about 30% loss last month over accounting recognition worries, Pegasystems Inc. (Nasdaq: PEGA) was boosted $2 7/8 to $21 1/2 after reporting its third quarter results last night. Just before it was to report earnings late in October, the company's auditors warned Pegasystems that it had a problem with the way the company was booking revenues from a reseller of its customer management software. The company was, and is still, quite ticked off at the very late notice that its auditors gave it. Moving forward, however, the company has restated financial results for for its second quarter and last night reported a Q3 loss of $0.08 per share on revenues of $7 million. Investors are willing to look past the problem -- awarding Pegasystems with a market capitalization of nearly $650 million -- and toward future growth in automated customer handling systems. Goldman Sachs and its highly respected software analyst Rick Sherlund added the company's shares to its recommended list today, satisfied with the company's situation but well aware that these issues may take some time to be resolved to investors' satisfaction.
QUICK TAKES: Variflex Inc. (Nasdaq: VFLX) rose $1 7/16 to $5 15/16 after the maker of recreational products such as in-line skates announced that a private limited partnership has acquired 28% of the company's common shares from a co-founder of the company... Network analysis software company Wandel & Goltermann Technologies (Nasdaq: WGTI) climbed $1 13/16 to $11 13/16 on announcing that its German parent company is considering a number of strategic alternatives for the company, including buying out minority holders of the publicly traded stock... The Good Guys Inc. (Nasdaq: GGUY) gained $1 to $8 after the consumer electronics retailer reported better margins and maintained market share even as fourth quarter same-store sales declined 3%... Auto hauler Allied Holdings (Nasdaq: HAUL) motored $2 1/2 higher to $20 1/4 after announcing that it has withdrawn a registration statement to sell two million shares of common stock and that it expects to beat the mean Q4 EPS estimate of $0.41.
Medical devices manufacturer Medtronic (NYSE: MDT) gained $4 7/8 to $47 3/8 after reporting Q2 EPS of $0.31 and commenting that sales of its implantable defibrillators were up more than 27%... Luxury goods company Gucci Group (NYSE: GUC) rose $4 5/16 to $39 11/16 on takeover talk... American Italian Pasta Co. (NYSE: PLB) added $1 3/8 to $23 1/2 after Reuters reported that the company has signed a joint venture deal to construct a pasta production facility with Harvest States Inc. in Wisconsin... Defense systems company Alliant Techsystems (NYSE: ATK) picked up $3 1/4 to $57 1/2 on announcing more successful test flights of its tactical unmanned Aerial Vehicle... Following the merger announcement of CoreStates Financial (NYSE: CFL) and First Union (NYSE: FTU), former CoreStates suitor Mellon Bank Corp. (NYSE: MEL) jumped $2 7/8 to $55 5/8 as analysts see the company merging or being acquired with a bank better able to compete with the giant First Union. Mellon's Dreyfus mutual fund unit is highly coveted in the banking world.
BMC Industries (NYSE: BMC) was crushed $13 1/8 to $17 3/4 after the only non-Asian maker of monitors and aperture masks for TVs and monitors announced that fourth quarter earnings will be in the range of $0.22 to $0.26 per share versus estimates of $0.53 per share. The coming shortfall is largely a result of inadequate demand forecasts for TVs. The company ramped up production and hired 500 new employees (doubling its workforce) at its Cortland, New York facility while the demand picture for large screen TVs slackened. Compounding BMC's problems were quality concerns that arose as a result of hiring many inexperienced workers too quickly, as well as the strong dollar. The weak yen made products from Japanese manufacturers less expensive for Japanese customers, compared with BMC's products. BMC trades at 9.4 times its 1998 earnings estimates of $1.88 per share, which places it on the cheap side if the demand cycle for TV sets begins to turn.
Informix (Nasdaq: IFMXE), the embattled developer of software for database management, lost $1 1/16 to $6 31/32 today as a result of a virtual barrage of negative news. A Nasdaq issue with an "E" at the end indicates that the NASD has determined that the issuer is delinquent in its required SEC filings. Unfortunately for Informix, it rectified that situation last night, reporting a Q3 EPS loss of $0.73 versus estimates for a loss of $0.21. The company was also stung by a restatement of revenue and earnings from January 1994 to June 1997. The company slashed revenue by $278 million and earnings by $236 million due to a "change" in revenue recognition; apparently the company was recognizing sales as products shipped into the channel and not after they moved through the channel (that is, someone actually paid for them). Informix has reported restructuring charges in all of its last three quarters, but hopes that the bad times are behind it. Glimmers of a nascent recovery can be seen in a number of recent multi-million dollar equity investments in Informix by companies that feel Informix's agnostic universal server products are a source of competitive advantage.
Fwd PE PSR ROE Informix N/A 1.15 19.54% Oracle 31 6.18 38.75% Sybase 51 1.12 -18.89% IBM 16 1.43 24.84%
QUICK CUTS: Rental equipment company RDO Equipment Co. (NYSE: RDO) lost $4 3/8 to $16 1/4 after being downgraded by Dain Bosworth "buy" from "strong buy"... Physician practice management company Physicians Resource Group (NYSE: PRG) lost $1 1/16 to $6 7/8 after reporting Q3 EPS of $0.11 (excluding charges) versus estimates for $0.13. The company also reported the firing of its chairman and chief executive officer, Emmett Moore, as well as announcing that it intends to stop expanding through acquisitions for the near future... Total Renal Care Holdings (NYSE: TRL), a kidney dialysis provider, dropped $3 5/16 to $27 13/16 after agreeing to acquire rival Renal Treatment Centers (NYSE: RXT) in a stock swap worth $1.3 billion. This move prompted Merrill Lynch to lower its near-term rating on the company to "neutral" from "accumulate," but Merrill still maintains its long-term "buy" rating.
Gruntal & Co. said today that it lowered its earnings estimates on shares of both Seagate Technology (NYSE: SEG), which dropped $1 1/2 to $22 13/16, and Quantum Corp. (Nasdaq: QNTM), down $1 1/2 to $26 1/8, after Seagate said second quarter results would be weaker than expected... Diversified energy concern Key Energy Group (AMEX: KEG) announced today that it had acquired the stock of Jeter Service Co. for $6.7 million in cash. News of the deal dropped Key for a $2 1/4 loss to $26 5/8... TRO Learning (Nasdaq: TUTR) was sent to detention, losing $1 3/8 to $6 as the designer of PC-based interactive, self-paced instructional programs announced that it expects to report a loss for fiscal 1997 that will be "substantially greater'' than analysts' estimates... Helen of Troy (Nasdaq: HELE), a personal care products company, was the face that launched thousands of investors out of the stock this morning, as shares fell $2 5/8 to $12 after the company reported that it expects Q3 earnings between $0.31 and $0.33 per share, slightly below estimates of $0.36.
The world's largest franchisee of Pizza Hut restaurants, NPC International (Nasdaq: NPCI), lost $2 1/8 to $13 3/16 after announcing that it anticipates its third quarter earnings will be between $0.15 to $0.19 per share, compared with estimates for $0.22... Non-power lawn and garden tool company Acorn Products (Nasdaq: ACRN) lost $2 3/4 to $11 3/4 after it reported that its loss from continuing operations was $0.05 per share for the first quarter of fiscal 1998, compared with estimates for a gain of $0.04 per share... ADFlex Solutions (Nasdaq: AFLX) dropped $3 1/2 to $16 7/8 after the flexible circuit interconnect maker registered 2.7 million common shares for a planned public offering... Electronics component maker SigmaTron International (Nasdaq: SGMA) fell $1 3/8 to $11 after announcing that it expects earnings for the fiscal second quarter to be "significantly lower" than year-ago earnings of $0.45 a share.
Detecting Distressed IPOs
Getting in on a hot initial public offering (IPO) is a common get-rich-quick fantasy. As the Wall Street Journal reported last week, even some corporate chieftains who don't need the money are willing to sacrifice their integrity to get a piece of these deals. Many underwriters have been all too happy to comply, doling out huge, nearly guaranteed profits to top executives at firms that will soon need their own offerings underwritten. Called "spinning," this quid pro quo practice is now being investigated by the SEC and Nasdaq.
What's often missed in the IPO bonanza, though, is that new offerings make bad investments, on average. For every highflyer that doubles on the first day of trading, there are a dozen other new issues that struggle to stay above their offering prices. Many don't. One recent study by the University of Iowa's Tim Loughran and University of Florida's Jay R. Ritter examined the performance of 4,753 IPOs between 1970 and 1990. These finance professors found that after six months on the market, the new issues had lost 1.1% versus a 3.4% gain for matching firms. In the five years following the offering, the average annual return for new issues was 5.1% versus 11.8% for their matched firms. New issues underperformed for a total of seven years.
Given the spectacular success of some IPOs, a lot of these new issues must be real dogs. Investors who can find ways to spot the howlers may either save themselves grief or profit from shorting these issues.
Last week, we looked at the appropriately named Big Dog Holdings (Nasdaq: BDOG), one such dog that suggested a possible template for distressed IPOs. As we saw, this retailer went public in late September at $14 per share, a price that assumed some rather spectacular future growth. It started trading at $15 1/2 but closed that first day back at $14, a bad sign given that IPOs are usually discounted by at least 10%. For the next five weeks it traded in a narrow range, never dropping below its issue price. Then came earnings (in line with expectations), some "buy" recommendations from the underwriters, and -- almost immediately -- a 30% collapse to $9 3/4.
Big Dog appears to offer a clear example of a stock that attracted little aftermarket interest at its selling price and therefore required and received diligent price support from the underwriters. Feeling they had done their duty, the underwriters stopped propping up the stock shortly after the earnings came out, leaving it to trade on fundamentals. The shares promptly sank due that old truism that when supply is greater than demand, prices fall.
The dynamics behind this Dog's howls would seem to be potentially common, though perhaps rarely so obvious. To sell a new issue, company executives go on a "road show" sponsored by the underwriters. This is the chance for the Street's institutional investors to hear the company's story and to focus on its details. Weak first day performance for an IPO, then, indicates that the broad investment community simply wasn't enthralled by the story, at least at this point.
One three-part screening process for finding potentially troubled IPOs, then, would go something like this: 1) look for the initial underperformers, those new issues that gain 10% or less on the first day of trading; 2) look for signs of artificial price support, such as a narrow trading range around the issue price; 3) wait for the next earnings report from the company to see if the story has improved while anticipating that underwriters may take this report as a good chance to bolt, if they haven't already.
For my own rather unscientific screen of recent IPOs, I consulted the IPO Zone and found 55 stocks issued since August 1 that gained 10% or less their first day of trading. Of this group, 33 stocks have been on the market for at least a month, with 19 of those now trading below their issue price, 12 above, and 2 unchanged. Seven of these actually closed their first day below their issue price ($5 or less for all but one of these stocks). Of these, 5 have fallen further while 2 have risen. Unsurprisingly given the choppy markets, 22 stocks issued since October 21 stumbled to a 10% or less gain out of the blocks, with 16 now trading below their IPO price and only 2 above it.
Clearly, avoiding a stock that opens poorly can save you some heartache. For example, interactive video firm Celerity Systems (Nasdaq: CLRT) went public at $7 1/2 on November 4 and closed the day at the issue price. It started disconnecting the next day and hit a low of $4 last Friday before recovering to the mid $5 range. Similarly, Didax (Nasdaq: AMEN), a group of Christian Internet consultants (no kidding), went public September 24 at $5 but ended the day at $4 1/2. It has never again closed above its issue price and recently hit a low around $2 3/4. Then there's Omega Research (Nasdaq: OMGA), the folks who bring you real time stock quotes. Issued at $11 on October 1, the stock closed at $11 3/4 that first day and has been taking small steps down ever since, recently landing at a low of $5.
While Big Dog's narrow trading pattern at the issue price appears to be quite unusual, we do see it with some of these companies. For example, Computer Motion (Nasdaq: RBOT), a leader in medical robotics, went public August 12 at $14 and closed at $14 1/4. It traded within that range for two weeks, only breaking above $14 1/2 after the September 10 announcement of a second quarter loss of $1.11 per share, roughly in line with analyst estimates. Still, the stock never closed above the high of $14 7/8 seen on its initial trade, suggesting that whatever temporary enthusiasm the report sparked, it wasn't enough to draw in new buyers. The stock fell below the issue price just two weeks after the earnings announcement. The CEO's departure (announced October 23) and the overall market's jitters haven't helped matters. The stock has now sunk to $10 1/2.
Still, there's no simple formula here. Even when it appears that a stock is receiving price support, the shares can take off if the fundamental story keeps improving. That's why it's worth waiting until the next earnings report before considering shorting the stock. Consider LeukoSite (Nasdaq: LKST), a biotech firm that is developing treatments for diseases associated with malfunctioning white blood cells. The company went public August 15 at $6 and closed the day flat. For three weeks it traded in a narrow range between $6 and $6 3/8. By the time LeukoSite announced third quarter earnings on November 14, the stock had shot up as high as $12 and is now at $11 3/8.
A 100-day snapshot of IPO activity is obviously just a partial picture and may be negatively biased given the general market's choppiness during this period. Still, this small survey suggests that new issues that close below their issue price are likely to fall further and that those that gain 10% or less their opening day are more likely than not to fall below that issue price in the near future. On the other hand, the peculiar trading that made Big Dog an attractive short candidate, at least in retrospect, seems relatively rare.
Investors looking to test this screening process must understand that trading patterns can tell you something useful about the unusual supply and demand dynamics of public offerings. On the other hand, it's a mistake to be seduced by technical patterns. As LeukoSite suggests, improvements in the fundamental story can lead a stock higher, and investors who ignore the fundamental analysis do so at their peril.
Still, the past two weeks offer plenty of fodder for this method of screening for distressed new issues. Recent stumblers include Precision Auto Care (Nasdaq: PACI), Metro-Goldwyn-Meyer (NYSE: MGM), and Friendly Ice Cream (Nasdaq: FRND). All of these stocks closed yesterday at or below their issue prices.
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