Attack of the Zombie IPO

Something terrible is happening. Decrepit and soulless corporations are weaseling into American equity markets by means of the IPO pipeline and wreaking havoc on investors. For lack of a better term, let's call these ghastly financial creatures "zombie IPOs." Below, I describe how to identify them before they afflict your portfolio.

Grab the wooden stake!
The definition of a zombie is a "soulless corpse brought back to life by mystical means, usually witchcraft." While dead on the inside, a zombie appears both alive and well to the untrained eye. This duality is the essence of a zombie IPO.

The principal calling card of a zombie IPO is debt. I don't mean a little debt. Or even a large amount. I mean so much debt that it consumes the entire financial soul of the afflicted concern.

The recently listed Caesars Entertainment (Nasdaq: CZR) provides a case in point. When Caesars went public earlier this year, it did so with nearly $19 billion in debt. Its stated book value at the time was $1.7 billion, but had you subtracted its unmarketable intangible assets such as goodwill, you would have seen that its tangible book value was a negative $6.4 billion. Despite the illusion of vitality, Caesars looked to me like merely the shell of a bona fide corporation the day it went public.

In the wake of Caesars' filing, a host of similarly debt-laden listings have followed.

Sources: Quarterly filings and registration statements.

Benjamin Graham, zombie slayer
The typical retort to this is that using a measure of book value to gauge worth is old-fashioned. Nowadays investors look to earnings and the ubiquitous price-to-earnings ratio.

However, this approach assumes that these measures are mutually exclusive, when in reality they're codependent.

Take Caesars again as our example. Because of its enormous debt load, which largely explains its negative tangible book value, the casino company is on the hook for close to $500 million in quarterly interest payments.

The problem becomes obvious when we compare this figure to Caesars' EBITDA -- a measure of operating income that stands for earnings before interest, taxes, depreciation, and amortization. This number came in at $306 million for the same period, nearly $200 million less than its interest payments!

While Caesars is the current ill-fated poster child among zombie IPOs, it's in good company. Recently public Manchester United is in the same boat, followed by Chuy's, Bloomin' Brands, and Burger King, all of which must dedicate an inordinate proportion of operating income to interest.

Sources: Quarterly filings and registration statements. Burger King's second quarter statement of cash flows covers a six-month time period encompassing the first two quarters of the year. I divided each by two. Manchester United's F-1 only provided annual figures for the year ending June 30, 2012. I divided each by four. The latter's capital expenditure figure also includes net proceeds from the purchase/sale of player registrations.

Indeed, in every case but one, these companies paid their creditors more than they earned for shareholders in the form of net income.

Defend your portfolio against zombie IPOs
The passage of the JOBS Act earlier this year demonstrated clearly that the rulemakers in New York and Washington aren't interested in protecting regular investors from zombie IPOs. That responsibility falls instead to you alone.

Fortunately, as I noted above, identifying these menacing creatures by their tell-tale negative tangible book values is not difficult. But it does require some time and effort on your part.

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