Searching for Value in Busted IPOs

 | Apr 02, 2013 | 1:00 PM EDT  | Comments
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One area of the market that is rarely thought of in connection with value investing is the market for initial public offerings.

IPOs are usually priced on the most favorable terms for the seller and therefore are rarely attractive on a valuation basis. This changes somewhat when you add a time lag and go back over the offerings of the last year. The vast majority of the deals have caught a solid bid as the markets have gone higher, moving from merely overvalued to stupidly priced. Some, however, stumble out of the gate and are quickly dumped by investors who dreamed of profits and glory from the offering.

When an IPO stumbles, the shares are abandoned by investors and underwriters alike. Wall Street coverage tends to dry up very quickly, and the stock can become an orphan. When this happens, the stock can often be undervalued and begin to be of interest to enterprising value types like myself.

One of the more interesting busted deals over the past year is Tilly's (TLYS), the surf lifestyle retailer. This one catches my eye because my daughter worked for the company as a store manager, and I was really impressed by its operations and policies. The stock popped a little after the offering, but the company missed a few quarters' estimates after the deal was done, and the stock is now more than 30% below its IPO price and trades at roughly two-thirds of the 52-week high. The company also lowered guidance for the next year, and the rout was on.

Looking at the numbers, the situation does not strike me as that dire. The company opened 20 new stores last year, including 14 in new markets. Online sales jumped ahead by 21% during the year and will remain a strong focus. The company plans to open 25 new stores in 2013, most of them in new markets for the brand. The balance sheet is in good shape, with $57 million of cash and securities on hand.

Insiders like the outlook, and they have been buying the decline in the stock. The shares are not yet "Tim-level" cheap, but they are an intriguing speculation at this level for growth investors who have a taste for retail stocks.

As for Edgen Group (EDG), I am impressed that the deal to bring it public ever got done in the first place. This is a highly levered company that provides specialty steel products to the oil and gas industry. The underwriters had a very small window to get this stock priced at $11 last April, and the stock has been a stinker ever since.

Having said that, it is an interesting business that represents two very undervalued and unloved segments of the stock market. The company sells tubular pipe, heavy plating, valves and other steel components to all segments of the oil and gas industry, as well as power generators to civil construction companies and miners. What we basically have here is the ultimate contrarian play in a steel company that sells its products to sectors that are almost as out of favor as steel companies themselves.

This has the feel of a stub stock that has a potentially huge payoff but no small measure of failure risk as well. There is over $600 million of debt supporting an asset base of over $900 million, according to the recently filed Form 10-K. Edgen has operating income over $100 million, but interest expense is a whopping $75 million.

However, a deeper look shows that some good things are happening here. Sales grew last year to $2.1 billion, from $1.7 billion. This is a 75-year-old company that has a long history of growing by acquisition, and the marketplace is ripe with opportunities if the company can make it work. Edgen's customer list includes most of the major oil and gas companies, and they operate around the world in key oil and gas regions. Net leverage is actually decreasing, having fallen over the past two years, and the company recently refinanced its senior secured notes, dropping the interest rate to 8.75%, from over 12%. The long-term goal is to reduce net leverage by half, using cash flow to pay down debt.

Stub stocks are a little difficult to value with typical methods, but this stock trades at about 5x projected earnings for next year. This year shows a loss, but a deeper examination shows that Edgen would have been profitable without a loss from early retirement of debt. The enterprise-value-to-EBITDA ratio is 5, which is pretty reasonable for a highly leveraged company operating at what is pretty much the bottom of the cycle for its products. This stock has some risks, but if the company keeps the balance sheet moving in the right direction until the energy and steel industries stage a recovery, it has home-run potential.

The busted IPO corner of the market requires a lot of rock-kicking and flipping, but occasionally one discovers ideas that are worthy of long-term consideration.

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