Will’s Articles

Initial Public Offerings ("IPOs"):

Trojan Horse IPOs:
The Next Way to Lose Money
(July 2004)

(About two years after I wrote this article on Trojan Horse IPO’s several major publications began to notice the issue, but still haven’t defined the problem or solution. Three to five years from now, investors will begin to realize that they failed to analyze these Trojan Horse IPOs properly or were misled by the private equity firm’s analysts and the lawsuits will begin. See:
• “In Today’s Buyouts, Payday Is Never Far Away”, Wall Street Journal, 25 July 2006, Page 1
• “Buy It, Strip It, Then Flip It”, Business Week, 7 August 2006
• “Goldman Finds Investing for Itself rewarding”, The New York Times, 26 July 2006
• “Last Year’s IPO Rally Should Linger in 2005”, Investor’s Business Daily, 3 January 2005)

There is a subset of current initial public stock offerings (“IPOs”) that will be on the front pages of the financial press within 18 months. The headlines will read something like:

“Trojan Horse IPOs Cost Shareowners Billions as Bubble Bursts.”

[Investor’s Business Daily touched on the emerging problem in a January 3, 2005 article titled, “Last Year’s IPO Rally should Linger in 2005.” The article said, “Private equity firms were active in taking their companies public in 2004. The pace is expected to continue in 2005.” It further quoted David Menlow, President of IPOfinancial.com, “(These new IPOs coming out of the private equity firms are) going to be more about the issuers trying to maximize their investment (returns)...(New) Investors don’t want IPOs that (send money) upstream to (the old) parent shareholders.”]
Here’s what is happening. Normally IPOs are done to raise money in the new IPO company so that it can invest for future growth for the new Shareowners. In Trojan Horse IPOs, most of the money raised in the IPO is sent to the OLD Shareowners using a variety of techniques. But an even bigger problem with the Trojan IPOs coming from the private equity firms is the amount of debt that they carry. Prior to doing the IPO, the private equity firms load the company to be IPO’d with a near junk status debt burden, and pay that borrowed cash up to the old Shareowners rather than investing the cash in the company to generate growth for the new Shareowners.

This means that new Trojan Horse IPOs cannot be evaluated by prospective new Shareowners using popular P/E techniques or even the PEG ratio technique.

To determine the value of these Trojan Horse IPOs, a new Shareowner must actually calculate the Enterprise Value of the IPO’d company using the techniques and the Valuation Statement outlined in my book Rich Shareowner, Poor Shareowner (Revised Edition).

Let’s take a brief look at a Trojan Horse IPO that was mentioned in IBD’s January 3, 2005 article, TRW Automotive (symbol: TRW). (Note: Because I retired 5 years ago from Nalco, I will not calculate an Enterprise Value for Nalco Holding Company (symbol: NLC) which was also mentioned in the article. But the results indicate a similar conclusion for Nalco’s Enterprise Value relative to its stock price in the range of $19.50.) Both of these companies were 2004 IPOs from the private equity funds of The Blackstone Group. TRW was IPO’d in January 2004 at $28. Nalco was IPO’d in November 2004 at $15.

Recall that the Enterprise Value of a company represents the present value of all of the cash flow that a company has or will have. It uses the investor’s desired benchmark yield as the discount rate. A reasonable benchmark yield to the investor is the return on the S&P 500 stock index, which has earned (inflation plus 8 percent p.a. compounded) over the past 70 years. The formula for Enterprise Value is:

Enterprise Value = Current Cash + Present Value of All
Future Free Cash Flow
(Including Growth) – Current Debt

Using the September 30, 2004 balance sheet data from Reuters, and giving the companies the benefit of EPS estimates for 2005 from First Call, the Enterprise Value for TRW can be estimated. (Note: The calculation uses 10% as the after tax return desired by new IPO Shareowners. 4% is the estimated after tax cost of interest bearing debt.) Deferred taxes are considered debt, as is pension liability. Data on off balance sheet debt was not available and would have increased the debt number. “Growth in sales, earnings and cash flow from companies acquired after the IPO do not count for the reasons elaborated in Chapters 20-22 of Rich Shareowner Poor Shareowner (Revised Edition). The following numbers are estimates using the above formula and NO GROWTH. For both TRW and Nalco organic growth has been problematic over the past several years. Cash flow growth after 2005 will be even more difficult since so many costs have already been stripped out of the companies by the private equity firms: