Saturday, October 27, 2012

Trading IPO Lock-Up Expirations


Initial Public Offerings have lock-ups. In a lock-up, existing holders of the IPO stock, people who own stock at the time of the new issue, agree not to sell for a certain period of time. 
This allows the underwriter to support the stock without having to worry about the existing holders dumping on his efforts. 
To give you an example of what happens when there is no lock-up, I recall one deal about 1984 that was a roll-up of existing oil and gas partnerships. The promoters offered a large number of owners of interests in oil and gas limited partnerships the chance to swap them for stock at a valuation of $5 per share. This stock was the subject of a registration statement, giving these investors stock in a soon to be public company.
When the issue hit the market, it may have had a print, a trade at $5 but the efforts to support the stock soon collapsed as all the holders of the stock sought to dump it for cash. The stock was soon at $1.50, never to see $5 ever again.
Underwriters soon learn that their performance largely is graded on the short term price of the stock. After six months or so, they are off the hook. The question for the underwriter is will the stock go to a premium in the immediate aftermarket. 
True., the underwriter has warrants lasting usually two years, allowing him to buy often one share for every ten he sold at the issue price, but most of these are worthless two years later. The ones that are exercised often have huge rewards. In other works, underwriter warrants are a something like a lottery ticket -- more likely worthless but a big payoff if they are not. 
As a trader, you can be certain that when the lock-ups expire, the supply of stock will increase. As most new issues are issued at a relatively high price because of promotion by the underwriters, and that promotion is long since over by the time of the lock-up expiration, you can be sure that a lock-up expiration is going to find a soft market. 
This is not to say that the stock will collapse, but as a trader, you do not want to be long into a lock-up expiration. 
If you are looking for a good short, one with a huge drop in price, you probably would not be looking at lock-ups for IPOs, as they do not mean huge drops in price, but they do mean a soft market. 
As an IPO market maker, you can be sure I would know the dates of all lockups, and  would never enter a lock-up expiration make sure I had a nice short position.     
We now have a chance to test these ideas, as Facebook, a stock that has had a disastrous aftermarket, now faces expiring lock-ups. 

                                           Chart courtesy of Stockcharts.com 

I read that 230 million employee shares will soon be free. -- 11% of the company's existing 2.1 billion shares outstanding.
Another tidal wave of stock, hits November 14, when 777 million shares are freed up. In a period of a few weeks, shares equal to almost half of Facebook's current shares outstanding can hit the market. 
The only reason not to make a knee-jerk decision to short this stock is that it is down into "fallen angel" territory already. 
You have to wonder what the underwriters and the company were thinking when they structured all this, including soaking up all available demand to begin with.   
It is not a question of how loyal or how enthusiastic about the future these shareholders are. People love money and many of these shareholders have huge fortunes awaiting them they will want to enjoy now.   
Just the amount of money needed to soak up all this stock almost guarantees another soft market. How many buyers are left for this stock?   
Another form of lock-up that you should not overlook is the availability of stock to be sold pursuant to Rule 144.  You may recall that that holding period for 144 is six months. Also recall that the insiders ("affiliates"), those who are key officers and directors and 10% shareholders, can sell 1% per quarter of the outstanding stock of that class, or if the class is listed on a stock exchange or quoted on Nasdaq, the greater of 1% or the average reported weekly trading volume during the four weeks preceding the filing a notice of sale on Form 144.
Always look for new supply and new demand in trading IPOs.  Your job is prediction.

Sunday, October 21, 2012

Why Facebook has declined

There are several factors but they basically all stem from the desire of the company to maximize the proceeds from the offering to the detriment of investors.

In a typical successful offering, the company and the underwriters leave a little on the table for the investors, which is to say the deliberately underprice the offering, say by 10%, to give the investors who buy at the offering price a small premium in the aftermarket.

This helps the underwriters sell the deal and keeps the investors happy with the company. 

Facebook was the deal of the year and sought after by many investors. Many investors sought stock in the deal just for the prestige of saying they participated in the offering.

The company took advantage of this by selling as much stock as possible, soaking up all of this excessive demand, leaving nothing on the table. 

Thus, no one was left to buy in the aftermarket. 




This was made worse when the company increased the amount of stock offered at the last minute and also started revealing bad news about the business.

Many buyers  in the offering thought they would not get as much stock as they asked for so they asked for more than they actually wanted. When their entire allocation was filled, they knew the demand was soft and so they sold and they also sold because they had then more stock than they really wanted.

The shorts, seeing this, smelled blood in the water and did a bear raid, dumping stock to push the price down.

This created down side momentum.

With this price drop, people started taking a critical look at the company. The shorts also encouraged this surge in bad opinions about the company. 

In fact, Facebook's business model has flaws. One thing that is not generally realized is that professional Internet marketers create many accounts. Facebook touts as its most important metric that they have one billion users. If however, an Internet market creates 100 accounts, the actual user count is much lower. 

In any event, the price decline is an example of what I call pendulum theory. The more you pull a pendulum one way, the more it swings the other. And so it is with stocks. The more they are overpriced, the more they will tend to swing to underpriced.

 Facebook was an easy short as it was the subject of wild mass public enthusiasm. Such stocks always are overpriced. 

The sheer size of the offering also hurt. Facebook's large offering soaked up much of the money that would have been allocated to such stocks. As they say, it took all the air out of the sails. 

Wednesday, October 17, 2012

Short Selling IPOs

As a former market maker in IPOs, it is my humble opinion that there are two types of short selling in IPOs.

First, the tactical short, whereby you take advantage of a temporary overpricing of the stock. This can be day trading -- in and out in as little as 15 minutes.

If you are an experienced trader, this should be second nature and we will not dwell on it.

However, the second type of short selling in initial public offerings has been very lucrative lately. This is the position short, whereby you are take a large position and hold it.

To do this, you have to be convince that the IPO is wildly overpriced. Usually it will be overpriced for one of two reasons: (1) the underwriters have succumbed to the company's demands that they sell the stock at some wild overvaluation, or (2) the public demand has reached a frenzy and the public is overpricing the stock.

The advantage to the short sellers in selling initial public offering is that the company and the underwriters will have whipped up demand for the issue, created a market to sell into.

The danger to the short is if the underwriter is able to support the issue and move it up. If the underwriter opens the stock at a modest premium to the offering price, and then the short starts selling only to find the stock moving up, the short has lost money. It is a matter of judging the market, and that comes with experience.

Take a look at Zynga:



I regarded Zynga as an overpriced dog at the issue price. When you compared it to the other social underwritings based on users, revenue, etc. it was clearly overpriced.

The underwriter did a great job supporting the stock and a brilliant research report helped push the stock up from the offering price of $10 to a high nearly 50% higher.

Alas for Zynga, the flaws in the business caught up with it, no doubt publicized by those with a short interest in the stock. The stock is now so low, it is a fallen angel, down to about 25% of the issue price.

It is not uncommon to see an underwriting fall maybe 50%, as most of them are over promoted to begin with, but to fall to 25%, that is a very sad comment on the company, the underwriting and on the investors who paid up for it.

My guess is that the stock may recover from this low price, but this is still not a stock I would look at buying.

Facebook was a screaming short -- too much hype, too little reality at that price. My spreadsheet also showed massive overvaluation compared with other such stocks. I told a social media client if he wanted to do an underwriting, he had to go public before Facebook hit the market as FB would take all the air out of the market -- all the money would go into Facebook.

The result was worse than I thought due to the company stuffing the market with all the stock that was demanded and leaving the market without any buyers in the aftermarket.

 There were a ton of shorts and reportedly it was hard to borrow the stock so you could short it.



As you can see, this was a gratifying experience for the shorts.

With any IPO short, when the stock falls to something like 50% of the offering price, it is time to look for the exits and cover.

Alternatively, you can just play trend lines to lead you to the best return on investment per unit time.

All of this starts with a spreadsheet analyzing pricing, and I will show you one shortly in a new post, with complete explanation of how it works and how to use it.

















Friday, October 12, 2012

How Facebook IPO became face plant IPO



Facebook would be the poster child for how not to do a public offering,

                                               Chart courtesy of Stockcharts.com

 except for the fact that Zynga holds that title:


                                               Chart courtesy of Stockcharts.com

So what went wrong, what are the consequences, and what to do in the future?


Hubris

With regard to Facebook and Zynga, much of the mis-perception on the part of the company comes from their buying their own story (notice I didn't say bullshit).

They believed that their tree would grow to the moon. Sorry, we are in a very competitive economy and everything regresses to the mean.


Pendulum Theory

In fact, we have "Pendulum Theory (TM)." Pendulum theory says that when you pull the pendulum further out in one direction, the more it swings back in the other.

The issue price on these IPOs was very high, and now the market price has swung very low. They are now what I call Fallen Angels.


Leaving Something on the Table

These companies tried to maximize their cash intake in their initial public offering. The tradition on Wall Street has been to leave some money on the table for the buyers so that the stock will trade at a reasonable premium. They did not do that, they greedily soaked up all the demand at a price that was pushed to the limit. Facebook actually increased the offering amount of shares at the last minute to soak up all the money on the table.

The idea of a smart underwriter is to leave buying out there to soak up the flippers and shorts and still have some demand for the deal in the aftermarket. This ensures a premium and you can call the deal a success if it holds its own for a few months.

Instead, all the demand was taken by the company, making the stock vulnerable and causing the shorts to celebrate.


Disclosure

We read now that Facebook was trying to polish its disclosure. I believe that in the offering document you tell it as ugly as you can. The purpose of the prospectus is to protect the company, not the investor. You also protect the investor by telling the harsh truth, and by putting the worst face up front, you protect the company. By hiding things, you can get into big trouble. They failed to appreciate that these deals were so hot they could have been very pessimistic and they still would have sold out.


Consequences

The consequences of this rape of the IPO buyer strategy are now evident.

We see lawsuits. Nobody sues if the stock is up or at least near the issue price. But everyone assumes fraud is the price is way down.

We see employees leaving, demoralized by the decline in the value of their incentive stock and options.

We see burned institutional buyers that will be happy to tell the company and the underwriters what to do with their next stock offering -- something involving rolling the stock certificates into a conical shape and storing them elsewhere.

We see management having to defend, defend, defend and that is not good for morale or company expansion.

Was it worth it, guys?


What to Do Now

The company has to eat crow and mend fences. Buying up that low priced stock with all the cash they got would not hurt.

The underwriters have to wait for the institutions to forget and try to make it up somehow.

The IPO buyers have to look out for companies that put themselves first. The shorts will be watching for those also.