A Look at Several Recent IPOs
Several interesting firms have gone public recently, but valuation is an issue.
Last quarter, we offered some thoughts on the initial public offering market and looked at three recently public stocks that we thought looked attractive: Energy Transfer Equity (ETE), SAIC (SAI), and Stanley (SXE). Since then, our opinion on each of these firms has not changed, but the share prices have.
Though IPO activity in the energy sector has cooled somewhat over the past three months, the share prices of many pipeline operators have risen steadily. Energy Transfer Equity is no exception; the stock is up about 19% since we highlighted it, and we no longer believe it is a bargain. The business, however, continues to perform well. Also, we think the financial performance of the recently acquired Transwestern pipeline demonstrates that management paid a great price for this asset, especially given the growth opportunities it faces.
Shares of Stanley have fallen a bit, while SAIC's shares have been essentially flat when compared with the numbers three months ago, and we still think each is attractively priced. Both firms recently reported strong quarterly results, but the cancellation of some nonessential contracts serviced by other commodity government contractors is weighing on the sector. In addition, congressional debate over troop funding could delay some of SAIC's contracts, while Stanley has faced protests concerning a contract it was recently awarded. Despite any trouble in the short term, we still believe that both firms will prosper over time thanks to their ability to uniquely service federal government and military contracts.
Since two of our picks from last quarter are still trading at what we believe are attractive valuations, we thought we'd take a look a handful of recent IPOs that we think investors should avoid at current prices. However, each is a firm we'd love to own if given the chance to buy at an attractive valuation. Last time we mentioned that financial services has been a "hot" sector for IPOs, a condition that tends to exist when valuations are stretched. Though the overall IPO market remains tepid, financials still seem to be sparking a lot of investor interest. Two recent financial IPOs, in particular, have attracted lots of attention and have seen their shares soar: NYMEX Holdings (NMX) and Fortress Investment Group (FIG). Both companies have earned our "wide" moat rating, but both are also currently have 1-star Morningstar Ratings for stocks because of their valuations.
Finally, National CineMedia (NCMI) has garnered some attention among Morningstar's analysts because of its interesting position in the world of advertising. Unlike the two financial firms, we think the shares are roughly fairly valued, but we aren't quite as enamored with the firm's competitive position. Below we've provided excerpts of our analysts' reports on these three firms. In future columns we'll discuss these stocks and other interesting ideas that emerge as we look through the ranks of the newly public.
Futures exchanges have one of the best business models going, and Nymex, which today is the largest physical commodity-based futures exchange in the world, has seen earnings take off since becoming a for-profit firm. In fact, earnings have more than doubled each year since 2003. Much of this gain can be attributed to the fundamental attractiveness of the futures industry. Trading demand has grown rapidly as new technology has made it easier to invest in futures contracts. The barriers to entry are also high, as futures exchanges hold a monopoly on the clearing of their contracts. Lastly, industry economics are very attractive, with low variable costs leading to impressive operating margins.
Nymex's refusal to allow electronic trading opened the door for the startup IntercontinentalExchange (ICE) to steal up to half of its crude oil market share. Nymex has since recaptured much of the lost share, but not until its monopoly in energy trading had been destroyed. We think the overall market is growing fast enough for both of these firms to succeed, and Nymex should continue to turn oil into cash for its investors. However, this firm is still riskier than the some of the other exchanges we cover--including CBOT Holdings (BOT) and Chicago Mercantile Exchange (CME). Nymex went public in November at $59 per share; enthusiasm for the exchanges has pushed the stock up to about $129, which we think is much too high.
Fortress Investment Group
As a publicly traded alternative asset manager, Fortress is the first of its kind in the U.S. The firm runs more than $30 billion in assets across a suite of private-equity and hedge fund products. These have been heady times for investment managers like Fortress; assets under management increased by more than 90% annually from 2001 to 2006. The good times won't last forever, but Fortress boasts advantages that should endure over the long haul. The firm has amassed an excellent performance record in both its hedge fund and private-equity strategies. In so doing, Fortress has carved out a niche that resonates with institutional investors, engendering deep loyalty and attracting additional investment capital. In addition, the firm's record should enhance its ability to launch new funds while reassuring prospective lenders of its turnaround acumen. The Fortress brand is also well recognized, a factor that's likely to increasingly benefit the company as the alternative investment field grows more crowded. Finally, as institutions increasingly broaden their gaze to hedge funds and private equity, they're likely to seek out firms with staying power, characterized by size, stability, and infrastructure.
Fortress went public in February at $18.50 per share and now trades around $30, but we think that the fair value of the shares is substantially lower. Our assessment assumes that demand for the firm's funds will remain brisk and profitability will remain strong, but the firm faces several risks that we think should force investors to require a fairly high return on this stock. These risks include the firm's reliance on performance-based fees, its byzantine ownership structure, and the potential that one of its principals may leave.
National CineMedia develops an entertainment and advertising program that is played before feature films at movie theaters. The company makes money by selling advertising inventory to advertisers, who have begun to appreciate that cinema advertising can be tailored to movie genre, rating, time, and theater location. Movie theaters also deliver an engaged audience, whereas radio, television, and outdoor advertising is mostly ignored by consumers. National CineMedia and its main competitor, Screenvision, effectively control 91% of the market through exclusive contracts with the theater chains. This makes it very difficult for a smaller competitor to gain any scale. National CineMedia also has 30-year exclusive contracts with the three largest movie theater chains in the country, which are also its founding members. The firm is very profitable, and it would have posted a 46% operating margin during 2006 had it existed in its current form.
There are some risks here, though. In exchange for lowering the fees National CineMedia pays for time on movie screens, the founding members loaded the company with debt and were entitled to the proceeds from the debt issuance and National CineMedia's initial public offering. National CineMedia must also pay 55% of its free cash flow to the founding members. Finally, National CineMedia also has complex ownership structure. The stock, which went public in February at $21 per share, now trades at $28. We think the current price is pretty close to its fair value, based on the assumption that growth will remain strong and profitability actually improves over time.
Michael Hodel does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.