imaginary profitsThe front page of the November 18 issue of Barron’s magazine asks and answers the following question. “Bubble? Yes, in some tech names and new issues.” The related article in the magazine points out that the Dow Jones Industrial Average, S&P 500 Index and the S&P Midcap 400 all hit record highs on Friday, November 15th.  Similarly, the market for initial public offerings (IPOs) has also been on a tear and is described by Barron’s as being as strong as it was back in 2007, before the onset of the Great Recession. As examples of the frothiness of the IPO market, the article states that “shares of upstart restaurant chains Noodles & Co. (NDLS) and Potbelly (PBPB) are rich enough to give you heartburn.”

We have no opinion about the two named companies, but we do believe that the valuation methodologies and the recent price action of one of these stocks, NDLS, is instructive with respect to the new issue market in general.

Noodles is a fast/casual chain restaurant that specializes in noodle dishes. It went public in late June of this year at $18.00 and nearly doubled on the first day of trading. By the first week of November, the price had risen above $51.00. Projected earnings for the third quarter were projected to be 11 cents per share. Conventional valuation methodology would say that this made the stock worth over 100 times earnings; to be precise, $51.00 divided by (11 cents times 4) would make the price-earnings ratio 115.9. – hence the ‘heartburn’ alluded to in Barron’s. (By way of comparison, Exxon Mobil’s price-earnings ratio between September 19 to November 19 of this year ranged between 11.23 and 12.47.)

On November 6, Noodles & Co. announced that projected earnings had come in on target at 11 cents. Revenue, however, had not grown at the projected 17%, but rather at 15%; shares of the company promptly fell 10%, or by over $5.00 per share. (To date, the shares have yet to regain any of this $5.00 in market value lost.)

In other words, a 2% miss against projected revenue resulted in a hard dollar loss to investors of 10% – five times as much. As much as Wall Street loves its jargon, there is no formula, ratio, equation or buzz word for the investor capital that disappears in this type of situation. One could, perhaps, call it the ‘imagination penalty’. In the case of NDLS on November 6, the imagination penalty was a multiple of 5. Unfortunately for investors, while the revenues and associated profits were imaginary, the investors’ losses are real.

When considering anything to do with an Initial Public Offering, beware that it may well be an Imaginary Profits Offering. All such offerings come with an imagination penalty that will not be stated in the prospectus. The greater the imaginary profits, the greater the unstated penalty will be. And while the profits may be imaginary, the losses to investors caused by the penalty will be very real.

Underwriters do not have carte blanche to mislead investors with an Imaginary Profits Offering. If you believe you have been misled, feel free to contact us at www.dlsecuritieslaw.com.  We will be happy to discuss your situation with you.