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Ziff-Davis Faces Possible Defaults on Heels of Recent IPO
By Christopher Byron
Special to TheStreet.com
1/8/99 3:38 PM ET
Eventually, it comes time to say enough's enough -- as in, enough of this baloney about
the Internet already. Enough with the "new paradigm" talk and the malarkey about the
profits that don't matter. In the end, business profits are the only thing that matters.
They're the numeral "one," after which comes all the "zeroes" of business success -- the
market-share growth numbers, the new product introductions, the stock options, the
whole ball of wax. Without a profitable business, all the other triumphs add up to
nothing.
Those thoughts come to mind in light of two (allegedly) cutting-edge media companies
that are much in the news these days. One is Yahoo! (YHOO:Nasdaq), the Internet
search-engine outfit, which at the moment appears to be one of the few Internet-based
operations that is actually making a profit. The other is Ziff-Davis (ZD:NYSE), the
magazine-publishing and trade-show outfit, which is bleeding losses out of every pore
and is desperately trying to raise cash by way of a pseudo-spinoff of its Internet
operations via a so-called "tracking stock" initial public offering.
In fact, these two companies have more -- much more -- to do with each other than
most investors seem to realize. Like a latter-day version of Mike Milken's old
junk-bond carousel from back in the 1980s, these two companies are, in effect, joined
financially at the breastbones. The difference this time is that instead of junk bonds,
we're talking junk equity, and instead of Drexel Burnham Lambert directing the
performance, we find the white-shoe firm of Morgan Stanley Dean Witter standing at
the podium, holding the baton.
The situation is simply stated: Ziff-Davis is in trouble, and its stock is yo-yoing, whereas
Yahoo! is thought to be healthy and its stock is soaring. But behind those two sets of
contrasting facts is a hidden process that explains -- and links -- them both: Ziff-Davis is
dying so that Yahoo! might live.
The story begins with Ziff's April 1998 IPO. As part of a cashout by Ziff's owner --
Softbank Corporation of Japan -- the IPO's underwriters at Morgan Stanley loaded Ziff
down with more than $1.5 billion in debt, then handed the proceeds over to Softbank,
thereby reducing Softbank's credit exposure to the company to zero. At the time, we
took one look at the asset shuffle and predicted the company would soon be flat on its
keester.
So let us now turn to Softbank, which has stakes in all sorts of Internet companies, and
ask what exactly it did with the money. As it happens, Softbank turns out to be the
largest single shareholder of Yahoo!, with 30% of its stock to its name. Thus, in July,
Softbank peeled off $250 million of its wad from the Ziff IPO cashout and bought
roughly 2.7 million additional Yahoo! shares directly from the company, at the
split-adjusted price of 91 11/16 per share. At about the same time, Softbank peeled off
another $400 million and bought close to 16 million shares of E*Trade Group
(EGRP:Nasdaq), the Internet brokerage firm.
And what precisely did E*Trade do with the $400 million? Well, according to its most
recent financial filing, for the fiscal year that ended Sept. 30, no sooner did E*Trade get
the money than it signed an "extensive advertising, sponsorship and promotional
program" on the Yahoo! Web site.
If we next follow the money (as they used to say in Watergate) from E*Trade to
Yahoo! and take a canter through that company's latest financial filings, want to guess
what we find? Buried deep in the back of the filing, where (presumably) no one would
notice, we find a Yahoo! confession that during the July-September 1998 period,
advertising revenue from "Softbank ... and its related companies" leaped from 4% of
Net revenue to 8%. In other words, folks, more than one-third of Yahoo!'s total
sequential revenue growth during the period came directly from Softbank-financed
advertising -- which is to say, via money that had been leeched from Ziff's balance sheet
by the Morgan Stanley IPO, then funneled by Softbank into the revenue coffers of
Yahoo!.
So what, you say? Well, here's so what: For the July-September period, the 24 financial
geniuses on Wall Street who follow Yahoo! had been collectively forecasting, on
average, earnings of 10 cents per share. But Yahoo! wound up "beating" the forecast by
a stunning 50%, reporting 15 cents per share in earnings. The difference -- $5.2 million
-- is not much more than the $4.3 million in ad revenue taken in during the period via
Softbank. Since the gross profit on ad revenue at Yahoo! runs to about 90% and all the
other business costs are pretty much fixed whether the ads come in or not, we may say
with some confidence that, were it not for the Softbank revenue, Yahoo!'s actual
third-quarter earnings would have been only 11 cents per share and not 15. The
company would have beaten the Street's estimate by a mere penny per share.
That hyped-up trouncing of the Street's consensus forecast, announced on Oct. 7,
launched Yahoo!'s stock on its most explosive price surge ever, from 104 per share to
more than 320 per share just three months later. In fact, of course, nearly 100% of the
run-up was fueled by the most egregious sort of related-party transaction: Ad revenue
supplied by a 30% shareholder of the company.
And what of Ziff, the debt-bloated carcass that provided the cash? Eight months after
going public, the company is a total basket case. In spite of the spring 1998 IPO, the
company has no working capital, and its revenue is slipping -- down 2.6% since the
start of the year to $731 million compared with the comparable 1997 period. Even on
an operating basis, the company loses money (another $14.8 million in the most recent
July-September period) -- and that's even before you throw in the interest on the debt.
Add that to the picture, and the company's losses will almost assuredly top $100 million
for the whole of 1998.
The big problem is, of course, the debt. More than $1.5 billion of it now sits on the
balance sheet, devouring nearly $150 million in interest payments every 12 months.
That's more in interest payments than the company will even earn in 1998 to make those
payments. This is so-called EBITDA (earnings before interest, taxes, depreciation and
amortization) -- Wall Street's ultimate low-bar financial hurdle for crippled businesses. It
was also the Street's principal selling point for promoting the deal: There'd be enough
EBITDA to meet the debt. Well, there wasn't, which is why the company's latest
quarterly financial filing discloses that the company expected, as of Dec. 31, 1998, to be
in violation of its loan covenants and is thus frantically trying to renegotiate the terms.
I mean, holy smokes, folks, it was only last April when the company went public! Now
it's looking at the prospect of loan defaults? That fact alone is an amazing commentary
on underwriters like the Morgan Stanley bunch -- one of the most puffed-chested,
snootily self-important firms in the business. After all, here they were willing to take this
thing to market at 15 1/2 per share, walking off with the lion's share of maybe $20
million in fees for their efforts -- which efforts basically boiled down to sticking their own
clients with a debt-mummified horror story that had virtually no chance of making a go
of it.
We wrote on the eve of the offering last spring that, "at the present rate of loss, the
combined operation looks likely to reach balance-sheet insolvency by the end of next
year." But, hey, what did we know? The company beat our estimate by a year!
So let us now turn to the earlier-mentioned "tracking stock" IPO (I personally prefer the
term "bailout IPO"), by which the company hopes somehow to escape from its
quagmire. As the Dec. 22 registration statement says, the idea is to use the proceeds
from the offering to pay down as much of Ziff's debt as possible. But how much does
the company think it will actually manage to raise? After all, this business -- to be called
ZDNet -- looks exactly like the one it is being carved out of, only worse: $37.5 million
in revenue for the nine months ended Sept. 30, $8.3 million in operating losses, $7.7
million in net losses and even $3.1 million in EBITDA losses.
What moron is going to pay anything for that? Don't forget, these are numbers from the
actual IPO registration statement, in which the underwriters (in this deal, it's Goldman
Sachs in the lead) try to make the thing look as prettified as possible. Prettified? This
deal has welts and lesions all over it! In fact, it's not even a real IPO at all, but a
"tracking stock" offering. These are some of the biggest Wall Street con jobs going.
Tracking stocks are created by issuing a class of stock that represents an equity interest
in the whole corporation as shown on the company's balance sheet, but is somehow
intended to "track" the performance of a particular corporate operation -- in this case,
Ziff's Internet Web site. The company hopes to trick investors into thinking this by
issuing separate financial statements for the two operations, but in reality they're one and
the same thing. With a tracking stock, you're supposed to think you have a stake in that
segment or division alone, but you actually own a share in the whole corporation.
As a result, the performance of tracking stocks stinks -- mainly because they never get
out from under the cloud of the companies that issued them in the first place ... troubled
companies that need to raise cash but can't get anyone to buy their stock, so they put a
false nose and mustache on the deal by calling the offering stock a whole new company
when it isn't. In February 1997, Circuit City Stores (CC:NYSE), the troubled
electronics retailer, spun off (sort of) its used-car business through a tracking stock,
Carmax (KMX:NYSE) at 20 per share. Those shares are now selling for about 5 1/2.
So, to ask again what jerk would buy a tracking stock issued by a troubled company, I
can certainly tell you what jerks the underwriters are hoping will buy it. The seemingly
infinite multitudes of jerks who stand ready to buy anything involving the Internet, that's
who. The same jerks who chased theglobe.com (TGLO:Nasdaq) from 9 to 97 1/2 in
15 minutes back in November and are now sitting with a 33 stock that is assuredly
worth nothing at all.
The same jerks who chased a fish-oil company Zapata (ZAP:NYSE) from 7 to 14 in a
single day back before Christmas because the company put out a press release saying it
would be opening a Web site.
The same jerks who chased a bulletin-board stock named PinkMonkey.com
(PMKY:OTC BB) from 1 to 17 back around Thanksgiving and are now holding shares
worth, more or less, 4 3/16.
The same jerks who ... oh, nuts to it, you know who they are. The same jerks Wall
Street firms like Morgan and Goldman have been preying on since this Internet-stock
baloney got going.
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