Riding the private equity gravy train

The buyout boom has even helped companies like Martha Stewart that aren't going private. Are those stocks overpriced?

By Katie Benner, Fortune reporter

NEW YORK (Fortune) -- Private equity firms have been everybody's Santa Claus this year, spending some $370 billion to take a whopping 1,010 companies private, up from a mere 324 companies in 2001.

What's often overlooked, however, is that the shopping spree can be a bonanza for firms that aren't going private. If you're a struggling public company, there's no better boost for your stock price than the perception that you might be about to be taken out in a leveraged buyout (LBO) by a deep-pocketed private equity firm.

Martha Stewart Omnimedia appears to have benefited from mere rumors of a private equity deal.

"Public market investors have to love private equity right now," says Roger McNamee, managing director and co-founder of Elevation Partners, a private equity firm that specializes in media companies. "Even if you do not own the target in an LBO, you can benefit as investors run up the stock of every company in the group. If your stock goes down, a private equity firm may step in and bail you out."

After the buyout boom: the bust?

There are a few prominent examples. Whether they've innocently benefited from this market dynamic or worked their hardest to tie themselves to a possible deal, Martha Stewart Omnimedia (Charts) and Corinthian Colleges (Charts) are two stocks that, some industry analysts and investors say, have risen on little more than a private equity prayer. A closer look suggests that without buyout rumors to inflate their sails, these stocks are duds.

Private equity: A good thing

Private equity has been hungry for media names, devouring radio giant for $18.7 billion Clear Channel Communications (Charts) in November, trade publisher VNU (Charts) in June for $11.6 billion, and this week's announcement of a $530 million deal for the Minneapolis Star-Tribune. So it makes sense that when market watchers look for the next big media bid, Martha Stewart is mentioned.

The company positions itself as a growing publishing empire with magazine, television and Internet businesses popular with consumers. But in terms of revenue, Martha Stewart Omnimedia is mainly a merchandising machine. The company's merchandising division made $5.7 million last quarter, 155 percent more than its magazine arm. Indeed, merchandising provides about 90 percent of the company¹s earnings before interest, tax, depreciation and amortization.

And that reliance makes it vulnerable. The company has boasted about deals with Kodak, KB Home (Charts) and Macy's, but 80 percent of its merchandising revenue still comes from its deal with Kmart that is set to expire in two years.

"This is not a company you're going to get a lot of extra leverage out of," says Dennis McAlpine, an analyst with McAlpine Associates, which specializes in media and entertainment stocks. He has a sell rating on the stock, does not own any shares and does not short the stock.

"The magazine is still not what it used to be," McAlpine said. "It's not making significant money. The TV show isn't making money. The only thing making money is the merchandising and that is because Kmart made a lousy deal."

Even so, MSO stock is trading near its 52-week high and is up about 25 this year. McAlpine attributes this to Martha's flirtation with private equity investors. To wit: on Nov. 30, Reuters quoted chief financial officer Howard Hochhauser as saying, "We've spoken to a lot of private equity companies. We have great management and great content; they have money. Let's marry the two and let's see what we can do together."

"Sure, private equity partners may have spoken to [MSO]. They could have said, 'Hi Martha, how are you doing'?" said McAlpine. "Just because they spoke doesn't mean anything. I spoke to the Playmate of the Year once, but nothing ever came of it."

Following the Reuters story, MSO stock has risen steadily, up about 9 percent in a month. That's despite the fact that no private equity firms have said they'd buy it, and the company earned the distinction of being nominated as Motley Fool's "Worst Stock for 2007," based on poor revenue growth and over reliance on Stewart herself.

A Martha Stewart spokeswoman would not comment on whether private equity speculation had moved the stock, attributing the rise to the company's management and content. The company's CFO clarified his Nov. 30 remarks for CNNMoney.com, asserting that the firm is focused on growth and acquisitions, and does not plan to go private.

School of hard knocks

Corinthian Colleges also saw its price rise this spring after Providence Equity Partners and Goldman Sachs bought rival Education Management Corp., sparking talk that the for-profit education space was awash in possible takeover targets.

"There has been talk surrounding the industry for some time that a private equity group might step in and put a stake in the ground, which is not completely surprising given valuations over the past year or more being depressed by regulatory headlines and questions regarding slowing growth," Credit Suisse analyst Gregory Cappelli wrote in a research note at the time.

Corinthian was mentioned by name and the stock climbed 7.5 percent that day. It hit a 52-week high in May, and even though the stock has dipped it's still up about 13 percent this year.

"We don't comment on share price moves one way or the other," said Anna Marie Dunlap, Corinthian's senior vice president of investor relations.

But Corinthian is not like its peers. Its revenues are shrinking while Apollo (Charts), DeVry (Charts) and ITT Educational Services (Charts) all saw revenue growth last quarter.

Furthermore, Corinthian is alone among for-profit schools with falling enrollments. The company's financial statements have also been late or spotted with errors. Nasdaq threatened to delist the stock due to a failure to file a recent quarterly report or its 2006 annual report. It just handed in those statements this week, but the delayed 10-K still had an error in it. The amended version shows that 46.6 percent of the company's revenue is tied to federal Stafford loans, one of the most widely used type of student loans, not 22.1 percent as previously reported.

Moreover, it was unable to file its 2006 report because of its ongoing investigation into questionable stock options practices.

For example, Corinthian's board of directors awarded a total of 750,000 share options to Chairman and CEO David Moore, and four other top officers, dated 10 days after Sept. 11, 2001, taking advantage of the historically low stock price. Following an investigation, the board released a report last month saying it found "no evidence of fraud or willful misconduct." But it went on to say that the options dates were "selected with the benefit of hindsight." Moore resigned on Dec. 18.

Can the boom last?

It's hard to see how public companies can continue to benefit from the private equity gravy train in the long run, because any boost that company stocks get from rumored deals will simply make them too expensive. "The issue that a lot of us in the private equity world talk about is the disconnect between fund valuation placed on companies and the fundamentals underlying those companies," said Bob Nolan, managing partner of private equity firm Halyard Capital. "There's a huge discrepancy between price and value."

Indeed, McNamee said private equity investors may look back at 2006 and wish they had behaved differently. "They certainly understand they are not buying at the bottom. The Dow is at an all time high, thanks in part to LBOs. But no one knows how close we are to the top."


Martha and Marvel and Malone, oh my!

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