Rosetta Stone Brings the IPO Market Back into Focus

| About: Rosetta Stone (RST)

The IPO Market is back in gear! So far in April we have had three new stocks hit the market… The most activity seen since July of 2008. Now while the deal rate is still well behind the levels seen in the middle of this decade, the trend is certainly encouraging. And not only are the deals getting priced, but at this point all three deals are trading above their offering price - a positive sign of demand.

Rosetta Stone Inc. (NYSE:RST) was the most recent company to come public and the stock was met with energetic buying. According to the prospectus, the stock was expected to price between $15 and $17. This range is usually driven by the underwriter’s analysis of the company and the price at which these underwriters believe they can sell the right amount of stock. There is a fine line with these pricing ranges because underwriters want to get the most they can for the company selling shares (Rosetta in this case), but they also want to make sure investors who buy on the deal get some initial profits. Otherwise it will be difficult to sell the next deal that comes down the pipeline.

When the time came to actually price the deal, Morgan Stanley and William Blair & Co. actually had enough buyers to sell the stock for $18 - and they were able to get $6.25 million shares sold for a total of $112.5 million before underwriting commissions. Half of the proceeds will go directly to the company, with the other half paid to selling shareholders (the original owners of the company).

Rosetta will use about $10 million to repay debt, another $8 million for tax withholdings, and will have the flexibility to use the rest of the capital as they see fit. While the successful launch of the stock is certainly a positive sign for the market (along with the IPO of (NASDAQ:CYOU) and Bridgepoint Education (NYSE:BPI)), RST may be vulnerable to a sharp pullback in coming weeks. Typically there can be a good bit of excitement surrounding such an offering - especially when the market is trading sharply higher as we have seen in the past 5-6 weeks. But IPOs often need some time to cool off before establishing a strong upward trend.

The Wall Street Journal compared RST to Intrepid Potash Inc. (NYSE:IPI) which also saw significant gains in its first day of trading. However, IPI still took more than a month to consolidate those gains before pushing higher, and after that the stock dropped more than 80% from June to December of last year.

Rosetta earned just 68 cents per share in 2008, and has noted that weakening traffic in malls and airports could hamper growth. Yet the stock is trading for more than $28 per share as I write which is quite an aggressive multiple. Obviously the company is young and could grow tremendously in the coming years, but the stock is priced so that there is significant risk to investors.

Another problem with new issues is the lack of visibility. Research firms who know the company the best are currently in the silent period and not allowed to issue recommendations. Once this silent period is over, they still have a conflict of interest which may bias their opinion to reveal more positive facts about the company and less of the risk. Until the stock has been trading for a few months, it may be difficult for the average investor to get quality information on the company.

During strong bull markets, IPOs usually offer great investments for supercharged returns. But in today’s volatile (and arguably overbought) market, the potential for gains may be dwarfed by the risk. It may be difficult to borrow shares to short RST until the stock has been trading for a week or so, but at some point over the next week will likely become a good candidate to play from the short side. I truly enjoy investing in IPOs during favorable market conditions, but the opportunity in RST does not currently appear very attractive.

Rosetta Stone Inc. (<a href='' title='Rosetta Stone Inc.'>RST</a>)

Disclosure: Author does not have a position in RST.