3 Reasons to Avoid Party Citys IPO

By Markets Fool.com

The management of specialty retailer Party City Holdco will undoubtedly do what it does best by throwing a big shindig following the firm's IPO later this week. If the issue is even moderately successful, noisemakers will buzz and drink will flow at the newly enriched firm.

Continue Reading Below

But I think long-term investors should decline an invitation to this celebration, and avoid buying and holding stock in the company. Here are three reasons why.

Shareholders won't be in charge
Although Party City is going public, its current ownership will still be firmly in control. That would be private equity operators Thomas H. Lee Partners and Advent International along with their affiliates. Collectively, these entities will own around 75% of the company after the IPO.

This means they will call all the shots, and those decisions likely won't be in the interest of its long-term future. Successful private equity players make money by exiting their investments at a profit, and sooner rather than later. They often load up on debt in order to pay themselves handsome dividends to help recoup their investments.

Looking at Party City's balance sheet, we can see over $2.1 billion in total debt, with revenue barely outpacing that at under $2.3 billion.

Servicing that debt isn't cheap. In fiscal 2014 the firm paid almost $156 million in interest; this drained away much of the $243 million in operating profit, leaving a relatively thin bottom line of $56 million.

Continue Reading Below

In 2013, meanwhile, a company subsidiary floated $350 million worth of debt securities in order to fund a dividend payment to the parent firm's shareholders.

The cover charge isn't going to be spent productively
All told, THL and Advent estimate that Party City will take in anywhere from $326 million to nearly $376 million, based on the midpoint of the issue price range, and depending on whether (and by how much) the IPO's underwriters exercise their share purchase options.

That number happens to be just around the same amount as that aforementioned debt issue. This is not a coincidence -- in Party City's latest SEC filing on its IPO, the company explicitly states that the bulk of the take from the issue will be used to help pay off these notes.

Another chunk of it will also be directed to the key shareholders, which will collect a $30 million-plus "termination fee" to end their management agreement with the firm. That agreement, by the way, cost Party City at least $3 million in each of the last two fiscal years.

This party has a painfully pervasive presence
Party City has a strong market position, with roughly 900 locations.

This seems overbuilt to me. A search on the store locator returns five results for the Los Angeles metropolitan area. Granted, LA's a sprawling place, but such a number for a large-sized specialty retailer seems excessive. By comparison, furniture giant IKEA has only three.

The only first-hand place to buy IKEA furniture is in one of the Swedish company's native outlets. In contrast, a customer wanting to load up on party supplies can find much if not all of these goods in one stop at a general retailer like Target or Walmart. The larger supermarkets and pharmacies also typically stock such items.

Avoid an IPO hangover
To me, the Party City IPO feels very much like an opportunistic cash-out for its ownership -- an excellent deal for them, but not so much for future shareholders.

That's because the company itself is stuffed with debt, and has high operating expenses -- keeping the lights on at 900 or so locations ain't cheap. Also, in spite of the IPO prospectus touting Party City's "innovative and exciting merchandise," for the most part it sells fairly commonplace items easily available elsewhere... and often in a one-stop shopping trip.

For those that disagree, the issue will take place this Thursday, with nearly 22 million shares going on sale priced at $15 to $17 apiece.

The lead underwriting syndicate includes Goldman Sachs, Bank of America Merrill Lynch, and Morgan Stanley. Party City Holdco will be listed on the New York Stock Exchange under the ticker symbol PRTY.

The article 3 Reasons to Avoid Party Citys IPO originally appeared on Fool.com.

Eric Volkman has no position in any stocks mentioned. The Motley Fool recommends Bank of America and Goldman Sachs, and owns shares of Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.