Alloy's Growth: Strange Alchemy

When we last left Alloy (ALOY - commentary - Cramer's Take), the Generation Y catalog/media company had two important questions outstanding: the company's organic growth rate, and what the growth rate would be if acquisitions stopped.

According to CFO (and nice guy) Sam Gradess, the organic growth rate -- growth not including the impact of acquisitions over the past year -- is 40% to 45%.

Was he sure about those numbers? "Yes," he said.

What if acquisitions stop? "We would have a company where the blended growth rate (from all of the company's businesses) would be in the neighborhood of 35% to 40% over the next few years," he said.

But Sam, I argued, how can you possibly know -- especially with the fickle world of teenagers -- how you'll do several years out? I mean, that's the kind of stuff investors swallowed back in the Internet age. Gradess explained that Alloy has a very "database-driven" analysis, and that the company is a "fast follower of what is happening on a fashion and activity perspective." He concedes, however, that ultimately "we have to prove it through actual results."

Old School New Economy

Indeed, Alloy is the ultimate manana story -- a throwback to the "just trust us" mantra of the Internet era -- and it's one to watch carefully going forward, especially if, as expected, it starts showing profits.

As is the case for all highly acquisitive companies, Alloy's earnings will get a boost this year thanks to new accounting rules that do away with goodwill amortization. Goodwill has been a big charge against earnings at Alloy, which last year made nine acquisitions. In some quarters, goodwill was equal to -- and in some cases, more than -- a company's entire purchase price.

"I wouldn't judge it as high or low," Gradess says. "It was an outcome of what we paid for the assets, which was a reflection of the earnings contribution of those assets. The businesses themselves, just on the face of the balance sheets, had minimal or negative net assets, which was not a reflection of the health of the business."

Does that mean Alloy overpaid for those companies? It just means those businesses -- many of them advertising or marketing companies -- "were not asset intensive," Gradess says. Time will tell. As part of the accounting change, the value of Alloy's goodwill is being evaluated by an outside valuation company.

"My belief is that the goodwill is [fair] , so we expect the goodwill will be validated," Gradess says. He adds, though, that "if there is any impairment, goodwill will be adjusted accordingly, which would be a direct hit on earnings" when they're announced in mid-March. Furthermore, while earnings appear to be improving (or the loss narrowing), operating-cash flow and free-cash flow are tumbling. That isn't the combo you want to see.

Finally, there's the issue of cash, which Alloy is rolling in. It has more than $100 million, thanks to a secondary offering last week (which was done several dollars per share lower than the company had hoped) and a private investment from Fletcher International of $30 million a month earlier. Without those deals, it was down to about $18 million.

Mum on Fletcher

Interestingly, the Fletcher deal wasn't announced in a press release, which is how the company revealed another private placement -- with other investors -- two months earlier. Instead, the Fletcher deal was left to an 8-K Securities and Exchange Commission filing on Jan. 29 -- the same day Alloy announced its secondary stock offering.

Gradess says Alloy didn't issue a press release on the private placement on the advice of legal counsel because it was so close to the announcement of the secondary offering. Yet on the same day -- the day the secondary announcement was announced and the 8-K on the Fletcher deal was filed -- Alloy issued a press release raising fourth-quarter revenue and earnings guidance.

Why would one press release be any more influential on future investors than the other? Because the Fletcher deal, taken at face value, was for an 11% premium to where Alloy's stock was trading on the day of the deal, something that might have looked good to the casual observer.

That brings us to the price Fletcher paid. Most private placements, like the one a few months earlier, are done at a discount to the market value. For that reason, Gradess says, Alloy had really hoped to make it public. "They cut us a check for $22 a share," he said.

But the real value of the transaction to Fletcher, according to several money managers who looked into the transaction, was substantially less when warrants are taken into consideration. Usually warrants in a private placement are good for only three years; Fletcher finagled a 10-year span. The longer the term of the warrants, analysts say, the greater their implied discount for Fletcher, because the warrants are worth more. Put another way, Fletcher's real price is sharply less than $22, and well below Alloy's share price of about $20 the day the deal was announced.

Price Questions

What did Fletcher really pay? Based on their warrant valuation, several sources have told me the total deal is worth closer to $12. Gradess says that a worst-case scenario valuation would make it about $13. Fletcher declined comment, saying it doesn't talk to the press.

But there's more: Why do a deal with Fletcher in the first place when the company was about to raise cash through a secondary offering? Investment firms like Fletcher, which specialize in private placements, are generally known as financiers of last resort, which means they tend to negotiate deals that are favorable to them. Gradess says the deal was a "bird in the hand" situation that was "attractively valued" for Alloy.

As it turns out, as part of the deal, Alloy also agreed to provide marketing and other services to Freebord Manufacturing, a small company in which Fletcher has an investment. Gradess says the deal will produce revenue in the "low seven figures" over the next year to Alloy. What's the likelihood that Alloy will acquire Freebord? "Diminimus" -- at least in the near term, Gradess said. But he didn't rule out the possibility of an acquisition at some point in the future.

And this note: Holly Becker of Lehman Brothers, which was lead underwriter of the company's stock offering, issued a buy recommendation on the stock. Why not a strong buy? She didn't return my call or email with the question.

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Herb Greenberg writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks, though he owns stock in TheStreet.com. He also doesn't invest in hedge funds or other private investment partnerships. He welcomes your feedback and invites you to send any to Herb Greenberg. Greenberg also writes a monthly column for Fortune.

Brian Harris assisted with the reporting of this column.