Watch Out for the Overhang

Thanks to lots of attention lately, including columns from Ben Holmes and James Cramer, the effect of expiring lockup expirations on share prices is becoming better known among everyday investors. But lockup expirations are more than just a one-day selling phenomenon. Perhaps Cramer put it best when he described lockup expirations as "large and quiet and endless." After all, insiders and early investors do not tend to dump all (or even most) of the shares freed from lockup immediately upon expiration.

Most interesting is a sidebar to a recent study from Pennsylvania State University, which suggests that after lockups expire, stocks fall hardest when venture capitalists are involved. This is important, because the new breed of IPOs are novel in two ways: First, the inordinate amount of restricted stock that is available for future sale, a.k.a. the overhang; and, second, the high percentage of shares held by venture capitalists.

That's why we have long been wary of IPOs sporting limited initial floats, and correspondingly high levels of potential overhang. Should these stocks fall under pressure, an excessive supply of available stock could make any subsequent recovery exceedingly difficult. Concentration of this potential supply in the hands of venture capitalists -- with their characteristic, low entry points, and lack of allegiance to (or stake in) the company's long-term future -- makes the likelihood of a rebound that much more remote.

For this reason, companies like Drugstore.com (DSCM), PlanetRx.com (PLRX),

and Medscape (MSCP) likely face a long, hard road to recovery.

All three were brought out with fairly limited original floats of 5 to 6 million shares. All, likewise, have a much heftier total number of shares outstanding between 40 and 50 million. For our purposes, the difference can realistically be viewed as potential overhang.

What's more, all suffered mightily heading into, and coming out of, the expiration of their post-IPO lockup restrictions. The point isn't whether lockup expirations caused or even exacerbated the weakness. The point is that, with so much stock still in the hands of low-entry holders, one can only assume that any subsequent rally will have to fight its way through supply at every level. Hence the "large and quiet and endless."

In theory, this workoff of the lockup expiration overhang could take several years. But I think the end is represented by the point at which a reasonable chunk of this unlocked supply rests in the (presumably stronger) hands of true insiders, the company's executives.

All things equal, the further a stock has moved toward either of these points, the easier the road it faces going forward. Which brings us to Internet retailer Cyberian Outpost (COOL).

So That's What the Overhang Does!

Following a limited 4 million-share IPO in July 1998, Cyberian Outpost faced a potential supply overhang of more than 24 million shares. The bad news: The stock plunged as more than 11 million shares subsequently hit the market. The good news: more than 11 million shares hit the market, leaving a remaining overhang of just 13 million shares, 55% of which are in the arguably stronger hands of "true" insiders.

What's more, since September 1999, six insiders have acquired 549,000 Cyberian shares at prices ranging from 3.87 to 14.28 per share. CEO Robert Bowman, the former President of ITT (IIN), has purchased 255,000 shares. CFO Katherine Vick acquired 99,190 shares through the exercise of options, marking her largest transaction since joining the company in 1997. Director Charles Jackson IV purchased 161,000 shares in his first acquisition. Director James Preston has bought 20,000 shares.

Once again, IPOs will only thrive if their business models continue to impress investors; the verdict is still out on Cyberian Outpost. The fact that so much of the initial overhang has since moved to stronger hands is one positive. The fact that insiders are hinting at their confidence in the fundamentals going forward is another. Either way, there is reason to believe that supply overhang could pose less of a threat for Cyberian Outpost than it does for many other stocks sharing the company's unfortunate predicament.

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