Penthouse, now Friend Finder Networks Inc., has taken another step forward in its pursuit of a public stock offering. The company filed an S-1 form, which discloses a considerable amount of financial and operating information about the historically secretive operation. There is a lot we can learn about the company from this new document, though the process will probably remind most adult company owners why they guard this type of information closely. All the scars are now visible.

There is no need for sympathy. While many in the adult world would view this as a horrible invasion of privacy, it's part of life for companies that want to tap the wealth of public capital markets. Instead of seeing this as a cautionary tale, it would be smarter to understand the process and plan for both the inquiry and criticism that follows documents related to a public offering.

Friend Finder Networks (FFN) is stepping out into the little known realm of mainstream finance. It's scary, but it can be rewarding, as well. FFN is making a bold move (because it has little choice). The timing may not be ideal, but companies thinking about going public sometime in the future can learn a lot from this unwilling trailblazer's experience.


From Triumph to Requiem in 12 Months

The story of this IPO began, purposefully or not, at the end of 2007. Penthouse announced its acquisition of Various-parent of such brands as Friend Finder and Adult Friend Finder-for the princely sum of $500 million. The firm paid 2.5 times Various' estimated revenues of $200 million (based on the statement issued at the time). CEO Marc Bell was criticized almost universally for overpaying. In addition to taking a beating in the mainstream financial press, several investment banking sources related the same sentiment in virtually the same words, "The multiple [i.e., 2.5] is too high." One source, familiar with the adult industry, gasped at a volume audible over the phone.

Nonetheless, there were some clear benefits to the acquisition, if not at that price. Penthouse lacked a strong online brand, and its other brands were struggling. Various offered an instant solution. It had large, trusted, growing properties, and anyone could see the opportunities for cross-promotion-which could be used to reinvigorate Penthouse's legacy properties. The ingredients were present-they just had to be brought together properly. Somehow, Penthouse, with estimated annual revenues of $50 million (as disclosed in its S-1) scrounged up the purchase price and made a large, unsecured bet on its future.

Almost exactly a year after its landmark acquisition of Various, Inc., Penthouse took another step toward glory. Or, survival? The firm changed its name and filed an S-1 with the Securities and Exchange Commission (SEC), setting its capital-raising goal at $460 million and finally revealing its precarious financial situation. While a successful initial public offering (IPO) would undoubtedly show that an adult company can play in the financial big leagues, it would be a mistake to view Bell's move as anything other than a last-ditch effort to save his (and his investors') stakes in a struggling business in a difficult financial climate.

The S-1 filed by FFN as part of the process of going public answers many questions that have been raised about the company's financial situation. And, it restates some facts (such as the purchase price of Various, which was $401 million, not the $500 million originally disclosed; and $50 million in 2007 revenues, not the $150 million that one could deduce from the press release issued late last year).

Now, we can crystallize our understanding of this company and get a sense of what this IPO really means.


Follow the Money

Penthouse/FFN has a long tradition of poor performance, but we can't criticize Bell for the managerial ineptitude of his predecessors. Yet, we can take a closer look at the decisions he's made so far. We're all geniuses when equipped with hindsight, and it looks like Bell made some pretty stupid moves. He borrowed heavily to buy Penthouse, and he borrowed heavily to buy Various.

FFN is, as they say on Wall Street, leveraged to the hilt (leverage = debt; see, you're becoming the next Gordon Gekko already). According to its S-1, the company has total liabilities of $691 million. Assuming that Penthouse borrowed the entire $401 million that it used to by Various, the company was already leveraged to the hilt, owing $290 million on revenues of much, much less.

And, it gets worse.

Penthouse (before changing its name to FFN) had secured at least the most recent round of debt financing at onerous terms. Bell's company made $59 million in interest payments during the first nine months of 2008, and in the S-1, it pretty much screams, "We need this money!" Officially, it's disclosed as, "Our ability to continue as a going concern is dependent on our ability to raise additional capital, including from this offering." The unofficial sentiment, though, reflects the broad perception of this proposed IPO on Wall Street. To call this thinly veiled, sources say, would be an understatement.

This is the direct result of the fact that $411 million of the company's debt was recently reclassified from long-term to short-term debt "due to our failure to comply with certain covenants and restrictions in the agreements governing our 2005 Notes and 2006 Notes and our subsidiary's First Lien Senior Secured Notes, Second Lien Subordinated Secured Notes and Subordinated Convertible Notes and for which waivers had not been obtained."

That's a mouthful, but the implications are straightforward. FFN has to come up with cash fast. The acceleration of its long-term debt leaves the company with total short-term obligations of $420.1 million and only $43.3 million in cash on hand.

Before judging Bell to be a moron, though, some context is necessary. In part, he was a victim of the exuberance that has characterized the alternative investment industry for the past few years. As the economy pulled out of its last tailspin-following the confluence of the dotcom collapse, the terror attacks of September 11, 2001 and the implosion of Enron-hedge funds and private equity funds led the way. These secretive vehicles sought to buy companies, fine-tune their operations and spin them off for hefty profits. To do this, they relied on debt ... lots of it.

With this approach, investors could use a little bit of their own money (and a lot of borrowed cash) to acquire valuable companies. The company would be loaded up with the debt, so if anything went wrong, the investors themselves would not be exposed. It's a great way to make a killing, if you can pull it off. Through the middle of 2007, credit was easy, and the cash flowed.

In acquiring Penthouse (and later Various), Bell simply participated in the prevailing trend. As long as money stayed cheap and his companies could produce enough revenue, he'd look like a genius without the hindsight.

But, something went wrong.

Credit markets collapsed in 2007, due to unexpected default rates in the subprime mortgage market. The infection spread from residential real estate to the broader financial system, and it became increasingly difficult to secure capital. Now, companies with costly loans can't get out of them by borrowing. They need to find alternative sources of capital.

If the FFN IPO looks like a last resort, well, it is. And, the financiers know it. The company has run out of choices. If it cannot come up with the cash it needs for its short-term debt obligations, it could default, and Bell and his investors would lose their operation. One source involved in the global financial services industry started to comment, then just shook his head. Another said only, "Wow, that's tough." To say the situation defies logic is an oversimplification, however, which is why none of my financial sources took this path. They recognize that FFN has to attempt an IPO. There is nothing else left.

This is more than a mere liquidity event-a chance for the early investors to cash out. It could become that final, defining moment in the checkered history of the Penthouse media empire.


Flight to Quality or Not, Tough Times Ahead

A moment of desperation could define the entire adult industry. A successful offering in a brutal market would demonstrate that investors can take porn seriously. A failure could set the goal that much farther away for the next adult company that tries. With the recent (and quick) collapse of Adult Entertainment Capital still fresh in our minds, the adult industry has already lost some ground this year. An unsuccessful FFN IPO would mean two disasters in as many attempts. Unfortunately, this seems to be the most likely result.

In a bear market, investors gravitate to safer opportunities. If you've heard the expression "flight to quality," this is it. Investors go for ol' reliable and eschew the edgy stuff. Without a doubt, FFN is packed with risk.

In terms of safety, FFN's S-1 tells the whole story. Its balance sheet, included in the filing, shows assets of approximately $647 million and liabilities of $691 million. This results in a shareholders' deficit of $44 million. Usually, companies show shareholders' equity, because assets exceed liabilities. It's a classic symptom of an over-leveraged business. The company was able to borrow more than it was worth, and now it is stuck. This is roughly the equivalent of having negative equity in a house or car.

If FFN's assets were sold, the proceeds would not be sufficient to cover the company's debt obligations. In a flight to quality, nobody would look at FFN, even if it is called FFN.

So, that leaves a different breed: investors attracted to the outsized returns that come with serious, calculated risk. These investors view promising companies as "on sale" when the market is depressed. Good companies become even better. They succeed by making several prudent investments, even if only a small fraction yield high returns. In all likelihood, this class of investors would pass on FFN. The risk is too high, and the big payday is remote.

The principal concern is that an unsuccessful IPO would sink the company. If the company goes public at a dirt-cheap price, very little capital would be raised, and the firm would not be able to take care of its credit problem.

There is no middle ground. FFN needs to raise enough cash to cover its $420 million in short-term obligations. If it fails to do so, it is at serious risk of default. The collapse of the company probably wouldn't be far behind.


FFN and the Big Picture

If FFN had a choice, now would not be the time to go public. Worldwide, the number of IPOs completed is down 78 percent from 2007, according to research by Ernst & Young. The amount of capital raised via IPO is off more than 60 percent. As of November 30, 2008, 298 planned IPOs had been withdrawn, which is probably for the best. Of the IPOs that were completed last year, more than half fell in price on the first day of trading, according to Renaissance Capital, and the average new issue was down 38 percent by year-end.

Does Renaissance Capital sound familiar? Check the S-1 that FFN filed. It's their investment bank. FFN's bankers call the U.S. IPO market in 2008 "abysmal by historical standards," in John Paczkowski's "Report: 2008 IPO Market Obviously Lousy" on Dow Jones-owned blog AllThingsD. Renaissance continues that this was "not surprising given the steep decline in equities." Pent-up demand among buyers, which is building, is unlikely to be unleashed, the bank believes, until the markets become a bit calmer.

And, we have a long way to go before investors will be comfortable.

The Standard & Poor's (S&P) 500 Index lost 38 percent of its value last year. The Dow Jones Industrial Average had 34 percent lopped off, and the NASDAQ got spanked to the tune of 40 percent.

Companies that would normally have a high likelihood of success would not go public in today's market. They would sacrifice too much of their upside by going forward with an IPO. Instead, they'd get their cash flow under control, maybe hit up their investors for a little extra capital to help them weather the storm and thank them for it with a better public market debut later.

Yet, none of this matters to FFN right now. It can't. The company has no choice but to hold its hat out to investors in public capital markets, and there is little money to go around.


So, What Happens?

An IPO is not a sure thing. The company still has to decide how many shares to issue and at what price to offer them to the investing public. There are plenty of chances for Bell to stop the process, though his filing suggests that this is a practical impossibility. The company needs $420 million and has no other place to look for it. But, for now, we watch and wait, as the company jumps through the remaining hoops.

If the IPO goes well, FFN will have accomplished the impossible. The company will have raised a substantial amount of capital under adverse conditions and with weak financials. The company is in rough shape, and now everyone knows it. Further, a big win on the stock exchange would be the first in an incredibly long time for an adult company. Let's face it: nobody will be fooled by the name change.

But, if, if, if. There is plenty that can go wrong, and most of it probably will.

FFN has little in its favor. It has approximately 10 percent of the cash it needs, and revenue is much softer than the company led the public to believe prior to the S-1 filing. Ironically, a bit more honesty over the past year would have prepared potential investors for this situation. The company's insistence on secrecy, however, has become a problem. The numbers revealed don't square with those announced previously, resulting in a loss of credibility. Twelve months of bravado have been punctuated with a desperate plea.

The current situation will run its course. Though there is little to be done, plenty can be learned. Adult companies that have any designs on going public someday-even if it's a decade or longer into the future-can change their behavior now to smooth what may happen later. Early financial disclosure, in which only a handful of companies in this industry engage, can have long-term benefits. Trends become evident, and operating histories can be seen. This translates to "track record," and a strong one can lead to forgiveness in tough years. Simply preventing the types of surprises that FFN dropped on us can make investors more willing to entertain a long-shot.