We continue to see a steady stream of company floats or Initial Public Offers (IPOs) coming to market, although the current IPO cycle appears quite mature. Unlike previous cycles this far advanced, this one is still offering some attractive opportunities for investors.
The typical IPO cycle
The IPO cycle typically starts with the listing of higher quality companies. To overcome investor apprehension, they are often priced quite attractively and accordingly they generally deliver good returns for investors. The success of these IPOs then allows lesser quality companies to come to market, with the quality falling away over the course of the cycle. The IPO cycle will continue for so long as the market remains receptive. Sometimes, it will be a market correction that ends the cycle. This was the case with the GFC, when IPOs stopped dead.
Other times the end comes about as a result of a run of poor performing IPOs or a high profile failure. For example, the last IPO cycle ended with Myer, which floated in late 2009, and whose share price halved within two years (it has halved again since). The IPO cycle lay dormant until around 2013 despite the fact that the market was strong until then. It was at this point that the current IPO upcycle began.
This IPO cycle
True to form, the current IPO cycle came with some early successes, including IPH, Mantra Group, Aconex, and Burson Group. All of these stocks have doubled or tripled since their IPO at the start of the cycle. What has perhaps been different this time is that there has not been the same obvious deterioration in quality over time. Both successes and failures have been spread quite evenly across this IPO cycle. Early in 2013 we had the IPOs of Vocation and Dick Smith, both of which found their fate in administration. And more recently we have had some high quality IPOs that have already delivered decent returns.
One recent example is BWX Limited, which owns the Sukin range of natural skincare creams. It is a quality company, with a strong brand, an astute CEO, and bright growth prospects. The company floated in November 2015 at a share price of $1.50. Since then, it announced strong first half year financial results in February 2016, and it is further down the track in its offshore expansion plans. It’s share price has already tripled since its IPO.
There have been a number of other decent companies that have undertaken IPOs recently with decent success. For example, in April we had the IPOs of Motorcycle Holdings (+38% since listing), Reliance Worldwide Corporation (+22%), and WiseTech Global (+32%). Recent successes like these are allowing this IPO cycle to continue, and while we are conscious that quality may well in fact deteriorate, we are still seeing some attractive opportunities coming our way.
A focus on quality, but IPOs have specific issues
At Bennelong (BAEP), we analyse all new companies coming to market just as we would those already listed. For us, that means focusing on the fundamentals and looking out for high quality, strongly-growing companies that are reasonably priced. However, in our analysis, there are a few peculiarities in the specific case of an IPO:
1. Research timeframe
The research effort for an IPO must be completed in a compressed timeframe and before the drop-dead date to bid for stock. Investors often have less than two weeks to put in bids once a prospectus is released. Fund managers will usually have longer, with broker research released a few weeks prior, and often with the benefit of meetings with management in the previous 6-12 months as part of so-called ‘non-deal roadshows’ (brokers use these to gauge interest for an IPO).
2. Track record
IPOs have limited financials and other important information. The typical prospectus will provide just two to three years of historical financials. Investors generally have little familiarity with the business, including its performance in various business conditions, and little exposure to management and their capabilities.
New investors thus start at a considerable disadvantage vis-à-vis the vendors of the business, who have normally been intimately involved with the company and management for far longer. Vendors have the luxury of choosing the timing of their exit, and this is likely to coincide with when the business is performing well. New investors must assess the sustainability of current earnings and whether forecasts are achievable.
On the other hand, the disclosure of a longer track record will often signify a strong business, not least because the disclosure probably comes because the record is attractive. A recent example is Reliance Worldwide, which is a well-run manufacturer of plumbing supplies and provided 10 years’ history of sales revenue, which had grown at 13% per annum. Of course, even in these cases, it is necessary to consider whether the future will be as bright as it has been in the past. For us at BAEP, this included undertaking a large number of meetings with customers and other industry contacts in the short timeframe we had.
Investors may be familiar with the business because it has been listed before in one form or another. Have things changed for the better? Generally, they have not, with Dick Smith a case in point. This business struggled for decades under Woolworths’ control, with numerous CEOs and strategic reviews before being sold in 2012. The private equity buyers relisted the business the following year at a materially higher valuation, after a very quick ‘turnaround’ that more than doubled profits and supposedly set the company on a more prosperous course. As it turned out, the troubled track record was indicative of the company’s ultimate outcome.
3. Vendor’s motivations
Understanding the vendor’s motivations allows investors to understand the opportunity. An important distinction should be drawn between two scenarios:
a) Existing shareholders selling their shares as part of the IPO, leaving them with no or little remaining interest in the company. Such vendors are effectively cashing out, and are likely to be motivated purely towards maximising the proceeds, with little regard for the company’s success once listed. Extra care is required here, with private equity exits such as Dick Smith and Myer serving up cautionary tales.
b) The company itself raising the money through the issue of new shares. Existing shareholders do not sell shares and remain in. Here, the capital raised goes to the company itself, to be used for its benefit to invest in growing the business. Existing shareholders retain their shares and price maximisation is not the sole motivating factor in setting the IPO price.
There are a two types of floats that are particularly attractive: privatisations and demergers.
a) Privatisations involve an IPO in which a government is the vendor and it sells a public asset. Governments are minded to give incoming investors, who happen to also be voters, a positive experience, and this often means pricing at a reasonably attractive level. Commonwealth Bank, CSL, Telstra, Aurizon and more recently Medibank are typical examples in which investors have done well.
b) Demergers involve the distribution of shares of a subsidiary company to the shareholders of the parent company. The new demerged company is let free to chart its own course, with management often more focused and incentivised. Except in the unusual case, demergers do not also involve raising new capital. Consequently, there is no need to sell the IPO to any new investors, and unlike most IPOs, there is no special sales effort behind the listing. A recent example of a successful demerger is Clydesdale Bank, which separated from National Australia Bank, and floated in February 2016. The demerger was undertaken because the business was considered non-core, but left alone, it has already prospered and its share price has risen accordingly.
Gaining comfort in a soon-to-be-listed company and its prospects as an investment is generally more difficult than those we’ve been researching for some time. However, the research effort is always worth it, even if only to become familiar with the company with the potential of investing further down the track. Keep an open mind, recognise that IPOs can be attractive, and remember that every company of course was once an IPO.
Mark East is Chief Investment Officer of Bennelong Australian Equity Partners (BAEP). This article is general information and does not consider the circumstances of any individual.