This article appeared in the November 2014 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.
By Richard Hemming, Under the Radar Report
If ever there was an Initial Public Offering (IPO) to get your mitts on it was the technology company Freelancer. The business, which is aimed at providing an auction site for labour, delivered an $800-million premium to its issue price on the day of the IPO almost a year ago.
If you were lucky enough to get its 50-cents issue price, your investment, based on the closing price of $2.50 on the first day of trading, was up 400 per cent.
As with many IPOs, a portion of the business was being sold to the public by its founders in the form of securities to be listed on ASX. The force behind Freelancer remains the charismatic Matthew Barrie, who had purchased the website six years earlier from a Swedish entrepreneur in Vanuatu. It is the stuff of which (sharemarket) legends are made.
Fast forward to today and the market for IPOs is arguably just as strong as it was a year ago, even accounting for recent sharemarket weakness. Freelancer's share price now hovers at 72 cents. This alone tells a story about IPOs and the factors that you need to watch for.
Technology IPOs in demand
That said Freelancer is still considered a success story. And whereas in previous bull markets for IPOs - between 2004 and 2007 and in 2010 - mining stocks were the preferred IPO commodity, in the past two years technology stocks are at the epicentre of the heat generated by buoyant market conditions.
In 2013, IPO volume was $10.8 billion and this year to mid-October the total raised in IPOs was $9.8 billion. In the past 10 years, the peak amount raised in one year was $13.3 billion in 2005 and the lowest was just before the recent bull market, $1.4 billion in 2012. The average each year is $6.5 billion.
If you include reverse listings, the numbers in the high-volume years could increase by as much as 25 per cent. A reverse listing is where a business is vended into a listed vehicle, often referred to as a shell, which has only cash as its assets. This vehicle has the defining feature of allowing the vendors to sell at any time, rather than have their stock escrowed for a period of time, and unable to be sold.
The strong IPO market is a reflection of bullish sentiment in the sharemarket as a whole. Even accounting for the market's 8.5 per cent fall between early September and mid-October, from which it has recovered half those losses, the benchmark S&P/ASX 200 Index is up almost 30 per cent in the past three years.
The investment bankers interviewed for this article are adamant that IPO volumes will continue to be strong, despite the recent selling associated with rising volatility.
One banker said: "Globally low interest rates and the build-up of money in super funds means the demand for IPOs will be there for a while. People are looking to park their funds somewhere and IPOs provide a good space."
However, the bankers say a good IPO is dependent more on the bull market continuing than on the anticipated earnings growth of any particular offering. As one says: "People need to see that the sharemarket is on an upward trend. No one wants to rely on increasing earnings."
Defensive earnings name of the game at big end
Yet the majority of the large IPOs of 2014 have done well precisely because their earnings are considered relatively bulletproof. These include cleaning services group Spotless, hygiene products producer Asaleo Care, and hospitals owner/operator Healthscope.
Unlike the technology stocks that are bigger in number, the key consideration in their success has been the defensive nature of their earnings, which makes them somewhat immune to economic conditions and the power of the discretionary dollar.
Asaleo Care is a producer of absorbent tissues such as toilet rolls and tampons; Healthscope runs private hospitals; Spotless is making moves into the provision of healthcare services. The earnings of these companies benefit from Australia's ageing demographics and their products and services are needed no matter what the state of the economy.
We know for certain that IPO value will rise in the short term, with the $5.5 billion or so being raised in shares in Australia's largest health insurer, MediBank Private, as ASX Investor Update is finalised.
The IPO will be the Government's biggest divestment through a stock sale since 2006.
The indicative price of MediBank Private shares, which puts it on a price-earnings ratio of at least 17 times, based on its prospectus, indicates the Government and its advisers consider its earnings to be as defensive as the companies mentioned above. Whether the public are of this mind is another matter.
Lessons from Freelancer
Even if you believe the investment bankers and that it's full speed ahead for the markets and IPOs, it is worth taking a closer look at Freelancer. The first point to note is that everyone agrees it can be a great business if it gets to a certain size, because it can achieve massive earnings growth while needing very little capital.
Even though Freelancer's revenue growth is impressive, it comes off a very low base, and investors came to realise it would take a while to make money. Put another way, it has some way to go before it reaches the kind of scale that delivers big dividends.
More important is the low liquidity in the stock. Only 30 million shares were offered to the public of the 436 million on issue, which is less than 7 per cent. The vast bulk of shares are held by Matthew Barrie and two other executives. When it comes to the stock price, this factor massively amplifies the sentiment, whether positive or negative.
It's nice if you can get it
Many sharemarket participants ruefully point out when asked about an IPO that it would be good if you could get stock. In many of the good ones, as Freelancer indicates, pre-float stock is delivered to a very small number of individuals who are closely connected to the vendors of the company, or to the stockbrokers involved in the listing.
This is where the MediBank Private float has an advantage, because it is in the Government's interests to disperse the stock as widely as possible. It is also in the Government's interest that it delivers a good return, because it presumably wants to sell other assets to the public.
Business model is the key
But most important, if you intend to hold onto the shares after the IPO for any length of time, is the company's business model and whether there is the prospect of dividends any time soon.
Technology analyst Nick Harris of Morgans says his firm has not been involved in the recent technology-related IPOs and backdoor listings, because the stockbroker's customer base is largely retirees, who are not comfortable with the risk associated with companies that do not yet have earnings. In any case, his words of warning should be listened to:
"People need to be conscious that these are very speculative, which means you can make a lot or lose a lot. Often, these are not profitable businesses but ideas with revenue. It is not the same as an established profitable company, so the risk and reward is very different to buying a dividend-paying company. You have to be careful about how much you put in them."
Not a level playing field
Looking at the wider IPO market, Under the Radar Report columnist and fund manager Andrew Brown says that when judging whether or not to invest in an IPO it is important to realise it is not a level playing field.
He says: "Investing in an IPO is no different from investing in a normal stock. You have to do the same homework. There is the possibility of different pricing, however. An IPO is not a free market where everyone has the same information and is able to participate. A retail investor does not always have freedom to participate in an IPO, whereas he or she can participate freely in the secondary market. This often works in favour of people getting stock in an IPO, but not always."
Veteran small-caps investor Frank Villante, of Celeste Funds Management, puts it another way and references the fact that many IPOs are the result of the sell-down by private equity funds:
"If an asset is being sold it is because vendors want to exit. The valuation is really important, and this does not matter whether it's private equity or a trade seller. It just has to be fair."
Factors to think about with IPOs
Vendors: Who are the vendors and why are they selling? If they have not held the company for very long it is important to know how much they purchased it for, what they did to it when they owned it, and whether the company comes attached with much debt. This is the sort of thing you look for when buying a house.
Size of minority shareholders: How big is the free float? If too small, it might not be worth holding on to because the bigger shareholders will want to get out at some point, causing pressure on the share price.
Quality: What is the quality of earnings like? Are the profit margins high? Has it delivered 10 per cent or more return on equity? How much competition is there for the company's product or service?
Cyclicality: How vulnerable is the business to a downturn in the economy? If the business has been achieving fast earnings growth, why should this continue? The base level of earnings over a long period is very important.
Valuation: How much value is there in the issue price compared with the market average and its competitors? Does it feel fair? Every managing director says there is no other company like his or hers, but every company is subject to demand and supply factors and market sentiment.
Disclosure. At the smaller end, investors should always question the level of disclosure in relation to the financials and company history. There are a lot of people working on the MediBank Private float, which means that a much smaller IPO might not be getting the attention it deserves.
About the author
Richard Hemming is editor of Under the Radar Report.
Upcoming floats has more information on IPOs, and Recent floats and listings provides information on entities that have listed on ASX in the previous two months. Note: information about upcoming floats can change quickly if companies close their IPO ahead of schedule, or decide to extend their offer. Check the ASX website or talk to your financial adviser for latest information. IPO listing and closing dates are indicative only.
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