Hugh Dive, Head of Listed Securities

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Tales from the Trenches - IPO window is firmly open!

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Last Tuesday private hospital operator Healthscope was listed on the ASX with a market capitalisation of $3.6 billion. This marked the largest initial public offering (IPO) since the Queensland government raised $4.1 billion from listing QR National in 2010. The IPO window is firmly open with $8 billion already raised from investors in 2014 on top of $7 billion in 2013, the bulk of which came just before Christmas.

IPO Windows

The term "IPO Window" refers to the points in time where generally after a prolonged period of rising equity markets, investors are willing to listen to the siren songs sung by the investment banks about new and exciting companies to invest in. In recent times we have seen the IPO window open up for tech stocks (1998-2000), mining and mining services companies (2005-2007) and most recently industrial companies being floated by private equity (2013-14).

During these periods the quality of companies listed can vary sharply, as for every JB Hi-Fi (+975% since October 2003) that becomes a success, there are many unsuccessful floats such as McAleese (-70% since November 2013) and Boart Longyear (-99% since listing in April 2007). Generally this window closes either due to a large negative macroeconomic event such as the GFC which reduces investors' appetite for risk, or a particularly poor large float that burns investors' fingers such as Myer in 2009.

IPO-window-is-firmly-open.JPG

Analysing the financials of an IPO

The process of analysing an IPO is similar to looking at any company; we analyse the company's financials (cash flow, balance sheet and profit and loss statements), interview senior management and speak with their customers and competitors. The challenge in analysing an IPO is that we have not seen how the new company performs in different market conditions. Also the level of historical detail provided is often below what other publicly listed companies provide. The financial analysis of IPOs is often also complicated by the vendors purchasing other businesses to bulk up the company prior to the IPO. Here investors have to be careful as the financial statements are presented on a pro forma or hypothetical basis, as if the newly acquired business had been owned for several years. This obviously can make forecasting a new company's future earnings quite challenging. Due to an IPO lacking a listed track record and investors having less financial data; a discount to currently-listed comparable companies should be applied when valuing an IPO.

Factors we look at in an IPO

  1. Why is the vendor selling? The motivation behind the IPO is one of the first things we look at. Historically investors tend to do well where the IPO is a spin-off from a large company exiting a line of business such as Orica and their paints division Dulux or the vendors are using the proceeds to expand their business. The probability of new investors doing well from an IPO is far lower when the seller is just looking to maximise their exit price and end their involvement with the company, a classic example of this is the Myer IPO.
  2. Is the business easily understood? Given the reduced level of historical financial data it is important that an investor can easily understand how the company makes money and its competitive advantage. When Shopping Centres Australasia was listed in November 2012, it was clear how the company made money from collecting rents on Woolworths' shopping centres. Last week we looked at an IPO for an Asian satellite network services provider planning to list on the ASX and struggled to understand both the business and its long-term competitive advantage.
  3. Is the price attractive? The sole reason behind any new investment is the view that it will generate a higher rate of return than alternative options. When we looked at Shopping Centres Australasia we viewed that at a PE of 12.5x and a 7% dividend yield, Woolworths had attractively priced the IPO and that we could expect some upside from investing in the IPO. Conversely the vendors priced the Healthscope IPO at a PE of almost 23x and at this level we saw minimal scope for price appreciation for new shareholders and thus declined to participate.
  4. Is the company profitable? Any IPO is presented to the market in the most favourable light (albeit with a large number of disclaimers) and at a time of the seller's choosing. Over the last six months we have seen a number of businesses being listed that have been unprofitable for a number of years, yet are expected to switch into profitability in the years immediately after the IPO. We put little store in the notion that companies are being listed for the altruistic benefit of new investors. Thus we are skeptical of such dramatic improvements after listing, especially when the IPO vendors have significant incentives to show profits before listing!

What is coming down the pipeline?

Like all investment managers, we are currently receiving around two to three 80 to 100 page pre-IPO research pieces a week, couriered to my desk by the sponsoring investment banks with a range of arguments of why we invest our clients' capital. Looking out over the next 12 months the IPO pipeline looks pretty full, with Medibank and share registry company Link Market Services being the two biggest companies that are expected to list over the next 12 months.

In looking at the above four key factors we would expect to have a very close look at Medibank. Typically when the government is the vendor of the IPO, they have an incentive to price the new issue to allow it to perform well after listing, as this is positive for retail investors (and voters!). Moreover private health insurance is an easily understood and profitable business. We would also expect that under private management, Medibank Private should be able to raise profits in the near term by reducing the higher cost base normally carried by state owned enterprises.

Disclaimer

This article has been prepared by Philo Capital Advisers Pty Ltd ABN 70 119 185 974 AFSL 301808 (Philo) and contains general investment advice only. The information in this article does not take account of your objectives, financial situation or needs or those of your client. Before acting on this information readers should consider whether it is appropriate to their situation. We recommend obtaining financial, legal and taxation advice before making any financial investment decision. To the extent permitted by law, neither Philo nor any of its related entities accepts any responsibility for errors or misstatements of any nature, irrespective of how these may arise, nor will it be liable for any loss or damage suffered as a result of any reliance on the information included in this article. The information in this article is based on information obtained from sources believed to be reliable and accurate at the time of publication but we do not make any representation or warranty that it is accurate, complete or up to date. We accept no obligation to correct or update the information or opinions in it. Opinions expressed are subject to change without notice. Past performance is not a reliable indicator of future performance. Any forecasts included in this article are predictive in character and may be affected by incorrect assumptions or by known or unknown risks and uncertainties. Nothing in this article shall be construed as a solicitation to make a financial investment.

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Hugh Dive, Head of Listed Securities


Prior to joining Philo, Hugh was Head of Basic Materials Group Investment Research; covering the chemicals, building materials and steel sectors. In the 2011 Reuters StarMine Equity Analyst Awards, he was rated 5th overall in Australia for stock picking and first in the Diversified Industrials and Chemicals sectors. Hugh has extensive portfolio management experience gained at Investors Mutual, with a successful track record managing both small and large cap value funds. In 2009, one of the funds he helped manage, the IML Future Leaders Fund, won the AFR Smart Investor Award for the best Australian small cap fund.


Hugh started in funds management with CC&L Investment Management in Vancouver; Canada’s largest independent fund manager with C$37B under management. At CC&L he focused on asset allocation and then Canadian equity analysis. Hugh holds bachelor’s degrees in both Economics and Law from Sydney University and the University of British Columbia, Canadian Securities Course (Honours) and is a CFA charter holder.

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