In May 2016, payments services company Afterpay Holdings floated on the Australian Securities Exchange (ASX). The payments disruptor raised $25 million at $1 a share in a heavily over-subscribed initial public offering (IPO), capitalising the company at $165 million.
Afterpay described its product in simple terms, as allowing end-customers to “buy now and pay later” without taking out a loan or paying upfront fees and interest. Afterpay pays the retailer upfront and takes on the non-payment risk: for this, the merchant pays Afterpay a fee. The carrot for merchants to do this is that Afterpay’s ease of use helps the retailer to increase their sales and average order sizes.
Afterpay was an early-stage business. It was earning revenue but was not profitable at operating EBITDA (earnings before interest, tax, depreciation and amortisation). The shares, which were issued at $1, surged on to the market, at $1.30. A little over two years later, Afterpay Touch (as it is now known) has expanded into the US market, has become profitable at net profit level (December 2017 interim result), and the stock trades at $14.38.
Now let’s look at another IPO, that of century-old department store operator, Myer, in October 2009. A household name in Australia, Myer floated with $3.3 billion of sales in the year of the IPO.
The consortium that owned Myer (comprising mostly private equity firms) had bought the department store chain in 2006 with $400 million of their own equity. They were able to take a $525 million dividend in the first year of ownership after selling key properties and running an inventory clearance sale. And then in 2009, they reaped another $2 billion-plus by selling out of the company through its IPO.
This was clearly a great result for the private equity funds’ investors. Investors in the IPO, however, have not fared as well.
It is history that Myer, sold at $4.10 in its float, started on the stock exchange at $3.88 and has kept falling, all the way to 44 cents. That’s a staggering 89% fall.
The two examples illustrate just how difficult it is to predict how IPOs will perform. IPO investment is an area fraught with danger, but it is a very popular area with Australian investors. So, how does an investor assess a float? Here are six tips.
1. Read the prospectus
The prospectus can be a daunting document, and often it seems to be as full of photographs as an issue of Vogue. (The Myer prospectus famously featured model Jennifer Hawkins on the front cover, and seemingly on every second page.) But you must read it before you invest – and don’t look at the photographs, no matter what they are.
Unfortunately, the sumptuous Myer prospectus totally missed the fact that retail was changing. Online retail, overseas competitors coming to Australia, specialist “category-killers,” changing customer preferences – Myer either failed to see these trends coming or under-estimated them. Its prospectus forecasts were ultimately not worth the high-quality paper on which they were printed.
The problem is that forecasts are based on assumptions, usually set out somewhere in the prospectus in the small print. The prospectus will tell you not only about the company, but about the market for that product or service: who the business’ competitors are, and why it thinks it can compete with them.
2. Who is selling, and what is their motivation for selling?
Afterpay’s co-founders, Anthony Eisen and Nick Molnar, floated the company to raise capital to expand their fledgling business, and take the model to new stores. Myer’s private-equity owners, TPG Capital and Blum Capital, exited their investment through the Myer IPO. There is nothing wrong with that: it’s one of the ways that private-equity investors make their money, after investing in their asset to prepare it for public float. But investors now prefer to see the private-equity owners stay in stocks for a known period, to make sure that they have “skin in the game,” along with the retail investors who are buying in.
Since Myer, IPO investors are a lot more sceptical about private-equity IPOs that represent a full vendor exit. Conversely, they will support even early-stage businesses, like Afterpay, where it is clear that the founders’ interests are aligned with the investors whose support they seek. IPOs where the money goes to the company to finance growth and expansion are generally better future investments than IPOs where the money goes to the existing shareholders who are selling out of the business.
3. How does the valuation stack up?
IPO investors should always be looking to compare what they are being asked to pay, with the valuations of similar companies. The most common valuation methods used are the price/earnings (P/E) ratio, which is the share price divided by the earnings-per-share figure; the dividend yield, which is the dividend-per-share figure divided by the share price, multiplied by 100 to give a percentage yield; the PEG (Price/Earnings/Growth) ratio, which is the share price divided by the earnings-per-share figure, and the resulting number divided by the earnings-per-share growth; and the price-to-NTA ratio, which is the share price divided by the company’s net tangible assets (NTA) figure.
Assessing these figures against those of the company’s peers, or those for the sharemarket sector, can give you an idea of relative value. The problem with this method is that in many cases – such as Afterpay – when there is no earnings or dividend, some of these ratios cannot be calculated.
4. Who is running the company?
It’s very important in an IPO to assess the company’s CEO and management team, to get a feel for their track record and whether they have been previously successful in the public-company arena, or in a similar business. This is especially important in smaller IPOs that may rely heavily on a few key people. It is difficult for retail investors to make this assessment, so make sure to do Google searches of every name in the management section of the prospectus, to see what kind of businesses they have previously been involved in, and to what level of success.
5. Are there any capital structure issues?
It’s important to understand what the company’s capital structure would look like if all options, convertible notes or performance shares granted to executives or investors were exercised. If it is excessive, this share issuance can dilute existing shareholders and affect the company’s earnings per share and return on equity. Also, if there are provisions for such performance-related issuance, make sure the ‘hurdles’ in place for the executives to earn them are actually tough enough.
Also, there may be “escrow” periods, which specify for how long the company’s main people may be restricted from selling their stock. While this situation is better than, say, a full private-equity exit, the knowledge of potential future sales can cause an “overhang” in the share price.
You don’t have to buy the stock in the IPO. The truth is that not even professional investors really knows whether the initial price is “right,” or whether the stock will be a good long-term investment. It often takes some time in the secondary (post-IPO) market before any structural issues related to the float manifest themselves.
There may also be a set period during which IPO’s underwriters provide buying support for the stock, as part of their contract. It can take time for the market to fairly value the stock. Some IPOs get away very strongly, and never trade again at their issue price – many others, even strong companies, take a while to find their feet, and can end up being bought for less than issue price.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regard to your circumstances.