While the opposition parties attempt to undermine potentially the largest IPO of the year, the partial sale of Mighty River Power (MRP), there is a list of smaller IPO’s which will not be de-railed by political posturing. The recent success of market darlings Xero, Diligent, Summerset and A2 Corporation have led to a level of market sentiment not seen since the late 90’s. While we support IPO’s for growth companies, this flurry of activity brings risks to unsuspecting investors.
We suggest a cautious approach to the impending IPO’s. Xero spent nearly 17 months below its issue price, Diligent circa 41months and A2 Corporation traded sideways for 7 years! Many investors, and investment bankers, under estimate the work required to deliver a successful post listing company. There are nuances around business models and market structures which impact on future revenue and earnings growth, which are not effectively dealt with in prospectuses. Instead, business models are often labelled or compared to other listed companies for brevity.
The clearest example of this is labelling a business as having a Software as a Service (or SaaS) business model to boost valuation. This is the business model that Xero utilises. It is then easy to ‘compare’ the relative valuations of US based SaaS businesses (and Xero) to come up with a high valuation for the company being listed. We consider this approach to be wrong and misleading.
The key concepts to analysing a prospective IPO remain the same as any business we look at, care must be taken not to be influenced by labels. The key points remain;
- Is the management and board motivated and able to hit future growth targets?
- How big is the market and how fast is it growing?
- What competitive advantage does the company have? Is this demonstrable through either rapid market share growth or a strong price position? Will this lead to strong EBIT margins for the business in the long term?
- How expensive is growth to deliver and how ‘lumpy’ is the company’s sales profile?
- Is there the risk of a current or new technology that could completely overtake the product or service that is provided by the business?
- Is the business being valued fairly? The valuation should give both current and new shareholders the ability to profit should the business fail to achieve its prospective revenues and profits, with good upside if it meets its targets.
Investors will be well served to come up with their own views on the questions above, rather than to rely on the information provided by the prospectuses or by individuals promoting the new issues. We will be.
Senior Equity Analyst