How to analyse an IPO

A company’s prospectus will give some of the best clues to the underlying business. It should lay out what the company does and what it hopes to do with the money raised. Details about the management team will also be made available. Investors need to feel comfortable with the business they are buying into and should be aware of any factors that could push them to walk away.

Investment proposition

One of the first factors would-be investors need to consider is, quite simply, whether or not they like the company and believe that it has room to grow. The listing business should have a sound business model with a strong competitive edge in its market that differentiates it from peers. Investors should feel they understand why a customer would want to pay for the products or services offered by that specific company as opposed to others that offer something similar, especially if its competitors are more established or well-known businesses. As with any other company an investor is looking to buy shares in, discipline is required when assessing the company’s strategy, competitive position, finances and the ability of the management team to run it properly.

Cantor Fitzgerald's head of corporate finance Rick Thompson encourages investors to question whether the money the company is looking to raise fits in with its strategy. The goal amount should be enough that shareholders feel it will see the business plans through. If it is not, that could signal bad planning on the part of the management team.

A more established business may fare better on the public market than one that has less of a track record. This makes it more likely that the company has found its place in the market and discovered its competitive advantage, especially if it has protected or valuable intellectual property. The most successful products or services are likely to be those that address an unmet need, or do it more effectively than others already listed.

Pricing and capital

Listing on the public market can be a great way for companies to raise money. But this access to cash should raise questions about what management plans to do with it, whether it will be to fund expansion plans or pay off existing debt, or some hybrid of the two. The former is often preferred since shareholders are often encouraged by a business that can demonstrate that it has plans to become bigger. However paying down debt also frees the company from the burden of interest payments, allowing it to invest in its core strategy and to improve its business model and efficiency.

If the answer is that the company is looking to raise capital to grow the business, the next question is whether it intends to expand through organic growth or through acquisitions. The former is often harder work but can be more rewarding in the longer term, while the latter is a quick fix to enlarge the business, but can be fraught with risk. It can be encouraging if the business is already profitable or cash generative, and if this is not yet the case then it should be able to identify a clear path to reach that point.

It is often assumed that a new company coming to market through an IPO will be priced at something of a discount to directly comparable companies already trading, which Trevor Griffiths, research analyst at N+1 Singer, says is commonly referred to as an “IPO discount”. It reflects the fact that there is no track record of the shares trading on the market or of management reporting results, as well as no experience of the company’s governance in a public market environment. “This increases risk, which can only really be dealt with by applying a valuation discount,” says Mr Griffiths. He added that potential investors should also look at the broker that is backing the IPO. This sponsoring broker should have sufficiently broad relationships with investors, including both institutional and retail wealth managers and platforms, to ensure that no stones are left unturned to find investors in the IPO.

But, says Mr Griffiths, “never underestimate the power of good fortune. Many IPOs fail through no fault of the company or its sponsors. Sometimes the market just turns down at the last moment and institutional demand for new issues can effectively evaporate overnight.” 

Management team

Any company that is looking to come to the public market, no matter how convincing the investment proposition, must have a trustworthy and reputable management team behind it. This team should be able to point to a good track record and ideally own chunks of shares themselves as a way to ensure that their interests are aligned with that of the business.

Becoming a public company is a significant step in the life of a business and a big commitment for management to take, according to AJ Bell investment director Russ Mould, and so the team must communicate clearly with their new shareholders and deliver on the promises that have been made during the run-up to flotation. “Some firms fail to do one, the other, or even both, with the result that the shares take a hammering as investors lose faith and sell the stock to the disappointment of all those concerned.

“Equally, management can do a good job, exceeding expectations, delivering better profits or dividends than expected and excel in keeping shareholders informed,” says Mr Mould.

Cantor Fitzgerald’s Mr Thompson observes that some individuals can be great at the start-up phase of a company, but once the business is off the ground and looking to go public this can change dramatically. “Not all entrepreneurs are suited to be chief executives of publicly listed companies. Some lack a degree of self-discipline and won’t listen to advisers,” he comments. “While there is no perfect chief executive, they do have to operate within a bandwidth of tolerance”.

Red flags

Investors should look at what the management team does with their shareholdings once the company hits the public market. Plans to sell all or a significant portion of their stakes in the business could be a red flag. If they are indeed planning to get rid of most or all of their shares then this should lead potential investors to wonder why they should be buying if the people who know the company best are looking to get out.

However, Mr Thompson says that founders selling down their stake may not always be a bad thing. The purpose of an IPO is to bring in new investors and to raise money, and so by selling a part of their share management can help improve the liquidity of the listed shares.

One instance where a total exit is common are private-equity-backed IPOs, where there is often the suspicion that backers have overburdened companies with debt before setting them free on the public market. But Mr Thompson suggests this is “too simplistic an analysis”, and while private equity became synonymous with financial engineering in the 1990s, this is not always the case today. Instead, he says, a private equity owner can often impose a lot of disciplines on a company that it would not have been exposed to otherwise (see page 25).

Phil Harris, manager of the EdenTree UK Equity Growth fund, cautions investors to be aware of the idea of an IPO cycle, where companies choose to come to the market after competitors complete a successful float. “When the IPO cycle starts, the quality of companies can be excellent. However, after a string of successes, the temptation is to try to float less appetising companies. The cycle then dies as these subsequent offerings fail due to aggressive pricing.” Mr Harris points to Misys and TI Automotive, which launched at the end of the IPO cycle last year and were subsequently cancelled, while Biffa (BIFF) barely got away despite slashing the initial listing price.

“The key is to look for the right attributes in an IPO regardless of the stage in the cycle. These are companies with interesting secular growth markets, high margins, strong returns on capital, and profits converted into cash,” he says. No matter how convincing an investment proposition, investors still need to be watchful of deal breakers that could push them to re-evaluate their view of the company. How heavily individual warning signs should be weighted will depend on the risk profile of the individual.

Which companies are in the best shape?

We’ve taken a look at the companies that have listed in the recent past on the main market and Aim to filter out those in the most robust shape. We screened companies that have floated on the London market during the past four years and applied the following criteria:

• Net debt of no more than two times cash profits.
• A return on capital within the first quartile of the FTSE All-Share or Aim All-Share during the last 12 months.
• Earnings growth of at least 10 per cent forecast for the next 12 months.
• Earnings growth of at least 10 per cent during the past two years.
• Gross margin progression during the past three years.
• Levered free cash flow within the first quartile of the respective index (as above).
• A market capitalisation of at least £80m.

Our stock screen shows business-to-business platform operator ULS Technology (ULS) as the healthiest IPO to list on Aim over the past four years, based on our criteria. It came to market in July 2014 at 40p a share, giving it an initial market capitalisation of £25.9m; since then the company’s value has tripled. The money it raised at float was used to pay down £1.85m of debt and to develop its SearchHub product and estate agent comparison website. It recently bought stakes in HomeOwners Alliance and Conveyancing Alliance Holdings as part of its efforts to increase its market share.

The runner-up was Focusrite (TUNE), a maker of sound equipment founded by a former Led Zeppelin audio engineer. It listed in December 2014 at 126p a share, raising £21.9m to pay exiting shareholders and gain access to the capital market, since which time the share price has more than doubled. At its most recent set of half-year results in May the company reported that it had nearly doubled net profit to £4.1m and increased its cash balance by around two-third to £9.4m. This has put it in a good position to make acquisitions to tap into the growing ‘prosumer’ music production market.

The company that came closest to meeting our criteria on the main market was Clipper Logistics (CLG), which works with retailers such as John Lewis and Asos to provide online shipping and returns. It went public in May 2014 at 100p a share to expand its customer base and move into Europe, and has since quadrupled in value. In its full-year results in July the company reported a 17.2 per cent rise in revenue to £290m, with cash profit up 2.8 per cent to £17.9m. Over the year it started an exciting new partnership with John Lewis called Clicklink Logistics Limited to operate a new click-and-collect service.

CASE STUDIES: THE GOOD

Boohoo.com

In 2014 a flurry of retail listings hit the public market. One that stood out was Boohoo.com (BOO), the clothing website aimed at fashion-conscious 16 to 24-year-olds and another recent IPO to emerge from our screen. The retailer was looking to raise up to £300m, £239.9m of which was to be used to repay convertible loan notes, while the other £50.1m was allocated for funding future growth. At the time Boohoo was already well established in the UK, Ireland and Australia but had ambitions to expand into the US, central Europe and Scandinavia.

Shares in Boohoo listed on Aim in March 2014 at 50p apiece, before they shot up to around 85p on the first day of trading. At the time, this gave the Manchester-based retailer an £850m market capitalisation – far above the expected £500m prior to admission – since which time its value has soared to £2.7bn.

Management did not sell down shares at the time of the float, but since then has needed to offer shares to satisfy institutional demand. Most recently, in June joint chief executive Mahmud Kamani sold around 11.3m shares at £24.8m. This was after the retailer had already completed an accelerated book build placing through which Mr Kamani and two of his siblings sold 36.6m shares. It also issued 22.7m new shares to raise £50m.

The company has kept true to its promise of international expansion. Apps launched for mobile and tablets in the UK, US and Australia have proved popular and now account for around 70 per cent of shopping sessions. At the half-year results to 31 August 2017 the company reported US revenue up 145 per cent at constant exchange rates to £39.6m, while in Europe growth came in at 77 per cent and 89 per cent for the rest of the world. This compares with domestic growth of more than doubled to £163m – still very healthy itself.

Boohoo has also gone on a spree of acquisitions this year to fuel its expansion. In January it paid £3.3m in cash for a two-thirds stake in 21 Three Clothing, otherwise known as PrettyLittleThing. Management felt that the “fast growing, international online retail brand” would complement the existing Boohoo site. Then in February it bought the intellectual property in retailer Nasty Gal for $20m (£15.6m), paid for through a combination of cash and a new bank debt facility of £12m. Management said the acquisitions represent a “step change in the size, structure and operation” of the group. The three brands will operate independently of one another, with different management teams and distinct products, but sales will all be included at group level. These acquisitions helped boost revenue by 51 per cent to £295m in the year to February. This included two months of trading from PrettyLittleThing with revenues of £11.2m.

IC view: Boohoo is optimistic that young people will continue to favour shopping online, which should give the it the scope to expand into a global business – thus fulfilling its IPO promise. With £119m of cash on the balance sheet at the last set of results it looks as though it could fund further acquisitions should it find anything that suits its needs. With the shares at 236p early investors have been amply rewarded, but a lofty PE ratio of 80 times forward earnings looks too high for new investors to buy in. Hold.

Fevertree Drinks

Shares in Fevertree Drinks (FEVR) have not lost their fizz since the drinks business listed on Aim in November 2014. At 2,153p, they are up an incredible 1,600 per cent from the 134p price at the time the company went public. Fevertree set out to raise a total of £93.3m, only £4m of which was to be invested back into the business. The remaining £89.3m was meant to pay off selling shareholders, notably founders Charles Rolls and Tim Warrillow, along with private equity backers LDC.

While it can be a red flag when founders sell down their shares so heavily, the Fevertree pair are doing so to keep up with the seemingly insatiable appetite from investors. Just as Fevertree’s share price has soared, so has its valuation. The shares are trading at a lofty forward earnings multiple, but investors still can’t seem to quench their thirst. Earlier this month Mr Warrillow sold 1.5m shares to help with liquidity and in May Mr Rolls ended up selling twice as many shares as he’d originally intended to keep up with demand from institutional investors. Mr Rolls and Mr Warrillow came to market with 27.8 per cent and 12.7 per cent stakes, respectively, but still hold around 11.2 per cent and 5.4 per cent. 

The ‘premiumisation’ of the food and drink market means we should not be too surprised at Fevertree’s success. It prides itself on unique ingredients, making it stand out from mainstream competitors such as Schweppes. The product has proved so popular that it has driven 99 per cent of the value growth in the entire UK mixer category within the retail market over the past 12 months.

There are other aspects to the business model that have underpinned Fevertree’s rapid, low-cost growth. Manufacturing is completely outsourced, mainly to UK-based company Brothers. At the time of listing the directors stated that this outsourced model meant that it could expand easily, delivering future growth without the need for significant further investment. Management has certainly delivered on the promise for growth. Fevertree came to market with a £154.5m market capitalisation and has since soared in value to £2.5bn. At the latest set of half-year results revenue was up 77 per cent over the six-month period to £71.9m, with a 102 per cent improvement in cash profits to £25.2m. The UK is still Fevertree’s largest market at 47 per cent of group sales, but international markets are starting to catch up. Continental Europe makes up about a third of sales, while the US contributes nearly a fifth.

IC view: The shares are trading at 70 times forward earnings, which looks like an expensive entry point for retail investors – but we have underestimated the strength of Fevertree’s growth before, and international prospects are good. Hold.

Eddie Stobart Logistics

Companies that have been taken off the market only to reappear years later can at times be a red flag, but not always. Take Eddie Stobart Logistics (ESL). It had previously been a part of Stobart Group (STOB) until the parent company sold a 51 per cent stake to private asset manager DBAY and held on to the remaining 49 per cent. In the three years that Eddie Stobart was privately owned it increased its debt so that it could buy more trucks to add to its fleet and expand its warehouse and IT capabilities.

Eddie Stobart came back to the market in April this year, raising £122m at 160p a share, which gave the company a £573m market capitalisation. Both Stobart Group and DBAY sold down their holdings in the IPO process to around 30 per cent. Paying down some of the debt it had racked up was the first priority for Eddie Stobart’s management after listing. Around £74m of the fundraising went towards paying back a mixture of bank debt and shareholder loans. The next priority was growth through acquisition. The company paid £45m to buy supply e-commerce logistics specialist iForce, and management has indicated that further acquisitions could be on the horizon. More recently the company took a 50 per cent stake in business-to-business operator Speedy Freight. Chief executive Alex Laffey said that the additions are meant to strengthen the group’s customer base.

The shares shot up to a high of 165p, but have since settled closer to the IPO price at 161p. At the maiden half-year results as its own listed company Eddie Stobart reported group revenue up 8 per cent to £287m, although profits fell to a pre-tax loss of £7.6m due mainly to costs associated with listing. Strip out IPO costs and revenue increased by 13 per cent.

IC view: IPO costs took a bit of the shine off the half year results for Eddie Stobart, but these are only one-off so future results should look much better. The free cash inflow of £11.1m should help support the dividend, which management at IPO said would target a 55 per cent payout ratio in the first year with a yield of around 3.6 per cent. At 15 times forward earnings the shares look cheaper than listed peer Clipper Logistics (CLIP), and we’re sticking with our buy call, especially as the parent company is still significantly invested. Buy.

CASE STUDIES: THE BAD

Foxtons

Foxtons (FOXT) had a promising debut, but it didn’t last for long. After listing at the top of its price range at 230p a share, giving a market capitalisation of £649m, the shares shot up 16 per cent on the first day of trading in September 2013. At the time, analysts suspected that this enthusiasm reflected the generally positive sentiment about the London property market. Government policies such as Help to Buy suggested that housing in the capital still had a way to run. The estate agent set out to raise £55m to pay down its debt. 

Although London property has not experienced a crash, the same cannot be said for Foxtons’ share price. By the February after listing the company has amassed a £1.1bn market cap with a 399p share price. But changes to stamp duty and tighter mortgage lending discouraged people from moving flat or jumping on the housing ladder. Foxtons has traditionally focused on central London property, and branching out to other British cities was not enough to sooth nervous investors.

The shares are now trading 70 per cent below the listing price at 68p. The most recent set of results did not paint the most promising picture. Pre-tax profits were down by 64 per cent to £3.8m. Sales revenue fell by 29 per cent to £22.2m, while revenue at the lettings business was down 2 per cent to £32.1m and mortgage broking division turnover declined by 9 per cent to £4.2m. Net free cash flow fell to £2.1m from £6.8m during the first half of 2016 and the dividend was cut from 1.67p to 0.43p. At 24 times forward earnings the shares are looking expensive.

IC view: Foxtons' troubles have not surprised us – it’s been widely speculated that Brexit could cause house prices and rent in the UK to become cheaper over time, which is not likely to benefit estate agents, and we’ve been bearish on its shares since the IPO, which looked like backers cashing out at the top of the cycle. Nothing’s really changed enough for us to change our minds. Sell.

DX Group

If at first you don’t succeed, things may not be that much better the second time around. DX Group (DX.) first floated in 2004 but was taken private two years later by the Candover private equity group. It gave listing another shot in 2014, aiming to raise £170m to expand its logistics business and pay down debt. The popularity of Royal Mail’s IPO just months before may have encouraged management that there was appetite in the market for another parcel delivery company – perhaps a good example of the deteriorating business quality of new market entrants later in an IPO cycle.

The shares came to market at 100p per share but have performed dismally ever since, falling 93 per cent to the current 7.2p a share. November 2016 was a particularly painful time for the company when shares fell 70 per cent in one day after it issued a warning that it would not meet profit forecasts for the full year. Once the results did roll around investors were further disappointed, wiping another fifth off the share price. Pre-tax profits had fallen 78 per cent to £2.4m which caused a £88.4m non-cash goodwill impairment. The problem was that fewer pieces of mail were being sent with DX Group and issues with resourcing drivers added to costs.

In his book The Debt Trap Sebastian Canderle looks in detail at DX group to see what lessons can be learned. Debt once again was a familiar problem: it had a net debt to cash profits multiple above six times before relisting in 2014, which would have been nearer 11 times if some of the company’s owners had not previously written down part of their loans. Investors effectively paid off the most costly of the remaining debt in exchange for a business with a poor history of overcoming the challenges of an operationally-challenging industry to deliver meaningful profit growth

IC view: Management tried to reassure investors that a new parcel exchange service was on its way along with a new central hub in the West Midlands, and pointed out that the courier service had grown by 14 per cent over the year. But this was lost on shareholders as the stock has continued to decline ever since. The market cap has fallen to a mere £14.3m and looks unlikely to stage a dramatic recovery any time soon. Sell.

CASE STUDY: THE UGLY

Private equity ownership can sometimes get a bad reputation, but the stories of Saga (SAGA) and AA (AA.) demonstrate two very different experiences. Over 50s product provider and roadside assistance, respectively, may not seem like obviously related businesses, but seven years ago the two were merged into holding company Acromas by private equity backers CVC, Charterhouse and Permira. The arrangement lasted until 2014 when Acromas sold most of its holding in Saga and its entire stake in AA. With hindsight, Acromas’s disposal of AA, while retaining about a third of Saga, was a sign of things to come.

Saga had a rocky start to life as a listed company. It came to market in May 2014 with an 185p flotation price, the bottom of the range in its prospectus, giving it a £2.1bn valuation. The company directors reckoned that listing would raise consumer awareness of the company, citing “extensive publicity” ahead of the IPO. But blunders around the float generated some unwanted press. The share price closed flat on the first day of trading, and some investors did not receive as many shares as they had paid for due to an error by outsourcing firm Capita. Saga also faced criticism that it had avoided being classified as an insurance business, instead opting to be known as a specialised consumer company, in an attempt to boost its valuation. The shares had fallen by around 16 per cent by the end of 2014.

This controversy may have been less than ideal around the float, but the company soon recovered its ground. By the middle of 2015 the shares were up by around 5 per cent from their original listing price, aided by the promise of the pension freedoms that would allow retirees options beyond an annuity. An ageing demographic continues to benefit the business, which caters to those over age 55 with non-life assurance and cruise holidays. Next up is a Saga Possibilities scheme that aims to cross-sell products to its members. At 198p, the shares are up around 7 per cent from float, underperforming the wider market.

Contrast this with AA. The roadside assistance company also touted a well-known brand, had the same private equity backers, and an aim to improve the profile of the company. It listed about a month after Saga at 250p a share, soaring 72 per cent by the following year. Its share price high of 430p was, rather ironically, reached on April Fool’s Day of 2015. The joke’s on AA, as its valuation tumbled from then.

Drivers trust AA to get them out of trouble, but the roadside assistant is less trustworthy with its debt. At its maiden set of results as a listed company it reported a whopping £2.9bn of net debt, nearly double its £1.7bn market capitalisation at the time. Add to this falling cash profits and added costs and what originally looked like a successful IPO turned into a collision course. But recovery could be on its way with a turnaround strategy in place. It’s been investing in its platform to become more user friendly in the digital age and sold the Irish business, using the proceeds to pay off some debt. Cash flow is back into positive territory and pre-tax profits came in at £100m in the year to January compared with £9m the year before, although its debt pile still looms at £2.7bn.

The fact that the private equity backers dropped their entire stake in AA but kept about a third of Saga suggests that they had more confidence in the latter. At admission Saga said it would aim to pay out between 40 and 50 per cent of profits in dividends, while AA would hold on to earnings to fund the development of the business and pay down debt. Saga now boasts a strong brand and a 4.7 per cent dividend yield while AA remains in a difficult (and sometimes controversial) recovery process. Buy Saga, hold AA.