Three upcoming floats with value holes

The current buoyant optimism on the Australian equity market is fragile because it does not reflect either earnings growth or improved profitability for the majority of listed companies.

Sensing this, float promoters are rushing to list as many companies as possible before Christmas. In this climate of buoyant share prices, investors often let their emotions get the better of them and pay less attention to price and value.

A 150-page prospectus, with all its compliance-driven disclosure and dense detail, becomes ‘the fat bit in front of the application form’. Knowing this, promoters are typically able to secure full or overvalued prices for vendors.

In any case, the aftermarket is where the fun begins for investors and you must remember that the marketplace for floats is rarely fair.

Let’s remember that the trading of newly listed companies in the secondary market has numerous competing forces operating concurrently. For instance, the vendors of the company have tried to maximise their sale proceeds. The advisors are trying to ensure that a small premium exists in the aftermarket above the issue price to prove their worth as agents. Traders are scrambling to secure stag profits, whilst institutions may be trying to build a position in a market which is temporarily highly liquid.

Value, so to speak, is in the eye of the beholder. But the information required to make an informed decision about value may not be generally available or fairly distributed to all investors. This is because of the “grey period” of time that exists prior to the float of a company where “continuous disclosure” rules do not seem to apply.

In the IPO market, retail buyers usually know far less about the business being floated than the vendor who owned the company privately before the offer. Worse, some buyers are better informed than others. Unlike in the secondary market, there are no laws or regulations banning private briefings by float promoters. This means that large fund managers get access to the listing company’s management to help them refine their views of the company’s worth. Retail investors get none of this privileged access and are forced to rely on the prospectus, articles in the media, and their own skills and experience.

(In passing I have a suggestion for our regulators. They should “escrow” institutions that are regarded as cornerstone investors in floats. My definition of cornerstone investor would be a holding of 1% or more of the listed securities by way of the float).

In my experience of markets, I believe that over the long term the acquisition of good companies in the secondary market is a preferable strategy than simply trading floats. An investor is far better off preparing a watch list of high-quality companies (my growth portfolio) and waiting to buy these when sentiment on equities is poor or depressed, or when the market incorrectly values a stock. Given IPOs tend to come to the market at or near market peaks, you could well buy a newly floated quality company on-market, at a discount to intrinsic value, within a year of the IPO.

What are the float proceeds being used for?

How should you consider a float’s quality and determine whether an IPO is worthy of attention? I will demonstrate this using three offers currently receiving investor attention – Nine Entertainment Co, Dick Smith Holdings and Veda Group – with reference to three criteria: the use of float proceeds, ROE (return on equity) and valuation, and the relationship between capital expenditure, depreciation expense and free cash flow.

Figure 1. Selected float data – Nine, Veda, Dick Smith

Source: Nine, Veda, Dick Smith prospectuses

Floats that do not raise new capital for investment simply transfer equity ownership from vendors to the public. When a vendor walks away with all, or nearly all, the float proceeds this signals that the vendor, who knows more about the business than you the investor, thinks the stock is a strong sell at the issue price. The float of Dick Smith, in which $405 million of the $418 million to be raised will be paid out to the private equity vendors, is therefore unattractive. Nine is not much better, while Veda is the most attractive on this count. I would be more impressed with Dick Smith if the private equity vendors retained meaningful skin in the game – holdings of, say, 30% – while signalling this business has growth potential by raising new equity capital. Time will tell, but the Dick Smith float has similar traits to that of Myer a few years ago.

Return on equity and valuation

The picture is also mixed here given inadequate pro forma ROEs at Nine and Veda and the forecast impressive 29% ROE at Dick Smith. As a general rule, if the forecast ROE is below 15%, which is a “base case” test for business quality, then I will not be interested in investigating an opportunity. Further, for new floats, I maintain that a Required Return (RR) of at least 13% is required given the immense speculation that surrounds the forecasts.

Value investors who utilise intrinsic value to derive value immediately realise that stocks with ROEs that are less than the RR are worth less than equity per share. This makes the Nine and Veda floats look seriously overvalued at the offer price for each.

Dick Smith’s 29% ROE is based on FY14 pro forma earnings of $40 million, as shown in the following excerpt from the prospectus. The forecast profit is a powerful turnaround from the mediocre performance under the last years of Woolworths’ ownership. The 29% ROE is at a premium to my 13% RR for this retail consumer electronics business, and so this would justify a valuation premium to equity per share.

Click to enlarge

The stock’s $520 million market capitalisation at the $2.20 issue price is curious in light of Woolworths’ sale of the business to private equity group Anchorage for $94 million just 15 months ago. Woolworths clearly sold Dick Smith cheaply, but I still question whether the business can be worth 5.5 times as much just a little over a year later when profits are only about twice as large.

Free cash flow and underinvestment by private equity

On glancing at cash flows and capital expenditure it appears that Dick Smith’s earnings may be aggressively forecast. From the tables above we can see that capital expenditure is 140% of depreciation and this may indicate underinvestment during Woolworths and private equity ownership. Depreciation expense is set to rise sharply in FY15 and thereby increase pressure on management to deliver further on the turnaround story.

Previous underinvestment appears even worse at Veda, and indeed both companies forecast free cash flow of less than earnings after tax. This leaves little room to internally fund growth. It looks like both companies will not be big dividend payers going forward, with a requirement to retain capital to sustain growth. However, none of this is a surprise because private equity owners normally underinvest to maximise free cash flow for servicing the typically large debt burdens incurred under the private equity model.

Conclusion

From an intrinsic value perspective none of the three companies attract as “must have” investments. Clearly they will float at, or above, issue price on opening. But this is not a true reflection of their quality or value. Rather, the operating performances that are disclosed over the coming years will be the true test and I am prepared to wait for the actual trading performance than speculate on that performance. If I pay more in the future, then so be it. But somehow I suspect that I won’t be.

John Abernethy is the Chief Investment Officer at Clime Asset Management, one of Australia’s top performing equity fund managers. To find out more about Clime Asset Management, visit their website at www.clime.com.au.

Clime Growth Portfolio Statistics

Return since June 30, 2013: 12.56%

Returns since Inception (April 19, 2012): 32.38%

Average Yield: 6.06%

Start Value: $141,128.64

Current Value: $158,854.42

Dividends accrued since June 30, 2013: $3,622.96