Investors are regularly presented with opportunities to invest via initial public offerings (IPOs) in companies that may appear to be promising businesses, but have not yet turned a profit. Without a track record of earnings, how can investors assess their future prospects?
IPOs without a track record of profits
Before listing, a company must comply with a number of admission rules, including a financial test to satisfy the Australian Securities Exchange (ASX) it meets minimum requirements for size, quality and operations. A company can satisfy this financial requirement by either demonstrating it has a track record of delivering a profit (the profit test) or alternatively has sufficient assets (the assets test). In turn, the assets test can be met in one of two ways, with a minimum of $5 million in net tangible assets (NTA), or a minimum $10 million market capitalisation (the ASX is considering changing the profit and assets tests thresholds).
Companies in the early stages of their lifecycle, such as IT and biotech start-ups and mining exploration companies, may be more likely to use the assets test to meet the admission requirements.
Here are nine factors we consider at Wilson Asset Management when assessing an IPO:
- Management quality and track record: When assessing an IPO with no earnings, management is the most important factor. As I have written in Cuffelinks previously, aspects we assess when valuing a company’s CEO and management team include their track record and whether or not they have had previous success in a similar venture. In 2009, the former CEO and Managing Director of REA Group Ltd (ASX: REA), Simon Baker, joined iProperty Group together with some of REA’s senior managers. As this management team had achieved great success with REA, we had confidence in their ability to achieve the same results with iProperty. Our faith was affirmed when the business was sold last year for $4.00 per share (to REA) after listing at 25 cents per share in September 2007.
- Management’s interests: When a company floats, the management, including the founder(s), have the opportunity to realise the value of their equity in the business by ‘selling-down’ their stake to new shareholders. It is critical that the management (particularly, the board and senior managers) holds equity in the company after the IPO. Their level of ‘skin in the game’ reflects their faith in the future success of the business. This is always a key factor but it is particularly important for early stage companies given their greater potential upside. A relevant example is the high profile internet streaming business Guvera which was recently barred from listing by the ASX. With a market valuation of $1.3 billion and no earnings, the management team’s intention was to sell-down the majority of their holdings in the business, according to media reports. Provisions in the prospectus to escrow shares in the company owned by management, and the length of these escrow periods, are important in determining if management has an interest in the company’s success over the longer term. It is also critical to ensure the interests of management will be aligned with the future shareholders’ interests through remuneration and incentive structures.
- Capital required to break-even: It is crucial to understand when a business anticipates it will reach a break-even point and determine how much capital is required to reach this stage. While an IPO provides an injection of capital to fund a company’s operations, it may require additional funding before it will break-even.
- Revenue: Although a company may not be turning a profit when it lists, it may be generating revenue which can be a good indicator of future earnings. While valuing an IPO based on its revenue multiple is often shunned by Australian investors, it is commonplace in the United States. In our recent experience, companies valued on this basis can perform strongly in the aftermarket. Technology company Aconex Limited (ASX: ACX) listed in December 2014 and is currently incurring additional costs as it invests in its future profitability. While it is approaching profitability, it is generating revenue through quality contracts with significant corporates. Importantly, it has actual revenues and shareholders are rewarding them with its shares soaring close to 300% since its IPO.
- Prior capital raisings: If a company listing has recently raised capital in the unlisted space, the price at which it was raised and the ‘uplift’ the existing shareholders will receive at IPO is important in understanding if the shares represent fair value.
- Intellectual property: If a company’s business model is reliant on the commercialisation of some intellectual property, investors need to understand those assets and ascribe them value over the longer term. For example, given the declining rate of cash withdrawals as Australia transitions from a cash-based to a cash-free economy, the value of an ATM software business would have been considerably greater ten years ago.
- Competition and barriers to entry: A business’s competition and the barriers to entering their market will potentially impact its future performance or viability. Potential competition from large industry players that can draw on their scale, networks and other existing assets to compete aggressively should be analysed. Three years ago, Mint Payments Limited (ASX: MNW) caught investors’ attention with their innovative wireless payment software. Inevitably, major nationals and multinationals like Apple, ANZ and Commonwealth Bank began competing with Mint through the launch of comparable products. Mint’s share price has dropped sharply.
- Third party endorsement: Third party support adds to a company’s credibility and can be a positive indicator of future performance. The presence of large corporates on a company’s share register is one form of endorsement. For example, given their considerable industry insight and experience, having Australian-based carsales.com Limited (ASX: CAR) on their register is a plus for iCar Asia Limited (ASX: ICQ).
- Future earnings valuation: It is worth considering how the market will value a business once it starts generating earnings to ensure it uses a sensible valuation tool such as price to earnings ratio or enterprise value.
Investing in a company without a track record of earnings via an IPO is a high risk game requiring investors’ patience. To determine if an IPO represents a good investment proposition, prospective shareholders must consider a range of factors and invest time to gain an in-depth understanding of the company and its operations.
Chris Stott is Chief Investment Officer at Wilson Asset Management.