Assessing companies who are planning to list on a stock exchange is often a lot more difficult that one that has been listed for years. There are a multitude of reasons, one of which is an absence of broker forecasts and thus, financial visibility. However, that precise reason means that companies undergoing Initial Public Offerings (IPOs) are prone to sharp share price swings in their first few weeks of trading, as both institutions and private investors make their decisions as to whether the company holds upside, or downside potential, and take their positions. In addition, investors are solely reliant upon fundamental analysis. Therefore, being able to screen the basics of an IPO is a useful tool. The 3 part series will form an introduction to IPO screening, and will point out the basics that investors should look for. Company review will resume after the series concludes.
Why do Companies List on Stock Exchanges?
The fundamental point to understand is shown in the question above. There can be numerous reasons for listing - a few key ones are listed below:
- To raise cash (When new shares are issued during an IPO, these shares carry a value, thus the company receives cash as it sells these new shares. This cash can be used to finance future growth, or pay down existing debt)
- It gives companies an ongoing ability to raise further cash in the future (Through the raising of additional equity)
- To allow pre-IPO investors to exit their investment (i.e. An IPO can be used as an exit strategy if management deem that it will generate meaningful returns for the pre-IPO shareholders)
- To broaden the investor base (This provides liquidity for major shareholders)
- As a strategy after a government or private equity owned firm is sold off (e.g. Royal Mail)
- To build up the company's brand and international profile (This can assist in building credibility with larger clients)
- A stock exchange listing can assist with launching a takeover or a merger
The Basic Details
The starting point for screening an IPO is with their Admissions Document. This is a report that contains a wealth of information about the company - it is a listing requirement that one of these must be produced for investors, when listing on the London Stock Exchange. This document can usually be found in one of two places on the company's website - under a section called AIM Rule 26, or under a section with a name along the lines of "Reports and Documents".
For the purpose of this section, I have drawn upon the Admissions document of Safecharge International Group (LSE:SCH) - the full admissions document can be found here. The first thing to notice is that the admissions document is 112 pages in length. Reading through the document can be a daunting prospect, but given that you are assessing it at the same time as potential investors means that, at some point, scan-reading through the entirety of the document is in your best interests. The first line of importance is the date at which trading in the company will begin. This can be found near the start of the admissions document. For Safecharge it reads:
The first page of importance is shown below. It includes the 'Admission Statistics' and has a generic page layout.
|Click image to view Full Size|
Figures are then given which relate to the share issue itself. The Number of Ordinary Shares in issue immediately following Admission multiplied by the Placing Price (in Pounds) gives the Market Capitalisation upon Admission. The Percentage of the Enlarged Share Capital being placed is also important, as it tells investors what percentage of the shares post-Admission will be held by new investors. If the percentage is low, then it indicates that most of the shares will be held by pre-IPO investors or directors. In such cases, it is then important to find out who these investors are and whether they are likely to sell out of the company, or continue to hold the shares. The Number of outstanding options over Ordinary Shares tells us about the potential dilution that shareholders could face. Safecharge has 5,179,330 shares are options, which represents potential dilution of 3.46%, which is fine. If the potential dilution runs above 10%, then that needs investigating.
Following this are the proceeds figures. As noted in the image, the company is planning to place 46,759,260 shares. There are currently 103,000,000 shares attributable to existing shareholders, so no extra money will be due to the company once these are listed. Therefore, the gross proceeds received by the company are the number of placed shares (46,759,260) multiplied by the placing price (in pounds). This gives the Gross Proceeds figure of £75.75m as shown. When a company lists, it has to hire advisers and firms to oversee the process. These advisers/firms take their payment once the IPO has complete, and take a slice of the gross proceeds. Therefore, the Net Proceeds are lower than the gross proceeds. The difference between the gross and net proceeds is the advisers fees. The net proceeds can be added to the company's cash balance when looking at the financials later on. The final details shown are for unique identification purposes.
Information on the Company
This section of the admissions document essentially outlines the activities of the business, but ultimately in a positive manner. It's a highly important sales pitch. The entirety of this section is worth reading, but when reading it look out for both the company's strengths and weaknesses. For example, is the company operating in a highly competitive industry or in a niche sector?
Let's take a brief look at Scholium Group (LSE:SCHO), a company that trades rare, antique books and journals. The rare-book-trading sector is undoubtedly a niche one. Included in this section are comments about what the proceeds of the IPO will be used for. A company's future strategy is more important than its existing one so ensure you check whether there are plans for radical changes within the business, using the IPO cash. If there are plans for radical changes, you need to note that the past trading performance may therefore not be representative of the future trading performance. For Scholium it reads:
The Directors intend that the net proceeds of the Placing will be applied primarily:
• to expand the Group’s stock of rare and antiquarian books and works on paper; and
• to fund a broadening of the Group’s activities, drawing on management’s experience, into trading, in affiliation with other dealers, in the wider rare and collectible goods market.
In Scholium's case it appears they are simply looking to scale up the business, so there shouldn't be a significant divergence from past financial results (in terms of gross margins etc.). The rest of the section is fairly self explanatory, although pay particular attention to the "Current Trading and Prospects" section, as that can inform investors of developments after the last set of financial results, and the creation of the admissions document. Essentially, you're just looking for a confirmation that all is well, and that the company is trading strongly.
The Group has generated profits since 1 October 2013 significantly ahead of its performance in
the same period in the prior year. The Board therefore currently anticipates that the Group’s performance for the year ending 31 March 2014 will be ahead of that of the year ended 31 March 2013. However the final result for the year ending 31 March 2014 will be dependent on the outcome of The European Fine Art Fair in late March 2014 in Maastricht and there can therefore be no guarantee that actual performance for the year ending 31 March 2014 will be ahead of that of the previous year. The Board believes that the Group has excellent prospects and, given its operational gearing, is well placed to generate a strong return on the net proceeds of the Placing, and that it will therefore deliver an attractive return to its Shareholders.
Based on the above, there is a slight worry in there that I've highlighted in red. On that basis, investors would be better off taking a conservative approach to valuing the business this year. Nonetheless, the text in green suggests that the outlook beyond the current financial year is strong.
Furthermore, look at the Dividend Policy to try to ascertain how likely it is that the business will pay out a dividend over the course of the next year or two. For Safecharge it reads:
From this you can establish the range of a dividend that will be paid. A quick document search for "EBITDA" gives EBITDA in 2013 of $5.447m. That equates to around £3.27m. The text reads 'up to half' which probably implies a range of between 25% and 50%. That gives a range of £0.8175m to £1.635m. Dividing by the shares in issue gives dividend estimates of between 0.584p and 1.09p. Using the 162p placing price, that gives a low dividend yield range of between 0.36% and 0.67%. This can be used for financial valuations later on.
Who are the Directors?
Knowing the backgrounds of the business directors is incredibly important when investing IPOs, and more importantly, in new start-up businesses. After all, as investors you don't have the comfort of having been able to witness the style of the directors, and how competent they are. Within this section focus upon the key board members (i.e. Executive Directors [CEO, CFO etc.] and the Chairman versus the Non-Executive Directors). Here are some of the questions you may want to ask yourself
- Have these board members been involved with past PLCs? If so, what has happened to those PLCs: a) During their role, and b) After their role. If the share price declined significantly during their role, that could suggest poor management, so check past news on those companies. On the other hand, was the company sold off at a large share price premium? That would suggest good management
- What links do the board have? Are certain board members high-level executives of other successful firms?
Looking at Safecharge, of particular interest is the Non-Executive Chairman Robert Withers, who looks to have significant (and successful) experience, which is a good sign.
- Do the directors hold a large amount of shares? This can be a double-edged sword. If they do hold a large amount of shares, then they will be incentivised to see the share price appreciate. On the other hand, a large chunk of the shares won't be in circulation, so liquidity could be poor, meaning the bid/ask spread could be wide. To check this, you can usually Ctrl+F for "Directors’ and other interests". Doing this for Safecharge and Scholium brings up the tables below. The relevant columns are the holdings post-admission. Relate these share holdings back into cash values using the placing price - that gives a better indication of what sort of incentives the directors have.
|Directors' holdings for Safecharge. The CEO holds 2.25% of shares, which doesn't sound like a lot, but given that amounts to a cash value of £5.47m, it's actually a huge incentive, which is positive|
- Do the directors hold many options, at what price can they be exercised, and what performance targets need to be met for them to vest? Click here for more information on directors' options
Part 1 of the introduction to IPO screening has outlined the basics of what an IPO is, why companies IPO, and the first points of interest to look out for. These are points that can be used to assess all types of companies, regardless of their sector of operation and business structure. Part 2 will look at assessing the risks of the business.