Introduction to IPO Screening: Risk Assessment

 

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. 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.

Assessing Company Risks

The next important part of IPO screening, is to look at the "Risk Factors" section of a company's admissions document. This outlines the main overt risks that the company could face moving forwards - includes such a section is once again a  requirement, so this can include a lot of particularly useful information. Unfortunately, the fact that it is a requirement also means that companies are obliged to include risks that aren't really likely to alter an investor's viewpoint. Therefore, investors need to be able to distinguish between risks that pose a credible threat to the company's future operations, and those that pose a negligible threat. There will be some sector-specific risks (For example, one of the risks for an Oil & Gas company may be their ability to renew the blocks in which they operate), which I will cover in later tutorials. The focus of this tutorial is to look at the risks facing non-resource income-producing companies.

The Overt Risks

I have categorised the risks into two sections. The first are the overt risks - the risks that the company outlined within their admissions document. The second are the covert risks - these are the risks which are harder to spot, and that may not be explicitly stated. For the overt risks, I'll look through an example admissions document - that of windows and doors manufacturer and retailer SafeStyle (LSE:SFE). The company came to market in late 2013. 16 overt risks are listed, so we'll go through these one-by-one intuitively assigning a mental rating of how important it is. SafeStyle's admissions document can be found here - I won't copy out each risk factor, so it'll help to have the admissions document open in another window. Take note that the threat levels assigned are specific to SafeStyle, and will vary with the company screened.

Regulatory - This risk is linked to the company operating in a highly regulated sector "including consumer protection and consumer credit regulations". Indeed, there is an underlying thought that companies such as SafeStyle are prone to persistent sales techniques. However, in the scheme of the entire business, this risk can't be defined as frequent. Investigations into malpractice are often infrequent and take a long time. It therefore doesn't post a high risk, as investors can often exit their position when they first learn of any potential malpractice. The real threat is if investors hold through the investigations and the company ends up being fined - that is an avoidable threat. Medium threat
It's worth recognising that companies operating within sectors could have a significant regulatory risk. This would be the case for companies operating in the gambling or tobacco sectors
 
Reputation with customer base - This is linked to the above point. The threat is lower than the regulatory threat as the company has scale, as evidenced by the ~£110m in revenues brought in during 2012. Barring a catastrophic problem within SafeStyle, the reputational threat is likely to be low. However, bearing in mind that the company is also heavily services based (people from SafeStyle install the products), there is more of a reputational threat compared to a product-based company. Low-Medium threat

Market and competition - This is more of a threat. The products that Safestyle offer are largely homogeneous, and there are few barriers of entry to the industry. Multi-chain companies such as SafeStyle often face competition from independents as well. However, companies are more likely to be prone to competition threats if they have matured revenue channels - revenues are SafeStyle grew by circa 16% between 2010 and 2012, which suggests that the risk is unlikely to be high. The windows/doors industry is particularly cyclical given that it also mirrors the state of the housing market. That works both ways in that it's good news in a strong economic environment, but not in a weak economic environment. Currently, the housing market continues to be strong and the economic recovery continues to move forward. Medium threat

Competition risk is likely to exist for companies who dominate a market with a high market share, and particularly those whose dominance is reliant on a key patent or innovative technology. If that patent can be bypassed or alternative technologies developed, then this risk is serious.

Future strategy - As per the picture below, the short description of this risk confirms that it is not material given the nature of the business. The company should continue to be able to gain market share. Low threat


Data Protection - Investors cannot legislate for this. Low threat

Acquisition risk - If acquisitions are pursued, investors can analyse these themselves. It is clearly in the company's best interest to acquire companies in a successful manner. Acquisitions are not particularly common for mid-cap companies either. This is not a threat that is specific to SafeStyle. Low threat

Reliance on key suppliers - This is a credible risk given that it relates to the core operations of the business. However, this risk is usually fairly easy to mitigate, by having backup plans in place. Furthermore, it's almost certain that SafeStyle will track the position of their key suppliers (e.g. how financially healthy they are), so can plan ahead. In reality this is a risk that every company will face in one form or another, and material problems are not common. In the admissions document, it also notes the below. Low-Medium threat

 
Operational costs - This appears to be of low risk to the group. Low threat

Dependence on key personnel - This is a formality. It it nearly always the case that successful companies are able to recruit high quality personnel in the case that they lose their current management. With a company of SafeStyle's size (Over £150m market cap), recruiting experienced personnel is unlikely to be a problem. Low threat

Self-employed individuals - A  formality. The admissions document states that there have been no issues relating to this in the past, plus the scale of any problem is likely to be small. Low threat

Liquidity and possible price volatility - A formality. The company is obliged to tell readers that the value of their investment may go down as well as up etc. However, there is a rather more subtle point related to this. As per the first tutorial, one of the details given is the percentage of shares that the newly issued shares represent, in relation to the total shares in issue. This is important.

If a large number of shares are held in the hands of directors and long-term institutional investors, then liquidity in the stock is likely to be poor. That can lead to a widened spread, thus a less attractive investment proposition. One way you can check for the likely liquidity post-IPO is to examine what proportion of shares post-IPO will be held by institutions and directors. Looking elsewhere in the admissions document, that percentage comes to around 10%. That means that there is likely to be decent liquidity within the market when the company lists, as the percentage is low. That means a tight spread and an improved investment proposition. That did turn out to be the case, although the stock has become more illiquid as there has been major institutional buying which has taken stock away from retail investors. Low threat

As a side point here, it looks like the IPO was an exit-strategy for a major shareholder. Notice that the pre-IPO investors sold down their stake.


Legislation and tax status - A formality. Low threat

Economic, political, judicial, administrative, taxation and other regulatory matters - A formality for Safestyle. Most of these do not have any impact of the company. Low threat

Forward looking statements - A formality. Low threat

Areas of investment risk - A formality. Low threat

Taxation - A formality given that Safestyle operates in the UK. Corporate tax rates in the UK are set to continue falling towards 20% so this is not an issue. However, for low income countries, there could be a tax threat. Low threat
On the whole, there is nothing particularly worrisome in the overt risks that SafeStyle have outlined. The general level of threats is low, and that will typically be the case for most companies. However, the occasions when threats really are material are the ones to look out for. As an example, JQW (LSE:JQW) had a material liquidity risk as a main board member held significantly over 50% of the total shares in issue, and several other large shareholders held large chunks of the stock. That has led to the spread in JQW being very volatile, and often extending to 4-5%. Moreover, JQW's share price is prone to volatility because of this. As you can see, many of the risks are just formalities, so can be brushed aside and ignored.

Sector-specific threats are likely to carry more weight. For example, a company operating in a gambling industry is prone to heightened regulatory risks. Many governments see as a demerit good, hence is taxed heavily and subject to relatively more frequent changes in legislation that can have material impacts upon the business. In April 2014, an increased tax on fixed-odds betting terminals was introduced, that led to sharp declines in the share prices of betting companies include William Hill and Ladbrokes. So whilst there may not be any material overt risks in SafeStyle's operations, there is every chance that there will be in other sectors.

The Covert Risks

Covert risks often carry a more credible threat that overt risks, but rely upon an investor to quantify them. This type of risk can take many forms, and these forms can vary massively dependent upon the firm and sector of operation in question. Due to the sheer number of forms that covert risks can take, I've only outlined a handful below. The 'answers' to these covert risks can always be found within a company's admissions document, although the location of the details may be more difficult to find. These are also more serious threats than most of the overt threats listed.

Country Risk - This is one of the more obvious covert risks. A company operating the same business in Sub-Saharan Africa and in the UK is likely to face an increased number of governmental issues in their African operations compared to their UK operations. Those issues often include governmental delays in the granting of certain permissions, and threats which include infrastructure threats. That could be as simple as a company finding it difficult to scale up their operations due to a lack of direct road routes between their factories, which risks losses of scale, which could lead to competitive disadvantages.

Other country risks could relate to the business environment. For example, in some countries, a business may find it difficult to receive payments for its goods and services on time. Alternatively, the business may be subject to a sudden change in legislature. Taking an extreme fabricated example, say that Oilio is a small oil company with licences in Estonia. If Estonia passed a law to prevent oil exploration, or hiked the royalty they would receive on any oil production to 80%, then oil exploration in Estonia may no longer be possible, or economical. In that case, Oilio would lose its main operating area, and undoubtedly suffer a major setback in its share price

Major Shareholder Risk - When investors hold a significant proportion of the stock (usually 15%+), they start to carry weight with reference to owning a large proportion of voting rights. Large shareholders can also requisition Extraordinary General Meetings (EGMs) to try and push through their ideas, which may not be in the best interests of the company. For example, one of those ideas may be to delist the company. Those risks mirror across to when directors hold large percentages of stock. As an example, LZYE Group's (LSE:LZYE) directors announced their intentions to de-list the company from the LSE in April 2014. That uncertainty and loss of a transparent market mechanism, led to the share price falling rapidly.

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A second point here relates to Chinese companies. Recently, many have listed on AIM and within very short order their major investors have been selling down stock rapidly. That has been a trend, rather than one company being an exception to the rule. Four examples include Camkids Group (LSE:CAMK), Naibu Global (LSE:NBU), China Chaintek (LSE:CTEK) and JQW (LSE:JQW). These sales have trashed the share prices - it would seem there is an underlying motive for these sales given that all four companies are based in China. Perhaps it is something to do with extracting money from China through foreign IPO schemes. Each of these companies has stunningly low valuations on the face of it - this proves that even when valuations look compelling, the major shareholder risk can mean that the shares are worth avoiding.

When looking at major shareholders, check the lock-ins that they have. Lock-ins are dates at which the major shareholders are not allowed to sell shares until (unless in an orderly fashion). Pay careful attention to those dates, as it can sometimes be beneficial to sell prior to them, just before the major shareholders start to sell down their stakes upon expiry.

General Financial Risks - This includes risks linked to large debt burdens or falling revenue trends. Could the company be subject to a large fall in its profits? See the site's other tutorials on fundamental analysis to help assess these risks - this will also be covered in the third tutorial

Liquidity Risk - This once again relates back to the proportion of shares that are issued to new holders when a stock lists, compared to the total shares in issue. If most shares are held by directors and institutions, the shares could be subject to wide bid-ask spreads because there are not many shares in circulation. That is because directors and institutions tend to hold onto their shares for long periods of time, rather than trading them in the market. That lack of circulation means that it can sometimes be difficult to find a buyer or seller for your stock, thus if bad news is released, you could find it difficult to exit your investment at an acceptable price (to you). This risk is normally noted on all admissions documents, but you should check yourself what sort of liquidity will be likely

Customer Dependency Risk - Many small-cap companies are reliant on a small number of customers for a significant proportion of their revenue. If that customer ceases business with the company, it can leave a hole in the company's finances. This point will be addressed in greater detail in the third tutorial

Exchange Rate Risk - Most UK-listed companies report in sterling, and ultimately it is sterling that is important for investors. Therefore, if a company operates abroad and does not have hedging contracts in place, it is subject to exchange rate movements. If the foreign exchange rate depreciates significantly against the Pounds, then the revenues recognised in sterling will be lower, thus the valuation of the company will be weaker. Look to see whether the company is heavily reliant on any particular exchange rates, and whether they have hedging contracts in place to mitigate unexpected movements. This point will be addressed in greater detail in the third tutorial

Further Cash Raising Risk - Does the company have a strong balance sheet and enough cash to finance material developments over the next year? Or does the company look like it will need cash in the future. In many admissions documents, the companies openly admit that they will need to look to raise cash after X months, and that can cap share price upside. The reason is that investors will know that a placing is on the horizon, and in all likelihood it will be at a discount to the share price. They therefore hold off buying the shares until that placing has been completed - they have no incentive to buy the shares beforehand

These are only a sample of some of the risks that are covert, and that are not openly covered by the 'Risk Factors' section of the admissions document. One of the most glaring risks that investors face is the Overvaluation Risk, where the IPO has been completed on levels that make the company in question look particularly expensive. That has been the case with BooHoo (LSE:BOO) in 2014, which has seen its share price lose the entirety of its share price premium, dropping from 70p to 50p in a matter of weeks, after it IPO'd around 100 times profits. The third and final part of the introduction to IPO screening will address valuing newly listed companies, and how to spot the overvaluation risk.