New issues – Old problems

The last few years have seen a large number of IPOs come to market. Now the dust has settled it is interesting to see the wide variation in performance. For example, Just Eat and Auto Trader have both risen over 50% since IPO, whilst Poundland and AO World have fallen over 40%1. Why do some IPOs succeed and others fail? Of course every example will be different. However I believe there are some common themes which investors would do well to consider before participating in any IPO2.

It is worth noting that AO World, Poundland, Just Eat and Auto Trader were all eagerly anticipated IPOs. Although they were all being sold to the market on high valuations, they were deemed to be high quality businesses, with excellent market positions, and strong growth potential, and therefore worthy of such valuations. As a result, there was high investor demand to participate in these IPOs, and on the first day of trading all four shares performed well, with AO World a particularly strong performer, rising 45%.

In my view, the reason why AO World and Poundland have underperformed since IPO is because they proved to be much lower quality, lower growth, and riskier businesses than the market expected. This became apparent to the market overtime, as the two companies started reporting disappointing financial results, and investors’ familiarity with the business models increased. As a result the market has significantly decreased the valuation for both companies.

In Poundland’s case, investors failed to properly consider its lack of pricing power (it does after all sell everything for £1!), and the strong levels of competition from other discount stores. When growth started to slow because of increased competition, and costs started to rise, in part due to the national living wage, the frailties of the business model became apparent. In AO World’s case, investors failed to consider the strong competition from existing store based retailers who have a similar price and service proposition, while also not factoring in the risks associated with their expansion into Europe. Costs from expansion into Europe grew beyond expectations, while growth slowed in the UK which the company responded to by increasing marketing costs. Unsurprisingly, investors were disappointed and the valuation fell.

In contrast, since their IPO, both Just Eat and Auto Trader have demonstrated the strength of their business models and growth potential. They have delivered financial results which have surpassed investor expectations, thereby validating investors’ initial perceptions of the businesses and justifying their high valuations. Of course both companies are not without their risks. Strong revenue and profit growth always attracts competition. For example the competitive strengths of Just Eat are under increased scrutiny at the moment due to the success of Deliveroo, and the possibility of amazon providing a similar service in the UK. But thus far, both Just Eat and Auto Trader have shown that their business models are resilient enough to withstand competition.

The above example is illustrative of how the interplay between fundamentals and expectations is what really drives shareholder returns. All four IPOs were presented as high quality, growth companies and as a result commanded similarly high valuations. But in practice, the four business models actually differ quite markedly. Poundland is a plain vanilla retailer operating in a highly competitive sector. AO World is an online business model, but in truth it has little to differentiate itself from other online behemoths. Just Eat and Auto Trader on the other hand are platform based business models. They offer a digitally enabled online service that significantly reduces transaction costs for restaurants and car dealers. The network effect means that as the customer base grows, the value of the service becomes greater, making it ever harder for competitors to compete. This is why, in my view, they have proven more resilient than AO World and Poundland. Importantly, this is not just a hindsight analysis as these differences were clearly identifiable at the time of the IPOs.

I tend to approach every IPO with a healthy level of scepticism because those selling the business will always seek to emphasise attractions and de-emphasise flaws. The performance of an IPO in the first few days of trading is always difficult to predict, however after this the shares will be increasingly driven by the company’s operational performance and how this compares to investors initial expectations. This is why the first few financial results of a company post IPO are so important because they start to indicate whether investors’ initial perceptions were correct or not.

Matthew Hall

 

1. Source: Bloomberg, 16/03/16
2. This is no recommendation to buy or sell any particular security

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Author - Matthew Hall

Matthew Hall

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