The propensity of sharemarket floats to downgrade their profit forecasts within a year of listing is breathtaking. Aggressive “pro forma” prospectus forecasts inflate the valuation, and management and advisers spruik the assumptions behind earning projections.
Within six to 12 months the company is forced to downgrade its earnings guidance – a credibility destroyer if ever there was one for an initial public offering (IPO). How can investors trust management if their forecasts have such a wide margin of error?
It confirms my theory that too many prospectuses are fiction rather than fact where it counts most: earnings projections (for companies that provide them). And that most floats are best bought when there is at least a year or two of trading history as a listed entity.
Waiting to buy floats in the secondary market when stock is more available means missing out on occasional stag gains and a rally after listing, but it provides an opportunity to buy higher-quality IPOs after they are smashed when their earnings disappoint.
Which brings me to Murray Goulburn, Australia’s largest dairy process company. MG Unit Trust raised $439 million in a July 2015 IPO amid much fanfare. It was a clever structure: investors could participate in Murray Goulburn’s earnings pool that is linked to the farmgate milk price, without dairy farmers relinquishing control of the dairy co-operative.
That broad structure was the basis of the $414-million IPO of Fonterra Shareholders’ Fund in 2012. Fonterra’s $4.34 issued units, covered for The Bull in September 2014, trade at $5.29,
The Murray Goulburn IPO benefited from a powerful theme: Australian dairy producers would benefit from China’s seemingly insatiable appetite for dairy as incomes rose. Strong gains in New Zealand daily producers a few years back reinforced the potential.
Funds raised from the MG Unit IPO would help Murray Goulburn invest in processing facilities, add more value to its dairy products, and enjoy higher profit margins. After a slow start, MG Unit rallied from a $2.10 issue price to almost $2.75 as agricultural stocks were re-rated.
Chart 1: MG Unit Trust
Source: The Bull
Then came easing dairy demand from China, farmgate milk prices under pressure and the prospect of overly ambitious dairy forecasts in MG’s prospectus. Murray Goulburn slashed its earnings forecasts this week by a whopping 33 to 38 per cent and its CEO, Gary Helou, resigned.
The share price, already under pressure, plunged from $2.14 to $1.24 on the news. Investors who paid $2.10 for MG Unit less than a year ago had lost almost half their investment on paper. By IPO standards, MG Unit’s first year as a listed entity was a disaster.
But every stock has its price. I’m normally avoid IPOs that miss prospectus forecasts because the first earnings downgrade is rarely the last. Also, Helou’s resignation adds another layer of risk to MG Unit when uncertainty is already high.
Still, MG Unit is worth watching for five reasons.
First, the underlying thematic of rising dairy consumption in China is intact. Predictably, the market overshoots on the potential of megatrends and company management fuels the optimism. Longer term, the coming boom in Asian middle-class consumption has to change diets and increase dairy demand.
Second, the MG Unit board looks like it has encouraged management to get as much bad news out as possible – a common strategy when CEOs resign and the board wants a cleaner slate for their replacement. MG Unit Trust looks like it has taken a conservative stance on milk powder sales this financial year and sharply reduced market expectations.
Third, MG Unit is strongly leveraged to an expected improvement in dairy commodity prices and a lower Australian dollar in the next year or two. Dairy food volumes are still in line with prospectus forecasts, so it’s a case of waiting for better prices.
The fourth factor is valuation relativities. Rising demand for Australian agriculture is a strong investment theme, but finding companies that are well placed and trading below their intrinsic or fair value is hard work. Several agriculture-related stocks look fully valued at best.
Sentiment is the fifth factor. MG Unit Trust is horribly out of favour. The extent of its downgrade, within a year of listing, has rattled investors. Management uncertainty will weigh on MG Unit Trust and it has plenty of work ahead to restore market confidence. More bad news could quickly take the price below $1.
Yet for all the negativity, Murray Goulburn has a good long-term record and an excellent opportunity in Asia. It’s paying a deserved price for over-optimism in its prospectus, which was strange given the dairy co-op has always been conservative.
I’m betting MG Unit Trust will head lower before it regains its market mojo, remain volatile for this calendar year, and offer a better buying opportunity for bargain hunters in coming months.
Tony Featherstone is a former managing editor of BRW and Shares magazines. This column does not imply any stock recommendations or offer financial advice. Readers should do further research of their own or talk to their adviser before acting on themes in this article. All prices and analysis at April 27, 2016.