One of the starkest pieces of evidence of the effect of the global financial crisis can be seen in the initial public offering (IPO) market. Before the crisis – in the financial year 2006-07 – 221 companies joined the Australian Securities Exchange (ASX), raising $10.5 billion.

In 2007-08, that number of companies fell slightly, to 201, although the value of the capital raised almost halved, to $5.9 billion.

But in 2008-09, float activity really hit the skids. According to Deloitte, just 27 companies arrived on the ASX, raising a paltry $1.1 billion. (The ASX reckons 45 “entities” listed during the financial year, raising $1.9 billion).

Without infrastructure company BrisConnections, that amount would have been $283 million – a pitiful amount in a $1.1 trillion market. And of course, BrisConnections has been a disastrous listing in price terms, having lost 90 per cent of its value.

But the float pipeline is slowly reviving.

In September, online car classified company Limited (CRZ) debuted on the market at a 13 per cent premium to its issue price. Carsales shares have never traded below the issue price of $3.50, and currently stand at $3.89.

Carsales was a substantial float, raising $812 million for its owners, led by PBL Media. But at $2.3 billion, the upcoming float of department store group Myer – expected to list in November – constitutes a much bigger test of the market’s appetite for new issues.

Myer is being sold by its owners, US private equity groups TPG and Blum Capital Partners and the Myer family. Not only will Myer be considered a test of the market’s appetite for floats, it will be considered a test for the price tension between vendor and buyers.

Private-equity vendors are very hard-nosed. They make money by buying companies – whether privately or off the sharemarket – and running them more efficiently, building up their value, and then selling them. They do this either in a ‘trade sale’ to another company, or back to investors through a sharemarket IPO. In many cases, they sell them back to the same investors.

In addition to Myer, potential candidates to be floated on the ASX by private equity firms are considered to be camping and outdoor gear retailer Kathmandu, the former Rebel Sports chain (now part of Ascendia Retail), clothing retailer Colorado Group, car parts distributor Repco, drinks firm Independent Liquor, cinema group Hoyts, credit research house Veda Advantage, share registry operator Link Market Services, takeaway food chain Red Rooster and REDGroup Retail, the renamed combination of the local arm of US bookstore chain Borders, which was bought by Pacific Equity Partners (PEP) in 2007 and local bookseller Angus & Robinson.

Grant Hyde, corporate finance partner at Deloitte, says the important thing to remember about private equity is that when it sells a float onto the sharemarket, it is exiting the investment. “The float crystallises the private equity owner’s internal rate of return (IRR) on the investment. Therefore, the private equity owner wants to maximise the price that it can get for the IPO,” says Hyde.

Most of the floats that either have come out recently or are on the blocks to come out are from private equity vendors, he says. “The reason for that it has in the market environment we’ve had in the last 18 months, it’s been hard for private equity to exit their investments, so there’s a backlog of investments that they’re looking to exit to get their IRRs. They rely on a bullish environment to do that, either a bullish M&A (mergers and acquisitions) market for a trade sale, or a bullish stockmarket for a float. Now that the private equity firms have a bullish market, they will be looking to get floats away at the best possible price.”

This creates very real “caveat emptor” issues for investors, says Kieran Kelly, managing director and senior portfolio manager at Sirius Funds Management. “Floats are managed so as to get the best possible price for the vendor, not the cheapest possible price for the people buying the shares. Myer is a good example: investors must understand that the timing follows a 50 per cent surge in the stock market and a 170 per cent lift in the David Jones price.”

Myer is being sold through an institutional book-build that sets an indicative share price range of $3.90 to $4.90, giving it a market capitalisation between $2.28 billion and $2.77 billion. This price range values Myer at a price/earnings (P/E) ratio of between 14.3 and 17.3 times forecast earnings for the 2009-10 financial year. In contrast, Myer’s archrival David Jones is trading at 17.8 times forecast 2010 earnings.

“I think it’s opportunistic, it’s over-priced, and I wouldn’t buy it even at the lower end of the range, at 14.9 times,” says Kelly. “I don’t think the pricing sufficiently recognises that we’re coming off the bottom of an interest-rate cycle, or that Australian retail sales for a couple of years have been propped up by extravagant and wasteful government spending, in terms of the stimulus packages. Much is being made of the fact that on P/E grounds, it compares favourably to David Jones on a P/E of 17 times. All that tells me is that David Jones is probably over-priced as well,” says Kelly.

He is particularly concerned at the marketing for the float, which has the supermodel (and Myer ambassador) Jennifer Hawkins on the cover of the prospectus and acting as the face of the share issue. “We haven’t had a large float in a while, Myer is a household name business and they have Jennifer Hawkins on the cover of the prospectus to give it glamour and attract attention. But a good float is all about price, the business and market position. I don’t think Myer is well-positioned on the market, it’s not upmarket like David Jones and it doesn’t have a downmarket brand either, it exists somewhere in the middle. It’s a business struggling for a niche. We just don’t think it’s good value.”

Worse, says Kelly, the Myer float “shows a very disconcerting tendency for the venture capitalists selling over-priced floats to an unsuspecting public.”

Independent share analyst Roger Montgomery also believes that Myer is over-valued, but he says that is perfectly understandable from the vendor’s point of view.

“If you or I were them, we’d be doing the same thing, it’s completely rational. They want to get the best price for their asset they can, not offer the best bargain for the buyers. They’ve signed up virtually every investment bank in Australia to push this thing, which removes any criticism. Everyone is out there trying to get it away. All that is completely understandable from TPG’s point of view, but it doesn’t change the fact that on my calculations, the stock is worth $2.90.”

Montgomery says Myer has $738 million of equity, some of it is capitalised interest costs, generating about 27-28 per cent return. “If investors are looking for 12-13 per cent return pre-tax for their investment, it’s worth $2.90 a share.”

In the prospectus, Myer projects the roll-out of 15 new stores over the next five years. Montgomery says he has taken the gross profits and EBIT (earnings before interest and tax) numbers and projected that out over the 15 new stores, assuming that each makes $40 million in revenue in the year that it opens.

“Even on that optimistic assumption – stores take a couple of years to become as profitable as an existing store – I end up with an intrinsic value for Myer in five years’ time of $3.90, which is the low end of the bookbuild range today. So at the low end of the range today, you’re being asked to pay the intrinsic value of the business in five years’ time. If you’re prepared to wait five years, you’re getting fair value.”

Montgomery says it is the “classic case” of a private equity vendor maximising its exit value. “The evidence of that is not in my calculation of intrinsic value, the evidence of that is the fact that they got the business for free, they’re going to walk away with 100 per cent of the proceeds, and they took cash out of the business while they owned it.”

Myer’s consortium of owners bought the business in 2006 for $1.4 billion, comprising $400 million of equity and $1 billion of debt. “In the first year they owned the business, they sold a 299-year lease on the Bourke Street store, for $605 million, and they had a big clearance sale, which netted them $150 million-odd. Then they actually then paid themselves about $525 million back in dividends and capital returns in the first year,” says Montgomery.

“They got ‘free carry’ on a $3 billion revenue business after one year, which effectively means they got the business for free. There’s nothing wrong with that: It’s just very smart. They recognised something that previous management couldn’t see. But now, having got the business for free, the evidence that they’re maximising the return to them is not only in the price they’re getting for it – or requesting – but also the fact that they issued 3.5 million shares to executives just prior to the announcement of the float, and also the cash they took from the business as they leave.”

Kelly says Myer is clearly relying on retail investors – its MyerOne loyalty card members – to get the float away. “I don’t believe that institutions are going to pay 17 times earnings for Myer. That’s one of the weaknesses of it: on day one, it’s going to list with, I think, very little institutional presence on the share register. That’s why I don’t see it as a potential ‘stag’ situation. (A ‘stag’ is where an IPO is sold for a profit when it lists on the market.)

“Say it goes off at 17 times earnings. If a reasonable stag profit is 10 per cent, that means Myer has to trade at 19 times. I think it’s over-priced at 17, so it’s outrageous at 19. Who’s going to buy it at 19 times? That’s what you’ve always got to work out in a stag situation: you’ve bought it, but who’s going to buy it from you?” says Kelly.

Suwai Hoh, managing director of Intrinsic Analytics, an online subscription fundamental valuation tool for small investors, says he is happy to buy Myer at the lower end of the price range, but would not want to pay more than $4.20.

“We ran a few cases and sensitivities, and based on very mundane growth, just at CPI (consumer price index, that is inflation) over the mid-term (five years), we’d say about $3.50-$3.80 was a fair enough price for it – about 14-15 times earnings from the way we work our numbers. But if you put in a bit of real growth, say 1 per cent above CPI, you start to look at a price around $4. Therefore if they come onto the market to the small shareholders at $3.90-$4, I think that’s OK.”

If you factor in 1 per cent real growth in the midterm and the long term, this yields a value range of $4.20-$4.70, says Hoh. “It depends on how fast they can grow their sales. If their performance is good they actually get up to $4.50-$4.70, but that’s unproven, and therefore there is a high risk to that scenario. I would probably be willing to subscribe up to maybe $4.20, but anything over that is too expensive,” he says.

Hyde says there is always tension between the vendor and the buyer, but for the sake of the health of the IPO market, it would be good to see Myer perform well in the after-market, as Carsales has done. One thing that the market will watch closely in this regard, he says, is the extent to which the vendors retain an interest post-float.

The Myer family, which currently holds an 8.8 per cent stake, reportedly plans to sell down its shareholding to no more than 1.5 per cent, and might exit altogether, while TPG and Blum Capital may retain a stake of up to 13.5 per cent following the IPO process – but the pair reserve the right to exit the share register altogether, depending on market conditions at the time of the float, the level of investor demand for the stock, and feedback from potential investors on whether they would prefer the company to remain on the register.

If the pair sell out completely, they could receive up to $1.9 billion from the sale of their combined 81.4 per cent stake. If so, when added to the $525 million dividend it received in 2007, TPG will have more than quadrupled its original $500 million investment.

Hyde says there are “competing issues” in whether a private equity vendor retains a stake after the float. “One, it gives potential investors the confidence that the firm is confident in the company’s performance; but two, it can also be perceived as an overhang of stock on the market, which will need to be sold down, therefore it puts pressure on the price.”

Another thing investors have to assess, he says, is the extent of the management’s stake in the company. “That’s a very important factor. Investors need to see that management is incentivised and aligned with shareholders in terms of trying to maximise shareholder value instead of their own,” he says.

If Myer “holds up” post float – and the stock market continues to perform well – Hyde expects to see a flurry of floats next year, but does not believe we will see 200-plus companies joining the market annually for quite some time. “I expect to see a lot of floats next year, simply because there are a lot of private equity firms looking to exit their investments.

“We’ll see a lot of companies middle-market companies looking to do rights issues and equity raisings to strengthen their balance sheets, because the big companies have already done that: there was $90 billion of capital raised in the year to 30 June. So there will be competition for capital from existing companies, but we do expect to see a pick-up in new IPOs.”

Hyde tells companies there is no point in listing on the ASX unless they’re going to have a market cap of $100 million-$150 million-plus. “If you’re not at that level, you just don’t get the following. Just because you’re listed on the stock exchange, it doesn’t necessarily mean that you’re going to be able to raise money easily post-float. You need to have that sort of market cap so that you’re followed by a few analysts: you need to have some interest in the stock.”  
If the market cap is less than $100 million-$150 million, arguably it should be held by private equity or privately, he says.

IPO Pipeline

Source: Mergermart/Deloitte

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