Seven IPOs worth a second look

The following article appeared in the AFR 1 April 2017 by Tony Featherstone. (Please excuse the formatting, AFR make if difficult to cut n paste. Never the less, a good read

The recent takeover bid for Spotless Group Holdings highlights the volatility of some sharemarket floats – and the opportunities for investors who avoid the hype around new listings and watch and wait for better value down the track. Spotless raised $994 million in an initial public offering (IPO) in May 2014. Shares in the private equity-backed firm tumbled from a $1.60 issue price to 70¢ earlier this month as the market lost confidence after earnings downgrades.

Downer EDI's takeover bid drove Spotless shares 50 per cent higher in a day. Investors who bought Spotless earlier this year got the company for less than half its IPO price.

Spotless is an extreme example of IPO volatility. Many floats rally in their first year as a listed company, then slump as reality sets when earnings forecasts are downgraded or early investors sell IPO stock when escrow restrictions lift.

"Several floats over the past few years have done well for a year or two before taking a big hit," says Julian Beaumont, chief investment officer at Bennelong Australian Equity Partners. "Often, the business is 'dressed up' for sale by vendors who scale back capital investment, cut costs or bring earnings forward to make the business look more profitable. Ultimately, the underlying business strength will prevail and be reflected in profitability."

Weekend AFR analysis of the 50 largest IPOs since 2014 shows that almost a third of these floats trade below their issue. Spotless, Estia Health, Healthscope, MG Unit Trust, Wellard, iSentia Group, 3P Learning, Adairs and Simonds Group headline a list of disappointing IPOs. A median gain of only 5 per cent for all 50 IPOs over 2014-17 (compared with the issue price) emphasises the risks.

There have, of course, been a handful of stars: Costa Group Holdings, APN Outdoor Group, Bapcor, SG Fleet Group, oOH! Media and Wisetech Global, for example. But even high-performing IPOs, such as the intellectual property service group IPH, have experienced a rollercoaster ride, notching big gains before thumping losses. IPO risks should be well known by now. The seller knows much more about the IPO than the buyer and IPO investors rely on pro-forma financial accounts based on vendor assumptions and projections.

Glennon Capital chief investment officer Michael Glennon says too many IPOs are priced for perfection. "There needs to be a bit of slack in the IPO valuation in case something operationally goes wrong," he says. Still, every IPO must be judged on its merits. And although private equity (PE) vended IPOs have been criticised, some PE floats have produced good gains over the years.

But there's a reason why top-rated fund managers, such as Bennelong, invest in only a few IPOs each year. Finding high-quality IPOs with an attractive valuation is hard work. Many professional investors prefer to wait until the IPO has more history as a listed entity and its financial accounts have had greater scrutiny. Sometimes that means missing a few goldmines to avoid many more landmines.

Beaumont says opportunities are emerging in mid- and small-cap stocks, including IPOs, after a correction that started in the fourth quarter of 2016.

"The quality of IPOs over the past three years has been relatively good overall. The market demanded higher quality after earlier disasters. The small-cap correction has made some of these IPOs more attractive because their valuations are no longer as toppy and, in select cases, their prospects have improved."

Here are seven small- and mid-cap IPOs from the past three years that fund managers favour:

Catapult Group International

The sports analytics provider starred after listing in December 2014, its 55¢ issued share racing to $4 within 18 months. Investors loved Catapult's prospects in wearables technology that helps elite sporting teams monitor athletes' performance and manage injury risk.

But Catapult's 2016 acquisition of XOS Technologies, a provider of digital and video analytics software, and Kodaplay, a developer of wearables analytics software for "prosumers" (keen amateurs) tested the market.

The correction in small-cap growth stocks in the fourth quarter of 2016 intensified selling in Catapult.

Monash Investors co-founder and director Simon Shields says this price weakness is an opportunity.

Shields rates Catapult's potential in the prosumer market, as amateurs and schools embrace the same sports analytics technology that elite teams have used for years.

"Catapult's next big leg of growth is prosumers," he says. "We envisage schools subscribing to the technology on a per-player, per-month subscription model, which in time will add to the visibility and recurring nature of Catapult's earnings and the strength of its business model."

Recent news that Major League Baseball in the United States had approved Catapult as a vendor for Global Positioning System-based wearables technology added 11 per cent to its share price. The approval exposes Catapult to 272 major and minor league baseball teams and lifts its profile among US schools for student baseball teams.

Shields says Catapult's estimated 12 per cent share of its industry is much larger than competitors. That enhances Catapult's ability to compete with lower-priced products.

This month, research group IDC predicted global sales of technology wearables – smart watches, smart clothing, "hearables" (smart headphones) and other gadgets – would double by 2021.

AirXpanders

Investors are right to beware US-based medical device companies that listed on the ASX. GI Dynamics Inc, a 2010 IPO, has disappointed and Reva Medical, another listing that year, have mostly traded below their issue price.

AirXpanders could be an exception. The US Food and Drug Administration in December 2016 approved the company's AeroForm Tissue Expander System, paving the way for a commercial product launch in the US this year. The technology was approved for sale in Australia in late 2014.

AeroForm is a needle-free alternative for women who choose breast reconstruction surgery after a mastectomy. The device uses a handheld wireless controller to activate small amounts of carbon dioxide up to three times a day, to stretch the tissue and prepare it for a breast implant.

Shields expects high take-up of the device in the US. "Australia has a waiting list of surgeons who want to be trained in the device and we expect that to be the case in the US. Although it will take time, the product rollout should be smooth and AirXpanders' sales should start to pick up from next financial year," Shields says.

AirXpanders values the addressable US market for its technology at more than $US800 million ($1 billion) and believes its technology will "positively redefine" the breast reconstruction process. US mastectomy rates are rising.

After raising $39 million through a June 2015 float, AirXpanders rallied from 50¢ to a 52-week high of $1.48. It then fell to 86¢ despite significant operational progress. The sell-off could be an opportunity for investors who understand the risks of micro-cap stocks.

QMS Media

Outdoor advertising companies starred in the 2014 IPO market. oOH! Media tripled its issue price at its peak and APN Outdoor Group more than doubled. A June 2015 float, QMS Media, has had less profile and smaller gains.

Out-of-home advertising has good prospects. The segment is increasing its share of total advertising as printed billboards are digitised. Electronic roadside ads are providing new options for advertisers and higher yields for ad suppliers.

Pengana Emerging Companies Fund co-manager Steve Black says investors have overlooked QMS for its larger outdoor rivals.

Black expects QMS to lift its 10 per cent market share. "We see QMS growing from about 60 digital billboards to more than 80 in the next few years. That will boost QMS's revenue and margins, and drive faster earnings growth," he says.

Market dynamics could favour QMS. oOH! Media and APN Outdoor's proposed merger, if approved by the Australian Competition and Consumer Commission in early May, will create a $1.7-billion company. The stock may be too large for some small-cap fund managers to own and a reason to take profits and focus on QMS for outdoor ad exposure.

Advertisers might spread their outdoor ad spend across a few providers, including QMS.

QMS trades on a 13 times FY18 earnings, using Pengana's valuation. "That's undemanding for a company in an industry that has attractive growth prospects as more billboards are digitised and more advertising dollars find their way to roadside ads," says Black.

National Veterinary Care

Investors could be forgiven for avoiding companies that engineer industry roll-ups. Too many have targeted fragmented industries, grown rapidly through acquisitions, issued equity like confetti and gorged on debt. Then collapsed.

National Veterinary Care looks a more conservative industry-consolidation story. Eleven acquisitions have been settled this financial year, giving the company 54 integrated vet clinics. A training academy and management services operation provide other revenue.

Pengana's Black says National Veterinary Care has room for growth. "The vet industry remains very fragmented with many small operators. We don't see a lot of local competition to buy vet practices driving up prices," he says,

Like other consolidators, National Veterinary Care drives synergies by adding bolt-on acquisitions to its network. Earnings arbitrage is another benefit: the market typically values earnings from listed companies on much higher multiples than those of small private companies.

National Veterinary Care trades on 16 times 2017-18 earnings on Pengana's valuation. A small, private veterinary practice might sell for four times its earnings.

Black says National Veterinary Care's valuation is attractive. "The company can grow its earnings by 20 per cent each year by adding more practices. It's a lower-risk strategy and there should be plenty of acquisition opportunities, at reasonable prices."

Australia had 2216 vet clinics in 2016. As baby-boomer veterinarians look to exit their business fully or partly in the next 10 years, the supply of clinics for sale should rise.

The $12 billion local pet industry has solid growth prospects as consumers spend more on companion animals and pet insurance. That means more trips to vets. Pet industry revenue in Australia has grown 42 per cent since 2013.

Xenith IP

A hot float often encourages rivals to raise capital, list and cash in on the sentiment. That was the case when IPH, an intellectual property services provider, delivered soaring gains after listing. Smaller vials, Xenith IP Group and QANTM Intellectual Property, launched successful floats within 18 months.

Xenith and QANTM are trading below their issue price and appear to have been affected by declining investor sentiment towards IPH. Pengana's Black favours Xenith, believing recent price weakness is an opportunity to buy a company in an attractive sector.

"Intellectual property services benefit from stable clients who don't tend to move firms a lot," says Black. "Their clients pay upfront and are not overly price sensitive. The IP services industry is not particularly cyclical and should continue to grow as companies seek to protect their technologies."

Xenith trades on less than 10 times 2017-18 earnings, on Pengana forecasts. "That's low given the nature of the industry and Xenith's position," says Black.

BWX

The cosmetics group was one of 2015's best floats, its $1.50 shares peaking at $5.70 within nine months of listing. BWX raised $39 million in November 2015 to develop a portfolio of skin and haircare brands that include Sukin, DermaSukin, USpa and Edward Beale.

Bennelong is one of BWX's largest shareholders with a 16.3 per cent stake.

Bennalong's Beaumont likes the long-term growth prospects for "affordable luxury" cosmetics and BWX's position as the leading natural skincare provider.

"Consumers here and overseas are spending more on mid-market cosmetics," he says. "BWX has a strong portfolio of brands, growing base of loyal customers and high margins."

BWX's international sales are gaining traction as new distribution channels are secured. The company last year announced Boots, a leading UK pharmacy retailer, is stocking the flagship Sukin range at 80 of its highest turnover stores.

"BWX's main challenge is managing its high growth," says Beaumont. "The company is doing a good job in reducing its reliance on third-party manufacturing and ensuring it can quickly scale its production and distribution to keep up with sales demand."

Beaumont expects BWX to achieve annual sales growth of about 30 per cent over the next few years. "Few small-cap stocks have such visible earnings growth," Beaumont says.

The global hair and skincare market, estimated at $465 billion by Euromonitor International, has a good outlook as more consumers in emerging markets join the middle-class in the next decade, boosting demand for skin and haircare products.

Reliance Worldwide Corporation

The plumbing-products manufacturer, last year's largest IPO, has performed solidly since listing. Reliance's $2.50 issued shares peaked at $3.56 a few months after its April 2016 listing as investors bet on stronger US housing demand.

The stock since has fallen to $2.85. Reliance's interim result slightly beat market expectations. Strong gains in the company's Americas division – the key to Reliance's fortunes – featured.

Reliance designs, makes and supplies water-flow and control products used in plumbing.

Bennelong has increased its Reliance stake to just over 9 per cent. "The company has good products and excellent distribution in the US through the two largest home-improvement chains (Home Depot and Lowes)," says Beaumont. "We expect Reliance to increase its US market share and grow its presence in other markets over time."

Beaumont says Reliance can cope better with cyclical housing downturns compared to other building-products manufacturers.