Why some IPOs aren’t all they’re cracked up to be
Despite a high number of hotly anticipated flotations in recent years, 2016 has been slow going for initial public offerings. Now the dust has settled, it is interesting to examine the wide variations in performance.
Compare Just Eat, Auto Trader, Poundland and AO World. All four came to market in the first few months of 2014 but, since then, Just Eat and Auto Trader have both risen by over 50 per cent, whereas Poundland and AO World have both fallen by over 40 per cent.
Why do some IPOs take off while others fall flat? While every stock is different, common themes emerge from these examples which careful investors ought to consider before participating in any IPO.
All four companies shared some seemingly common traits: All had eagerly anticipated IPOs. Although sold on high valuations, they were all deemed to be high quality businesses, with excellent market positions, strong growth potential, and therefore deserving of their elevated prices. Consequently, investor demand was high and on the first day of trading all four shares performed well. AO World in particular rose 45 per cent.
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In practice, the four business models differ markedly.
Poundland is a plain vanilla retailer operating in a highly competitive sector. Investors failed to consider properly its obvious lack of pricing power and, when costs started to rise, the frailties of the business model became apparent.
AO World is an online business that specialises in white goods but otherwise has little to differentiate itself from other online behemoths. Additionally, European expansion costs grew beyond expectations at the same time as UK growth slowed. By way of response, the company increased marketing costs in a bid to boost sales. Unsurprisingly, investors were disappointed and the valuation fell.
By comparison, Just Eat and Auto Trader are platform-based business models, offering a digital service that significantly reduces transaction costs for restaurants and car dealers, respectively.
As first-movers, the value of their service becomes greater as their customer base grows, making it ever harder for rivals to compete.
Post-flotation, the exceptional results of both companies validated their investors’ initial perceptions and further justified their high valuations.
Importantly, this is not a case of hindsight analysis; these differences were clearly identifiable at the time of the IPOs.
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AO World and Poundland have underperformed simply because they really were much lower quality, lower growth, and riskier businesses than the majority of the market expected. Investors only realised this when the disappointing financial results came in and the flaws in the business models became apparent.
IPO performance may be difficult to predict, but it is the interplay between fundamentals and expectations which ultimately drives share prices.
Those selling a business will always seek to emphasise the positive over the negative, so a listed company’s first few results inevitably establish whether reality can ever match this hype.
As such, I approach every IPO with a healthy level of scepticism.