Initial Public Offers (IPOs) are used by the investor community at large as a lottery of sorts. In this rush to clock quick gains, the risks are often overlooked and the IPO Red herring prospectus (RHP) is ignored by most. RHP is a detailed document of 500-600 pages that tells everything about the company – business model, promoters, financials, IPO objectives, risks, etc. Investors are well-served to read the RHP as we will see below.
Make sure that the business you invest in has strong underlying fundamentals and generates real earnings (profit and positive cash flows). This ensures the business doesn’t need external capital (such as debt or equity) to grow. Note that leverage is not necessarily bad. Companies raise debt for their capital requirements to enhance shareholders' value. Caution has to be exercised in case of companies that continuously raise capital that adds to the interest burden or dilutes equity for existing shareholders.
Sooner or later, the share prices will reflect the company’s true health. .
Example 1 - Reliance Power. In 2007, there was a lot of talk about power sector being the hottest sector and signs of a bubble were visible. In the midst of this, Reliance Power got their mega IPO (₹11563 crore) in January 2008.
(i) Reliance Power had paltry revenue of ₹2.25 crore for the year ended March 31, 2007 and a tiny profit of ₹16 lakh. Tata Power had revenue of ₹6475 crore and net profit of ₹759 Cr while NTPC had revenue of ₹34079 crore and net profit of ₹6898 crore. (ii) Valuations were astronomical when compared to peers (NTPC, Tata Power, Gujarat Industries Power). Compared to the sector average price to earnings (P/E) of 14.5x and sector average price to boook value (P/BV) of 1.86x, Reliance Power was priced at 5625x P/E and 45x P/BV.
The IPO saw over ₹7.5 lakh crore of demand and more than 72 times oversubscription. A few minutes of research would have saved many investors. Reliance Power is down 97 per cent from its issue price of ₹450. It trades at ₹14.35 now.
Example 2 – Bharat Road Networks (BRNL) IPO opened in Sept 2017. A glance at their financials depicted the bad financial condition of the company. The company had continuous losses and bad cash flows.
Being a construction company, they had a lot of working capital needs and long gestation/long payback periods. All the facts made it clear that the issue was risky. Looks like the IPO was just to pay off some debt and delay the time of its liquidity problems. The IPO price was ₹205, and the CMP is ₹33, having destroyed 84 per centwealth!
Margin of safety
It is important to buy companies at cheap/affordable valuations so that there is a margin of safety. Value investing is about buying an asset worth ₹100 at ₹60 or lower, leaving a margin of safety. In simple words, don’t pay the price of a Ferrari for a Maruti 800.
During the IPO bull run of 2017-18, Prataap Snacks tapped the markets with a price of ₹930-938. The issue was priced at 196 P/E based on the FY17 consolidated diluted earnings per share (EPS). It was quite obvious that the company was asking for extremely expensive valuations in both absolute and relative terms as its peers were trading at 50-80x P/E.
Thanks to the IPO madness, it was subscribed 47.39x times. On listing day, the stock went to ₹1300 and post that it has never even touched the IPO price again. It now trades at ₹655.
One should closely analyze the dealing of the company with various stakeholders and the workings between the parent company and the subsidiary to check if the subsidiary is not suffering for the benefit of the parent. Investors are better served putting money in companies whose promoters treat themselves at par with minority shareholders.
Example 1 - In August 2019, Sterling Wilson Solar (SWSL), the solar EPC arm of the Shapoorji Pallonji Group (SPG), came up with its IPO at ₹780 per share. Its RHP mentioned that SPG owed ₹2563 crore to SWSL which was to be repaid within 90 days of the IPO (IPO was an offer for sale worth ₹3125 crore by the promoter group).
Per RHP, as on March 31, 2019, 35.76 per cent of the company’s shares were pledged by the promoter group, and debt to equity ratio was 2.7x. Their trade receivables were also quite high at 35 per cent of total balance sheet and 22 per cent of total sales.
On November 14, 2019, SPG asked for an extension citing 'rapid deterioration in the credit markets’ as a reason. As a result, the stock started hitting lower circuits continuously and hit a 52-week low of ₹77 and currently trades at ₹236. The promoters’ promise of debt repayment was not met and borrowing through the subsidiary was used for benefit of the parent.
Example 2 - The promoters of Tara Jewels allotted shares to themselves at ₹10 in 2010 end (228,880 shares worth ₹22.8 lakh). They said it was a fundraise for working capital.
Two years later (November 2012) they brought the company’s IPO at ₹230 per share, a 23x jump from their buying price. What is unbelievable is that the promoters could have used their cash at bank (₹26 crore) to cover the working capital expense. The company was a wealth destroyer and doesn’t even trade on the exchanges now.
To sum it up, investors should spend time reading RHP and understanding the capital structure of the company, risks, business model, peers/competitors, related party transactions and pricing of the issue amongst many other things to form a complete view of the IPO.
The writer is COO at JST Investments