Five factors investors should keep in mind before subscribing to an IPO

An estimated INR20,000 crore worth of initial public offerings (IPOs) are set to hit the Indian market in the coming months. NSE, Central Depository Services, Nakshatra World and Cochin Shipyard are among the names that plan to launch IPOs in coming months.

As an investor, what are the factors that you should look into before subscribing to an IPO?

1) Track Record of the Management

We often do a credibility check before lending even INR1,000 rupees to a person just to make sure that the borrower repays the money on time. Similarly, investors should always check the track record of the management before subscribing to an IPO. For instance, RBL bank, a private sector bank offered its shares to the public in August 2017. It was oversubscribed 69 times! The stock was listed at INR274 on the National Stock Exchange, a 22% premium against its issue price of Rs 225 per share. 
Currently, it trades at INR576.

What were the factors behind the success of RBL’s IPO?

The biggest factor was the strong leadership, the new management of RBL bank had taken over the command in the year 2010 and since then the bank has witnessed a complete transformation. Under the new leadership, RBL bank has witnessed a robust growth in branch expansion. From a small regional bank based out of Kolhapur in Maharashtra, its network of 215 branches is now spread across 16 states and union territories. Another factor was the robust profitability, during 2013-2016, RBL Bank’s net interest income and net profit have grown at a CAGR of 47%.

2) What is the primary objective of the IPO?

Most of us would not lend our hard earned money to someone who intends to use the sum for unproductive purposes. Similarly, it is extremely important to read about the purpose behind the IPO; how is the management planning to utilize the proceeds from the IPO?

Investors should find out whether the management intends to utilize the proceeds for future expansion/debt repayment etc or the promoters/private equity (PE) firms want to exit the company by offloading their shares.

Although experts often advise that investors should avoid IPOs where the PEs are using the IPOs to exit fully, as such exit raises doubts about the future prospects of the Company. But that has not been the case always.

For instance, Jubilant FoodWorks Ltd (formerly Domino’s Pizza India) came up with its IPO in January 2010. This IPO was one of the few IPOs in India which was primarily an exit route for the existing PE investors.

JP Morgan and India Private Equity Fund (IPEF), which together held 31% stake in Jubilant FoodWorks, exited their decade-old investment.

However, contrary to the common belief, the Company turned out to be one of the best performing IPOs since 2008. It has posted returns of over 640%, from its offer price.

Hence, investors should carefully evaluate partial or complete exit by PEs before taking a decision. While doing the evaluation, the investors should look at various factors such as the business model of the company, the growth visibility and the macro-economic factors.

3) Importance of the business model:

Any company with weak financials and weak fundamentals is not expected to do well upon listing. This is common sense!

For investors, the primary source of information should strictly be the red herring prospectus, which contains various details related to the financial health of the company and the management’s business outlook. 

4) Profitability & Valuations

Is the stock expensive?

CL Educate, the parent of coaching services provider Career Launcher, launched its IPO in March 2017. The IPO’s issue price pegged the stock’s valuation at 42 times the 2017 EPS estimates. This was substantially higher than its comparable peer MT Educare Ltd. Such high valuations should be backed by robust profitability (return ratios, profit margins) and future earnings potential. However, CL Educate’s 2015-16 revenue growth and EBITDA margins at 3.30% and 12.70%, respectively were much lower than the revenue growth (26.50%) and EBITDA margins (20%) of its peer MT Educare.

 So, now you know why did CL Educate’s shares fell nearly 17% on market debut.

5) Sector Analysis (entry barriers, sectoral risks)

Investors should always look for the risks associated with the industry in which the company operates.

For instance, Indian aviation sector has moderately high entry barriers as the industry is capital intensive and it is highly regulated as well. For airlines operating in India, Air turbine fuel (ATF), lease rental and maintenance & overhaul account for over 70% of their costs. All these three components are linked to the US dollar. Hence, fluctuations in the rupee exchange rate directly impacts 70% of the operating costs of the Indian aviation companies. Such high dependency on external factors makes the aviation sector’s profitability extremely volatile.

On the other hand, if we look at the education sector, the entry barriers are few. However, the sector has proved to be very costly for investors. Accessories Ltd, Tree House Education and Educomp Solutions Ltd are trading well below their listing prices. MT Educare, which performed relatively better, currently trades at INR 79.90, 6.50% higher than its IPO (March 2012) price.

Sensex Vs IPO Index (2012-2017)

 

 

This article is strictly meant for educational purpose and it may be of interest to researchers as well as students. The Astute Investor acknowledges the fact that a couple of estimates/figures provided in this report have been sourced from various financial news websites (Reuters, Money Control, 4-traders) and research reports available in the public domain.

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