Downward pressure on IPO valuations

This article first appeared in The Edge Financial Daily, on April 8, 2019.
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KUALA LUMPUR: Year 2019 is expected to be the year with a few mega initial public offerings (IPOs), at least three if not more, after a long absence.

However, it appears that the promoters are facing a challenging time to value the companies at the level they want.

It is learnt that the investing fraternity is valuing the long-anticipated IPOs — QSR Brands (M) Holdings Bhd and Leong Hup International Bhd — at price-earnings ratio (PER) below 20 times, compared with the ideal valuation of 25 times, or higher, that the promoters intend to seek initially.

QSR, seeking listing the second time, is owned by the Employees Provident Fund, CVC Capital Partners and Johor Corp. The listing exercise is believed to provide an exit for CVC Capital and for Johor Corp to unlock some investment values.

Likewise, Malaysia’s biggest home improvement retailer, Mr DIY, which is anticipated to raise some RM1.5 billion, is said to be in the same scenario. Sources said that Mr DIY is looking for a PER of 25 times.

Fund managers also believe that its substantial shareholder, Creador Sdn Bhd, is looking for an exit from its investment.

Notably, poultry producer Leong Hup and fast-food chain operator QSR Brands are said to have postponed their listings from last year in hopes for better valuations, besides having some issues to be ironed out along the IPO process.

Fund managers contacted by The Edge Financial Daily revealed that there seems to be a mismatch between the controlling shareholders and the market in terms of valuation.

The declined risk appetite is no thanks to the less-than-rosy economic outlook, both domestic and global.

Investors are not willing to pay premium valuation as they want some “buffer” in case the worst-case scenario pan out.

Phillip Capital Management Sdn Bhd chief investment officer Ang Kok Heng highlighted that if companies are asking for a high valuation, fund managers and investment banks may be reluctant to take up the IPOs.

“They can’t be asking for too high valuation ... the underwriters will always want the valuation to be lower as they are taking risks (of taking up unsubscribed shares),” said Ang.

“If you put it too high, the investment banks won’t want the job (underwriting the IPO) and secondly many fund managers would not be keen on the offer too. This risks the IPO failing,” Ang said.

He noted that valuation should not be put so high to instill confidence.

Fortress Capital Management director Geoffrey Ng said both Leong Hup and QSR were expecting valuations of over 20 times PER, which were too high, even when compared with other poultry players at between 10 to 15 times.

The drop in the FBM KLCI, which reflected the fall in the component stocks valuation, does not help matters too. The benchmark index has fallen from a record high of 1,895.18 points in April 19 last year to 1,641.81 points last Friday.

Fortress Capital’s Ng noted that the weaker index has affected confidence in the market moving forward, as well as liquidity.

“Liquidity has fallen from last year. When liquidity is poorer, this has resulted in investors being more cautious,” said Ng.

Ng said if the companies could compromise on lower valuations, investors will jump on board to subscribe for the IPOs as there is still some upside potential despite the poor market conditions.

And once these stocks are traded in the secondary market, and more investors continue to see value in the said counters, this would then prove they are successful IPOs despite the tepid market conditions.

Being a fund manager, Ng views that IPO promoters and investors are often on opposing sides in terms of a new listing’s valuation. To him, it may not be wise to demand too high a premium when valuing an IPO, particularly if the market sentiment is not that bullish.

It is wise to leave some upside potential on the table for investors. Otherwise, companies’ share prices are unlikely to climb much after the listing.

This will then result in the stock staying either flat or falling below its IPO price, said Ng, adding that if the second scenario happens, it will trigger more selling pressure as investors who are weak holders will start selling their IPO shares.

There are market talks that the listing of Mr DIY, in which the private equity fund holds an 18% stake, has been pushed back by the promoter due to high valuation expectations.

Commenting on Mr DIY, Ang noted that it might probably have compared its valuation with companies such as 7-Eleven Malaysia Holdings Bhd and Mynews Holdings Bhd — whose PERs are both close to 30 times — as it is similar to the retail chain businesses.

“[However], 7-Eleven and Mynews sells consumer daily food, while Mr DIY sells household items. So, I don’t think they are the same type,” said Ang.

Meanwhile, Ng said IPO valuations are also very much dependent on the function of growth. He said if a company’s earnings are growing at 30% to 40%, such a pace may be justified by a PER of 25 times. Otherwise, it would be considered stretched.

Against the current cautious sentiment globally, it appears that it is not easy for major shareholders to push the envelope too much when valuing their companies.

Bluntly put, Lotte Chemicals Titan Holdings Bhd could be an example.