Has McGrath Ltd shot itself in the foot?
The recent share price tumble experienced by high profile Sydney-based real estate agency McGrath Ltd (ASX: MEA) – which has fallen by around 54% since listing on the ASX at $2.10 early December – should remind investors of what can happen when IPOs play shamelessly to human sentiment.
Having timed the float to coincide with the top of the [Sydney] property market cycle, McGrath opportunistically decided to 'feed the market' while it was quacking loudest.
Admittedly, four months is a long time in real estate, but it's inconceivable that McGrath didn't foresee the notable cyclical downturn within the Sydney market well ahead of its IPO last December.
McGrath recently announced a significant downgrade in revenues and earnings for the 2016 financial year on the fairly implausible pretext it was a complete surprise to forecast numbers within its IPO prospectus.
McGrath's management is attributing much of the shock downgrade to what's been described as an unforeseen 25% to 30% decline in listings in the Smollen areas – 10 real estate offices operating predominantly on Sydney's North Shore acquired as part of the proceeds of the IPO – compared to expectations when the company listed in December 2015.
As a result of a decline in listing numbers – especially in the first-half of April – plus delays due to implementation of a new IT system, recruitment and postponing the launch of several project marketing developments into full year 2017 – McGrath is expecting earnings before interest, tax, depreciation and amortisation (EBITDA) to be between $26 and $27 million, with EBITDA down $4 to $5 million.
Instead of the expected 16% growth in the number of property sale transactions and total sale value – resulting in a 14% increase in EBITDA over full year 2015 – McGrath is now on track to report lower earnings than it did in FY15 ($27.2 million).
McGrath's directors have also foreshadowed a 22-33% cut in the target dividend for this financial year to between 3-3.5 cents. However, the company has wisely offered no profit guidance for 2017.
With north and north-west Sydney listings now expected to be 25-30% lower than prospectus forecasts – due largely due to a drop off in the number of Chinese buyers – the numbers McGrath used within its IPO prospectus now look aspirational at best.
However, recent profit downgrades are hard to comprehend given that it's less than a month since CEO John McGrath advised media that "all the fundamentals" were still in place prior to listing the company in December.
It was presumably on the basis of this sentiment that Perpetual, McGrath's biggest institutional backer, lifted its stake in McGrath from 11.56% to 13.23%.
Given the distaste the market has for IPOs that fail to meet prospectus forecasts, there was clearly greater share price downside in store for McGrath, which explains why management decided to coincide the announcement with a trading halt last Friday.
When the shares resumed trading on Monday, the share price fell from the $1.30 it had been trading at before entering the trading halt to 98c.
Its wisdom after the fact, but the McGrath IPO is also a reminder to investors to be wary of IPOs in which existing owners 'cash out' by selling a large part of their stake to share investors.
As we've learnt from former IPOs like Nine Entertainment (ASX: NEC ) and Myer Holdings (ASX: MYR), funds raised during an IPO should be more about strengthening the balance sheet and providing for future expansion rather than lining the pockets of those bringing the stock to market.
Around half ($64.2 million) of the $129.6 million raised [At IPO] went to the existing shareholders, and $31 million went towards the upfront acquisition of the Smollen Group and its 10 real estate offices in Sydney.
That left a remainder of around 25% of the money raised for paying off debt, working capital and other sundry expenses associated with the offer and Smollen Group acquisition, hence leaving precious little left to fund its expansion plan.
With McGrath's enterprise value to earnings multiple, significantly above traditional industry multiples of two to three times sales earnings, the market will be a lot more wary of a proposed float by rival LJ Hooker.
Given the underlying strength of McGrath's balance sheet and its outstanding return on equity (ROE) – which has averaged 88.2% since 2012 – an over inflated enterprise value to earnings multiple, and unfulfilled IPO forecasts have done much to undermine what is otherwise a quality business.
The bigger question now is whether the decision to IPO this business was singularly focused on cashing-out existing shareholders.
While McGrath may appeal to short-sellers, those attracted to the underlying business will find more compelling entry points following ongoing downgrades.