The biggest IPO of all Time

Since mid-June the oil price is up 15%, which has breathed fresh hope into beleaguered energy companies globally.  The catalyst for the recovery in the oil price was the announcement that Saudi Arabia, OPEC’s largest producer, will limit exports to 6.6 million barrels a day in August, 1 million lower than production this time last year.  This has been interpreted as rational profit maximising behaviour by the world’s largest producer, which has traditionally sought to defend market share and maximise oil revenues to prop up the Kingdom’s budget.

We see this as behaviour designed to boost the profit margins temporarily, similar to what is done by many vendors prior to any IPO.  In early 2018 the Saudi’s are looking to conduct an initial public offering (IPO) of around 5% of energy giant Saudi Aramco for a predicted price of US$100 billion. In this week’s piece, we are going to look at how to analyse IPOs and specifically this one, which is likely to be the biggest IPO of all time.

When analysing IPOs, few have been more eloquent on this subject than Benjamin Graham, the Father of Value Investing;

“Our recommendation is that all investors should be wary of new issues – which usually mean, simply, that these should be subjected to careful examination and unusually severe tests before they are purchased. There are two reasons for this double caveat. The first is that new issues have special salesmanship behind them, which calls therefore for a special degree of sales resistance. The second is that most new issues are sold under ‘favorable market conditions’ – which means favorable for the sellers and consequently less favorable for the buyer.” (The Intelligent Investor 1949 edition, p.80)

The biggest IPO in history

Last January the Saudi Arabian Crown Prince Mohammad bin Salman Al Saud announced that the Saudi government intends to offer shares representing about 5% of Saudi Aramco, its national oil company. Aramco has been under government control since the Saudi Arabian Oil Company was nationalised nationalized in the 1974 following US support for Israel in the Yom Kippur War.

Aramco is the largest global oil producer and therefore this IPO marks a shift in thinking in the Kingdom as the proceeds are being used to help diversify the economy away from oil. The IPO is planned to be listed on exchanges in Riyadh, with a secondary listing in London, New York, Hong Kong or Singapore. The expected value of 5% being floated in 2018 is touted as around US$100 billion which would value the entire company around US$2 trillion. This is significantly larger than Apple (US$742 billion), Google (US$653 billion) or Exxon Mobil ($342 billion). Under these circumstances the Saudi’s have a very strong incentive to move the oil price higher over the next 9 months!

Factors to look at in an IPO

Why is the vendor selling?

The motivation behind the IPO is one of the first things we consider. Historically investors tend to do well where the IPO is a spin-off from a large company exiting a line of business. An example of this is Orica and their paints division Dulux. New investors also tend to do well when the vendors are using the proceeds to expand their business. The probability of new investors doing well from an IPO is far lower when the seller is just looking to maximise their exit price. A classic example of this is the Myer IPO. In the case of Aramco, the IPO is designed to help makes changes to the Saudi economy and increase investments in non-oil assets. Cynically it could be viewed that the vendor is concerned about the longer-term demand for oil with increasing amounts of Teslas roaming the streets, though only 5% is being floated off at this stage.

Is the business easily understood?

Given the reduced level of historical financial data it is important that an investor can easily understand how the company makes money and maintains competitive advantage. When Shopping Centres Australasia was listed in November 2012, it was clear how the company made money from collecting rents on Woolworths’ shopping centres. Similarly, in the case of the best float of 2015 (+127% since listing) it was easy to understand the Costa Group’s business model of growing mushrooms, berries, citrus and tomatoes with the logistics operations to deliver these to consumers.

Whilst the Aramco business of extracting oil easy to understand, like most IPOs the financial data may be limited. The secretive company has never needed to disclose any kind of financial statements and details about the company’s most important asset, its oil reserves are state secrets.

Is the company profitable?

Any IPO is presented to the market in the most favourable light (albeit with a large number of disclaimers), and at a time of the seller’s choosing. Over the last six months we have seen a number of businesses being listed that have been unprofitable for a number of years, yet are expected to switch into profitability in the years immediately after the IPO. We put little store in the notion that companies are being listed for the altruistic benefit of new investors. Thus, investors should be sceptical of predictions of dramatic improvements after listing, especially when the IPO vendors have significant incentives to show profits before listing!

Saudi Aramco is likely to be very profitable with international energy consultant estimating costs of production around US$9 per barrel. The cost of production is so cheap as the oil in Saudi is primarily located near the surface of the desert and pooled in vast fields, so unlike Australia it doesn’t need to invest very expensive offshore oil platforms taping into reserves often 100kms off the coast.

The question for minority investors is the extent to which this enormous company will be run in the interests of the minority investors committing $100 billion or whether profits may be diverted to the state.  Two months ago, the Crown Prince said that decisions about oil and gas production and investment will remain in the hands of the Saudi government after the IPO.  In March 2017 in what looks like a move to improve the books prior to the IPO, the Saudi government reduced the tax rate levied on Aramco from 85% to 50%. Investors in this IPO would probably be concerned that this tax rate could change post-IPO to fund government budget deficits given that Aramco currently accounts for 80% of the Kingdom’s budget revenue.

Is the price attractive?

The sole reason behind any new investment is the view that it will generate a higher rate of return than alternative options in an investor’s portfolio.  It is too early to make any pronouncements as the financials have not been released, but any investment would want to take a conservative long-term oil price into account and discount stronger oil prices that we may see over the next nine months.

Despite what is contained in the marketing documents for every IPO, in determining a valuation potential investor should apply a discount to currently listed companies. Due to an IPO lacking a listed track record and investors having less financial data; a discount to currently-listed comparable companies should be applied when valuing an IPO. In the case of Aramco, in our opinion the price investors should pay would be a 20% discount or greater to valuations at which companies such as Exxon Mobil, Chevron or Shell are trading at.

Our Take

Whilst new IPOs are presented as fresh, exciting ways for investors to make money and access different high growth companies or assets, we see that the best approach to evaluating IPOs is to start from the default position that the vendors are trying to cheat you and then work backwards from there.  The best IPOs I have seen over the past 20 years have been one’s where the vendor is under-pricing the asset being sold, leaving some upside or “margin of safety” for the new investors.

Understandably this is a very rare occurrence for profit-maximising private equity owners and possibly Middle Eastern Kingdoms.  The Saudi government (just like private equity vendors) may face some domestic backlash for pricing the IPO too low if Aramco performs strongly post listing!


Half Year Report Card for Australian Equities

The last six months have been stressful for Australian equity investors, despite the calm suggested by the ASX200 delivering a total return of +3.2% (capital appreciation plus dividends). December’s Santa Claus rally/Trump reflation trade went a bit sour in January, similar to the feeling given by excessive consumption of four litre cask white wine from Southern Queensland. The market then staged a recovery from February to April, before grinding down slowly on weaker commodity prices, surprise bank taxes and the potential for higher global interest rates towards the end of 2017.

In this week’s piece, we are going to look at what has happened over the first half of the year, examine some key themes and analyse the catalysts that contributed to the best and worst performers.









Growth at any price

One of the key themes to emerge in the first half of 2017 has been a willingness among investors to bid up the share prices of companies delivering earnings growth. This activity seemed to ignore the high valuations paid to access these growing profits. This can be seen in the top performing healthcare, utilities and industrial sectors, whose performance was driven by companies such as CSL (Price to earnings ratio or PE 31x), AGL Energy (PE 21x) and Sydney Airport (PE 44x). Whilst these are all very solid companies that I have owned in the past, at current prices they offer little in the way of a valuation “margin of safety” needed when investing in equities.  The wisdom of being circumspect towards fully valued high growth companies can be seen in the performance in 2017 of companies such as Dominos Pizza and TPG Telecom, both of which have fallen heavily when their growth engines began to splutter.

The hunt for yield halts

The two worst performing sectors in 2017 have been the “yield” sectors of telecoms and listed property, though paradoxically the interest rate sensitive utilities sector continued to move higher. The yield sectors have been sold off as the US Federal Reserve increased their interest rate target to 1-1.25% and signalled a further rate rise later on in 2017. For foreign investors, this decreases the relative attractiveness of investing in Australian “yield” stocks such as Telstra (-12%) and Scentre Group (-13%). Domestically the RBA is taking a different stance, holding the cash rate at 1.5% in June and  that a further rate cut could occur later in 2017.

A mixed story for financials

From looking at the above table on the right, financials would appear to have had a reasonable start to 2017, returning a respectable 2% after dividends, however for investors it has been a bumpy ride.  The major banks performed well up until the announcement of a surprise bank levy in the May budget that wiped $14 billion off their collective market capitalisation. Commonwealth Bank (+2%) outperformed ANZ Bank (-4%) and Westpac (-3%), despite the latter two banks reporting in May lower loan losses and profits in line with expectations.

Whilst 2017 has been tough for investors in the banks, the sun shone down on the domestic insurers IAG (+16%) and Suncorp (+12%), as well as the fund managers Challenger (+17%), Magellan (+14%) and Perpetual (+14%) due to a combination of inflows and performance fees. QBE Insurance’s share price (0%) once again went up by the stairs and down by the lift. After reporting a solid result in February that suggested that the company’s turn-around was working, in June QBE unveiled higher than expected claims from its Asian and Latin American businesses, which caused the share price to fall 8%.

Large Outperforms small

Over 2017, the larger companies listed on the ASX (ASX100 +3%) have outperformed the smaller companies (Small Ords +1%). Outside the banks and the energy companies, the larger capitalisation stocks have had a pretty benign 2017, with the average return dragged upwards by the performance of CSL (+29%), Rio Tinto (+12%), Transurban (+11%) and Woolworths (+8%). The key drivers of small capitalisation index underperformance have been the underperformance of mining stocks Oceana (-12%), Independence (-27%) and retailers Premier (-7%) and Super Retail Group (-17%).  Company-specific issues caused falls in vitamin producer Blackmores (-7%) and retirement home provider Aveo (-20%).

Star pupils and the laggards in 2017

Stars and what caused them to shine

In the table above on the left we have listed the top 10 stocks in the ASX 100, and from looking down the list of the stars it is mainly stock specific factors that have driven performance. Qantas benefited from continued falls in the oil price and higher fare prices, whereas BlueScope’s turnaround continues with the steelmaker reporting 200% profit growth in February and announcing a share buy-back. This caps an amazing recovery for a company that was in a very challenging position five years ago, which resulted in a massive equity issue almost 80% below the level at which the company is currently buying back stock.

As mentioned above CSL, Flight Centre, Cochlear and Aristocrat have benefited from the theme of buying earnings growth at any price. Building materials company Boral’s share price has surged based on a recovery in their US business and continued demand for construction materials to fuel the Australian housing boom.

Laggards and their negative catalysts

In every period there are stragglers as well as winners, and on the right side of the above table we have the worst 10 performing stocks. The common theme driving the underperformance of Harvey Norman, Vicinity, and Scentre are concerns that the impending entry of Amazon into the Australian retail market will destroy retailer profitability and result in vacancies in our echoing shopping centres.

Looking through the rest of the list, Santos has followed the oil price downwards, whereas Brambles and Domino’s Pizza have been de-rated on unexpected profit downgrades. The telecommunications sector was a glamour sector in 2016 but has been on the nose with investors in 2017. Increased mobile competition, lower margins, and uncertainty around the NBN have negatively impacted the share prices of Telstra and TPG Telecom.

Our Take

Looking to the second half of 2017 we see that the market has been predominantly negative on the “Amazon effect” and in August many of the affected companies will have the opportunity to reveal how their businesses are performing. Whilst Amazon has had a significant impact on US retailers and thus the owners of many US shopping malls, we see those concerns as being overplayed (though we are underweight retailers in the Atlas High Income Property Fund). Over the last 30 years the US has added a significant amount of retail floorspace such that it is now estimated at 2.2m² of retail floorspace per capita, this compares with around 1m² of retail floorspace per capita in Australia.   

Looking further afield, we expect the banks to show profit growth from the upward repricing of investor and interest-only loans, though it will be a balancing act for bank management teams, as they will find it harder to fight the bank tax with expanding profits.  The resouce companies are likely to report shrinking earnings with commodities drift lower as the effects of Chinese stimulus plans from 2016 continue to fade.   As global rates begin to rise in the back half of 2017, this will put downward pressure on the AUD which will benefit companies with USD earnings such as QBE, Incitect Pivot and Amcor.  In aggregate we expect Australian equities to deliver modest gains in the second half of 2017, mainly as equities continue to present a better investment option to bonds.

Monthly Performance June 2017

  • June was a very volatile month in Listed Property with the index initially gaining 2% before ending the month down -4.8%, mainly driven by a -3% fall on the final day of the month on a bond market mini sell-off.
  • The Fund’s unit price fell -3.1% as declines in share prices were offset to some degree by income received from distributions and calls that the Fund sold that expired worthless. In the broad based sell-off in late June there were few places for investors to hide.
  • The fund generated 1.3% in income over the month of June and we will look to increase the Fund’s ability to generate additional income from the assets held.
  • June was a significant month for the Atlas High Income Property Fund, which is now listed on the ASX’s mFunds platform (AFM01).

Go to  Monthly Newsletters for a more detailed discussion of the listed property market in May and the fund’s strategy