It has become a tradition that when I get home from an overseas trip my first meal is from Guzman y Gomez (“GYG”). I am not the only one to share an obsession with this Aussie Mexican fast-food chain.

They started as a single store in Newtown in 2006. They have since opened over 180 stores and are set to become a billion-dollar company in 2025.

They’ve grown. Fast. Their food is in such high demand that they are the third largest buyer for avocado in Australia behind Woolies and Coles. All eyes are on GYG as they prepare for an initial public offering (IPO) in 2024.

The current environment of high interest rates, inflation and declining valuations means that many private companies have taken their foot off the pedal and are delaying IPOs. Profits are currently at a premium and we’ve seen less risky investments like cash and bonds deliver higher yields. Private company research provider Pitchbook estimated that there are around 220 companies that should have listed over the last 18 months that are waiting for the right market conditions. Safe to say that there will be no shortage of IPOs in the near future.

So should you get involved in an IPO, or stick to investing in GYG’s burritos?

What is an IPO?

An IPO is an Initial Public Offering. It is a process that a private company undertakes to become public. Almost all companies start as a private company, receiving money from founders, angel investors and venture capital companies. In the case of Guzman y Gomez, this included big names such as Hamish Douglass (Magellan), Guy Russo (MD of Kmart) and Barrenjoey Capital. Eventually, private funding will not be enough to support the growth of the company and the original funders will want a way to easily sell their stake.

Looking at the IPO market as a whole, its performance is characterised by volatility. This is partly due to a considerable change in the IPO market over the last 10-15 years. It has seen a shift in investor preferences.

Many companies are going public before they are profitable. They are taking advantage of the fact that in an easy money environment many investors didn’t care about profitability.

IPO performance

Guzman y Gomez has plans to list on the ASX, despite their growing international presence. In the last 5 years, the FTSE Renaissance US IPO which tracks designed to track the activity and performance of newly public companies returned 22%. FTSE USA returned 76.7% in the same period.  

Realistically, this is not how investors consider investing in IPOs. You wouldn’t invest in an IPO fund in the same way that you would invest in a broad market index of established companies.

Many investors consider companies on an individual basis. They will consider if the stock’s forecasted earnings are promising, and these earnings projections may be far out in the future. NASDAQ estimates that since the 1980s, the number of unprofitable IPOs have risen from around 20% to 80% of the total IPOs each year.

Median financial metrics

Despite a lack of profitability, the market seems to be laser focused on prospective future earnings. The first day returns on average of these unprofitable companies exceed the first day returns of profitable companies. Investors still have faith in company growth once public capital has been raised.

When should investors consider an IPO?

Profit is important. It is what allows companies to participate in all the activities that investors love – paying dividends, investing in growth, or strengthening the balance sheet. This means that IPOs may not suit investors that rely on sustainable income, don’t have a long-time horizon and want to avoid volatility.

It is difficult for nascent companies to generate profits while growing quickly. Revenue and additional capital are reinvested into the business to continue to fund growth. Typical investments include marketing efforts, research and development, and growing the workforce.

Investors tolerate a lack of profitability in the hope that this investment will ultimately transition to a sustainable and profitable business. The challenge for growing companies is to make the right choices when deploying capital as they navigate competition, regulatory complexities and operational intricacies. This can be an overwhelming time for management.

Profitable or unprofitable, investing in an IPO is similar to any other investment. The price you pay matters. What are you paying to own a portion of that company and its future profits? Usually when an investor is considering investing in an IPO it is because they like the company and think that there are strong prospects for the future. This may all be true, but it is likely that many other investors are thinking the same way and can result in an oversubscribed IPO offering. Once it hits the public market, the share price may shoot up due to this demand.

As time passes and financial information becomes publicly available and transparent, professional investors and analysts usually reassess their valuations.

Guzman y Gomez’s revenue is impressive.  Their revenue reached $759 million in the 2023 financial year, a lift of 32% on the 2022 fiscal year. Underlying earnings increased 56% to $32 million. Underlying net profit was nearly $18 million and one-off costs pushed it to a net loss of $2.3 million If they list next year, investors should expect more investment into growth. They should also expect more transparency into financials with their listing.

Considerations when investing in an IPO  

A newly listed company is no different than any other company and investors should evaluate them in the same way. However, many investors succumb to hype and a compelling narrative and that is a particular danger with IPOs. Investment banks are being paid to market the stock to investors to ensure that the IPO is a success. Brokers often create an additional sense of exclusivity by being selective about how the shares are doled out. Investors should be careful that after the road shows end, the shares are allotted and the founders cash out, they are not stuck with a company that can’t live up to expectations.

There are two issues investors should look out for in the current market, profitability and interest rates.

Profitability is a difficult metric to measure the success of a private company. It must be seen in the context of revenue growth, total addressable market, customer acquisition and retention rates. Private companies seek venture capital investments, who in turn expect growth. Earnings are put back into the company for growth, instead of the other activities such as distributing dividends or strengthening balance sheets.

Pitchbook’s IPO Market Outlook explains that the valuations that we see for these companies are benchmarked on future projections rather than current figures. They give Uber as an example. At the time of its IPO, the company posted a net loss of $3.2 billion, yet the growth in revenues and number of trips were expanding quickly. From 2016 to 2018, revenue increased by 162.8%, while rides booked through the rideshare platform increased by 9 billion during that time, a growth of 900%.

We’re coming out of a period of ultra-low interest rates. Investor appetites have decreased for riskier assets – such as newly issued IPOs. This means that there are higher financing expenses due to higher interest rates, and there’s less demand from investors.