Listen on:

Ad: Morningstar Investor is built for investors by investors. It provides independent research and data on over 40,000 securities, tools to build and maintain an investment portfolio and investor education resources to support you, regardless of where you are on your investing journey.

Explore opportunities with our monthly global best ideas. Explore our ETF model portfolios. Plan better with two years of dividend forecasts for ASX listed stocks and stay informed with independent thought leadership.

We've built tools to help you construct, monitor and maintain your portfolio, including our portfolio manager, integrated with one of Australia's leading portfolio tracking tools, Sharesight. Morningstar has been empowering investor success for over 35 years. We're passionate about your outcomes and are here every step of the way as you achieve them. Take out a free four-week trial to access our resources. Find the details in the episode notes.

Mark LaMonica: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances or needs.

Shani Jayamanne: So Mark, one of my favorite meals and one of our favorite meals, I guess, because we get our lunch together and have it, is Guzman. And when I get home from an overseas trip, it has become tradition that my first meal is from Guzman. So it's a bit of an unhealthy obsession. I do miss it when I'm overseas.

LaMonica: So this is what you think about when you're traveling. You think about, I can't wait to come home…

Jayamanne: …and get my hands on some nacho fries.

LaMonica: Well there we go. You know, you used to really be into my nachos.

Jayamanne: I still am. You're actually making them for me tomorrow.

LaMonica: That's true. Are you excited?

Jayamanne: I'm really excited actually.

LaMonica: Well, that's good news. Well, you are actually not the only one that has an obsession with Aussie Mexican fast food Guzman. I obviously like it as well. But the history of Guzman, which I'm sure you're aware of, Shani, is they started a single store in Newtown in 2006 and now they have 180 stores and they're set to become $1 billion company in 2025.

Jayamanne: That's right, Mark. And they've grown really fast. Their food is in such high demand that they are the third largest buyer for avocado in Australia behind Woolies and Coles.

LaMonica: And there is a point in us talking about Mexican food, Shani, because recently Guzman came out and they said they were looking to have an IPO in 2024. And so people are obviously paying attention.

Jayamanne: And what's an IPO, Mark?

LaMonica: It is an initial public offering. So they are going public. And they also plan to keep expanding. So they're going to open 30 new stores in the next year and only about half of those new stores are directly attributable to how many burritos Shani eats. And they are running through some issues that I think most companies are now. So their gross margins are being squeezed due to rising food cost prices and higher wages from the burrito artists. And they have been able to pass that on a little bit to consumers. So they've raised prices, and this has really dented Shani's budget, they've raised prices 8.2%.

Jayamanne: All right. Well, regardless of this, franchises are doing very well with Guzman. They're seeing a median return on investment of 47%.

LaMonica: And many investors, of course, are hoping to get a return on a potential future investment in Guzman. And so there's a lot of interest around this IPO that's going to hopefully come out in 2024.

Jayamanne: And it's not the only IPO that investors are eagerly waiting. 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.

LaMonica: And as we've talked about a lot on here, profits are currently at a premium. And we've seen less risky investments like cash and bonds start to deliver higher yields. And Morningstar does have a, I guess, division, we'll call it, called PitchBook. And they do private company research. And they've estimated that there are around 220 companies that should have listed over the last 18 months that are waiting for the right market conditions.

Jayamanne: So safe to say that there will be no shortage of IPOs in the near future. So here's a question. Should you get involved in an IPO? So let's start with what an IPO is.

LaMonica: All right. So as I said before, an IPO is an initial public offering. And it's the process that a private company undertakes to become public. And almost all companies start out as private companies. So they receive money from founders, maybe the founders' families, angel investors and venture capital companies.

Jayamanne: In the case of Guzman, this included big names such as Hamish Douglass of Magellan fame and Guy Russo, who is the MD of Kmart, and Barrenjoey Capital.

LaMonica: But eventually what happens is that private funding will not be enough to support the growth of the company. And of course, those original founders or funders, sorry, and potentially they could be the founders as well, will want a way to easily sell their stake.

Jayamanne: So how does an IPO work?

LaMonica: Okay. Well, the first step is that an investment bank gets involved to manage the whole IPO process. And, you know, ones you've probably heard of are Goldman Sachs and JPMorgan, for example.

Jayamanne: The job of these investment banks is that they round up potential buyers, including institutional investors, and gauge the interest of an IPO. Then they assemble a team that handles the regulatory hurdles and the operations to actually list a company.

LaMonica: And then the next step is due diligence. And that's when there's finally transparency into the finances of the company. And the books get cleaned up, and I don't mean in a fraudulent way, but the books get cleaned up, they complete all the regulatory forms and paperwork, and they start publicizing the opportunities for the company. And part of this process is, of course, doing what public companies need. That's establishing a board of directors that will protect shareholder interests.

Jayamanne: Then the IPO gets approved. They set a date for the IPO, how many shares that they are issuing, and the price. And the last thing to do is go public. They list and act like any other stock on the market.

LaMonica: Okay. So maybe a good question is, how has investing in IPOs performed in the past?

Jayamanne: So if we look at the IPO market as a whole, it is quite volatile. This is partly due to a considerable change in the IPO market that we've seen over the last 10 to 15 years. And we've seen investor preferences shift.

LaMonica: And what we've seen is that over that period, that 10 to 15 years, many companies are going public before they are profitable. And they were taking advantage of the fact that in an easy money environment, many investors just didn't care about profitability.

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

LaMonica: And realistically, of course this is not how investors should consider investing in IPOs. It's kind of the equivalent of investing in companies that start with the letter T. There is no rhyme and reason. They're all very different. And you wouldn't invest in an IPO fund in the same way that you would invest in a broad market index of established companies. Because of course, as I was saying, you know, there's going to be some bad apples, a few shell companies. There's going to be companies that list at a price that's too high. You just wouldn't invest in every IPO that listed in a year.

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

LaMonica: And 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, which of course makes no sense. But still, investors must have faith in company growth once public capital has been raised.

Jayamanne: So when should investors consider an IPO?

LaMonica: Well, ultimately, of course, profit is important for us as investors. It's what allows companies to participate in all the activities that we love as investors. So paying dividends, investing in growth or strengthening their balance sheets.

Jayamanne: This means that IPOs may not suit investors that rely on sustainable income, don't have long time horizons and want to avoid volatility.

LaMonica: And it's difficult sometimes for these new companies to generate profits while growing quickly. So revenue and additional capital are reinvested into the business to continue to fund growth. So the typical investments include marketing efforts, research and development and growing the workforce.

Jayamanne: And investors tolerate a lack of profitability in the hope that the 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 a pretty challenging environment, an environment of competition, regulatory complexities and operational intricacies. And this can be a pretty overwhelming time for management.

LaMonica: So 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 is because they like the company and think that there are strong prospects for the future.

Jayamanne: This may all be true, but it's 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.

LaMonica: And as time passes and financial information becomes publicly available and transparent, professional investors and analysts usually reassess their evaluations.

Jayamanne: And Guzman'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.

LaMonica: So, Shani mentioned earlier that a lot of companies are choosing not to list. And really that's because there are two main issues that IPOs are facing in the current market.

Jayamanne: The first is the issue that we are talking about, which is profitability and valuation.

LaMonica: And profitability is a difficult measure to measure the success of a private company. It has to be contextualized before you make a judgment call on a company's stock. And it has to be contextualized with revenue growth, total addressable market, customer acquisition costs and retention rates.

Jayamanne: Private companies seek venture capital investments who in turn expect growth. Earnings are put back into the company for growth instead of other activities such as distributing dividends or strengthening balance sheets.

LaMonica: And PitchBook has recently written a report called the IPO Market Outlook. And this report explains that the valuations that we see for these companies are benchmarked on future projections rather than current figures. This of course makes sense for any company you're investing in their future prospects and not their past performance.

Jayamanne: And they do 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 ride share platform increased by 9 billion during that time, a growth of 900%.

LaMonica: So as important as it is for investors to look at profitability, it is equally important to understand the future prospects of the company and their ability to generate profit in the future.

Jayamanne: As well, of course, the price at which you can purchase a stock.

LaMonica: So the second issue that we mentioned earlier that's impacting IPOs is something we're reading about every day and that is interest rates.

Jayamanne: We're coming out of a period of ultra-low interest rates. What we're seeing is that 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.

LaMonica: And we've come full circle here. The environment has meant that many IPOs have been delayed, but funding has also dried up. We're going to see many IPOs coming onto the market in the near future. So it's important that investors are aware of the full picture.

Jayamanne: And ensure that if you are investing in a company that isn't generating a profit, you look at the trajectory of gross margins. This will give you a picture of growth that isn't depressed by growth activities such as marketing and research and development.

LaMonica: Then if you're investing in a company, take a step back and try to understand whether you're investing in it because of the hype surrounding the IPO or because you genuinely believe in the company's prospects. You don't want to pay too much for an IPO that isn't able to live up to investor expectations. So, Shani, without knowing any of that and only, of course, knowing that they make your favorite food and something you think about when you're overseas, what do you think, Guzman?

Jayamanne: I mean, I think I put enough money into Guzman already. So maybe I'll stay away from it.

LaMonica: Oh, stay away from it.

Jayamanne: Yeah.

LaMonica: Okay, interesting. What about the thing where you go to Guzman and you buy a burrito and you think I own some of this? So a little bit of this comes to me. Okay. Well, thank you guys very much. Hopefully at some point we will do an IPO for Investing Compass. But before then, we would love any emails that you want to send me with questions or show ideas and, of course, any comments and ratings in your podcast app.

(Disclaimer: Any advice in this podcast is general advice or regulated financial advice under New Zealand law prepared by Morningstar Australasia Proprietary Limited and/or Morningstar Research Limited without reference to your financial objectives, situations or needs. You should consider the advice in light of these matters and any relevant product disclosure statement before making any decision to invest. To obtain advice for your own situation, contact a financial advisor.)