Just how similar are the Ingham’s and Dick Smith IPOs? Both are (or in Dick Smith’s case, were) iconic Australian businesses. Private equity firms bought both businesses from trade owners. They then floated them for healthy gains (Ingham’s lists this coming Monday). And in both cases, private equity sold a truckload of assets prior to listing, leaving incoming shareholders with hollow balance sheets.
But as far as one can tell based on the Ingham’s prospectus, that’s where the similarities end. Dick Smith’s main undoing was booking stock purchase rebates as revenue at time of purchase instead of at time of sale. No signs of that from Ingham’s.
So does that make Ingham’s a solid addition to your portfolio?
The first thing I did when I downloaded the prospectus was search for the word ‘Woolworths’. This took me straight to page 35. And there it was, powerful supermarket customers such as Woolworths, Coles, IGA and their Kiwi counterparts Countdown and PAK’nSAVE comprise over half of Ingham’s revenue. Throw in fast food giants like KFC and that total moves to 70%.
And therein lies a problem. The big risk for Ingham’s is not that it turns out to be another Dick Smith but rather another Goodman Fielder, Asaleo Care or Patties Foods. Or any other supplier to the supermarket channel, even Pacific Brands. When you have a commoditised product, dealing with powerful customers is not a recipe for earnings growth. It’s a recipe for wealth destruction.
Perhaps some investors will disagree with me because Ingham’s is an Australian icon. Tell that to the Woolworths and Coles buying departments. Make no mistake, iconic or well-known brands do not equal brand equity. Helgas, MeadowLea, Sorbent, Libra, Four’N Twenty and Bonds weren’t able to steer the fortunes of the above-mentioned companies towards growth. Pricing power is everything in domestic wholesaling and unless a product has true brand equity such as Coca-Cola, the supermarkets will dominate price negotiations.
Sure, maybe things will go ok for a year or two, while prices are locked in for the short-term and the vendor’s remaining shares are in escrow. But let’s look at what happened to the above-mentioned supermarket suppliers in the years following their IPOs.
After two or three years, their share prices started falling off a cliff. Why? They were dressed up for IPO as dependable staple goods manufacturers, paying a steady dividend stream from their stable profits. After a few years the reality set in. These companies would struggle to maintain profitability in the face of gruelling price negotiations with their powerful customers. Earnings were far more volatile than the inelastic demand for their products.
It’s hard not to see the same thing happening to Ingham’s. The business is expected to generate a return on equity of 76% in the 2017 financial year. How long will Woolies let that go on for?
And don’t get me started on valuation. The private equity vendors bought the business in 2013 for $869 million, sold $540 million of property in 2015 and are now floating it for an enterprise value of $1.6 billion. This implies a price to earnings multiple of 12 times based on forecast 2017 earnings, which are a whopping 91% higher than what the business earned two years earlier. For mine, this looks fairly valued at best, with little margin of safety given the risks.