I am sometimes accused by my wife and colleagues of being a “wet blanket”. In other words immune to the excitement of new ventures or ideas. But when it comes to IPOs that’s probably the right frame of mind to have. I shall proceed to throw some cold water over the IPO of HSS Hire which is listing in early February if all goes according to plan – the prospectus for which is now available.
Academics Elroy Dimson and Paul Marsh have recently published an analysis of the performance of new small company listings in the UK. Since 1987 they have typically underperformed the market over the two years after their IPO. Obviously there are exceptions, and often there is a short term gain to be made by selling in the market quickly, but in general IPOs are to be avoided. Dimson and Marsh also showed that investing in more mature companies gave much better returns.
HSS Hire operate tool hire shops and has been expanding at a good rate. Revenue has been growing rapidly although profits are more variable. They surely are in a market governed by the general level of economic activity in the country. With the prospective price range announced for the float, the market capitalisation will be approximately £365 million.
The “Announcement to Float” document which may be all retail investors bother to read is a masterpiece of the copywriters art. Here are some of the phrases in there that are designed to stimulate the interest of investors: “A leading player in a growing market“, “Distinctive and differentiated market position“, “market leading brand“, “integrated and scalable distribution network“, “nationwide branch network with significant growth potential“, “well diversified“, “end-markets with significant barriers to entry“, “capital efficient business model“, “drives premium returns“, “experienced board” and “high quality operational management“.
This comment in there from CEO Chris Davies sums it up: “HSS has outperformed the UK tool and equipment hire market in recent years by offering its customers a powerful combination of safety, value, availability and support, delivered by c. 2,900 well-trained and motivated colleagues with a passion for delivering outstanding service……“.
OK it sounds good, so lets just have a look at the detail in the Prospectus and the financial numbers.
Under risk factors (page 20) it says “The equipment rental industry is highly competitive and fragmented” and “The markets in which the Group operates are served by numerous competitors“. So much for the “barriers to entry” mentioned previously. Indeed page 45 tells us that there are 4,000 small and large players in this market. On HSS’s current revenue it appears to have about 5% of the UK market. Although the prospectus does provide evidence that the overall market is growing and it is possible that HSS is taking business from some of the smaller players by developing more local outlets, it is hardly a market with major barriers to entry.
Why are barriers to entry important? Because they are one of the few ways that one can obtain a superior return on capital. Yes it is possible to grow revenue and earnings by investing more and more capital (what might be called the “Tesco syndrome”), which makes the management look good but it’s not something informed investors like. We’ll look at return on capital in HSS in a moment.
Page 93 of the prospectus shows the company currently has debt of £316 million, which you might consider high in relation to the revenue and profits profile of the business. Needless to say the reduction in debt by the issue of equity is one reason given for the IPO. About £85 million will be redeemed by the issue of new shares worth £103 million with the rest used for other business expansion activities. That will still leave the company relatively highly geared and with a large interest bill in relation to the profits.
What’s the return on capital at HSS? Well the annualised latest pre-tax profits are £8.3 million. The capital employed might be measured on Net Assets. But that figure is minus £11.8 million which is somewhat unusual – there are no retained earnings and minimal share premiums (the company has clearly been financed primarily by debt). Using another measure of Return on Assets which is earnings divided by total assets (the latter being £406m mainly comprising intangible assets plus property, plant and equipment), gives a figure of 2.0%. Hardly adequate.
What’s the prospective EBITDA multiple or P/E based on the likely market capitalisation (they prefer to talk about EBITDA rather than earnings as it leaves out the interest figure and other nasty things).
Proforma income statements and balance sheets after the IPO are given on pages 8 to 10 of the prospectus. Adjusted EBITDA of £67m gives a multiple of 5.4. Or historic Adjusted Post Tax profits (using the standard Corporation Tax rate) of say £2.4m giving a P/E of 152.
Those figures ignore some hefty “exceptionals” including a £7.7m loss on an interest rate swap.
Other risk factors might be the susceptibility to poor weather and the continuing large stake by the existing major shareholder.
My analysis of this business concluded at this point because however bullish the prospects of this business might be (the company seems committed to a growth strategy), the historic profile of the business gives cause for concern.
No doubt other financial commentators will be publishing their specific recommendations over the next few days, so it might be worthwhile to keep an eye on whether enthusiasm for the stock makes it worth considering as a short term punt. But investors need to ask themselves: is this a quality business that would justify a long term holding?
Roger Lawson
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