How to read an IPO prospectus

Several initial public offerings have become a big hit with its shares enthusiastically received. Many people subscribe for IPO shares in the hope for short-term profit to be taken in a few days after listing. For this kind of short term trading, investors need not worry too much about the fundamentals of the company in question. More important are the news flow and the general market environment then prevailing. i regard IPO punting as casino dice gaming, of which the outcomes pretty much depend on luck. Those who are lucky enough could earn a meal of dim sum and tea.

i am skeptical about IPO punting, and prefer to invest in companies with well established track record. Still, i am interested in reading IPO prospectuses for my future reference of those companies of concern. An investment decision might be made years after the listing.

Prospectus usually contains the detailed information about the company and its business that annual reports skip.

It is hard for people to digest a prospectus as heavy and thick as a "Yellow Page" phone directory. Here, i offer a few easy, yet effective, steps to help you go through a prospectus.

You may search the prospectus by company in the HKEx website.

You will see the following section in a typical prospectus:

Important
Expected Timetable
Contents
Summary
Definitions
Glossary
Risk Factors
Information about this prospectus
Directors and parties involved in the offering
Corporate information
Industry overview
Business
Directors, senior management and employees
Substantial shareholders
Share capital
Financial information
Future plans and use of proceeds
Underwriting
Structure of the share offer
How to apply for the public offer shares
Appendix I -- Accountants' report
Appendix II -- Unaudited pro forma financial information
Appendix III -- Profit forecast
Appendix IV -- Property valuation


Step 1: Start with the "Important" section.

Who are the sponsors?

Check if the sponsors have previously involved in any problematic listing. Be aware of those sponsors. Big investment banks, such as the reputed American, Swiss and French ones, is a plus. But please don't blindly follow the fame, which will weaken your judgment on the full picture.

Find the number of old, or "existing" shares to be sold. Old shares accounting for a high proportion, say 40%, of the total offering is a negative sign. The high proportion probably indicates the original shareholders are no longer interested in the business, and hence look for an exit.


Step 2: Go to "Summary".

What is the business?

Companies with simple and easy-to-understand businesses are preferable. Those serving big customers and have strong market positions are even better. Be cautious if the business doesn't make any sense to you.


Step 3: Go to "Appendix I -- Accountants' Report"

Take nice-looking results for granted. Try to stand in the shoes of the management, and you would ensure the results for the three years prior to listing look good. More important is to check the income sources, which are stated in the turnover breakdown down the explanatory notes (presented in a tabular format). See if the income sources are the same as described in the "Summary" section.

Follow the cash flow statement through the periods under review. Get a sense how cash flew into and out of the company during the years. In particular, note the cash inflows from operating activities and cash outflows for purchases of property, plant and equipment (PPE). If operating cash inflows fell short of investment (PPE) outflows, the company would probably need to make up the difference by borrowing from banks. Also, mind the advances due to and from directors and related companies, and dividend payouts. High lending to directors and related companies and high dividend payouts are negative signs.

Then, roll down the pages to the very end of this section. There is a subsection called "Subsequent events". Since there is a time lag between the closing of the balance sheet period and the IPO, the company can "hide" some of the less appealing activities inside this time gap. i have seen companies pay fat dividends to shareholders during this period. In worse cases, the dividend can exceed the earnings over the past three years.

Roll back a few pages upward, and you will see "Related party transactions". Most likely, it is hard to figure out the complicated relationship between the parties. If there are lots of these transaction and these transactions accounted for substantial proportion of the business, you should suspect such business arrangements.


Step 4: Go to "Risk Factors"

You will find something like: "In case of natural disasters such as earthquakes and volcano eruptions, the group's business will be adversely affected." Don't give up and read this section carefully, line by line. This is the most important session of all.

This session would warn you if the business is heavily reliant on a few large customers or suppliers. It would also raise concerns about the sustainability of the company's competitive advantages. Worse, the group is undergoing legal disputes.


Step 5: Go to "Directors, senior management and employees".

Directors representing a wide variety of educational, experience and even ethical background is a plus. Family business is not desirable for two reasons. First, a group of related parties will control the board. Second, and more importantly, lower-ranked management staff sense the glass ceiling for job promotion, affecting the working morale.

Note that those who are non-executive directors without the "independent" prefix are most likely family relatives. They cannot perform the function of surveillance like independent non-executive directors, do, nor do they work on a day-to-day basis like executive directors do. So, what are they for? i don't know.


Step 6: Go to Appendix IV -- Property valuation

Check what kind of properties the company owns. i have seen some companies own residential properties in Mid-Levels and Ho Man Tin as "staff quarters" for their chairmen, including parking space.


Step 7: Go to "Future plans and use of proceeds"

See what the company plans to do with the listing proceeds. In most cases, those proceeds will be earmarked for the expansion of production capacities, acquisitions and working capital. The media like criticizing companies for their use of the proceeds for repaying debts. i am not so irritated by the debt repayment if the financial situation justify such an act. At least you will see the results where the money is spent.

i am more concerned by uses of the proceeds for research and development, especially for obscure high-tech projects. Money can go easy in these cases.


Step 8: Go back to "Summary" and look for the subheading "Offer Statistics".

Here, you will see the valuation of the shares. Use the "pro forma diluted", or "fully diluted" price-earnings multiple (PE). The IPO valuation is of less reference value than the market valuation that emerges only after the shares are floated in the market. Still, i would suspect valuations too high (higher than 16x) or too low (lower than 7x).


If you are satisfied with what you see in a prospectus, the next step is to watch how the company performs in terms of earnings in the next two to three years before you decide to buy the shares for long-term investment. i hope i these advices will help you read a prospectus.

Mar 8, 2006
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