SPAC, a view post QA

REMINDER/ DISCLAIMER: THIS IS NOT A RECOMMENDATION TO BUY OR SELL HIBISCUS OR ANY SPAC OR ANY SHARES. IT IS INTENDED TO EDUCATIONAL AND DISCUSSION PURPOSE WITH A VIEW TO PROMOTE MORE ANALYTICAL INVESTING AND LESS GAMBLING.
 
I decided to continue to share more of my understanding of SPAC due to the very encouraging responses I received on the previous two postings on SPAC, the first which discussed on the nature and understanding of SPAC and the second one which talked about the enigma of trying to grapple with the valuation of  SPACs.

I started by listing down all the SPAC in Malaysia again. While the imeediate number that came to my mind was 3, I stopped writing after the names Sona and Cliq. I hesitated to include Hibiscus as i recalled that it had completed its qualifying acquisition (QA).

The question that I had to answer was: was Hibiscus still a SPAC or should I now consider it as an oil and gas company? The answer to this question it only then would I be able to appropriately understand, assess and evaluate the company.

The first thing I checked was the Bursa Malaysia classification. Nope, Hibiscus is no longer classified as a SPAC. How about Bloomberg? When I checked on 7 June 2013, it is stated as Sector: Financials; Industry: Specialty Finance. Sounds like SPAC to me. Well now we have two different 'market experts' with two different opinions on the nature of the beast entity.

But the nature of the company is not as simple as a reclassification on the board. In the actual sense, it should be determined by its business model.

As I had argued in previous posting, I view a SPAC before the QA as a private equity fund. The question is whether post QA, does a SPAC cease to be a private equity company and become a normal operating company or does it continue to be a private equity company. The answer will change the perspective in which I view a SPAC, the risk assessment and the evaluation (some may say valuation).

Let me try to explain why. A private equity company makes money from buying, investing and finally exiting the investment. Cashing in from the dividends and proceeds of the sale of the investee company. It does not need to hold a majority stake as it is more interested in the ability to groom and sell the company later rather than managing and living of the profits and cashflow of the company. The proceeds of the sale of the initial investment will be used to find another acquisition which it will try to replicate the success with the initial investments. The value of the investment in the private equity will grow  based on the size of the assets it has and the quality of the private equity will depend on the liquidity or ability to convert those assets into cash.

A normal operating company, especially a normal operating company listed on an exchange has to have a business model and business operations that are in perpetuity. The operations must be on going concern basis and the company must have control over the assets (most importantly cashflow) and the business direction of the operations and assets, particularly when it comes to paying dividends. In other words, the company must have an identifiable core business. And to be listed, the core business must be able to satisfy the listing requirements of the exchange. If this is the business model, then the evaluation and valuation will be done on the fundamental of the company in the same manner as all the other companies operating in the same industry, which in this case the oil and gas industry with the likes of Yinson, SapuraKencana, UMWO&G, Bumi Armada and others.

So, where do I put Hibiscus as? As a private equity or a normal operating company? The only way I can objectively  put my mind at ease is to look at the equity guidelines of the Securities Commission Malaysia to see if Hibiscus would have made it as it is to the exchange.

Under 'Profit Test' an applicant needs to have a core business, defined as "the business which provides the principal source of operating revenue or after-tax profit to a corporation and which comprises the principal activities of the corporation and its subsidiary companies". Well, assuming we take the QA of Hibiscus as the 'core business', it may have passed this test if it provided the principal source of revenue and profit for Hibiscus. But that is only because Hibiscus bought and now owns 35% stake in Lime, which allowed for equity accounting. It does not come across as a typical core business in a normal IPO where ususally we would see the listing company owning 100% of the core business via direct ownership of the assets and operation or the operating company. Well, if not 100%, then a majority control is more familiar to us. In other words, no matter how big Lime grows into, the stake is only 35% (Lets not get into the RM20 million requirement and track record.)

Why is the majority control of core business is important to me? It is because if i were to treat the company as a perpetuity, I must have the comfort that it can determine the perpetuity itself, independently and without any hindrance. If I were to own less than 50% of a company, I have a much restricted rights and say on this matter. I am a minority shareholder. I mean if we were to put, size aside, the control over the core contributor of profit between Hibiscus and SapuraKencana, UMWOG or Yinson, we would able able to see the difference there.

Is it wrong? NO. Remember, the purpose i made this comparison is just to put the business model in the proper perspective according to my views. I do this so that I can try to make sense of the valuation and pricing of the shares of Hibiscus. The 35% stake in Lime has some value, and in some cases it could be more valuable than 100% of other company. 

However, lets assume all is good and lets take one common valuation indicator, the PE ratio. Based on the following, the PE for 2013 was 66.80 times! Really? That is way higher than SapuraKencana or even UMWOG, let alone the industry average of approximately 13 times.
Stock Price : 1.75 (2013-12-31)
EPS : 2.62
P/E Ratio: 66.80

How else could I make sense of all this? Well, another possible way for me to look at the price is to assume a different business model for the company.

A private equity model usually values the 'assets' on piecemeal basis. They are valued based on the a view to exit. From there, we would be able to arrive at the value of the private equity fund by adding on all the pieces of investments together. Interestingly enough, I stumbled upon a research report by a local institution that did exactly just that for Hibiscus: valuation based on the sum of parts. And the stock price of RM1.75 was within their range of estimated worth of the company.

Well, what is the takeaway here? Well, in my opinion, price is different from the value, as I have discussed previously. The demand for shares depends on the expectations of profits to be made from the movements of the shares and expectations are a function of how the investors view the company.

 If I had assumed that a SPAC post acquisition is a typical oil and gas company, I would have been baffled as to why the demand was so high compared to the fundamental of the company. However, it feels that the price makes more sense when I view the company as still a private equity venture: something that carries a high potential (hence expectations) together with an equally high amount of risk.

REMINDER/ DISCLAIMER: THIS IS NOT A RECOMMENDATION TO BUY OR SELL HIBISCUS OR ANY SPAC OR ANY SHARES. IT IS INTENDED TO EDUCATIONAL AND DISCUSSION PURPOSE WITH A VIEW TO PROMOTE MORE ANALYTICAL INVESTING AND LESS GAMBLING.

Share price: demand, supply and expectation

The price of a share is indeed an interesting item. It had brought joy to many and brought tears to just as many (if not more) investors.

Why is it interesting? To me it is interesting because the 'behaviour' of the price is unique. While it uses the same platform of demand, supply and price equilibrium mechanics of a commodity (sugar, rice, coffee etc), the characteristics could not be more different.

Understanding the characteristics and behavior of  the share price is so important that it would either place the investors as a clairvoyant, a gambler or a buffoon. 

Share price is the equilibrium price at any point of time when a buyer and seller agreed to buy and sell an amount of shares.

The above would immediately make us think of the supply and demand curves that determine the prices of commodities like sugar and rice. The price of commodities are also determined by the the intersection between the supply and demand curves. A typical demand and supply curves of a commodity would like an 'X' where the demand is higher as the price gets lower (indicating people will consume more) and the supply gets higher as the price gets higher (indicating people will produce and sell more).

But then there is a major difference between the commodity and share. Commodities are purchased to be consumed, shares are purchased to be sold back again (let's ignore dividend for the time being). You cannot chew on the share certificates or even bring it to the neighborhood grocer to buy fish (unless he trades in shares too). Generally, it has to be sold and converted into cash at the end of the day. Therefore, shares are bought with the EXPECTATION to make profit by selling the shares.

Therefore, in my opinion, the demand curve for shares are not driven by actual price but rather expectation of profit or future price. Therefore, that would explain why sometimes, as the price of the share increases, the more demand it seemed to attract. Until at one point when the expectation of further profit is nil, then the demand starts to fall.

Same with the supply side, instead of the supply being driven by the price of the shares, it is actually being driven by the expectation of future price and profit (or losses). If the expectation of the profit increases, the supply would be less as people would hang on to the shares to expect more profit.

However, we have to remember that on the supply side, there is another important factor which is realization of profit, i.e converting cash into shares or cashing in on the opportunity. This is sometimes, especially for institutional investors, may be insensitive to price or expectation as they would be set at an arbitrary figure for example 'sell when share price makes 30% gain for example". While the demand side may have this rule, it is less prevalent.

The effect of expectations on share price, in my opinion, explains a lot of things.

It explains the frustrations of investors trading on fundamental analysis and valuation as to why sometimes despite the wonderful fundamental results, the share price does not budge, or worse drops. In my book, that is because it failed to increase expectations.

Expectations are a function of the number of investors and their expectation level.

If the shares are not known to many investors, in other words they are below the radar, then any fundamental result would have a minimal effect on the shares simply because there are not going to be many investor affected by it. That is why research reports and newspaper highlights are crucial. That is why investor relationship are vital for any publicly listed company.

If we have discovered a gem of a share based on our own fundamental analysis, no matter how accurate our calculations were, it would mean nothing if our expectations are not shared by others. Not that we are wrong or anything, it is simply that other are not aware (or worse not interested or not in their mandate).

Similarly, if we were to conduct a technical analysis of a certain share, we might seem to believe that the share had turned a corner and is expected to rise. But again, if this is not known to others the price would not budge until a significant number starts to see the same thing and have the same expectations. And since the trend of a technical chart is built upon the actual historical prices of the share itself (sort of a self fulfilling prophecy),  the absence of a large number of people believing in the prophecy would then render it unfulfilled.

But this does not mean fundamental analysis or technical analysis is not important, just that we have to remember that a correct analysis does not guarantee you a profit in the stock market. It simply gives you a chance at making a profit when everyone else catches up with your findings AND you have enough staying power to wait when they do.

Decyphering SPAC of Oil & Gas companies, the valuation enigma

First and foremost, I would like to thank the readers for the unexpectedly rousing responses to the first part of discussions on SPAC, which we had tried to unravel certain aspects of the SPAC in Malaysia.

This time round we are going to look a bit deeper into the valuation aspect of the SPAC, at IPO, before qualifying acquisition and after qualifying acquisition.

At IPO

As we all know, SPAC is a 'shell' company and in my view, works in a similar fashion as a private equity fund/outfit.Basically it does not have any business, just a 'plan to make money in the oil and gas sector' and a group of experienced professionals who, in a way, 'promised' to turn that plan into a reality via acquiring businesses or part of businesses (inorganic growth). There were in a way, no hard assets and the only 'assets' would be the know-how and know-who of the management and promoters of the SPAC.

Because of the absence of businesses, there would be no fundamental analysis or valuation based on the fundamental to find the intrinsic value of the SPAC. No PE, Price to book, EV/EBITDA or the likes. The parameters were simply not there. We can't do it. We can't even do a projection of DCF because no possible business has been identified at that juncture. That was why some quarters dubbed such pooling of funds as 'blind fund'. I don't agree with that term though, I would term is as 'pure faith' fund.

This would also explain why some investors who had invested in IPOs before might be a bit baffled, especially if they were used to having a point of reference, an intrinsic value to give an indication on the value of the shares that they were paying.

I hold this opinion about the value and price of shares listed on an exchange. They are different but linked. The intrinsic value of the shares is not the same as the price of the shares. What were transacted on the exchange were the prices of the shares, determined by the supply and demand of the shares - someone was willing to sell at that price to someone who was willing to buy at that price. Simple as that.

Intrinsic value or valuation, in my book, is akin to a shadow in a painting  or drawing. If we were to draw a chicken on a clean white canvas , the chicken will look like it is hanging in midair (this is fasting month so my analogies and references are automatically drawn to food or its source, my apologies). Once we drew the shadow for the chicken, then we would be able get the perspective of position. That, in my book, what intrinsic valuation does. It brings perspective to the price of the shares (the picture of the chicken).

So, in the case of a SPAC, that was what was missing. You have a price yet you have no calculation of intrinsic value. That should explain why some people could not grasp with the price of the SPAC - they are unable to get a perspective on the price. There was no reference point.

So then how did they arrive at RM0.75 sen a share or RM0.50 sen a share or even RM1.00 per share? What were the basis?

The only way I was able to put this into perspective was to go back to the most basic of valuation and not rely on the per share valuation techniques available. I looked at the price of equity stake. Meaning I had lumped the entire shareholders together and split them into two groups, original shareholder and IPO shareholders.

The original shareholders and IPO shareholders would make up 100% of the total equity stake in the company, no more, no less (Yes there were warrants  but they were almost evenly distributed so we can ignore it for the moment). So, if the IPO shareholders, collectively, held 75% of the SPAC after the IPO, that means the original shareholders, collectively, would have held 25% stake in the company.

To repeat what I wrote in the previous article:

"In the case of SPAC, the investing public paid the IPO price to get the investment. Collectively, the public paid RM235 million for approximately 74% stake in Hibiscus Petroleum, RM364 million for roughly 75% stake in CLIQ Enengy and RM550 million for roughly 77% stake in Sona Petroleum.
The rest of the respective stake in the companies are owned by the management and pre-ipo investors and this is how much they are worth (approximately) at IPO: Hibiscus (RM78 million), CLIQ (RM109 million) and Sona (RM155 million). Since there are no assets in the company except the expertise of the management, I would look at it as this being the value of the management (mostly) and their aim to generate return by making successful acquisition(s) in the oil and gas industry."

Therefore, in order words, if I was to compare the three SPACs, the common denominator would be how much were the total value/worth 'given' to the original shareholders for their collective skills and connections. As rough 'ranking' (not to be taken as real valuation) indication for discussion purpose:
Hibiscus: RM78 million ( divided by 24% will give you RM3 million per 1% interest
CLIQ: RM109 million (divided by 25%, RM4.36 million per 1% interest)
SONA: RM155 million (divided by 23%, RM6.74 million per 1% interest)

Whether this is too much or too little is anybody's guess. This is, in my view and please correct me if I am wrong, the 'price' the shareholders paid to the management of the SPAC for creating this opportunity.

Before qualifying acquisition

At this juncture, the shares would be listed and traded on the stock exchange.

But the situation with regards to the intrinsic value remained the same, as there are no business and hard assets to speak of.

But the situation surrounding the shares and their prices have changed. While the IPO price was fixed, the open market price was not and would move depending on the supply and demand for the shares. But again, without the intrinsic valuations, it would be purely supply and demand.

It would be understandable if some investors, who are used to having fundamental valuation to back the price, feeling a bit queasy, almost sea sick. Some of my friends argued that I should anchor the price of SPAC to the 90% of the IPO proceeds as that was hard cash. Indeed that may be the floor IF there was no qualifying acquisition and the SPAC is still under the obligation to return the 90% of the proceeds back to the holders of the IPO shares.

I can buy into this argument at this juncture. As long as I have an unimpeded, unrestricted right, to 90% of the IPO price, the the value 'backing' the shares should be exactly that. I mean cash is cash. If the share price dropped below 90% of the IPO price, I would technically be making an arbitrage on the shares. There would be no risk (with the option to pull out on full receipt of the cash with interest) and I would be making a profit on the difference between the share price and the cash receipt (in case of pull outs).

But if there is any possibility or risk of me not getting the cash receipt in full when I opt out, then this does not work. Also I have to remember that I can only exercise this option during special occasions: when the company is seeking approval for a qualifying acquisition or after 3 years with no qualifying acquisition.

The same friends used this cash return clause to argue that SPAC investment is safe. SPAC ensured that you will get your money back (assuming the 3% annual interest makes up for the 10% of the IPO proceeds that were non-returnable) within 3 years. Well, my answer is that if you wanted risk free investment, then put the money in any (islamic :-) ) bank, you will at least make some profit at the end of the year. In my view, investment in SPAC is an equity investment which must be compared with the opportunity cost of investing in equity, oil and gas companies to be more accurate.

After qualifying acquisition

After a SPAC made its qualifying acquisition, it should now have its intrinsic value brought by the fundamentals of the acquiree company (or part thereof). It is therefore important to note the affect of the qualifying acquisition to the fundamental or intrinsic valuation of the SPAC post acquisition.  Would the numbers be able to support the share price (or IPO price) when compared with the rest of the oil and gas players.

Back to the analogy of drawing earlier, the picture of the chicken now has a shadow, a point of reference. And when we put that picture of our chicken to the picture of another chicken, we would get a perspective of scale. In a sense, where did the company rank amongst its peers.

In this situation, the SPAC is no longer a SPAC, but an oil and gas company and could be compared, fundamentally, with other oil and gas companies. And the price will adjust accordingly.

Reminder: The above are my personal views and shared with the intention of creating discussions (and in turn increases [my] understanding) of the SPAC. It is NO WAY a recommendation to buy or sell any SPAC.

Roadmap to IPO - Part 1- Price is not the value

Since I last posted my plan to start blogging a series of posts about IPO, the responses have been encouraging. Thank you friends!

In the introduction of this series, I touched on the definition of an IPO and that has generated some comments. Most interestingly, comments that says an IPO is a way for the investors to exit from the company. It is true, but there is more to it.

IPO as an exit

Imagine you are an owner of a private company that does a profitable business. You have invested say, 100,000 ringgit into the business and the money has become other assets like machines, stocks etc. Your only income at this point would be the profits of the business, less any reinvestment (you cannot take out those cash that you need to reinvest in the company for whatever reason). The value of your initial investment has also increased by the amount of cash you have generated from the profits and all your accumulated assets (the machines and such) less your liabilities.

Let us say that now the assets of your business has grown to RM200,000. Wow..it looked like you have doubled your wealth!

Or is it?

Let's say you had an accident and badly needs RM200,000 cash in a week. Or a business opportunity arise and you need cash of RM200,000 to grab that opportunity. And your only asset is the business that is worth RM200,000.

Now you need to turn that investment into cash. You cannot pay the car repair workshop with the shares of your company (most of the time at least). You need to realize your investment, turning it into instrument of payment and trade - cash.

What are your options? Yes, you can sell your shares in the company to someone. You scout around and tell people, "Hey, I need cash and I am willing to give this company to you - all its assets and all the future income you can get from it". Then someone (might) come along and pay you for the company or a portion of the company.

So an IPO is like that and in that sense it is technically an exit for a portion of your investments if not all. But instead of finding a private person to buy your shares, an IPO is a systematic way to offer your shares /investments to the public at large. Bankers call this the stock market, a part of the capital market.

Price is not the value

And remember the price that 'someone' paid for your RM200,000 company. It might not (most likely will not) be RM200,000. Regardless of how much it means to you, it will transact at how much it means to the buyer. If he is willing to pay only RM150,000 then that is what you get. That is the price. It is definitely not the value to you but that is the price.

Coming up next

1. An IPO lets you do wonderful things which sometimes defy common logic. You can sell a loss making company. Twitter never made a profit and valued at USD12 billion at least.

2. The price might be wrong at the start. Facebook IPO went underwater but now has shoot up way above.

3. The price might be wrong. period.

I will elaborate more about the above in the next posting.


---note---

Yazdi occasionally holds and runs corporate finance workshops, where you could gather the financial sense required to succeed in business or at your workplace. His past participants included senior managements (including a CEO or two) and executives of financial industry (including fund managers, analysts) as well as business practitioners.

If you would like to know more about his upcoming workshop of corporate finance in general, please free to drop your email at this link, here. We will not spam your mailbox - let's keep that personal between us. We appreciate your support and if you could share this with whoever you think might benefit from this (like friends or colleagues), we thank you a gazillion times.

Roadmap to an Initial Public Offering (IPO)

Initial public offering, or an IPO, is something that we normally associate with the success of a company and a process whereby the company will get loads of cash from the investors. It is the time when a company starts offering its shares to the public through the capital market and stock exchange. Companies like Felda Global Ventures, Sime Darby, Sapura, Facebook, Apple, Microsoft have all gone public.

It is indeed a wonderful thing for some companies but not all. Some failed.

I plan to start a series of writings based on IPO that will mirror the workshop that is going to be conducted under the same name. Comments are most, most welcomed.

The outline:

Roadmap to IPO

1.       The background and  economics of an IPO

a.       The objective of businesses and principles of corporate finance

b.      The capital market and the exchanges

c.       Creating  shareholder value

d.      Why go public? Is it the right thing to do?

2.       The benefits and drawbacks of being a listed company

a.       The benefits of being listed

b.      The cost of IPO and being listed

3.       Preparing for an IPO

a.       Types of company / entity that can go for an IPO

                                                   i.      Company

                                                 ii.      SPACs

                                                iii.      REITS

                                               iv.      ETF and closed-end funds

b.      Preparing for the IPO Journey

c.       Assessing the suitability and readiness  for an IPO

d.      IPO options and choosing a market for the IPO

e.      Market timing

f.        Building business process, infrastructure and compliance

g.       Establishing corporate governance

4.       Regulatory and disclosure requirements

a.       The securities laws , regulations and regulators

b.      Laws and regulatory requirements pertaining to IPO

c.       Listing routes and back-door listing

d.      Disclosure requirements

5.       The IPO process

a.       Building the right team to manage the IPO

b.      The complete cycle of an IPO process

c.       Obtaining approvals from regulators

d.      Investor relations and communications

e.      Prospectus

f.        Promoting, pricing and underwriting for the company

g.       Public offering options and its features

6.       Valuation in an IPO

a.       Valuing shares in an IPO

                                                   i.      DCF Valuations

                                                 ii.      Relative valuations

b.      Valuation issues and considerations

7.       Life as a listed company

a.       Investor / Analyst management

b.      Delivering value and promises

c.       Disclosure requirements

d.      PN17

---note---

Yazdi occasionally holds and runs corporate finance workshops, where you could gather the financial sense required to succeed in business or at your workplace. His past participants included senior managements (including a CEO or two) and executives of financial industry (including fund managers, analysts) as well as business practitioners.

If you would like to know more about his upcoming workshop of corporate finance in general, please free to drop your email at this link, here. We will not spam your mailbox - let's keep that personal between us. We appreciate your support and if you could share this with whoever you think might benefit from this (like friends or colleagues), we thank you a gazillion times.