QUESTION
| Requirements:
Question 1. Critically discuss reasons for the phenomenon of initial underpricing when firms undertake Initial Public Offerings. (50%) Question 2. Recent years have been exceptionally difficult for new firms who desperately need financing to grow. A general lack of capital and funding in the financial markets means that companies need an exceptionally strong story to sell to investors if they are going to be successful in their fund-raising efforts. You are required to investigate the IPO of Ocado in July 2010 and provide a critical analysis of what happened. You are specifically required to discuss the following: a) What were the reasons why the firm went to the markets to raise financing? From your own research, what were the main risk factors facing the firm? b) Provide a detailed chronology of the IPO attempt. Your discussion should provide your own insights of each event. c) Consider the post IPO share price performance (one week post IPO). What are your views? You should consult a range of sources and collect news stories on your IPO. However you need to make use of relevant academic literature in your analysis. (50%)
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| Assessment Criteria: in determining the grade to be awarded, examiners will take into account the following:
– evidence of independent research, in particular the ability to identify relevant materials, including academic articles, books and real world examples (if necessary) to support the arguments. – ability to critically employ appropriate academic literature, including theoretical predictions and empirical findings to construct arguments, and – clear and concise writing.
You should allocate approximately 1,000 words for each question.
Please note that your answer for both questions should be based on the relevant academic literature (both theoretical and empirical) and should be appropriately referenced.
Real-world examples, if cited, should be referred to the sources, e.g. financial newspapers, regulatory reports, company annual reports etc. |
| Referencing: you must reference your work correctly using the Harvard method. Failure to do so will result in the deduction of marks and possible proceedings under the University’s Regulations as to the Use of Unfair Means |
| Independence of working:
You are reminded of the University’s Regulations on the Use of Unfair Means, which are outlined in the School’s Handbooks. Should you be found to be in breach of them you will be subject to disciplinary procedures. |
| Submission Details: |
| Other matters: |
SOLUTION
About OCADO:
OCADO is a retail company mainly based on the internet that delivers goods (food related products, beverages, household goods etc.) similar to a supermarket (Ocadogroup). It positions itself as an online grocer that provides an easy platform for the customers to buy their goods and provides a unique experience than the existing supermarket and more importantly provides home delivery of the goods. On 5th July 2010, OCADO issued the prospectus of its Initial Public Offering (Dineen, S, 2010) which provides complete details about the company, the online retail industry and the risk factors involved in investing in the company.
Firms generally issue IPOs in order to raise capital mainly for expansion and also for a market so as to allow the founders to liquidate a share of their ownership. Ritter J, and Welch I (2002) have cited few theories (Life Cycle theories, Market Timing Theories) in their study which explain why companies decide to go public. The life cycle theory emphasises that the companies prefer to stay private in its early stages and aim to go public once they grow in size. On the other hand the Market Timing theory states that companies wait for market situations so that they get high valuations while going public. In the case of OCADO, the main motivation is to the strategic objective of step by step development. The management expects to raise £200 million from the issue out of which £45 million will be used within six months to pay off some of the debt that the company has taken. The proceeds from the IPO are expected to be used for the following purposes:
- Capacity expansion by almost 72% through infusion of around £80 million
- Aims to invest £ 2-10 million every year to develop new and improve existing spokes
- Part of the issue would be used in construction which forms the major move in the expansion strategy to create another Customer Fulfilment Centre which is expected to cost around £210 million.
IPOs generally are expected to be riskier investments as the capital markets are exposed to the market forces. Similarly, the IPO of Ocado is exposed to different risk factors which are mentioned in detail in the prospectus. Some of them are:
- The low demand in the online grocery market in the country would affect Ocado’s performance which is a loss making company. It is not keen on distributing dividends as it does not expect to be profitable in the near future.
- The capacity of the company is defined by the Customer Fulfilment Centre (CFC) and currently Ocado has only one CFC, thus, restricting its operations as a result of which the revenues are also limited. However, the company plans to expand through the proceeds of this issue.
- OCADO is one of the few players in the online grocery industry which is still new for the consumers and it is exposed to many risks such as intellectual property rights, security related issues with internet business etc. Moreover, it is not difficult to start an enterprise in the internet industry where the funding is easily available, thus, exposing the company to threat from new entrants.
- Other than the mentioned risks, the main risk factor is the demand for IPOs in the market. The market conditions are such that few companies like New Look (retail sector), Fairfield Energy, Ferrous Resources etc. have postponed their IPOs due to lack of demand (Sakoui A, Johnson M, 2010). Thus, it might be difficult for Ocado to find full subscription at the quoted price.
Ocado has mentioned in their prospectus the schedule of the IPO shown in the figure below:
Figure 1: Expected Timetable for the offers, Prospectus Ocado
The prospectus has been issued on 5th July 2010 and the application period starts from the very next day till EOD of 18th July for the customers and the employees. However, for the minor shareholders and the selling option holders the last date to confirm is 13th July and 20th July is termed as the last date for the receipt of intentions about the offer. The offer price and allocation of the ordinary shares and the conditional dealings of shares are expected to be allowed on the London Stock Exchange the very next day i.e. 21st July. However, unconditional dealings will commence from 26th July, and on the very same day the ordinary shares are expected to be credit to the Ocado share account which is expected to be available online from 4th August 2010. The whole process is, thus, expected to take less than a month to complete. The over or under subscription of the issue will be declared on the 21st which will decide how the issue has performed.
IPO under pricing and under performance of have been the focus of many theoretical and empirical studies. In a certain study of IPOs, Brau JC and Fawcett SE (2006) found that IPOs have averaged 18% under pricing between 1960 and 2003. IPOs are under priced in order o ensure that investors subscribe to the issue and a higher price on the first day of listing reflects a positive sign about the company. However, in the case of OCADO, analysts believe that the issue has been over priced and the company has been overvalued. The performance of the Ocado’s stock in the London Stock Exchange for the next week is shown in the figure below:
Figure 2: performance of the Ocado Stock in LTSE, business monitor international
Prior to the floatation due to lack of demand in the market the management had to slash down the price, despite of this the share price of the company opened lower than the floatation price and decreased further during the day resulting in lowering of the valuation to £853m than expected £1.18bn (Lowery A, 2010).
The IPO issue of OCADO can be viewed as an ambitious attempt by the company when the investors’ sentiments are weak. There were not enough subscribers to the IPO due to several reasons. Pritsker M (2005) highlights two reasons for underperformance of an IPO, they are:
- the return expectations in the long run exceed that of the short run
- Adjustment for a benchmark risk reduces the expected returns of the asset
Thus, we can conclude that OCADO’s IPO failure can be due to any of the reasons mentioned above or it is merely due to the lack of demand for IPOs and the current market conditions.
References
Brau JC, Fawcett SE, February 2006, Initial Public Offerings: An Analysis of Theory and Practice, The Journal of Finance, vol. lxi, no. 1, [online] Available at: < http://marriottschool.net/emp/brau/JF%202006%20Vol.%2061%20IPO%20Theory%20and%20Practice.pdf> [Accessed 23 April 2012]
Business Motor International, 27 July 2010, Private Equity Firms Driving M&A Activity in Food, [online] Available at: < http://store.businessmonitor.com/article/370001> [Accessed 23 April 2012]
Dineen, S, 5 July 2010, Ocado issues IPO prospectus. CITY A.M, [online] Available at: < http://www.cityam.com/news-and-analysis/ocado-issues-ipo-prospectus> [Accessed 23 April 2012]
Figure 2: performance of the Ocado Stock in LTSE, business monitor international, 27 July 2010, Private Equity Firms Driving M&A Activity in Food
Finch J, 20 July 2010, Ocado forced to slash float price. The Guardian, [online] Available at: < http://www.guardian.co.uk/business/2010/jul/20/ocado-slash-shares-float-price> [Accessed 23 April 2012]
Lowery A, 21 July 2010, Ocado shares fall 12% in troubled IPO. This is money.co.uk, [online] Available at: < http://www.thisismoney.co.uk/money/markets/article-1699503/Ocado-shares-fall-12-in-troubled-IPO.html > [Accessed 23 April 2012]
Ocadogroup, What makes Ocado Unique, [online] Available at: < http://www.ocadogroup.com/> [Accessed 23 April 2012]
Pritsker M, 18 November 2005, A Fully-Rational Liquidity-Based Theory of IPO Underpricing and Underperformance, [online] Available at: <http://business.rice.edu/uploadedFiles/Faculty_and_Research/Academic_Areas/Finance/Seminar_PDFs/pdf05_06_ipoliquidity8.15.pdf> [Accessed 23 April 2012]
Ritter J, Welch I, Feb 2002, A Review of IPO Activity, Pricing, And Allocations, [online] Available at: < http://www.nber.org/papers/w8805.pdf> [Accessed 23 April 2012]
Sakoui A, 30 Aug 2010, Johnson M, UK investor power scuppers many IPOs. Financial Times, [online] Available at: <http://www.ft.com/intl/cms/s/0/3c7fe8bc-b468-11df-8208-00144feabdc0.html#axzz1srkvVRzx> [Accessed 23 April 2012]
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