Valuecruncher places a mid-point valuation of $3.65 per share on lines company Horizon Energy with a sensitivity range of $3.46 to $3.85. At the time of the valuation Horizon was trading at $3.50.

Horizon Business Summary

Horizon’s core business is delivering electricity from the Transpower operated national grid to approximately 23,000 customers in the Eastern Bay of Plenty. The Commerce Commission set the pricing framework for lines companies such as Horizon in 2004 based on a price-threshold calculated as a function of inflation. This price threshold and the low growth in electricity demand in the Eastern Bay of Plenty limit Horizon’s growth opportunities. The current pricing framework is in place until 2009. Lines companies are pressing for a revised framework that incorporates the increased costs associated with managing and upgrading distribution networks, particularly in low population density regions. Horizon is looking to develop non-regulated business units to generate growth and recently set up a contracting arm that focus on lines maintenance, tree inspection and cutting services.

NZ Electricity Distribution

The fragmented nature of the regional electricity distribution companies would typically lend itself to consolidation. The ownership structure (typically community trusts) and the limited commercial viability of low-density distribution networks under the current regulatory environment has limited the consolidation of smaller players. As a listed entity Horizon would be well placed to play a leading role in any consolidation of regional lines companies.
Valuation Assumptions

Valuecruncher has assumed that revenues will grow at a constant 3% based on the regulatory framework and expected electricity demand growth. The financial projections assume that Horizon maintain their current EBIT margins (27.6%). Valuecruncher has used a cost of capital of 8%.
Uncertainty and Risks

In the long-term the key-uncertainty facing Horizon is what pricing framework will be implemented in 2009, this will have a significant impact the re-investment strategy adopted by lines companies. In the short-term the key risk is the impact of adverse weather events on profitability.

Comparable Company Analysis

Vector is the only other listed company in New Zealand involved in electricity distribution. Vector has limited relevance as a comparable company due to it’s larger size and range of business units, including gas sales and distribution. Horizon is currently trading at an EV/EBITDA multiple of 10 compared to Vector at 9.4.

Valuecruncher Valuation Report - Horizon Energy Distribution Limited

The recent successful Xero initial public offering (IPO) and the current BurgerFuel IPO have drawn comparisons to the 42 Below listing in 2003. The common characteristics of these 3 IPOs are that the companies involved all had minimal or negative earnings, valuations that implied significant growth and a global strategy. The products, markets and business models of the 3 companies are completely different. Commentators have cited the returns provided to investors in 42 Below, “Shareholders made a lot of money out of it” (at approximately 2 min 20 sec), as a guide to the potential returns available from growth companies. Valuecruncher has posted previously on both the Xero and BurgerFuel IPOs. Given the comparisons Valuecruncher has decided to review the return provided to investors in the 42 Below IPO.

42 Below undertook an IPO in September 2003 issuing 31 million shares at $0.50 raising $15.5 million (every 3 shares purchased in the IPO was accompanied by 1 warrant with an exercise price of $0.50 available for exercise during October 2005). The issue price of $0.50 implied a post-money valuation of $60.5 million. At the time of listing 42 Below had negative earnings.

Post the IPO 42 Below traded significantly below the IPO price of $0.50 and remained below $0.50 for the majority of the first year it was listed. In the year ending 31 March 2004 42 Below had operating revenues of $4.41 million and an operating deficit of $1.125 million. This is to be expected from a company such as 42 Below that is developing products, expanding into new markets and building a brand.

42 Below continued to grow sales and in the 2005 financial year had operating revenues of $12.58 million producing an operating deficit of $5.22 million. A key driver of revenue growth in the 2005 year was increased sales in the U.S.. During the 2005 calendar year 42 Below consistently traded above $0.50 and at times over $0.80. In 2005 42 Below engaged Macquarie to advise on strategic issues surrounding development of international opportunities, the Bacardi offer arose as a result of this process.

In the 2006 financial year 42 Below continued to exhibit strong revenue growth increasing operating revenue to $17.0 million and improving the operating deficit to $2.8 million. A key contributor to these improved results was a foreign exchange gain of approximately $1.2 million.

After being listed for 2 1/2 years and nearly 4 full years of financial reporting 42 Below had grown revenues to approximately $17 million, established a strong brand in the New Zealand market for premium spirits and had grown sales in the U.S. to over $6 million in 2006. Despite this 42 Below was still not profitable. Although 42 Below were growing revenues, these revenues were spread across geographical segments (primarily New Zealand and the United States). Based on management forecasts for the 2007 financial year 42 Below was expecting trading revenues to grow to $18.2 and EBIT of ($4.9) million [compared to ($3.7) million in 2006].

On 27 September 2006 Bacardi made a full takeover offer for 42 Below at a price of $0.77. The day prior to the offer 42 Below closed at $0.57 and had traded at a volume weighted average price of $0.55 in the 6 months prior to the offer. Valuecruncher has discussed the framework required to evaluate the Bacardi offer in a previous post.

The offer from Bacardi represents a 54% return for an investor in the IPO, this represents an annualised return of 15.5%. Based on the $0.57 price the day before the offer the gross return would have been 14% or 4.5% annualised. In Valuecruncher’s opinion the Bacardi offer represented an excellent opportunity for investors to realise value from a company that had done a great job building a brand and penetrating the tough U.S. market but was showing no signs of reaching profitability.

A professional early stage investor (i.e. a venture capitalist) targets a 10x return on investment over a period of 5-7 years. The 42 Below return for IPO investors (even with the sale to Bacardi) is well below this targeted level.

Although the 15.5% annualised return realised via the Bacardi offer was a significant improvement on the pre-offer price it can hardly be described as a “home run” return for investors in a startup IPO. Citing the 42 Below result as validation for investing in early stage growth companies on the NZX is misleading. Each investment should be considered on it’s merits. Companies such as Xero have the ability to develop into global players and have significant upside potential but investors should not be relying on a 42 Below style exit to realise their return. If these growth companies achieve a significant global presence investors should expect a return well in excess of 15% per annum (of course any return is a function of the price paid).

Note: This analysis focuses on the return to an investor in the 42 Below IPO who adopted a buy and hold strategy and does not incorporate potential returns from any warrants exercised. 

Last week Valuecruncher commented on the BurgerFuel IPO. The post focused on the post IPO valuation of $60 million and carried out some high-level and subjective analysis of what that valuation implied in terms of BurgerFuel stores in 5 years. This analysis was restricted by the limited information provided in the prospectus. The BurgerFuel Team has responded (via a comment in the previous post) to the analysis and highlighted alternative assumptions for a couple of the key variables in our analysis. Valuecruncher is surprised that BurgerFuel are commenting during the IPO process and would like to reiterate BurgerFuel’s point that “responses do not constitute prospective or forecast financial information”.

The two key assumptions queried by BurgerFuel were:

• Revenue in year 5 from franchise setup fees.
• Growth in average sales per store.

In the original post Valuecruncher did not explicitly account for the revenues from franchise setup fees, we stated approximately 700 stores would be required to generate the $76.6 million expected in year 5 (based on our analysis). At $1 million sales per store 700 stores was a conservative approximation that incorporated an allowance for franchise setup fees. It is difficult to estimate the the setup fee figure because you don’t know how many franchises will be sold to franchisees in that year.

Valuecruncher assumed that average store sales were $1 million (based on information contained in the prospectus). BurgerFuel raise the valid point that this number could increase over time and suggest an 8% pa growth rate. Although the prospectus contains historic store numbers and system sales they have not included a historic same store sales growth figure, this information would be useful to any investor evaluating the opportunity and Valuecruncher can see no reason why it wasn’t included. The average store sales of $1 million dollars reflects the performance of the current NZ operations, we have no idea what level of sales will be achieved in other markets (Lance Wiggs provides an overview of the competitive landscape) or what level of sales stores will experience as they open but find it hard to justify an abitrary assumption of 8% pa growth. 

Based on the revised assumptions provided by BurgerFuel the 5-year target drops from Valuecruncher’s figure 700 stores to 350 stores (350 stores represents opening an average of 1.3 stores per week every week for the next 5 years). Valuecruncher stands by the original assumptions used but the response highlights the uncertainty involved and how sensitive the analysis is to your assumptions. 

The return generated by an investment is a function of the price paid and Valuecruncher believes the current valuation does not reflect the risk and uncertainty associated with the BurgerFuel opportunity. BurgerFuel and their advisors should have conducted detailed analysis of the opportunity when determining the IPO price, it would have been nice if they could have shared some of their assumptions and expectations with potential investors in the prospectus.