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November 14, 2006

The Best IPO of 2006 is ... Efuture Information Technology Inc.

posted by MR WAVETHEORY at 11/14/2006 10:09:00 PM
If you are a venture capitalist, you know how important IPOs can be. IPOs are the bread and butter of venture fund returns. IPOs set apart the top venture capital firms from the wannabes. They don't just return the money that you invested 1x or 2x. The top IPOs can return 10x or more. That is why I track IPOs. I was as surprised as anyone when I learned that the best performing IPO for 2006 is a small company called Efuture Information Technology Inc. (Nasdaq EFUT). Efuture has returned 627% as of today since its debut on November 1, 2006. That is a whopping 6x the initial offering price of $6. Who were the lucky investors? A few lucky souls from Beijing and Hainan whom I'm sure you would have never heard of. Certainly, I had never heard of them.

The Business of eFuture
According to the prospectus, eFuture is a Chinese enterprise software company.
We are a leading provider of integrated software and professional services for manufacturers, distributors, wholesalers, logistics companies and retailers in China’s supply chain front market. At the present time, our customers are centered in the retail, automotive, general household appliance and consumer goods industries. Our software products, however, can optimize the operations of businesses in a wide variety of industries. We expect to broaden our scope of customers over time.

A Small IPO That Delivered Big Returns

eFuture debuted on November 1, 2006 at $6 per share (press release). Efuture issued 1,133,500 ordinary shares at $6.00/shar, raising 6.8 million dollars. That is quite a small IPO by any measure. In fact, the size of the deal is very small by IPO standards and a venture capital firm could have done it. So, why did the company not just do a VC round? I think many Chinese companies are going directly to the IPO markets because the venture capital market in China is very underdeveloped and so many of the companies you see that have "China" in their names tend to be microcaps.

What I find interesting is the promotional nature of the press release, eFuture brags about its position in the marketplace.

eFuture is the first Chinese software company listed in NASDAQ CAPITAL MARKET, and also the first software company in the front supply chain market, therefore, it will spark the interests of domestic and overseas investors sooner or later.

I think the answer was sooner rather than later.

Why Did the IPO Perform So Well?
If all you cared about were returns, then this is a quality deal. Looking at the underwriters, you would not have been able to tell. The underwriter of the deal is Anderson & Strudwick, Inc. and this is Anderson & Strudwick's first Chinese deal. The underwriters were very smart in their deal structuring. The underwriters received warrants in this deal. The number of warrants was not specified in the documents and neither was the strike price. But judging from where the stock is trading, the warrants may be well in the money.

We have entered into a Warrant Agreement with our underwriter in connection with our contemplated public offering. Pursuant to this agreement, we have granted the underwriter with the following registration rights relating to the shares underlying the warrant granted to the underwriter as partial consideration for services rendered in connection with our contemplated public offering:

So, why did the IPO perform so well? The answer: Supply and demand. With 1.1 million shares outstanding and a float that according to Yahoo! Finance is just 45,000 shares, the supply of shares was just not enough to meet speculative demand. The 45,000 share float seems very small to me. Let's assume that 45,000 is the right number. That means today, EFuture traded 317x its float. (Volume was 14,267,029 million shares today.). That implies the float turned over 48x per hour! Talk about speculation!

I have been trying to explain the rapid rise of eFuture because the gains in this IPO have been enormous. One explanation for the small float could be that this was a bought deal meaning that the underwriters bought all the shares at $6 per share and therefore were responsible for distributing it. In bought deals, the underwriter actually buys all the stock from the company. That means there are no shares around to be bought - except from the underwriter. That explains the supply side of the equation. How about the demand side? Now, assume you had heard about eFuture from a friend and imagine you really wanted to buy this stock and there is only one seller - Anderson & Strudwick. You the buyer would have to pay whatever the seller asks. If there are large numbers of speculators like you, then demand trumps supply and the stock goes up until it reaches a market clearing price. Is this rational? Economics 101 says that it is. Is the valuation rational? That is another story.

Another explanation for Efuture's meteoric rise is that there may have been speculators who were shorting the stock betting that the stock would decline. After all, eFuture had climbed inexplicably from $14.98 to $19.89 to $29.49 in 3 days, and any Hedge Fund Hero would have thought, "I'm smart. eFuture is trading at 50x earnings. It is barely growing. No brainer short." This is how things could have played out. Sensing opportunity, our Hedge Fund Hero goes and shorts a couple of lots at $25, then $28, then $31. eFuture just wouldn't stop. Everything would have been perfect - except our Hedge Fund Hero got caught in a short squeeze.

What is a short squeeze you might be wondering? When you try to short a stock, your broker actually has to go out and locate it. Your broker has to find the stock certificates. With a float of 45,000 shares just 3 days hot off the press, there simply are no shares to locate. How do you find shares of a company 3 days post IPO? Add to that the fact that it could have been a bought deal, and our Hedge Fund Hero ran into Hero Trouble. The solution: Scramble for cover. Our Hedge Fund Hero buys every share out there. Except, there is one small problem: There is only one seller. You guessed it: Anderson & Strudwick.

Revenues and Profits
From a financial perspective, eFuture barely has any revenues. In 2005, eFuture generated $4,862,829 in revenues and $677,834 in profits vs $4,300,284 and $560,742 in 2004 (assuming an exchange rate of 8.07 RMB/$). That means based on today's closing, the stock is trading at 96X 2005 earnings. Expensive? I think any investor, whether value or growth, will concede that a company that is growing at 20% is very expensive when it trades at 96x earnings. Add to that a liquidity discount since it is a new company and you have a very expensive stock.


How much did the pre-IPO investors make?
According to the SEC filings, eFuture was started with RMB 500,000. That's about $62,500. Eventually, the company raised roughly RMB 10,000,000. That's about $1.25 million.

e-Future (Beijing) Tornado Information Technology Inc. (“e-Future Beijing”) was established as a domestic Chinese company in April 2000 with total share capital of RMB 500,000, of which Hainan Future Computer Company Limited (“Hainan Future”) contributed RMB 400,000 (80%) and Dafu Zou contributed RMB 100,000 (20%). In July 2000, Mr. Zou transferred his shares to Johnson Li, our Vice President for RMB 100,000. In July 2000, e-Future Beijing was reorganized and its capital was increased to RMB 5,000,000. In connection with the recapitalization, Hainan Future increased its investment in e-Future Beijing to RMB 4,000,000, and Mr. Li increased his investment to RMB 1,000,000. Since its inception in January 2000, e-Future Beijing has developed and integrated software for China’s supply chain front market.


There are 1.5 million shares outstanding and that means eFuture's market capitalization is $65.4 million (closing price of $43.60 x 1.5 million shares). That means the investors in this company have made 52x their money. That is a monster return.

What is the IRR?
The IRR for investors over 6 years is 93%. Talk about a blowout return! Any vintage 2000 fund would die to have that kind of return.

Conclusion
Efuture is very speculative. Should investors care? Yes, because by definition investors are betting on the long term performance of a company and investors cannot afford to overpay. Should speculators care? No. Speculators care only about one thing: supply and demand. If there is a supply and demand imbalance, it's a great opportunity to pounce.

Before I leave you off, I think there are several lessons that any investor can learn from eFuture.

1) Chinese IPOs can behave like rocket ships. They can also tank very fast. (Read How to Invest in China Stocks.) Many of them are really venture type investments that have decided to go public early - well before any US company would. IPOs are by nature very speculative. Chinese IPOs are even more so.
2) Shorting IPOs can be very dangerous. Just ask our fictional Hedge Fund Hero. Our Hero discovered there were no shares to borrow and got roasted. Don't be a Hedge Fund Hero especially with retirement money.
3) Speculate only with speculative capital. Invest with investment capital.

I want to emphasize that eFuture is one of the most wildest speculative crazes I have seen. Speculate only with capital you can afford to part ways with. I will not speculate on its forward looking performance, but one thing I do know is that whatever goes up has to come down. That is an inevitable law of gravity. It's only a matter of when (Check out Borland. Borland was once a darling of the software industry worth $4 billion. Today it is worth $400 million). I prefer to watch from the sidelines.

The Top Performing IPOs of 2006 (Last 12 Months)
Below is a chart of the top performing IPOs of 2006 ranked by Total Return which is defined as the current price of the stock vs the IPO price. You can see that until recently, the top performing IPO of 2006 was Under Armour, Inc. (Nasdaq UARM) which was a Goldman Sachs deal.

Company Name Symbol Date Underwriter Offer Price First Day Close Price Current Price Total Return Aftermarket Return
Efuture Information Technology Inc. EFUT 11/1/2006 Anderson & Strudwick, Inc. $6.00 $14.28 $43.60 626.67% 205.32%
Under Armour Inc. UARM 11/17/2005 Goldman Sachs $13.00 $25.30 $45.31 248.50% 79.10%
Riverbed Technology RVBD 9/20/2006 Goldman Sachs $9.75 $15.30 $28.23 189.50% 84.50%
Chipotle Mexican Grill CMG 1/25/2006 Morgan Stanley $22.00 $44.00 $57.87 163.00% 31.50%
Omrix Biopharmaceuticals OMRI 4/20/2006 UBS Investment Bank $10.00 $10.03 $25.90 159.00% 158.20%
Brookdale Senior Living BKD 11/21/2005 Goldman Sachs $19.00 $25.43 $46.80 146.30% 84.00%
MasterCard Incorporated MA 5/24/2006 Goldman Sachs $39.00 $46.00 $95.20 144.10% 107.00%
Acorda Therapeutics ACOR 2/9/2006 Banc of America $6.00 $6.72 $14.62 143.70% 117.60%
Crocs Inc. CROX 2/7/2006 Piper Jaffray $21.00 $28.55 $48.13 129.20% 68.60%
Volcano Corporation VOLC 6/14/2006 J.P. Morgan $8.00 $8.80 $17.85 123.10% 102.80%
New Oriental Education EDU 9/6/2006 Credit Suisse $15.00 $20.88 $31.85 112.30% 52.50%
SunPower Corp SPWR 11/16/2005 Credit Suisse $18.00 $25.45 $38.14 111.90% 49.90%
Copa Holdings CPA 12/14/2005 Morgan Stanley $20.00 $24.25 $41.41 107.10% 70.80%
Home Inns & Hotels Management HMIN 10/25/2006 Credit Suisse $13.80 $22.50 $28.30 105.10% 25.80%
Techwell TWLL 6/20/2006 Lehman Brothers $9.00 $8.75 $17.86 98.40% 104.10%
Vocus Inc. VOCS 12/6/2005 Thomas Weisel $9.00 $10.00 $17.45 93.90% 74.50%
Liquidity Services LQDT 2/22/2006 Friedman Billings $10.00 $12.29 $19.05 90.50% 55.00%
Osiris Therapeutics OSIR 8/3/2006 Jefferies $11.00 $11.00 $20.89 89.90% 89.90%
Suntech Power Holdings STP 12/13/2005 Credit Suisse $15.00 $21.20 $27.99 86.60% 32.00%
eHealth EHTH 10/12/2006 Morgan Stanley $14.00 $22.90 $25.90 85.00% 13.10%
Pacific Airport Group PAC 2/23/2006 Credit Suisse $21.00 $28.26 $38.45 83.10% 36.10%
Houston Wire & Cable Co. HWCC 6/14/2006 William Blair $13.00 $15.21 $23.78 82.90% 56.30%
DivX, Inc. DIVX 9/21/2006 J.P. Morgan $16.00 $18.70 $28.99 81.20% 55.00%
Synchronoss Technologies SNCR 6/14/2006 Goldman Sachs $8.00 $8.85 $13.65 70.60% 54.20%
J.Crew JCG 6/27/2006 Goldman Sachs $20.00 $25.55 $33.90 69.50% 32.70%
CTC Media CTCM 5/31/2006 Morgan Stanley $14.00 $17.00 $23.25 66.10% 36.80%

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2 Comments:

Anonymous Anonymous said...

This is really great article about EFUT IPO.
I just wonder if people can really short any IPOs

4:33 PM  
Blogger passion@itsbEsT said...

found it useful. thanks! what about 2007 and 2008?

8:46 AM  

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