Should you buy OzForex?

Described as the hottest initial public offering this year, OzForex (ASX: OFX) starts life as publicly traded company today. The company is valued at $480 million, 21.7 times forecast earnings for the 12 months to September 30, 2014, with an indicative dividend yield of 3-4% based on a targeted payout ratio of 70-80% of forecast profit.

The company was founded in 1998 and quickly built its business undercutting the dismal foreign exchange rates offered by the big four banks on international money transfers. The client base has largely been retail and small to medium size enterprises, often wholesale importers of goods into Australia. The banks will typically charge a 2-4% spread, high compared to what a business like OzForex can offer.

The group is being sold by founders Matt Gilmour and Gary Lloyd, who will retain a 4% stake each. Macquarie Group (ASX: MQG) and private equity firms the Carlyle Group and Accel Partners are also selling their holdings. In the 2013 financial year the group made a net profit of $17.1 million.

Sound tempting? Well investors should consider some key risks you won’t find amongst the media hype. For a long time OzForex had something of a free shot at undercutting the banks, however this market is now getting increasingly crowded.

In fact OzForex has been getting a dose of its own medicine recently, as smaller competitors like Associated Foreign Exchange look to steal market share and undercut Oz Forex’s own rates. The big four banks are also said to be considering fight back strategies. This all adds up to an increasingly competitive picture.

International money transfer businesses are also heavily regulated due to the associated money-laundering risks. This can make obtaining remittance licenses in jurisdictions outside Australia difficult and bring additional costs in managing risk and compliance when expanding at home or abroad.

A look through Oz Forex’s Financial Services Guide will also reveal the practice of paying employees a commission based on a percentage of the profit derived on each transaction. In other words, the higher the spread the greater the employee’s commission. This practice has come under regulatory scrutiny in 2013, with the implementation of The Future of Financial Advice Reforms. The legislation limits conflicted remuneration practices and may be revisited in the future. Paying fee-earning employees on this basis is a key part of a business model that, if threatened, may have serious consequences.

Foolish takeaway

When a company decides to go public investors should ask themselves several questions before deciding to buy in. The key question being who are the owners and why have they decided now is the best time to sell out and attract investors?

This IPO has certainly received some good publicity and the group looks set to start life trading on a high multiple to forecast earnings. Any dip in those earnings could spell trouble though and investors should think very carefully before jumping onboard. There are plenty of other smaller companies that provide opportunity. Discover two stellar small-cap opportunities now, in our brand-new research report, “2 Small Cap Superstars” — simply click here to download your FREE copy.

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Motley Fool contributor Tom Richardson owns shares Macquarie Group.

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