Why the McGrath share price could be headed for a massive fall

The McGrath Limited (ASX: MEA) share price could come under significant pressure when shares resume trading, thanks to weak property market conditions.

McGrath shares went into a trading halt this morning, with an announcement to the ASX stating:

It [McGrath] is currently reviewing the 2016 financial year prospectus forecast in light of current market and trading conditions. The trading halt is requested in order to allow McGrath time to finalise its analysis of information and review by the Board.

That sounds ominously like the real estate company is going to miss its 2016 prospectus forecasts – despite only listing in December 2015 – something we warned about when it listed and I quote,

The real estate company faces the prospect of missing its prospectus forecasts if existing trends in the housing market continue.

We warned again in early March as the McGrath share price dropped to $1.37 that the chances of the share price plunging further from there were clear.

When a property company lists on the ASX at the height of a property boom, investors should naturally be sceptical. There were clues in the prospectus too that the listing on the ASX wasn’t all about “an improved capacity to attract and retain quality staff and agents through the ability to offer listed equity as an incentive and retention tool“, as the prospectus stated.

You only have to look at where the proceeds of the IPO went…

  • Roughly half or $64.2 million of the $129.6 million raised went to the existing shareholders as a nice big payout.
  • $31 million went to pay for the acquisition of the Smollen Group and its 10 real estate offices in Sydney. Shane Smollen, the 75% owner of the Smollen Group was previously McGrath’s Sales Director, and the McGrath prospectus states that the company was familiar with the Smollen Group with a long franchise relationship of over 8 years.
  • That $31 million was only the up-front payment too. The full purchase price was $52.5 million, plus up to $17.5 million in deferred consideration, payable equally in cash and shares.
  • The remainder went on paying off debt, working capital and other sundry expenses associated with the offer and the acquisition of the Smollen Group.

In other words, listing on the ASX appears to have been more about insiders realising a return on their holding than anything else.

Foolish takeaway

More bad news could be on the way too. If we knew about the falling property market in December, and yet the company is only just advising the market, a shareholder class action would not be an impossibility. That is of course, if the company is going to miss prospectus forecasts. There is a small chance that the news is positive.

The bottom line is that investors need to be hugely sceptical about any IPO, particularly those that don’t use all the funds raised to advance the company in a meaningful way. Paying out existing shareholders is one huge red flag – whether it’s private equity or other owners.

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Motley Fool writer/analyst Mike King doesn't own shares in any companies mentioned. You can follow Mike on Twitter @TMFKinga

Unless otherwise noted, the author does not have a position in any stocks mentioned by the author in the comments below. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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