The first rule of IPOs – and how Kromek broke it

published 3 April 2014

First impressions matter. When you're introduced to someone new, you form a view of them based on all sorts of signals appearance, body language, how they speak. Some of those cues might be a bit irrational, but we use our experience of people and life to form snap judgements.

The same applies to companies. So when a new company comes to the stock market through an initial public offering (IPO), it's of vital importance they create the right image straight away. The very first impressions will be carefully managed through the roadshows and well-rehearsed investor meetings. But what really matters is that the company keeps the early promises made to the market.

Any profit forecasts or revenue expectations simply have to be met. There's a big element of trust involved, because as an IPO investor you only have a limited amount of information and no history to go on.

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That's why I generally prefer a patient approach to assessing IPOs, to see whether my first impression of a company, good or bad, is a sustainable one. And the company I want to tell you about today, Kromek (LON: KMK), certainly proves this theory right.

Kromek's multi-billion-dollar market' ambition

I had a brief meeting with the management of Kromek earlier this year and thought it was an interesting story. The company is one of a series of technology stocks to be spun out of the British university system, from Durham in this case. It listed on Aim in October raising £13m.

Kromek CEO Dr Arnab Basu has a PhD in physics and is very comfortable explaining the science behind the company. He is also experienced in business. His company has over 180 patents and owns technology that generates high-definition colour x-ray images. Kromek believes it has a multi-billion-dollar addressable market and had forecast strong growth.

Medical is Kromek's biggest sector opportunity where it works with the major equipment manufacturers such as GE, Siemens, Toshiba and Philips. Kromek's technology provides much-improved image quality, which in turn allows for more accurate diagnoses.

Kromek also serves the security screening market. There is demand for airport x-ray machines to become increasingly sensitive and sophisticated. In the last decade, we've been used to restrictions on liquid being carried into the passenger cabin, but these rules are being relaxed. Kromek has its own branded detector approved for detection of liquids, and expects strong growth in this market too.

The third leg is nuclear detection, where it has the US Department of Defense as a customer, as well as nuclear industry decommissioning contractors.

All these markets are exciting, and carry great promise if Kromek can gain even a small market share.

Bad customers - a young company's worst nightmare

All started well. At the share-price high back in January the company was valued at £80m, which reflected hopes for strong growth as Kromek entered the commercial phase of its development. Management was "confident about the future prospects for the business".

The first-half results in January showed turnover of only £2.7m, but a very strong second half was expected, with the full year forecast to generate £11.3m of sales. The company said this was backed by £8m of orders taken during the first half of the year.

From there, sales were forecast to nearly double in the year about to start, and then rise by another 45% to almost £32m by April 2016. Kromek would be nicely profitable by then with the shares on a price/earnings ratio of 13 times. With that sort of growth rate, I'd expect the stock to be on at least twice that rating, which would give us a price target of around 200p.

Unfortunately, it hasn't worked out like that. The transition from the development phase to the commercial phase often takes longer than hoped, especially where new technology is concerned. It's also common for contracts with large slow-moving customers to get stretched out a lot longer than a fast-moving small company would like.

Last week's profit warning said that revenue was likely to be far below expectations due to delays in a number of large contracts across a range of customers, and in all three of the company's divisions. Next year's results will be affected as well. The disastrous trading statement caused the shares to fall by 43%.

Can Kromek recover from its bad first impression?

Sadly, Kromek has ended up creating a terrible first impression. The shares now trade at 37p compared to the IPO price of 51p and that high of 82p. After the IPO promise about the exciting technology and growth opportunity, we now have a picture of an overly optimistic management who have much less control and visibility over their order book than they would like.

In my last article, I said I preferred a patient approach to assessing IPOs, and that it often paid to wait and see when sorting the wheat from the chaff. Kromek is a good example of why I have this view. I was certainly tempted by the story, but I wanted a bit more evidence that those aggressive growth forecasts could be met. The problem for Kromek is that it won't get the benefit of the doubt going forward. We'll all want to see the evidence before rehabilitating the shares. If you create a bad early impression, it can be a long road back.