Thinking of buying Roots shares? Better read this first

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There's a strong sense of déjà vu in reading the Roots Corp. initial public offering prospectus. A distinctly Canadian clothing company that calls itself a "lifestyle brand" that says it's "successfully exporting our heritage globally," with strong domestic sales and opportunities for U.S. and international expansion.

It reads a lot like the Canada Goose stock-offering materials from March. And Roots would likely be pleased to replicate Goose's flight, as the shares are up 50 per cent in the six months since its debut.

There is, however, another similarity to be mindful of. As I noted in March, Canada Goose was purchased by its private investors in 2013 for just more than $200-million, then sold to the public at a valuation of more than $2-billion, a figure that has only increased.

We don't know the Roots numbers yet, as the preliminary prospectus filed on Thursday doesn't say exactly how many shares will be offered, nor at what price. But we do know, from a note deep in the filing, that its owners paid just more than $300-million for the company in December, 2015 – less than two years ago. With Bloomberg News reporting Roots is eyeing a valuation of at least $700-million, and the possibility that investors might bid it up even more, the question becomes again: Are the private owners the only ones who will get a bargain in this IPO?

Now, certainly, the case is not as strong this time around; the tenfold increase in Canada Goose was eye-opening, while the mere doubling or more in Roots shares in less than two years is more in line with the IPO system. As I noted before, early investors and insiders in IPO companies will nearly always make out better than you, the ordinary investor. And if you avoid stocks that someone else has already made more money than you, you might not ever find anything to buy.

As well, the discrepancy in valuation seems justified. Canada Goose was able to report three-year revenue growth of 38.3 per cent; net income gains at a rate of 196 per cent; and "adjusted EBITDA," (earnings before interest, taxes, depreciation and amortization) which excludes a number of normal expenses, at an 85-per-cent rate.

By contrast, Roots has posted annual sales growth of 14 per cent over the previous three years, and its prospectus offers no assurance of great acceleration: The company offers guidance of compound annual growth in sales between 13 per cent and 17 per cent from 2016 to 2019. Its preferred profit measures of adjusted EBITDA and adjusted net income should grow in ranges of 14 per cent to 18 per cent and 18 per cent to 23 per cent, respectively, over the same period.

A word about that: Roots is by no means alone among Canadian companies in stripping out all manner of expenses in making its adjustments, but the list is long, and the adjustments boost the numbers considerably. Net income of $14.8-million in the past 12 months per International Financial Reporting Standards becomes $22.7-million in "adjusted net income" and $44.8-million in "adjusted EBITDA" with Roots' tweaks.

Which earnings measure you choose for valuation, of course, will help you decide if a $700-million market capitalization is reasonable. It's just more than 15 times adjusted EBITDA – but roughly 50 times net income.

Also worth noting is that, unless plans change, this IPO is not designed to raise capital to help with the expansion the company is selling to shareholders in the early pages of the prospectus. Instead, the document notes "we will not receive any proceeds from the offering" and the selling shareholders such as private-equity sponsor Searchlight Capital are the ones collecting the cash. When Roots amends its documents, we'll see just how many shares the private investors are keeping in order to have skin in the game along with their new partners, the investors in the public markets.

Will any of this dissuade investors? Perhaps not too many. The Globe spoke with Bruce Campbell, the president of Campbell, Lee & Ross Investment Management Inc., who said he'd consider buying the stock once he sees more from the company, particularly its investor "roadshow."

While he's concerned about Canadian retailers' "spotty" track record with U.S. expansion, he says Canada Goose's performance should give Roots and its investors some comfort. Mr. Campbell, in fact, bought Canada Goose shares for clients on its IPO, but sold the stock shortly after it hit the market, locking in its notable run-up.

It's looking like a repeat flight in many ways: Expect investor enthusiasm to boost Roots shares in the early going – despite any concerns about valuation, quality of financial reporting, or insider selling. Whether the stock can deliver in the longer term, however, may be a large enough question that suggests taking your money and running away.