The year's first billion-dollar IPO is in the works

More than three months into 2009, the year's first billion-dollar initial public offering out of Hong Kong -- and Asia -- is finally ready to launch and will provide a crucial test of whether investors are willing to commit money to a newcomer in the international markets. According to sources, China Zhongwang Holdings, a Chinese aluminium extrusion products maker, has started pre-marketing an IPO that is expected to raise at least $1 billion. The aim is to launch a formal roadshow on Monday and to list in Hong Kong on May 7.

Citic Securities, J.P. Morgan and UBS are joint bookrunners for the offering which will be only the third listing greater than $50 million in Hong Kong this year, following Real Gold Mining in February and Chinese alcohol distributor Silver Base last week. Both these companies raised just above $130 million and saw enough demand to price at the top of the indicated range. However, despite the strong run-up in the Hong Kong market -- the Hang Seng Index has gained 38% since March 9 and closed at a fresh six-month high of 15,669 points yesterday -- Real Gold and Silver Base are both still trading below their issue prices.

Indeed, the impressive rebound in the secondary market and even the fact that block sell-downs are increasing in number and coming at gradually narrowing discounts, doesn't automatically mean that an unknown company will get the same favourable response. One obvious way to arouse interest is to price the stock cheaply so that it is almost certain to result in gains in the secondary market, as long as the secondary market continues to perform. Another way would be to pitch the company's business in line with the current economic environment -- in other words, it mustn't depend on US and European consumer demand, but rather the key drivers should be domestic or regional factors.

Zhongwang fits that bill perfectly, and market watchers say it could be just the ticket for a revival of the Hong Kong IPO market that has been largely dormant for the past six months. Not only is the company targeting the domestic Chinese market, but its increasing focus on products for the railway industry also make it a key beneficiary of China's aggressive build-out and spending plans for this sector, as well as a play on the government's Rmb4 trillion ($585 million) economic stimulus package which is to a large extent focused on infrastructure spending.

The Liaoning-based company is the largest aluminium extrusion company in Asia, with a production capacity of 535,000 tonnes, and supplies an increasing number of tailor-made moulded aluminium products to industrial clients, including train carriages. A few years back, the company generated most of its revenues from products targeted at the construction industry, but in a display of great foresight of what lay in store for that sector, the founding chairman, Liu Zhongtian, who is also still the sole owner of the company, decided to shift the focus to the industrial sector where margins are higher and the main competition consists of companies that are many times smaller than Zhongwang. The shift has led to significant earnings growth over the past few years.

The company has a strong market position in China due to its advanced equipment, including the largest extrusion machinery in China, and integrated production process. It also plans to increase its production capacity to 800,000 tonnes by 2011, which should help increase its market share to 10% from 7% in 2007, syndicate analysts say.

Sources say Zhongwang will sell close to 26% of the company, in the form of 1.4 billion new shares, plus a 15% overallotment option. As is typical for Hong Kong, 10% of that will be earmarked for Hong Kong retail investors, while the rest will be offered to institutional accounts. There will also be normal clawback triggers that may increase the retail tranche to up to 50% in case of very heavy demand from retail investors.

In the past, a deal of this size would typically include a few cornerstone investors, but in the current environment, nobody wants to commit to even a six-month lockup so the best the company can hope for is to secure a few sizeable anchor orders before the deal is launched to the rest of the market. Even though such investors are free to sell when the stock starts trading, they will help get momentum in the book and that could be worth a lot. If investors think there is a risk that the deal may not get done, they may not spend time researching it. According to one source, the bookrunners are talking to a few investors about supporting the deal in this way.

Sources say the most comparable stock is Singapore-listed Jilin Midas, which also makes extrusion products primarily for locomotive coach and other rail-related manufacturers. However, Zhongwang is 20 times larger than Midas in terms of output, has 10 times the revenue and 12 times the net profit. As of last year, Midas had a higher net profit margin of 22.6%, compared with 17% for Zhongwang, but as Zhongwang continues to shift its product mix towards the industrial sector, syndicate analysts expects its margin to exceed 30% this year.

Midas is currently valued at 11.5 times its forward earnings, which should provide a floor for Zhongwang. A second comparable is Hong Kong-listed Xingfa Aluminium, which makes aluminium extrusion products, but is focused almost entirely on the less profitable construction sector. There is no analyst coverage on Xingfa, however, and therefore no earnings projections on which to base a forward valuation.

At the upper end, analysts are looking at downstream customers such as China South Locomotive and Rolling Stock, China Railway Group, and China Railway Construction, which are trading at 2009 price-to-earnings ratios of 16.2, 18, and 19.6 times respectively, based on market prices at the end of last week. Syndicate analysts argue that fair value lies somewhere in the middle of those two groups and in any case at a premium to Midas.

That said, even if Zhongwang were to price at just 10 times this year's projected earnings of about Rmb3 billion ($440 million), it would end up with a market capitalisation of $4.4 billion and a deal size of about $1.1 billion, meaning the talk of a billion-dollar deal isn't too excessive -- assuming one believes the earnings forecasts.

According to syndicate research, a net profit of Rmb3 billion implies 58% growth from the Rmb1.9 billion bottom line in 2008, which is a slowdown from the 124% growth between 2007 and 2008. Last year's sharp jump was primarily due to the shift in the product mix towards more industrial products -- in 2006 27% of its revenues came from industrial products and by last year this had increased to 55%. Analysts expect this development to continue and project more than 90% of the top-line income will come from the industrial segment by 2011. However, the big margin expansion has already come and, in the future, the net profit growth rates are likely to be a lot slower. The research reports project 14% growth in 2010 and 6%-11% in 2011. Revenues are expected to grow at 10%-15% over the next three years.

Assuming the roadshow goes ahead on Monday, the bookbuilding will last for about a week-and-a-half. The Hong Kong public offering will launch on April 24 and the retail and institutional tranches will both close on April 29.