Aoyuan sets challenge with attractive valuation

The Guangdong-based real estate developer is seeking to raise up to $467 million and has set a challenge for other larger IPO candidates with its attractive valuation.
It may not be as big as the other two property plays currently seeking a listing in Hong Kong, but with an attractive valuation China Aoyuan Property Group is putting up a worthy fight for investorsÆ attention. The Guangdong-based residential real estate developer, whose Chinese name means Olympic Gardens, kicks off its institutional roadshow today with the aim of raising up to HK$3.64 billion ($467 million).

According to sources, Aoyuan will be offering its shares at a sizeable discount to both Sino-Ocean Land Holdings and Soho China (the other two listing candidates), which could be exactly what is needed to get people to take a look at the deal in the first place û especially in light of the current competition for funds and the lingering concerns about a further fallout from the US subprime crisis.

Once they do though, they will discover that Aoyuan does also have at least the potential to become a highly profitable investment, based on a low cost land bank, high margins, a strong brand recognition in its home province and the fact that its residential projects are all located in affluent high growth areas. Sources say its core profit could more than double this year and then almost double again in 2008 driven by a surge in sales volumes.

The company reported a core profit of Rmb254 million ($33.8 million) in 2006.

To be sure, the offering is not a one-way bet and the same sources argue that the earnings risks are higher than for most of its peers as the company has locked in only 10% of this yearÆs earnings projection in the first half. However, even if some of the completions and sales that are projected to come at the end of this year were to be delayed into early 2008, it mainly means that they will give an additional boost to next yearÆs earnings instead.

The IPO will comprise a base deal of 700 million new shares, or about 31% of the company, that will be offered to investors at a price between HK$4.10 and HK$5.20. There is also a greenshoe of 50% new shares and 50% existing shares which could boost the maximum deal size by an additional 15% to $537 million, if exercised in full.

Credit Suisse and Morgan Stanley are joint bookrunners for the offering, which could help attract interest to the deal based on Morgan StanleyÆs track record of bringing Mainland developers to the Hong Kong market. Several of the property companies it has introduced to investors in recent years have rallied sharply after their listings and investors will obviously be hoping for yet another repeat. Its latest two offerings, Country Garden (joint bookrunner with UBS) and KWG Property, have gained 143% and 61% since their respective listings in April and July.

Another confidence builder should be the five cornerstone investors, who, according to sources, have agreed to buy a combined $90 million worth of shares in the IPO. Depending on the final price, this will give them between 19% and 24.5% of the total deal. The cornerstones are retail conglomerate Wharf Holdings; property and logistics firm the Kerry Group; privately owned Nan Fung Group, which is active within property development and textile manufacturing; asset management firm China Cinda; and Sun Hung Kai Properties.

The price range pitches Aoyuan at a discount of around 4.4% to 19.6% to its pre-shoe net asset value, which compares to an average premium of 11% for other listed developers with a similar size land bank. At the low end of its price range, Sino-Ocean is valued at a 7.2% discount to NAV and at the top end at a 2.2% premium. Soho ChinaÆs offering ranges from a 17.7% discount to a premium of 1%. The estimates are based on a bookrunner consensus of current NAV including the IPO proceeds.

Aoyuan also looks cheap to its peers, which include Beijing Capital Land, Shanghai Forte Land, Yanlord Land, KWG Property, Hong Long Holdings and SPG Land, on a price-to-earnings basis, although people close to the deal say investors arenÆt watching this as closely since compared with many other property plays, Aoyuan isnÆt a high asset turn developer. The price range values the company at 7.2 times to 9 times its 2008 earnings, which compares with 11 times for its peers. Again, Sino-Ocean and Soho China are offered at much higher 2008 multiples of 13.5 to 16.1 times and 11.5 to 15.3 times, respectively.

With a landbank of about five million square metres, Aoyuan cannot rival Sino-Ocean or Soho China in terms of scale, and it needs to be priced appropriately, notes one source close to the offering.

ôThis is not a must buy and the valuation has to reflect that,ö adds another. ôThere is a high level of interest, but investors need to get comfortable with the execution, the future replenishment of its land bank and the earnings track record.ö

What speaks for Aoyuan is a disciplined land acquisition strategy which has resulted in low land costs of no more than 7%-8% of its selling prices. This, observers argue, should help the company to maintain its gross development margin after land appreciation tax provisions at just above 30% in both 2007 and 2008. The net margin is currently about 23%, compared with an industry average of 20%.

The company focuses on the Guangdong province (50% of its land banks is located here) which accounted for 12.7% of ChinaÆs gross domestic product in the second quarter this year and is one of the countryÆs wealthiest provinces. Among the key growth drivers are three projects in GuangzhouÆs fast-growing Nansha district, which will account for just over one third of AoyuanÆs expected completions in 2007 and 2008. One of these is a residential development with villas and high-rise apartments, one is a commercial development and the third a combined residential and commercial project. Two of these sites were acquired eight years ago, suggesting margins will be high.

Since 2005, Aoyuan has also been expanding into other provinces and cities that are regarded as future high-growth areas, including the Jiangxi and Guangxi provinces and the city of Chongqing. This has brought the company's projects on hand to a total of 11, which should support its production over the next four to five years, observers say.

Overall, sources say the company is expected to book sales from about 10 projects this year and next. This would mean a jump in sales volumes from last yearÆs 200,000 sqm of gross floor area (GFA) to 400,000 this year and 700,000 in 2008, one source notes.

The companyÆs residential developments, which target more affluent middle-class buyers, tend to be multi-phased integrated projects of more than 350,000 sqm that take several years to develop. Typically, they are located in suburban areas within a 20- to 30-minute drive from the nearest urban centre, which helps keep the acquisition cost down and allows the company to benefit from ChinaÆs ongoing urbanisation trend.

Among the noteworthy risks is $60 million of outstanding convertible bonds that can be converted into equity at the IPO price starting from six months after the listing. Held by a hedge fund that it close to one of AoyuanÆs venture capital investors, these bonds could result in a 15% dilution of earnings per share in 2007 and about 5.5% in 2008. The entire CB issue is $140 million, but $80 million of that will be redeemed by the company at the time of listing.

The companyÆs founding chairman, Guo Zi Wen, will still hold about 51% of the company after the listing, while venture capital fund Cathay Sino Property will see its stake drop to about 13.5%.

The IPO will have the usual structure with 10% of the shares earmarked for retail investors and the rest offered to institutional investors. A standard clawback mechanism could boost the retail tranche to 50% of the total in case of strong demand.

The retail portion of the deal will be open between September 21 and 27, with the final price set to be determined at the end of US trading on the 27th. The trading debut is scheduled for October 9.

Sino-Ocean is seeking to raise between $1.3 billion and $1.5 billion with the help of BOC International, Goldman Sachs and Morgan Stanley, while Soho China is hoping to raise between $1.25 billion and $1.65 billion through Goldman Sachs, HSBC and UBS.
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