BoComm begins pre-marketing

Wide valuation range reflects a lack of benchmarks and uncertain markets.

Following a special listing hearing committee meeting at the Hong Kong Stock Exchange this Monday, China's Bank of Communications (BoComm) was given the go-ahead to begin pre-marketing yesterday (May 25) via joint leads Goldman Sachs and HSBC.

A successful deal is critically important to the Chinese government since it has used BoComm as a template for the restructuring of the entire Chinese banking sector. This leaves the leads with the difficult balancing act of making sure the deal prices at a comfortable premium to book value and also goes on to trade well in the secondary market.

As the most efficient and dynamic bank of its kind, BoComm is likely to provide the high water mark for Chinese banking sector valuations. As such, its flotation needs to come at a reasonable premium to book value because the Chinese government currently forbids IPO's to be priced below book value and there are numerous other state-owned banking entities all hoping to list overseas in the coming few years.

If BoComm comes too close to book value, it will not leave enough pricing slack for others to follow. However, if the leads push the valuation too far and the deal tanks in the secondary market, it will set an awful precedent that may sabotage future offerings from the sector.

The leads' job is made all the more difficult by volatile global market conditions, which have scared off large swathes of the investor base and ceded a lot of pricing power to those that remain. Unsurprisingly in these circumstances the leads have begun testing investor feedback with an extremely wide valuation range.

Fund managers say they have been canvassed with a range that values the bank at Rmb1.9 to Rmb3 per share. This equates to a 2005 post money price to book valuation of 1.23 to 1.94 times and an IPO proceeds range of $1.5 billion to $2.4 billion.

The bottom of the range is dictated by the price HSBC paid for its 19.97% stake in August last year. At Rmb1.86 per share, the bank paid $1.75 billion for a stake that valued BoComm at 1.35 times on a 2005 pre-money valuation of $6.5 billion and 1.2 times on a post money basis.

If the IPO is priced below the level HSBC purchased its stake, the bank has to be topped up with either new cash or shares. HSBC will also buy 19.97% of the IPO in order to maintain its current shareholding level.

Including the top up, BoComm will issue 13% of its enlarged share capital pre-greenshoe and 14.7% post shoe. Unusually for an H-share deal, the IPO will constitute a 100% primary share offering. Normally SOE's are required to sell 10% in secondary shares in order to make a contribution to the government's social security fund.

In addition to this one waiver, the leads have won a second waiver to control allocations by minimizing retail participation. There will be a 5% minimum allocation and a 20% maximum allocation compared to the normal 10% minimum and 50% maximum.

Alongside the two leads, Daiwa SMBC will run a POWL (Public Offer Without Listing) in Japan, while co-leads will comprise ABN AMRO, BoComm Securities, China Everbright and Credit Suisse First Boston. Formal roadshows will begin on June 6, with pricing scheduled for June 17 US time.

As part of its shareholding agreement, HSBC is prevented from selling out of its stake for four years. However, the key swing factor is whether it will be able to increase it. Under the terms of its initial acquisition it is allowed to purchase up to 40% of the bank at the IPO price if the regulations allow it after 2008.

Currently a single foreign investor is only allowed to own up to 20% of a domestic financial institution, but all are hoping this will change as China's opens its financial markets in 2007 to meet its WTO agreements. Clearly HSBC management, if not the Asian ECM team, will be hoping BoComm's IPO prices as cheaply as possible, since this will give the bank an incredibly cheap option to gain control of one, if not the best, managed banks in China.

Likewise the Chinese government may have decided this is the price it needs to pay to ensure the Chinese banking sector is accorded a premium valuation. This is because HSBC's brand name is likely to be the single biggest selling point for the IPO.

Lead managers will argue that HSBC's presence should re-assure investors they are not dealing with a balance sheet that closely resembles an unquantifiable black hole. Firstly, they will argue that investors should have more confidence about BoComm's current stated book value since HSBC will have done extensive due diligence of the bank's loan portfolio prior to the purchase of its stake.

Secondly, the secondment of HSBC staff into BoComm's risk management division may help convince investors the bank will not start re-forming new NPL's. Thanks to an $8.6 billion series of government capital injections and NPL carve-outs, BoComm has been able to proceed with its IPO backed by a fairly clean balance sheet.

Analysts say its NPL ratio has come down from just over 13% in 2003 to 2.93% at the end of 2004. The Chinese banking sector average is about 15%.

Most believe NPLs will stay around their current level for the next couple of years, although they say BoComm needs to improve its provisioning, which currently stands around 45% compared to 74% at Bank of China Hong Kong.

Key for BoComm will be how far the HSBC halo effect enables it to shift its valuation up towards the level of two times book. Comparisons with other Asian markets are difficult, since there are no ready comparables.

Regionally the sector averages around 1.7 to 1.8 times. However, there are some big differences.

At the one end of the scale, Korea, Taiwan, the Philippines and Thailand average about 1.2 to 1.5 times. At the other end, Hong Kong is currently valued at about 2.6 times followed by Indonesia and India at 1.8 to two times.

There is normally a very strong correlation between ROE and price to book. Hong Kong, for example, averages a high level of about 17.2% and is the most expensively priced market in Asia.

Bank of China Hong Kong is forecast to achieve a return of about 14.5% in 2005 and is currently trading at 2.05 times price to book. On this basis, the low end of BoComm's IPO range makes pricing look attractive since analysts are forecasting ROE of about 14% to 15% in 2005, up from 4.5% in 2004.

Analysts say Bank of China Hong Kong provides an obvious benchmark since 30% of its loan book is China related (mostly lending to Hong Kong incorporated Chinese companies). However, it is at best an indirect benchmark since its valuation is propelled by the dynamics of the Hong Kong banking sector - a highly competitive but fundamentally stable market governed by the direction of property prices.

Where the two do share a number of similarities is the risk factors investors should focus on - fraud, corporate governance and inadequate risk management. When Bank of China Hong Kong completed its IPO in July 2002, it managed to surprise just about everyone on the upside and price at a premium to the Hong Kong banking sector.

At a time when the sector averaged 1.34 times, Bank of China Hong Kong came at 1.65 times, attracting an order book of $19 billion. Few expect BoComm to achieve a similar feat given how sluggish market conditions remain.

One big uncertainty is how corporates and Hong Kong retail will react. In 2002, both ignored the negative issues and swung behind Bank of China Hong Kong in a big way. At the time, lead managers attributed this to the groundswell of customer loyalty the bank had been able to build during its 80-year history in Hong Kong.

BoComm will not be able to automatically rely on the same backstop bid. What it will need to do is convince investors of its growth potential. By contrast, some analysts believe Bank of China Hong Kong will record negative net profit growth in 2005.

In 2003, BoComm recorded net profits of Rmb4.83 billion ($584 million), falling to Rmb1.6 billion in 2004 after the Chinese government cancelled an Rmb9.67 billion tax credit relating to NPL disposals. In 2005, the company is forecasting net profits of Rmb7.87 billion ($950 million).

Based on this forecast, the IPO is being pitched on a range of 10.8 to 17.1 times 2005 earnings.

Specialists say that roughly 60% of BoComm's revenues derive from corporate lending and only 10% from consumer lending. Key will be how quickly it can develop a higher margin consumer lending franchise and whether it can do so without incurring rising default levels in a market where it is difficult to enforce re-payment.

Its consumer lending franchise currently stands in line with national levels. In a recent research report UBS estimated that 10% (Rmb1.9 trillion) of all bank loans in China are consumer related and that most of these (75% to 90%) are mortgage loans.

The investment bank concluded that China stands poised on the brink of a consumer finance boom and forecast that mortgage lending and credit card usage will grow by a five-year CAGR of respectively 35% and 70%. BoComm is hoping to benefit from this through a credit card JV it has established with HSBC - the two plan to start issue co-branded cards this year. The bank already has 30 million holders of debit cards.

UBS went on to say that if domestic banks can make greater inroads into the consumer finance sector they should be able to improve their ROA (Return on Assets) since corporate lending currently yields 0.5% compared to 1.6% for mortgages, 1.1% for auto loans and 3.5% for credit cards.

Prior to its restructuring in 2002, BoComm was able to manage an ROA of just 0.17%. Post IPO it is hoping to boost it to 0.6%, which is still low relative to Hong Kong banks. Bank of China Hong, for example, is forecast to record an ROA of 1.29% in 2005.

Most of the risks it faces are macro and investors' willingness to pay up for the IPO may be largely determined by factors outside of BoComm's control. As the fifth largest bank in China, BoComm is a key player, but still insignificant within the wider context of government policy towards the financial sector and overall economy.

A lot of its lending rates, for example, are fixed.

So too, the bank's ability to grow its mortgage book may be severely curtailed if the government continues to clamp down on speculation in the property market. So far this year, the government has targeted the property sector as the main focus of renewed efforts to cool down an overheating economy.

Investors may also question just how free of government control BoComm itself is. Post IPO, the Ministry of Finance will still be the largest shareholder and two of its three "independent" directors are actually government officials.

This in turn may prompt questions about the extent and potential for further instances of fraud.

Proceeds from the IPO will be used to bolster the bank's capital ratio, which stood at 9.72% at the end of 2004. Specialists say the group should be able to hit a figure in the low to mid teens by the end of 2005, which will enable it support a reasonable dividend pay-out ratio. Bank of China Hong is one of the highest yielding banks in Hong Kong - 5% dividend yield and forecast CAR of 15.7%.

Post IPO, BoComm should rank as the fourth largest listed bank in Hong Kong behind HSBC, Standard Chartered and Bank of China. As such it will be a key constituent for Hong Kong and China index players. Whether the valuation and equity story are attractive enough to scoop up other global investors remains to be seen.

Based on the pre-marketed range, BoComm will have a market capitalization of $10.2 billion to $16.3 billion versus $19.5 billion for Bank of China Hong Kong.

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