Chalco times it right

The company benefits from a swing back to cyclical stocks.

What many thought would prove to be one of the most difficult Chinese equity offerings of recent years has turned out to be one of the luckiest. After deliberating for weeks whether to launch an IPO for Aluminum Corp of China (Chalco), lead managers Morgan Stanley and CICC have managed to hit the market just as investors move out of cash and seek to position themselves for 2002.

Sector specialists consequently believe that the company has been able to secure a valuation that industry fundamentals might not yet justify. As one puts it, "This company has been priced cheap relative to global comparables, but we believe that global comparables are running ahead of themselves, so on an absolute basis it's not that cheap at all. Global investors have been given a directive to move into cyclicals and because there's so much money flowing into the sector, both early and late cyclical stocks have benefited. The fact is that aluminum is a late cyclical sector and spot prices are still trending down."

"The question I would be asking myself," says George Lequime, HSBC's New York aluminum analyst, "is whether I'd want to buy into an aluminum stock when an initial rally in cyclical stocks appears to be peaking. Alcoa, the world's largest aluminum producer, has moved from a $30 to $40 share price in the space of two months. It's now trading on a p/e multiple of 24 times 2001 earnings, when historically it trades in a 12 to 18 band."

Institutional investors, however, clearly decided they did want to own the stock and books closed in New York (Tuesday) 10 times oversubscribed. Observers note that one of the most interesting features was the large number of sector funds relative to Asian funds and the muted take up of the Hong Kong IPO, which was only just covered.

"There were some fairly big regional funds that put in smaller orders than might have been expected, but the sector funds came into the book in a big way," one comments.

A total of just over 250 investors participated, with a geographical split that saw 26% of paper go to Asia, 46% to Europe and 28% to the US. A couple of accounts were said to have placed orders for about 30% of the deal and about 10 accounts for about 10% of the deal.

Pricing came at HK$1.38 just above the mid point of a HK$1.15 to HK$1.45 range, with the ADR priced at $17.70, where one ADR equals 100 shares. Pre-greenshoe, the company raised HK$3.57 billion ($458 million). A total of 2.585 billion shares were allocated, of which 2.35 billion were placed with institutional and retail investors, plus strategic investor Alcoa and 235.29 million shares with China Development Bank, China Cinda and China Orient as part of a debt-for-equity swap.

This meant that Alcoa took up 32% of the total offering, with institutional investors on 58% and Hong Kong retail investors, the remaining 10%. Of the institutional placement, US retail investors took up roughly 8%.

Assuming the exercise of a 15% greenshoe, the final shareholding structure will see parent company Chinalco owning 43.4%, public shareholders 19.8%, Alcoa 8%, China Cinda 15%, China Orient 5.6%, China Development Bank 5.2%, Guangxi Development 1.8% and Guizhou Development 1.2%.

Because of a lack of direct comparables in either the China or wider Asian market, the leads applied the same China discount to Chalco that the three big oil IPO's for Petrochina, Sinopec and CNOOC have achieved over the past year-and-a-half. "Chalco was priced at a p/e discount of about 40% to 50% to global comps," says one banker. "Against 2001 earnings, it came at 9.7 times on a p/e basis and 4.6 times on an EV/EBITDA basis."

However, because aluminum stocks have risen sharply over the past two months, Chalco was able to come at a higher premium to NAV (Net Asset Value) than its predecessors. Where, for example, Sinopec was priced at a 19.5% premium to NAV, Chalco priced at a 22.5% premium.

Valuation assumptions include an average aluminum price of 68 cents per pound over 2002 rising to 80 cents per pound over 2003. Analysts comment that the current spot price is 63 cents per pound, but a number believe that prices have not yet found their bottom.

HSBC's Lequime adds, "During the last cycle, aluminum prices hit a low of 56 cents per pound and we think that all metals will continue to have a difficult time for the next six to nine months. However, China is one of the few places where demand is still growing strongly and so the key question is how sustainable is its growth when the rest of the world is still suffering from overcapacity."

Like many IPO's from the Mainland before it, the China growth play was one of the chief selling points of the stock. Unlike global comps, which are trying to digest overcapacity to the tune of 264,000 tonnes, China is a net importer of alumina, the raw product smelted into aluminum. According to aluminum research group, Brook Hunt, aluminum consumption in China has grown at a compound annual growth rate of 11.7% between 1996 and 2000.

Chalco benefits both as a result of its monopoly position within the domestic industry and tariff protection imposed by the Chinese government. The company is the only alumina producer in the country (4.3 metric tonnes during 2000) and largest producer of primary aluminum with a 23.7% domestic market share.

Where tariffs are concerned, observers point out that even when they are removed, the company will still have a significant cost advantage per tonne over any international competitor. "The Chinese aluminum market is growing two to three times faster than anywhere else in the world," says one banker. "If an investor wants to play the aluminum market, then China is the place to be."

Analysts further add that the presence of Alcoa as a strategic investor and joint venture partner for the Pingguo plant gave the offering a significant boost, because it persuaded investors that the US group will bring its technological expertise to bear on Chalco's ageing plants.

Chalco will use proceeds from the offering to pay down debt, fund capex and improve its efficiency ratios. As of June 30, the company had $1.29 billion in debt outstanding, but has said it intends to become net cash positive by the end of 2003/early 2004. For the first half of the year, it reported net income of $120.1 million on revenues of $955.25 million.

One of the key planks of its future expansion plan is the construction of a 280,000 tonne primary aluminum plant in Shanxi province, due for completion in 2006. The company recently signed a MOU with Beijing Datang Power and says that it is about to embark on a 25 year power and purchase agreement that will save it 20% on its average electricity costs of its existing smelters.

Chalco was formed under the government's re-organisation of the domestic aluminum industry and is composed of four integrated alumina and primary aluminum production plants, two alumina refineries, one primary aluminum smelter and one research institute. From 1996 to 2000, the company's alumina production grew by a CAGR of 14% and it has said that it expects to maintain a similar growth rate over the same period going forwards.

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