China Coal Energy targets $1.7 billion in Hong Kong IPO

The Mainland's second largest coal producer sets the price range at a discount to its larger peer China Shenhua Coal.
China Coal Energy, which kicked off the institutional portion of its initial public offering yesterday, is looking to raise up to $1.7 billion, according to sources.

The targeted size is slightly larger than the $1.2 billion to $1.5 billion talked about during pre-marketing and follows overwhelming demand for a series of other Hong Kong IPOs in the market over the past week. ChinaÆs second largest coal producer (based on revenue) could be in for more of a challenge, however, after the Hang Seng Index dropped 2.9%, or 564 points, on Tuesday this week in its worst one-day performance since the September 11 terrorist attacks on New York in 2001.

The set back, which came after eight straight weeks of gains that have seen the index add 1,700 points or 9.8%, was partly reversed yesterday, but even so it may have caused many investors to refocus their attention on preserving the portfolio gains they have made year-to-date. The correction, which also saw the H-share index lose 4.5% in one day, was triggered by a sharp decline on Wall Street amid concerns over a potential slowdown in consumer spending.

However, sources close to China Coal say the response during pre-marketing has been strong. One reason is the companyÆs integrated business model, which aside from the extraction and production of thermal coal for the power industry, also includes a proprietary trading and import/export agency services business. Last year as much as 45% of its coal sales, or 41 million tonnes, came from this side of the business, making China Coal one of ChinaÆs top coal trading companies.

It is also ChinaÆs largest coal mining equipment manufacturer and one of the largest providers of coking coal that isnÆt affiliated with a steel company. However, in 2005, coal mining and processing (including trading) still accounted for 84% of revenues and 93% of net profits.

ôMost investors are looking at this company because of its mining business which is feeding the strong demand for power in China, and see the other businesses more as a bonus that could provide additional growth,ö says one observer.

US private equity firm First Reserve has agreed to take a $100 million strategic stake in the company through the IPO and will sell another $25 million worth of shares to American Metals & Coal International. According to sources, a group of Hong Kong corporate investors will also help anchor the deal by buying approximately 15% of the IPO. Those buyers are likely to include Citic Pacific, China Life Insurance, Henderson Land Development chairman Lee Shau Kee who is thought to be investing through his private investment company, Cheung KongÆs Li Ka-shing and New World Development chairman Cheng Yu-tung.

The company, which is being brought to market by CICC, Citigroup and Morgan Stanley, is offering 3.25 billion new H-shares or 29% of its enlarged share capital and has set the price range at HK$3.20 to HK$4.05, according to one source.

Five per cent of the offering has been earmarked for Hong Kong retail investors, although this could increase to a maximum 20% if there is strong demand. There is also a 15% greenshoe that could boost total proceeds to $1.95 billion.

The price range will value the company at 9 to 11.5 times its estimated 2007 earnings, which compares with a 2007 multiple just above 13 times for Hong Kong-listed China Shenhua Energy, which is widely regarded as the closest comparable.

Yanzhou Coal Mining, which trades at a 2007 P/E of about 9 times, produces only one-third as much coal as China Coal and also focuses primarily on the spot market, which makes it more exposed to price risk. One syndicate analyst notes that China Coal should earn a premium versus Yanzhou Coal to allow for its better corporate governance and growth potential. International coal mining peers, including Peabody, Arch Coal and Massey, trade at 2007 P/E multiples ranging from 10 to 13.6 times.

With fund managers having expressed a desire to buy the newcomer at a discount between 5% and 15% to Shenhua Coal due to the rivalÆs larger scale and greater profitability, there could be some price sensitivity in the order book depending on investorsÆ views on the growth prospects of the two companies. The top end of the price range translates into a 13% discount to Shenhua Coal, based on current market prices.

China Coal is expected to post flat to slightly lower earnings in 2006, versus last yearÆs Rmb3.34 billion ($426 million), partly due to an income tax adjustment and a revised sales structure. But this will be followed by 25%-30% net income growth in 2007 and 10%-20% in 2008, according to pre-deal syndicate research.

The growth will come despite projections of a 5% and 3% decline in average selling prices of coal in these two years and is expected to be driven by higher sales volumes at the top-line, while economies of scale and a better production and sales mix should lead to more cost efficiencies and margin improvements. Potential acquisitions from the parent company could provide an additional earnings driver, the research notes.

The company, which is owned by ChinaÆs largest coal exporter, China National Coal Group, has 3 billion tonnes of marketable coal reserves, which translates into a reserve life of 68 years û the longest among any coal producer globally. It currently operates nine coal mines in the provinces of Shanxi, Shaanxi and Jiangsu with a total production of 49 million tonnes of raw coal in 2005, which it plans to expand to 93 million tonnes by 2008. By comparison, Shenhua Energy has twice the amount of reserves and its production amounted to 121 million tonnes last year.

China Coal is planning capital expenditures of Rmb20.6 billion in the 2006-2008 period, of which Rmb13.7 billion ($1.75 billion) will be used to expand its coal production.

China CoalÆs most efficient production area at Pingshuo, which accounted for 82% of total output that year, is about to double in size in the same period by developing two new mines and expanding its existing three. This area is expected to account for 92% of the companyÆs incremental output in the 2006-2008 period.

The pre-deal research also estimates that the groupÆs non-core division, primarily the coking business and the coal equipment manufacturing, will be a strong earnings driver and will see its contribution to net profit increase to 22% by 2008 from 7% in 2005.

Among the key concerns surrounding the company is the potential for a decline in coal prices which have stabilised in first nine months this year after almost doubling in the past four years. According to one banker familiar with the company, China Coal does about 80% of its coal sales on a contract basis, meaning it is not that affected by the day to day movements in coal prices. However, one syndicate research report estimates that each drop in the domestic thermal coal price would undermine the companyÆs bottom line by 2.8%-2.9% in each of the coming three years.
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