China Construction Bank rolls out IPO

CCB''s monster IPO gets underway after a strategic investment by CSFB is scrapped.

Pre-marketing began yesterday (September 26) for the first IPO by one of China's gang of four state-owned banking giants. The prospective Hong Kong listing of China Construction Bank (CCB) represents a significant new milestone for the Chinese government as it opens up a financial system many experts had only fairly recently thought teetering towards collapse.

After being cleaned out of NPL's and re-capitalized, a spruced up CCB is now being propelled onto the world stage as a poster child of China's financial reform effort. It will dwarf its recent predecessor, Bank of Communications (BoComm), whose $160 billion asset base is three times smaller than CCB's $472 billion level (end 2004 figures).

Indeed, CCB's asset base is bigger than Kookmin Bank, DBS and Standard Chartered Bank combined. In Asia, it ranks second only to HSBC and globally, it comes in at number 24 ahead of all the Australian banks and US powerhouses such as Wells Fargo.

At upwards of $8 billion, CCB's IPO will also rank significantly larger than Hong Kong's previous record holder China Unicom, which raised $5.49 billion in 2000. However, like Bank of China Hong Kong and BoComm before it, CCB will try to increase pricing leverage by parceling itself out among a number of different investor constituencies.

Strategic investors Bank of America (BoA) and Temasek will, for example, account for $1.5 billion of the IPO proceeds. Back in June, the former agreed to pay $3 billion for a 9% stake, of which $500 million will be invested through the IPO.

The bank has further options to increase its stake to 19.9% at the IPO price, meaning these options will increase in value if CCB continues to improve its earnings and stock market performance. BoA will also be subject to a three-year lock-up.

One month after BoA, Temasek agreed to pay $1.4 billion for a 5.1% stake and will invest a further $1 billion at IPO - increasing its stake to 6.4% pre shoe. A further 12% will constitute the freefloat, with the Chinese government owning 72% and small promoters the remaining 0.6%.

Like BoComm, its offering will be all primary shares.

Where retail investors are concerned, CCB has won a waiver to cap the maximum allocation at 20% and lower the minimum to 5%. On this basis, about $1 billion to $1.4 billion should be allocated to the Hong Kong public.

On top of this, Daiwa SMBC and Nomura Securities will run a POWL (Public Offering Without Listing) in Japan, which is likely to account for at least another $200 million.

This will leave institutions and the legions of corporates, which are already said to be piling into the order book, with about $3 billion to $4 billion to play for.

Originally, a further $500 million was to have been invested by the Credit Suisse group as the bank's entry price for a lead management slot on the IPO. However, in a move that is likely to leave Citi executives reaching for the smelling salts, CSFB's strategic investment has now been abandoned.

CCB's decision to drop CSFB's proposed investment was made last Thursday after it became clear the IPO would otherwise get delayed. This is because the only 'connected party' a bookrunner can technically allocate stock to is its own asset management arm unless it has received special regulatory approval.

CSFB, however, had been mandated late in the IPO process as a replacement for Citigroup, which had decided not to make a strategic investment in CCB and consequently been dropped as a bookrunner. As such, CSFB had not yet received special approval from the stock exchange by the time the IPO reached the final stages of listing committee approval and CCB did not want to wait around to get it.

At the same time, dropping CSFB was not really an option given its presence would mollify those members of Hong Kong's listing hearing committee who had been voicing concerns about the independence of fellow lead managers CICC and Morgan Stanley, both of whom have strong links to CCB.

All concerned were further aware that the Hong Kong government's jumbo offering in Link Reit is waiting for CCB to clear the market. This seems to be one of the main reasons why the latter is on a fast track and will have a slightly shorter pre-marketing and roadshow period than most Hong Kong IPO's, with pricing looking likely around the week ending October 21.

BoComm provides valuation benchmark

Fund managers say syndicate banks have assigned a fair value range that spans about 1.8 to 2.5 times 2005 book, with most banks coming in around the level of 1.9 to two times. Taking into account the need for an IPO discount, this suggests CCB is unlikely to price much below 1.6 times book, or above 1.8 times.

On a pre-money basis, CCB has a book value of roughly Rmb220 billion ($27.25 billion). On a post money basis, it will raise $6.1 billion (pre shoe) based on a valuation of 1.6 times book and up to $7.2 billion at 1.8 times. Factoring in a 15% greenshoe, IPO proceeds could top $8 billion at the expensive end of valuation estimates.

Achieving the latter will to a certain extent depend on BoComm's trading pattern over the coming few weeks. The bank is currently trading around 2.1 times 2005 book, having risen 26% since its IPO at HK$2.50 per share in mid-June. Many analysts now think it is fully valued and believe it may come under selling pressure as investors consider switching into CCB.

At IPO, BoComm priced at 1.58 times book on a post money basis, similar to the level achieved by Bank of China Hong Kong in 2002, which priced at 1.65 times. Both BoComm and Bank of China Hong Kong trade just below the Hong Kong average of roughly 2.4 times book.

Hong Kong has always been the most expensive market in Asia.

Other pricing comparables include the four Chinese banks listed in Shanghai - China Merchants Bank, Minsheng Bank, Shanghai Pudong Development Bank and Hua Xia. The quartet span about 1.6 to 2.5 times book and are considered more relevant benchmarks now the A-share market has traded down to more meaningful valuation levels.

But it is only when CCB is valued on a PER basis that it becomes more obvious why the IPO is expected to be a big success. Based on a 2005 syndicate average profit forecast of Rmb39 billion ($4.8 billion), CCB is being pitched on a range of about eight to 10 times earnings.

On a 2006 basis, it comes out at about seven to 8.5 times based on a profit forecast around the Rmb44 billion ($5.47 billion) mark.

By contrast, BoComm is now trading at about 18 times 2005 earnings and 15 times 2006 earnings. Bank of China Hong Kong also averages 18 times 2005 earnings and 18 times 2006, while the Shanghai-listed Chinese banks range in a 13 to 16 times band.

Selling points

Fund managers already pitched by the lead managers say CCB is being positioned as a bank that has learnt how to balance growth and risk. This argument is centred on the fact that CCB's earnings growth is outstripping asset growth, with the former growing in the low 20% range and the latter in the mid-teens range.

International investors may also be comforted by the Chinese government's deftness in reforming the banking sector. Despite the massive problems it has faced, the government has yet to put a foot wrong.

Legacy problems have been addressed by selling NPLs to state-owned asset management companies and replenishing banks' capital with state funds - CCB received a $22.5 billion capital injection at the end of 2003.

Looking forwards, the government has been helping banks shift away from a policy-lending role towards commercial independence. Restrictions on deposit and lending rates are being gradually lifted.

So too, the government is progressively broadening the areas in which banks can operate - wealth management, mutual funds etc.

Its latest push towards international standards is being achieved through foreign strategic investment and IPOs. The government hopes strategic investors will be able to improve domestic banks' risk assessment processes through the provision of technical expertise.

Where foreign IPOs are concerned, the government believes constant scrutiny by international portfolio investors will reinforce the need for continued good corporate governance and improving shareholder returns. Many outside observers have applauded its capital markets strategy.

International investors have been gradually acclimatized to the Chinese financial sector. In 2002, they were able to buy indirect exposure to a large Mainland financial entity through a Hong Kong proxy (Bank of China Hong Kong).

Earlier this year BoComm gave them raw exposure tempered by the likelihood of HSBC gaining majority control within a couple of years.

Specialists argue that CCB's financial metrics stack up well against BoComm. For instance, CCB is forecast to achieve a 2005 Net Interest Margin of 2. 87% compared to 2.56% at BoComm.

Similarly, CCB is likely to report a better 2005 cost to income ratio of 43% compared to 48% at BoComm. Specialists emphasise that CCB has slashed costs over the past couple of years - reducing its branch network by a third.

Post money, CCB will also report the strongest capital adequacy ratio of any listed Chinese bank - 13%. With the exception of BoComm, the rest of the listed Chinese banking sector is trailing just above the BIS 8% minimum.

The need to bolster capital through fresh capital raisings remains a chief concern hanging over the stock prices of the Shanghai-listed banks.

Low capital ratios are also one reason why Chinese banks have been reporting relatively good Return on Equity (ROE) ratios. However, this negative does not apply to CCB given the strength of its CAR ratio, of which tier 1 equity accounts for 10%.

Analysts also forecast that CCB will achieve a 2005 ROE of about 17.5% and an ROA ratio of 0.9%. BoComm is forecast to return an ROE of 13% and ROA of 0.6%.

In a recent high profile report on the Chinese banking sector UBS said it believed that, "Only banks able to generate ROA's above 0.7% by 2007 (with upside to 1%) can be valued above two times book, as such ROAs would be necessary, based on leverage of 15 to 20 times, to achieve ROE's above 15%."

At the end of the first half, CCB reported a gross NPL ratio of 3.8%, slightly higher than the 2.5% level achieved by BoComm. Yet as analysts point out, these low figures mask the fact that CCB and BoComm both have a large number of pre-cautionary loans - 16.7% at CCB 15.4% in the case of BoComm (end 2004 figures).

At the same time, analysts say these ratios remain relatively safe given that most loans are highly collateralised. CCB currently provisions its NPLs at 63.52% versus 45% at BoComm.

Potential risks

Analysts argue that the greatest challenge will be to maintain a clean balance sheet and prevent NPL re-formation. Some might argue, that operational risks rise in tandem with the size of the bank.

On top of this, investors also need to consider their macro view of the Chinese economy and what impact this will have on the banking sector.

As a result of the government's credit tightening measures last year, Chinese banks started re-forming NPLs during the latter half of 2004. But equity analysts say the re-formation ratio at the listed banks has so far been lower than expected - 0.5% to 1% on average per annum, compared to 8% earlier this decade.

Credit analysts are somewhere more sceptical. Earlier this month, Moody's put CCB's E+ bank financial strength rating on review for potential upgrade. In its ratings release it said it would be looking for evidence of asset quality stabilization.

It pointed out that financial improvement to date have largely been driven by government initiatives. These led CCB's NPLs to drop from 15.5% to 3.9% between 2002 and 2004, while coverage ratios improved from 10.1% to 61.6% over the same time period and capital was strengthened from 6.9% to 11.3%.

It cautioned that, "a clear track record of performance improvements - as a result of the bank's own efforts - has yet to emerge."

CCB also has the largest exposure to the Chinese property market of all the listed banks. This is likely to act as a negative should investors decide the government will continue to clamp down on an overheating property market.

Over the longer-term, on the other hand, it will act as a net positive. Despite its reputation as a state-owned dinosaur, CCB has actually made much greater strides into higher margin consumer banking products than many of its private sector counterparts. At the end of 2004, CCB had a 20.7% market share in personal loans, second only to ICBC. BoComm had a 3.7% market share.

CCB also had a 19.3% share of the mortgage market, again second only to ICBC.

CCB will also try to tempt investors with a reasonable dividend yield. Based on a pay-out ratio of 35% to 40% of net income, CCB should yield around 3%.

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