China Cosco IPO: more than a sequel to China Shipping?

Has China Cosco learnt the lessons of China Shipping''s difficult IPO this time one year ago?

China Cosco Holdings (CCH), the world's seventh largest container shipping company and fifth largest port operator, began pre-marketing its $1.5 billion to $2 billion H-share IPO on Monday.

Under the lead management of HSBC, JPMorgan and UBS, the group will start formal roadshows on June 13, with pricing scheduled for the weekend of June 25. Alongside the three bookrunners, Daiwa SMBC will run a Public Offering Without Listing (POWL) in Japan, while Macquarie and ICBC Securities will act as co-leads.

Post greenshoe, the company will offer 40% of its enlarged share capital and based on syndicate consensus earning forecasts for 2005 of around $510 million, this equates to a forward P/E ratio of 7.3 to 9.8 times earnings. In terms of 2006 earnings, the syndicate is forecasting net profit to fall to around $420 million, which bumps the valuation up to about 8.8 to 11.82 times earnings.

Valuing the deal is complicated by the fact that CCH has a blended business profile, with 65% of 2005 revenue expected to be generated by its container shipping business and 35% from its container leasing, ports and logistics businesses. This integrated business model is likely to be one of the biggest selling points of the deal, since the company will argue it can deliver far greater synergies and efficiencies from a door-to-door service rather than the more traditional port-to-port service of the world's major container shipping companies.

However, it also means there are very few direct comparables and none in Asia. On a global basis, the world's largest container shipping company and port operator AP Moller-Maersk is currently trading around 9.5 to 10 times 2005 earnings and 10.5 to 11 times 2006 earnings.

In Asia, fund managers can use two valuation metrics. CCH's ports and logistics business is already listed on the Hong Kong Stock Exchange via its 52.4% owned subsidiary Cosco Pacific. This arm is currently trading around 15 times 2005 earnings.

In terms of the container shipping business, there are a number of comparables including its biggest rival China Shipping, which listed on the HKSE in early June last year. At the time of its IPO, China Shipping achieved a forward P/E of 6.5 times earnings and is currently trading around 3.8 times forward earnings.

Overall, Asia's 10 big container shipping companies average a 2005 P/E of about 6.5 to seven times. However, there are some big variations, with the China related shippers tending to trade at the bottom end of the scale. Orient Overseas (OOIL) and Neptune Orient Lines, for example, are both currently trading at 3.6 times.

A blended P/E based on: Cosco Pacific's 15 times multiple; the Chinese shippers' 3.7 times average multiple and; the company's forecast 2005 revenue breakdown, gives CCH a fair value multiple of about 7.5 times forward earnings. Based on these figures, an IPO range of 7.3 to 8 times looks aggressive and particularly given that it does not factor in an IPO discount.

However, lead managers will argue that this does not take into account the synergies of CCH's integrated business model, which should provide a valuation kicker and makes the range look much more attractive. They will also point to the P/E trading ranges of the Taiwanese container shipping companies such as Yang Ming Marine, which operate similar routes to CCH and trade on higher multiples of around five to six times earnings.

Fund managers' willingness to listen to this logic is likely to be highly correlated to their current view of the global shipping cycle - whether or not it has topped out and if it has, how steep and long the downturn will be. When China Shipping marketed its IPO in May 2004, this proved to be the single biggest concern for potential investors.

One year later and these concerns can only have become further magnified as the current cycle stretches on. It began its upswing towards the end of 2002 and has provided container shipping companies with two years of record profits.

Some believe the sector has now entered a super cycle, with strong fundamentals ensuring that 2005 is also a banner year, followed by a smaller than expected drop off in 2006.

Syndicate research suggests that CCH's freight rates will remain flat in 2005, before falling about 15% in 2006.

Others worry that freight rates may plunge much deeper after being hit by a double whammy - slowing global growth (following evidence of weak retail sales in mature markets), plus slowing growth on the Mainland (following renewed efforts by the Chinese government to control its overheating economy).

In 2002, at the bottom of the last cycle, CCH recorded a net loss of $153.3 million.

These concerns are evident in the trading pattern of China Shipping. The company's $985 million IPO got off on a bad footing last year as a result of syndicate disagreements about the right valuation in the face of soft market conditions.

The deal was eventually underpinned by strong corporate support, with 36.5% of the deal placed with corporates, 34% with institutional investors, 19.5% with Japanese retail investors and the remaining 10% with Hong Kong retail investors.

Having been priced at the bottom end of the range at HK$3.175, the deal traded up in the secondary market in line with key shipping indices, which hit all time highs at the end of 2004 as China exports continued to propel global trade growth. By April 8, the stock hit its own high of HK$4.125, but has traded down about 23% since then.

Partly it can be attributed to supply pressures generated by the prospect of CCH's deal. But mainly it is the result of concerns about the cycle and global growth. Analysts say that stock prices typically peak about six months before the cycle begins to turn.

Those that believe the cycle will run on into 2006 argue that the current sell-off presents an attractive re-entry point. They conclude that the supply side will continue to be constrained by port congestion and huge backlogs at global shipyards, while the demand supply will be bolstered by the outsourcing trend and China's inexorable rise as the world's most important manufacturing hub.

Fund managers say that UBS, for example, forecasts that the container shipping sector should see volume growth of 12% in 2005 and 10% in 2006.

They further add that Cosco Pacific should provide a defensive buffer for CCH since it diversifies the group's revenue stream and has a far more stable earnings base. Together the two can also play off each other, with Cosco Pacific guaranteeing its sister company Cosco Containers (Coscon) priority berthing space and fast turnaround times at its port operations.

Analysts say this is one of the reasons why Coscon has been able to achieve a high on-time ratio of 96.5% for its transpacific services, which account for 28.6% of all shipping volume. Intra-Asian routes account for a further 26.5% and Asia/Europe 21.7%.

As of March 2005, Coscon operated 119 container vessels with a total capacity of 303,197 TEU. This made it China's largest container shipper ahead of China Shipping on 105 vessels and 254,000 TEU, as well as Asia's third largest shipper and the world's seventh largest.

The average age of its fleet was 9.3 years, slightly higher than the industry average of 8.3 years.

At the same time, CCH is the largest port operator and the world's fifth largest in terms of TEU throughput - 23.5 million TEU in 2004. It has a total of 17 terminals, of which 15 are in China.

Through its subsidiary Florens, it is also the world's fifth largest container leasing company with leasing capacity of 913,748 TEU at the end of 2004. In addition, it has a 16.23% stake in CIMC, the world's largest container manufacturer.

In 2004, Cosco Pacific derived 48% of its net profit from the leasing business, 41% from ports and 5% from logistics. It accounted for 21% of CCH's overall net profit of Rmb 4.16 billion ($503 million).

Syndicate research from the three bookrunners suggests CCH will be able to achieve net profit growth of about 5% to 10% in 2005, before witnessing an 18% to 20% drop-off in 2006. Cosco Pacific should provide a big earnings kicker, with HSBC forecasting that it could comprise 44% of total earnings in 2006, up from about 35% in 2005.

Analysts say Cosco Pacific could grow net earnings by up to 40% this year, with the ports business growing by about 13% and leasing by about 6% to 7%. The container manufacturing business it purchased in late 2004 should also account for up to 20% of net profit for the first time.

A large percentage of the IPO proceeds are being used to fund capacity expansion, which will result in the addition of ships with TEU capacity of 178,300 in 2005 and 187,945 in 2006. By 2010, analysts believe CCH will have total capacity of 800,000 compared to 1.3 million at AP Moller-Maersk (should the latter succeed in its bid to buy the world's third largest shipper, Royal P&O Nedlloyd).

Part of the proceeds ($600 million) will also be used to reduce net gearing to 70% post IPO.

One of the key swing factors determining CCH's ability to price up from the bottom of its IPO range will be the impact of new capacity on freight rates. According to industry consultants Clarkson, some three million TEU of container ships have been contracted for delivery between 2005 and 2007 - a record 46% of the world's existing global fleet.

This ratio exceeds the 35% record in the previous two shipbuilding peaks in 1997 and 2001, which were both followed by sharp downturns. Some analysts suggest that young, aggressive and fast growing companies such as China Shipping may start to cut freight rates in order to maintain market share in these circumstances.

The most pessimistic worry that the perceived threat of overcapacity may upset the delicate equilibrium by triggering rate reductions at a time when supportive underlying fundamentals could actually stretch the cycle out much longer.

However, fund managers say that JPMorgan's IPO research counter argues that the supply/demand balance will remain favourable until the beginning of 2007 since much of the 2006 capacity additions will not be delivered until late in the year.

A second swing factor comprises the impact of higher time-charter rates on operating margins. The current global supply/demand imbalance means leasing companies have been able to charge higher rates for their ships.

But this should affect CCH less than other shippers because it owns a higher percentage of its fleet and also receives preferential treatment from the leasing arm of Cosco Pacific. Analysts say CCH owns 77% of its fleet compared to an Asian industry average of around 45%.

A second and more problematic weight on the company's operating margins is the impact of rising fuel prices. Analysts say that fuel or bunker costs typically account for about 30% to 40% of a container line's cost base.

Were a sudden spike in fuel costs to co-incide with a drop off in freight rates - whether due to overcapacity, slowing global growth or some combination of the two - it could precipitate a particularly vicious cyclical downturn.

Non syndicate bankers believe CCH may prove to be one of the more testing IPO's of the year thanks to difficult global equity markets, negative sentiment towards China and a lack of even short-term visibility over the shipping cycle. However, like China Shipping before it, they also conclude that CCH will be able to leverage all of its different demand components to ensure a successful outcome for what ranks as one of China's most well known brand names.

Like China Shipping, CCH has also indicated that it will pay not less than 25% of net profits in dividends. Cosco Pacific is currently trading on a forward yield of 2.8%.