China Life: cheap valuation?

Will a large issue size and reliance on institutional participation necessitate a compelling valuation for the IPO?

Pre-marketing for a 6.47 billion share offering (pre greenshoe) in China Life began last Friday under the lead management of CICC, Citigroup, Credit Suisse First Boston and Deutsche Bank.

Regulatory delays mean the $1.9 billion to $3.2 billion deal is now on an accelerated timetable to make sure it begins trading before Christmas. Formal roadshows are scheduled for December 1 and institutional pricing for December 11, followed by trading in New York on December 16 and Hong Kong on December 17.

China Life should represent the world's biggest IPO this year. But does the combination of a large issue size, late timing, and lack of investor awareness suggest the need for a more enticing valuation than might otherwise have been expected?

The insurance sector is not well understood in Asia and this is complicated by the fact that US and European investors use completely different valuation metrics to analyse life companies. In Europe, for example, the main variable is Embedded Value (EV) and in the US, price to book value (P/B).

In terms of P/B, life insurance companies typically trade at a premium to non-life insurance companies. For pre-marketing, the leads have gone out with the standard wide valuation range in order to complete price discovery. In China Life's case, the range straddles a discount and a small premium to the company's recently listed peer, PICC. The latter is currently trading at HK$2.58, having shot up in the immediate aftermarket from its IPO price of HK$1.80.

This represents a price to 2003 book value spanning 1.65 times to 1.8 times - subject to individual analysts' estimates. China Life is being pitched on a consensus syndicate P/B valuation of 1.3 to 2.1 times based on its filed share price range of HK$2.58 to HK$3.89. Many had initially expected it to come at a minimum of two times.

Based on these indicative levels, China Life will price at a premium to the US average of 1.5 times, but at a discount to most Asian comparables. At one end of the spectrum, there is Taiwan's Cathay Life on 3.4 times and at the other end, Malaysia's MAA Holdings on 2.6 times and Singapore's Great Eastern Holdings on 2.1 times.

Analysts say MAA is probably the best comparable of the three, since it has a low penetration rate of 3.7% similar to China's 2.2%. Taiwan, on the other hand, is considered a mature market on 7.4%.

On an embedded value basis (EV), China Life's valuation looks far more aggressive. This is because EV accords greater weight to growth, China Life's biggest selling point. Embedded value is expressed as book value plus future cash flow from policies already written.

Many analysts believe China Life's strong growth prospects mean it should trade at a premium to peers. Global comparables currently average 1.3 times. In Asia, Cathay Life trades around 1.6 times and MAA at 0.8 times.

China Life is being pitched at roughly 1.6 to 2.8 times. This is based on an EV of about RMB47 billion ($5.7 billion) as of June 2003.

China Life's embedded value was calculated by Tillinghast-Towers Perrin, which was hired to compile an actuarial report for the IPO. Tillinghast used three discount rates of 10%, 12.5% and 15% and the RMB47 billion figure derives from the middle of the three.

The final valuation metric is price to earnings and here China Life is being pitched at about 13 to 20 times compared to a global average of about 17.5 times. However, there can be considerable distortions in the "E" as some global insurers do not amortise agents' commissions. China Life does.

In order to maximize pricing leverage, the four leads have included a POWL (Public Offer Without Listing) in Japan, which will be handled by Daiwa SMBC and Nomura. Both are co-leads on the international tranche, which also includes Fox Pitt Kelton, Lehman Brothers, Merrill Lynch and UBS. The latter four houses are also co-managers in the US.

The main source of confusion surrounds the likelihood of a strategic investor taking up a significant proportion of the deal. Some observers have heard rumours that a non-life company is poised to take up to 30% of the offering. However, others say this is not true.

The leads have also attempted to make sure the deal has a better institutional tilt by applying for a waiver to limit retail participation to 20% no matter how hugely oversubscribed the final order book. But it is also possible that limiting retail participation in the primary book will create pent-up demand and underpin secondary market trading. Knowing that retail momentum will carry the deal through secondary market trading may in turn encourage more reluctant institutions to participate.

One other major concern has been whether institutions will close their books early this year as most funds are up and investors will want to safeguard returns. However, supporters argue that institutions have long known the deal is coming and have left cash to invest.

Specialists say that China Life will not pay a dividend until 2005 because China GAAP has onerous accounting standards, which wipes out the company's net income. In FY2002, the company reported a net income level of $546 million and $378 million in the six months to June 30 2003 under US GAAP.

According to the national regulator CIRC, insurance premiums grew at a CAGR of 37.7% from 1999 to 2002 compared to a global average of about 2.6%. Analysts are forecasting that China Life will record net profit growth in the mid 20% mark over the next three years and increase ROE from the mid to the high teens.

At the same time, its reserves will also have to increase. As one specialist points out, "China Life is a new company, with no history before 1999 since all the old policies with high guarantees were transferred to the parent. But the regulations state that new companies have to put up a disproportionate share of reserves early on and this will continue to be a problem for a high growth company like China Life."

On the plus side, China Life has none of the legacy issues that have haunted the Chinese life insurance sector through selling high guarantee products at a time of low investment returns. The CIRC has dispelled concerns that there may be flow-back risk from the parent by stating that it will inject funds to make up for any shortfall arising in the special purpose fund, which holds the old policies.

Since 1999, it has instituted a 2.5% cap on guarantees to prevent the same thing happening again. China Life's investment return is estimated between 3.5% and 4% over the past two years.

Supporters conclude that China Life combines a dominant and stable market share (45%), with high growth backed by a low penetration rate and high GDP. In a recent research report, Standard & Poor's concluded that, "China's nascent insurance industry faces substantial challenges if it is to progress to a more developed stage. The risks facing the industry stem mainly from its historically poor financial strength, investment restrictions and its relatively unsophisticated market.

"These risks, however, are counterbalanced by strong growth as a result of a low penetration ratio and an improving regulatory framework."

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