China Paradise: trying to unplug demand

Pre-marketing ends for China''s third largest electronics retailer.

Formal roadshows will start this Monday (September 26) for a $110 million to $150 million Hong Kong IPO by China Paradise Electronics, also know as China Yongle. Timing of the potential Red chip issue is not ideal given the underperformance of its main comparable, GOME Electronic Appliances, China's largest electronics retailer.

The Hong Kong listed stock has dropped 35% since the end of June following the announcement of weaker than expected first half results, which showed a slim 4% rise in net income. Year-to-date it is down 31.56%.

Yet GOME's weak performance has been counterbalanced by the strong performance of China's second largest electronics retailer, Suning Appliances, which is listed in Shanghai and currently up almost 50% year-to-date.

Unpicking the true performance drivers of China's private sector entities is never easy and in the case of the electronics retailers, investors have conflicting data points to deal with. Some analysts, for example, believe GOME's weak results presage intensifying competition in China's electronics retail sector that will lead to the same kind of margin pressure already experienced by the country's food retailers.

Others argue that GOME's sudden share price drop has more to do with company specific reasons and corporate governance concerns. Either way, the uncertain backdrop to China Paradise's IPO has led the company's private equity investors to postpone plans to sell stock.

As a result, the offering will comprise all new shares. Post greenshoe, the company will issue 21.7% of its share capital. In order to meet the Hong Kong Stock's Exchange requirement for a 25% freefloat, the company will also count the 3.3% stake owned by CDH. A further 54% will be owned by company management and 21% by Morgan Stanley's private equity arm, which paid $50 million for its stake at the end of 2004.

Morgan Stanley and Cazenove are lead managers of the IPO, with BNP Paribas Peregrine as co-lead. Pricing is expected on Friday October 7.

Proceeds will be used to fund the company's rapid expansion plan. Management have said that $50 million will finance the opening of 68 news stores by the end of 2005 and $20 million for acquisitions. In July, China Paradise said it would pay $17.8 million to purchase the 32 stores owned by Xiamen-based electronics retailer Tsann Kuen.

However, specialists say the company has been telling investors it will be highly selective when deciding where to open new stores. In doing so it hopes to counter concerns that rapid expansion is pressurising earnings.

In an influential research report published this summer, Credit Suisse First Boston argued that China's electronics retailers are showing signs of weakening ratios on a sales per store basis thanks to intensifying competition in core markets and expansion into third and fourth tier cities where sales growth is slower and it takes longer for a store to become profitable.

It also said that higher operating expenses were started to becoming a problem, with rental costs, salaries and distribution costs as a percentage to sales continuing to rise.

The investment bank cited China Chain and Franchise Association (CCFA) figures, which show that Chinese electronics retailers achieved declining sales growth of 53% in 2003 and 44% in 2004. However, store growth moved in the opposite direction, with 30% more new stores opened in 2003 and 48% in 2004.

China Paradise currently has 121 stores nationwide compared to Suning's 149 and GOME's 188. Its stores are also far more concentrated than its two rivals, with two thirds situated in the Yangtze Delta region, of which 40 are in Shanghai.

The company was founded in 1998 and has a shorter track-record than GOME, which has been around for just over a decade and is now established in every single Chinese province bar Tibet and Anhui.

This means China Paradise is currently reporting a stronger growth profile, with sales rising 67% in 2004, versus 51% at Suning and 35% at GOME. The company reported 2004 net income of $22 million and analysts are forecasting 56% growth in 2005 to roughly $36 million and 25% in 2006 to roughly $45 million.

Based on these figures, China Paradise is being marketed on a 2005 P/E ratio of about 14 to 19 times. This will place it at a premium to GOME, which is currently trading around 15.5 times. Both companies will trade at a discount to Chinese listed retailers such as Lianhua and Wumart, which are trading around 20 times.

Analysts say that one of the company's major challenges will be to differentiate itself from its competitors as Chinese consumers have little brand awareness and even less loyalty. Being unable to provide in-house credit does not help in this respect.

However, the electronics retailing sector is as yet untouched by foreign competition, although Hong Kong's Fortress has ambitious expansion plans on the Mainland and Best Buy, the biggest US electronics retailer, is planning to open up in Shanghai.

Together the top three domestic electronics retailers have a market share of around 8%, a figure that has doubled over the past two years in line with the rapid opening of new stores. Specialists argue that larger operations should benefit companies like China Paradise since Chinese suppliers offer rebates for bulk orders. Chinese electronics retailers also take goods on a sale and pay basis, forcing sales risk back onto the supplier.

The underlying growth profile of the market is also undoubtedly strong, with sales of household goods and electronics appliances rising by a CAGR of 14% over the past six years.

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