China Yurun bets on brand, growth for IPO

Mainland pork processor hopes to prepare a juicy banquet for its investors.

China Yurun Food, China's third largest pork processing company is betting that its brand, growth prospects and superior quality will help it raise up to HK$1.5 billion ($192 million) from its Hong Kong IPO later this month. The company will finish its roadshows in San Francisco and price its offer next Thursday (September 22), Hong Kong time under the lead of Goldman Sachs.

The range has been set at HK$2.85 to HK$3.70 per share, or 11.8 to 15.3 times 2005 forecast earnings, estimated at Rmb 350 million ($43 million) for this year, compared to Rmb 169 million in 2004. The company will offer 416.1 million shares, equating to a proceeds range of HK$1.185 billion to HK$1.539 billion.

In terms of comparables, specialists cite Shanghai-listed Shuanghui Development and Hong Kong-listed People's Food. Shuanghui currenlty trades at 17.2 times forecast 2005 earnings, while People's Food, which originally listed in Singapore and then carried out a second listing in Hong Kong, trades at 7.2 times. Mengniu Dairies, China's top milk producer, trades at 20 times.

One specialist says that despite the problems with the Shanghai stock market and the structural reforms it is going through, the comparison with Shuanghui is nevertheless valid.

"Price earnings ratios in the Shanghai market have come down enormously and Shuanghui grew at 20% last year, so it's worth the high ratio," he says

A major reason for Yurun's relatively high valuation is its growth, say specialists, which equated to a compound annual growth rate of 74% between 2002 and 2004. Shuanghui managed 22% over the same time period, while People's Food came in at minus 7%. Yurun's net profits jumped 131% year-on-year in Q1 of this year, while People's Food dropped 26% and Shuanghui improved by just 10%.

In terms of net profit margins, in Q1 2005, Yurun managed 8.6%, while Shuanghui managed 2.9%. People's Food managed 9%, after reporting 16% in 2002 and 11% in 2003. In contrast, Yurun has reported steadily rising margins: 3.6% in 2002, 4.9% in 2004 and 6.5% in 2004.

In terms of gross margins, Yurun managed 15.2% in Q1 2005, Shuanghui 11% and People's Food 12.8%. Underpinning Yurun's high valuation is also its brand appeal. In that sense it is similar to Mengniu, which commands premium prices based on its high profile, argue specialists.

In contrast to Mengniu Dairies, which splits a large market share with two to three other top players, Yurun has less than a 5% of the total market, meaning the company has plenty of room for further growth notes a specialist, who foresees a wave of consolidation in the sector underpinning strong growth for Yurun.

The comparison to Mengniu Diaries, which has risen 52% since its $202 million Hong Kong IPO last year, extends further. Mengniu also has investments from CDH Investment, a leading Chinese private equity fund, which holds 8.12% in Yurun. Goldman Sachs Funds has 9% in Yurun, while Morgan Stanley similarly has a 20% stake in Mengniu. Prowell Ventures, the investment vehicle for the Singapore government investment vehicle GIC, holds 7.68% of Yurun and also invested in Mengniu.

China Yurun's coporate governance has come under scrutiny due to loans of Rmb1.2 billion, which were made to chairman Zhu Yicai in 2004 during his takeover of a Nanjing department store. One specialist says that Yurun Group was fully owned by Zhu Yicai at the time, making the loans perfectly legal, although investors in the listco will be hoping that it does not happen after it is floated.

One specialist says it is important to remember that when the loans were made last year, the listco did not exist.

"All the assets were in one pool, owned by Zhu Yicai and his wife. Transfers between different lines are perfectly normal," he comments.

"Now, the pork business has been sliced off and debt left with the non-pork business. The Chinese banks involved have written to the company and accepted the transfer," he says. Outstanding short term loans at China Yurun amounted to Rmb205 million in Q1 2005.

Sources close to the deal dispute any interpretation that the loans undermined the company's production growth during 2004. Instead they argue that health scares caused the company to slow down production in Sichuan, one of the areas hit by hog disease.

In any case, the board of directors should bolster corporate governance. It will consist of three independent directors, three non-executive directors from Prowell, Goldman and CDH respectively and six executive directors. The board chairman of Mengniu is also an independent director for Yurun.

One source says that it is important not to be too cynical about private entrepreneurs IPO'ing in Hong Kong, pointing out that the likes of Baidu, Shandai and Shanda are also privately owned and have provided their investors with handsome returns.

Yurun's business scope consists of two parts. Upstream the company focuses on chilled and frozen pork, while downstream the company sells high temperature meat and low temperature meat. While the first category is sold raw, the last two categories are ready to eat.

The temperatures refer to the temperatures at which they are processed, 121 degrees centigrade and 99 degrees respectively. It is especially in low temperature meat that the company is regarded as having edge.

This segment, in which Yurun has the strongest branded presence, accounted for 24% of the listco's revenue in Q1 this year. For Shuanghui, that segment of the market accounts for 16% of revenue and for People's Food 7%. Low temperature meats comprise relatively pricey quality meats which need to be kept in the fridge at home. High temperature meats refer to cheaper, heavily processed items with a lower meat content, which can be stored at room temperature.

The company also predicts a bright future for chilled meats, as opposed to frozen meats, as they suit an urban population with the means to buy fresher meats.

Yurun has 200 staff working in research and development, enabling the company to offer 530 varieties of meat in the low temperature meat segment and 211 varieties of high temperature meat segment.

With 60% of meat consumed in China being pork, and some 618 million pigs slaughtered last year, up from 412 million pigs in 1996 on the back of increased prosperity, pork is the meat which dominates the Chinese diet. Chicken comes second followed by beef and lamb.

The company does not raise pigs but buys them in from farmers. In order to ensure sick pigs do not enter the slaughter houses which the company operates, the company tests the temperature of the pigs coming in on two separate occasions. A raised temperature is a useful indicator of general health, as was seen during the SARS outbreak in 2003 when similar checks were performed on humans.

One specialists says that the slaughter company (a recently acquired SOE), using equipment imported from the US and the EU, provides the artificially chilled environment to make slaughtering the animals as hygienic as possible. It is likely, he says, that infections enter the food chain through the wet market slaughter of pigs in 'mum and pop' operations, where it occurs at room temperature. Some 90% of Chinese pigs are slaughtered in this way.

The company is listing as a red chip. Under such a structure, an offshore entity is set up which enters China as a foreign-invested enterprises and buys the assets of the Chinese party wishing to IPO offshore, usually at net asset value. These are the assets which are then sold to investors via the IPO.

It is in order to avoid the high upfront costs involved in buying so many assets off the Chinese entity that the listco entered into a 20-year leasing arrangement with Zhu's privately-owned mainland entity. These leases relate to land and buildings, but not the plants and equipment. The rent is at market rate, according to sources close to the deal.

Zhu also recently came under scrutiny for his controlling shareholding in Oriental Investment, a Hong Kong listed company (HK0735).

Zhu was an executive director from 2002 to March 2004. Sources close to the company said that it was common in 2002 for investors to buy Hong Kong shell companies, and that Zhu, not especially sophisticated in financial terms at the time, but interested in financing channels for his company, was approached by a friend for the investment. As soon as the possibility of a proper IPO came up, he resigned his directorship.

Following the IPO, Zhu and his wife will hold 53.4% of the listco (pre-15% greenshoe), Goldman 6.75%, CDH 3.65% and GIC 3.46%. Some 29.74% will be held by retail and institutional investors. In total, 86% of the 416.09 million shares are primary and 16% are secondary, the profits of the latter accruing to CDH and GIC, both selling 40% of their stake. The post-IPO lock up will last six months for the private equity investors and two years for Zhu.