Chinese coal miner kicks off Hong Kong IPO

Hidili Industry is offered at a significant discount to its listed peers, but still hopes to raise more than $500 million at the top of the range.
Summer is officially over in Hong Kong with the launch today of the formal roadshow for Hidili Industry International DevelopmentÆs initial public offering which could raise $500 million if priced towards the top of the price range.

The privately owned Chinese coking coal producer will be the first company to seek a listing in Hong Kong after the global equity market correction last month and consequently will be the first test of whether investors are willing to put their money on unproven stocks.

The response should be particularly interesting for the parties involved in the upcoming IPO of Sino-Ocean Real Estate, which kicks off pre-marketing today, and online roll-playing game provider Kingsoft, which started investor education last Thursday, as both have yet to decide on the final size and price range of their respective offers. It is widely expected that investors will ask for wider IPO discounts and more generous valuations versus peers in the same sector to compensate for the increased volatility that has followed in the wake of the subprime crisis.

That said, enthusiasm about the pilot scheme that will allow Chinese nationals to buy shares in Hong Kong has sparked a buying frenzy of Mainland-linked stocks in Hong Kong that has helped the Hang Seng Index to recover all of the losses caused by the subprime crisis in just two weeks. The index closed at a new record high on Friday, which ought to instil at least some confidence among potential investors.

Hidili also looks like a good candidate to re-open the market after the summer break as it is not that big in terms of size. It also offers a fairly unique story as it will be the first Hong Kong-listed coal producer to focus solely on coking coal which, because of its higher heat content, makes it ideal for the iron and steel industries. The other three Hong Kong-listed coal companies primarily produce thermal coal that is used by power generators. The valuation also looks reasonable with a significant discount to its peers.

Hidili is aiming to sell 600 million shares or 30% of its share capital and, according to sources, it has set a price range of HK$5.05 to HK$6.65. This will give a total deal size of HK$3.03 billion to HK$3.99 billion ($388 million to $511 million). The range is quite wide, which suggests the issuer wants some flexibility in case the markets remain volatile.

The deal will also include a 15% greenshoe that could lift the total proceeds to as much as $588 million. To help build momentum in the book, sole bookrunner UBS has signed up four cornerstone investors who will jointly buy $80 million worth of shares in IPO. Depending on the final price this will give them between 16% and 21% of the total deal pre-shoe.

The cornerstones are believed to be Hong Kong property tycoons Lee Shau Kee and Joseph Lau as well as Bank of East Asia Chairman David Li and the Malaysian Kuok family which controls the Kerry Group, Shangri-La Asia and the South China Morning Post. All four frequently participate in Hong Kong IPOs as cornerstones and are well-known for their ability to attract other investors û especially retail players - to a deal.

People familiar with the deal say several other parties had expressed an interest in becoming cornerstones, which could result in additional support once the bookbuilding starts.

Of the total shares on offer, 83.3% will be new paper while the rest will be sold by Baring Private Equity and HidiliÆs 33-year-old founding chairman and CEO Xian Yang. Baring holds a 20% stake in the listing vehicle which it obtained through the conversion of a convertible bond issue earlier this year and will sell 80 million shares. The chairman, who currently owns 80% of the company, is selling 20 million shares, or a modest 1% of the outstanding share capital.

As usual, 10% of the offer will be earmarked for retail investors, but a standard clawback mechanism could boost this to a maximum of 50% in case of strong demand.

Hidili currently has 14 operational mines in the Sichuan province and acquired five new mines in the Guizhou province in the first quarter this year that will begin production in the second half. Including these new mines and capacity expansion at its existing operations, the company is expected to increase its raw coal output by 31% to 2.9 million tonnes in 2007 and to 3.7 million tonnes in 2008, according to a syndicate research report.

At the end of March this year, the company had 179 million tonnes of coal reserves and 217 million tonnes of resources. The raw coal is put through a washing facility and is then either sold or processed further in a coking plant that produces coke and other by-products. In 2006, Hidili sold 612,000 tonnes of washed coal, 472,000 tonnes of coke and 335,000 tonnes of high-ash thermal coal, all according to the syndicate report.

Among HidiliÆs key selling points are the high quality of its coal reserves and the fact that its new mines in Guizhou are close to its major customers in southwestern China and have better transport connections û through established railways - to the steel plants in the Hunan, Guangdong and Guangxi provinces than the many coal mines in the Northern Shanxi province. This means Hidili has a cost advantage over several of its competitors in the north which face bottlenecks in railway or shipping capacity, observers note.

According to earlier research reports, UBS forecasts that China will see 8%-12% annual growth in steel production in 2007 to 2009, compared with just 5% for the global market and this will obviously benefit the producers of coking coal and coke, which are the major raw materials for steel production.

According to an energy sector analyst, only 17.3% of ChinaÆs coal production was used for steel production in 2006 with the rest going to feed the fuel needs in the power industry, but as demand for both categories of coal is expected to remain solid this is a secondary consideration.

ôDemand will not be a problem over the next few years. The key issues are the coal price trend, the valuation of the company and the quality of the management,ö he says.

The price for the two different coals have been on a similar upward trend in China with a more than 18% increase in the first half of this year, but the price for coking coal is about 50% higher than for thermal coal. And given that both types face similar overhead costs for mining and extraction and transportation, coking coal also has higher profit margins, the analyst says.

Aside from having to make a call on the direction of coal prices, investors will also need to consider the execution risks associated with HidiliÆs aggressive expansion plans. And then there is of course the poor safety record of ChinaÆs many underground coal mines with frequent fatal accidents caused by explosions or flooding.

According to the sources, the IPO price translates into 11.5 to 14.5 times its estimated 2008 earnings, which is in line with the low- to mid-teens valuation that fund managers had earlier indicated they may be willing to pay. It equates to a discount of at least 34% and as much as 47% to larger players China Coal and China Shenhua Energy, which both trade at about 22 times next yearÆs earnings after a strong run-up over the past three months. Smaller Yanzhou Coal is currently valued at about 18.5 times.

The syndicate report expects HidiliÆs revenues to increase by 53% in to Rmb1.25 billion ($166 million) in 2007 and by 58% in 2008, while the bottom-line is forecast to grow at 44% (excluding the fair value adjustment of its CB) in 2007 to Rmb552 million and by another 56% in 2008. The growth will be supported by a 10% increase in the selling price of the coking coal that Hidili produces at its Panzhihua mines in Sichuan and the estimate is that every 1% increase in the coking coal price will lead to a 0.7% rise in the 2007 net profit and a 1% increase in the 2008 profit.

Other revenue drivers will be an increase of long-term sales volumes to its existing customers and an expansion into the production of alloy pig iron that it began in 2006.

Aside from the capacity expansion that will come on stream this year, the company is also planning to acquire more mines and has already signed preliminary agreements to buy another 11 coal mines in Guizhou over the next 10-12 months. These mines have total resources of 238 million tonnes and could help to boost its profit growth above current estimates. Any acquisition is at the discretion of Hidili.

The offer will stay open until September 13 with the pricing expected to be determined the following day. The trading debut is scheduled for September 21.
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