Finally, a Hong Kong IPO on the horizon

Underground shopping mall operator Renhe takes on the challenge of becoming the first company to attempt a Hong Kong IPO after the summer.
Renhe Commercial Holdings yesterday kicked off pre-marketing for an initial public offering that sources say will now likely be in the range of $600 million to $800 million. If successful, the Chinese operator and developer of underground shopping centres will be the first company to list in Hong Kong in more than a month and the outcome of the offering is seen as crucial for whether the long list of IPO candidates in the pipeline will be able to launch their own deals.

The continued volatility in the secondary market has already forced a significant reduction in RenheÆs fund-raising expectations from talk of as much as $1.5 billion to $2 billion earlier in the year to reports of $800 million to $1 billion as recently as last week. Now an issue of up to $800 million is being planned. Part of the reason for the smaller size is that the company has obtained a waiver to sell only 15% of its enlarged share capital, versus the earlier planned 25%. But valuations have obviously also come down and sources argue that the offering will have to come reasonably cheap in order to lure investors back to the IPO market, their confidence dented by the fact that some of the companies that listed in May and early June are still trading below their IPO prices.

That said, the company chose a good day to start its pre-marketing activities with the Hang Seng Index surging 4.3% yesterday to 20,794 points as Asian markets responded positively to the US governmentÆs bailout over the weekend of mortgage lenders Freddie Mac and Fannie Mae. And while nobody expects gains of that magnitude to continue, there is hope that the US rescue plan will result in a bit more stability in the financial markets. Volatile secondary markets make it difficult to set a price range for upcoming IPO as the valuations of the comps can change dramatically over just a few days, altering the relative attractiveness of the newcomer. This is especially true in markets like Hong Kong where the price range must be set two to three weeks before the stock actually starts trading.

Despite yesterdayÆs rally, the Hong Kong stock market is still down 25% year-to-date and the Hang Seng Index is currently trading less than 1,100 points above its 52-week low, providing a somewhat shaky backdrop.

However, the initial feedback for Renhe is said to be positive, although some investors say the company is a bit difficult to assess since it falls somewhere in between the commercial real estate and the retail sectors. It operates shopping malls, but doesnÆt get a percentage of the sales generated by its tenants û rather its revenues mainly come from leasing and sales of shop units in its underground malls. However, a pickup or slowdown in retail sales over time will undoubtedly have an impact on the demand for shops at its premises and thus on the leasing price.

At the same time, Renhe isnÆt legally classified as a developer since all its malls are built as civil air defence shelters (the government can take them over and use them as such at times of war) and as a result is exempted from land use right premiums, land appreciation tax and property tax û giving it a distinct advantage over the traditional developers of commercial properties. In addition, it doesnÆt own any landbank, but rather has operational rights for the facilities it builds for 40 years.

Consequently, the valuation is far from straight forward and, according to a couple of investors, is further complicated by the fact that research issued by the syndicate banks differs on what is considered the most appropriate valuation method and the best comparables. One report leans more towards a valuation based on real estate comps, while another prefers to benchmark the company primarily against the Chinese department store operators and business-to-business facilitators. However, both reports use a multitude of valuation methods in their quest for a fair value, resulting in widely differing outcomes.

The company itself is helping out by providing a profit forecast for 2008 of Rmb1.9 billion ($278 million). Based on this, the planned issue size would translate into a price-to-earnings multiple ranging from 14.4 to 19. At the end of August, the Hong Kong-listed Chinese developers traded at an average P/E of 9.8 times, according to one report, while Chinese retail stocks were on average quoted a 18.8 times this yearÆs earnings.

RenheÆs key selling points û and these are a lot easier to grasp û are its projections for high earnings growth and its impressive margins, which are a direct result of its favourable tax treatment and the fact that it doesnÆt have to pay for the land it uses. The net profit margin has widened to about 74% in 2007 from 18% in 2005 and is expected to stay between 50% and 60% over the next couple of years. The Rmb1.9 billion net profit projected by the company for this year represents an increase of 614% over last yearÆs Rmb266.7 million and if the company is able to complete the six new malls that it is planning for 2009, syndicate analysts estimate that the net profit will exceed Rmb5 billion that year.

Another interesting point is that by placing its malls under ground, Renhe is able to gain access to prime commercial areas in cities where land supply above ground is limited. The fact that its tunnel shaped malls offer sheltered walkways that are air-conditioned in summer and heated in winter also helps to attract visitor to its shops, which are a combination of retail and wholesale outlets. Although it outsources all the construction work, the company has developed a construction method that enables it to complete the work above ground in a very short time û typically less than one month û causing minimum disruption to traffic.

According to Euromonitor, Renhe is the largest privately-owned operator and developer of underground shopping centres for clothing and accessories in China in terms of gross floor area. It opened its first underground shopping centre in Harbin in 1992 and now has three interconnected malls in that city and one in Guangzhou, as well as two malls under development in Zhengzhou and Shenyang which are scheduled to be opened for business in October and December this year. These six malls span a combined gross floor area of 374,000 square metres. It has also obtained the necessary approvals from the National Civil Air Defense Office for a further eight projects with an aggregate gross floor area of about 980,000 sqm. These approvals will add four new cities to its list of projects and take Renhe another step towards its aim of becoming a nationwide player. However, the aggressive expansion will bring a certain amount of execution risk û not least with regard to the completion timetable.

The company will be offering 3 billion new shares in the IPO, with 10% set aside for Hong Kong retail investors. The four joint bookrunners - BOC International, HSBC, Morgan Stanley and UBS û are also in talks with potential cornerstone investors with the aim of being able to pre-place a portion of the deal before it is opened to other investors. However, investors are typically not that interested in committing to a lockup at times like these with high volatility and low trading volumes and Renhe may have to settle for a few anchor investors instead, sources say. Like cornerstones, anchor investors agree to buy a pre-determined portion of the deal, but they do not have to commit to a lockup and they are not named in the prospectus.

The company is controlled by a Mrs Hawken, who owns 81%. The rest is in the hands of a group of external investors who were invited to take a stake in December 2007 and January 2008 through the purchase of class A preference shares. Largest among them is New World Investors, which owns 8.55% prior to the IPO, Capital Funds with 4.34% and Global Giant Enterprises with 4.0%. Venture capital firm Sequoia Capital owns 0.98%.

The timetable hasnÆt been set in stone yet, but sources say the company may kick-off the formal roadshow as early as next week after only one week of pre-marketing, which would allow for a listing by the end of this month.
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