Huabao's new flavour appeals to equity investors

In a sign of returning market confidence, Huabao completes largest Hong Kong placement since the market correction in May to maintain free-float requirement after backdoor listing.
The controlling shareholder of Hong Kong-listed Huabao International Holdings has sold HK$1.52 billion ($196 million) worth of shares in the company to maintain the free-float at the required 25% following a reverse takeover by Huabao of her China-based tobacco flavouring company.

The placement, which was increased to 690 million shares from a base size of 600 million following solid demand, is the largest Hong Kong block trade since Aluminum Corp of China raised US$600 million on May 9, before the market correction. The trade shows that confidence is returning to levels where the market is able to support primary issues by companies that arenÆt already known to investors

Interest is still very much down to valuations, however. Indeed, because Huabao is in the process of being re-rated to account for its new business line this deal had the benefit of being marketed at a very deep discount to the existing share price as well as at a cheaper valuation compared with the only other Hong Kong-listed company in the same industry.

HuabaoÆs HK$4 billion ($515 million) acquisition of Chemactive Investments, which was announced in early June - and completed on August 1 following shareholdersÆ approval - was paid for by the issuance of 2.2 billion preference shares to its owner Chu Lam Yiu. The shares were convertible into 90% of the enlarged share capital of the company.

Ms Chu already controlled 70% of the existing share capital of Huabao - which was essentially a listed shell company comprising a loss-making consumer electronics business. Likewise because she held existing preference shares and warrants that would have enabled her to increase her stake to almost 91% of the pre-acquisition company, a full conversion of all her indirect shareholdings would have resulted in her holding 97.57% of Huabao in its new shape.

YesterdayÆs placement solved that problem as it allowed her to convert all her preference shares, which were unattractive because they carried no dividend rights, and still maintain the companyÆs free-float at 25%, which is the minimum under Hong Kong listing rules.

Deutsche Bank was sole bookrunner for the deal and joint lead manager together with DBS Asia Capital. The two banks were also joint financial advisers to Huabao with regard to the acquisition of the new business.

The shares were offered at a price between HK$1.95 and HK$2.20, which equalled a discount of 21.4% to 30.4% to TuesdayÆs closing price of HK$2.80. (The shares were suspended Wednesday and Thursday to complete the placement). They were sold at the top end of the range at HK$2.20 after the book was said to have been 3-4 times oversubscribed with very little price sensitivity.

The deep discount to the market price was possible partly because the preference shares were initially issued to Ms Chu at a price of HK$1.80 û a 3.2% discount to the market price at the time - allowing her to make a profit even at the bottom of the indicated range. The share price reached a high of HK$2.89 on July 25, the day before the shareholders approved the acquisition of Chemactive Investments.

According to sources, the key challenge was to explain the new business to investors who werenÆt familiar with the industry. This explained why it took a longer-than-usual 26 hours from the launch on Wednesday morning to wrap up the trade.

ôThe acquisition is also a company-transforming transaction, which is obvious by the fact that the market cap of the company has increased to $1 billion from about $75 million, so the share offering is almost an IPO,ö notes one observer.

Once they understood the concept, however, investors were happy to buy into the business, which has a high cashflow and low capex requirements as well as a strong market position as a supplier of flavours and fragrances to the top 10 cigarette companies in China. All those companies are growing strongly. This is thanks to an M&A wave that - encouraged by the government - has seen the number of mainland tobacco companies drop to 44 from about 200 three years ago. The number is expected to be reduced further and eventually leave only the 10 big ones in the market.

About 70% of the demand for the share sale came from Asia, primarily Hong Kong and Singapore, while the remainder was split between Europe and the US. According to a source familiar with the offering, the book contained a good mix of hedge funds and long-only investors.

The placement price translates into a PE multiple of 15.6 times projected earnings for the current fiscal year ending March 2007. This compares with a 2007 PE of 18 times for Hong Kong-listed China Flavors & Fragrances, whose market cap is only 20-25% of HuabaoÆs. CFF is more focused on producing flavours and fragrances for the food industry, however û an area which Huabao has started to expand into but which accounted for only 10% of its net sales in the most recent fiscal year.

The backdoor listing of the business will give the company access to the capital markets as it enters a new growth phase which will include more focus on the food side of the industry.

The company was valued at a slight premium to its international and US peers, however, which tend to trade at forward PE multiples of 12 to 14 times, but according to the observer investors were willing to accept this because Huabao has ôa much better growth profileö.

In the fiscal year to March 2006 the flavours and fragrances business posted a 169% jump in net profit to HK$300.8 million ($39 million).

¬ Haymarket Media Limited. All rights reserved.
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