Investors bank on China

Bank of China''s IPO is unexpectedly priced near the top of its indicative range after amassing a $19 billion order book of 450 institutions, 242 corporates, 80,000 Japanese retail investors and 385,000 of domestic retail.

A faultless marketing strategy and the loyalty of the bank's corporate and retail customer base has propelled Bank of China's $2.47 billion (pre shoe) flotation to the kind of successful completion that few envisaged at the outset. Its achievement has also been all the more remarkable given the extreme volatility of global equity markets, the precarious state of the Chinese banking sector and sluggish economic backdrop in Hong Kong, where banks have been engaged in a fierce price war.

Yet pricing Saturday saw a 2.298 billion share offering come towards the top end of its HK$6.93 to HK$9.50 indicative range. A placement tranche of 1.49 billion shares, accounting for 65% of the deal, was priced at HK$8.50 per share and a retail tranche of 804.3 million shares, accounting for the remaining 35%, was priced at HK$8.075, after the implementation of a 5% discount and clawbacks from the institutional offering. There is also a greenshoe of 334 million shares, which could bump total proceeds up to $2.83 billion.

At this level the bank has been valued on a price to book ratio of 1.65 times 2002 earnings and a p/e ratio of 16 times forward earnings. Taking into account the fact that most listings are normally priced with an IPO discount, this represents a significant premium to the Hong Kong banking sector. For example, the Territory's nine largest listed banks with pure domestic exposure (excluding HSBC and Standard Chartered) average a current price to book ratio of 1.34 times and with the removal of Hang Seng Bank, which skews the figure, the average is dragged down even further to just 1.01 times.

Bank of China has been rewarded for its brand name not to mention the size, scale and potential synergies inherent between both the newly merged Hong Kong sister banks and their Mainland parent. Bankers from the joint global co-ordinators Bank of China International, Goldman Sachs and UBS Warburg all say it is hard to overemphasise the significance of a deal, which provides many echoes of China Mobile's experience back in 1997.

As Mark Machin, co-head of Asian equity capital markets at Goldman Sachs comments, "Like China Mobile, this a landmark transaction for China and also one that's been completed at a very difficult time for global equity markets. Both the European and US equity markets are at five-year lows and the Dow Jones has lost 15% since roadshows began."

Similarly Colin West, head of Asian ECM at UBS Warburg concludes, "As the first global offering by a Chinese financial institution, it was incredibly important to make sure this deal worked. Bank of China has provided a role model for the Chinese government and its IPO heralds the beginning of a much wider restructuring of the Chinese banking sector."

Many syndicate and non-syndicate observers have also congratulated the leads on their marketing strategy. This appears to have been less a case of jamming paper in every available direction but rather of playing off different investor constituencies to build momentum and leverage up final pricing. By maximising distribution channels and setting a very wide price range, the three have been able to entice investors with the prospect of a cheap deal while using the deal's core investor base as a springboard to wider participation and more expensive pricing.

In particular, the deal's importance to the Chinese government is underlined by the participation of an unprecedented number of corporate investors. Including high net worth investors participating through their investment vehicles, corporate investors accounted for $4 billion in overall demand, with a total of 240 separate orders. These ranged from Hong Kong blue chips such as Cheung Kong and Sun Hung Kai to small Mainland manufacturing entities with a corporate banking relationship. Nearly 20 of these corporate investors also pledged orders for more than $50 million each. They included Standard Chartered Bank, which has taken a $50 million equivalent strategic stake in the bank and will be the only one subject to a lock-up period.

Similar to the corporate investors, about 25 institutional investors were also said to have placed orders for more than $50 million, with the international book closing at the $5.1 billion level at the bottom end of the pricing range and roughly $3.1 billion level at the final pricing level. Some 450 investors participated and by demand, 46% of orders came from Asia, 33% from Europe and 21% from the US.

Adding the corporate and institutional demand together, the book closed 2.7 times oversubscribed at the final pricing level and together the 45 strategic investors nearly covered the entire deal between them, accounting for roughly $2.25 billion in demand. The most price sensitive orders were said to have largely been from the US and as global equity markets began to melt down on Friday, a number of anchor orders placed by the big global funds also dropped off.

Where the Japanese and Hong Kong retail tranches were concerned, there was equally high demand. A Public Offer Without Listing (POWL) in Japan led by Nomura attracted total demand of $2.9 billion and roughly 80,000 orders with an average order size of $35,000 to $40,000. As a result of the strong demand, the POWL will account for 12% of the deal, equivalent to 275 million shares.

The Hong Kong retail offer started out as a 229.8 million share deal, but after books closed roughly 30 times oversubscribed, with $7 billion in demand, the number of shares was increased to 804.3 million. In terms of final allocations, this meant that 35% has gone to retail, roughly 30% to corporates, 23% to institutions and 12% to Japanese retail.

Interestingly, all four investor segments were said to have viewed the transaction differently. For many of the corporate investors, Bank of China's IPO was a relationship building exercise with the bank and Chinese government. For Japanese retail investors, it was a China growth story and first Chinese POWL of its kind. For Hong Kong retail investors, it was, as ever, an opportunity to make money and a reflection of the bank's deep roots in the Territory.

"A lot of people outside Hong Kong have failed to realise just how integral a part of the local fabric this bank is," says one observer. "Local investors didn't view Bank of China as a poorly-run Mainland entity, but a bank which has funded businesses of their parents and grandparents for the last 80 years."

"They feel an obligation towards it," he adds, "And because they have a direct relationship with it, they've seen how many improvements there have been over the past few years."

For international investors these improvements required a leap of faith that many were not prepared to make. Of the half dozen fund managers interviewed by FinanceAsia, nearly all said that they would only participate if the deal was priced at the bottom end of the range and only then because they needed to match its index weighting, or thought they could make a trading profit.

Typical of the comments was one fund manager, who wished to remain anonymous. "We're not enthusiastic about the banking sector in Hong Kong because there aren't any growth opportunities," he argues. "And if we had to buy something it wouldn't be Bank of China because it's asking investors to pay a sector premium when it is still little more than a dozen very small and competitive banks bolted together. It does not yet have any scale, but it does have a lot of NPLs and we don't see either situation changing very soon."

George Koh of Morley Fund Management in Singapore further adds, "Bank of China's earnings quality is not superior to its peers and we are only favourable towards the bank at the bottom end of the range. We're not positive on the outlook for the Hong Kong banking sector and Bank of China has very high NPLs."

All agree that the equity story hinges on cost cutting and NPL reduction. Above the mid point of the range, most say that the valuation assumes that Bank of China will be able to achieve all it says it will and more. A number wonder whether political pressure will stop it doing what it needs to do to deliver shareholder returns and how much influence the parent will continue to exert.

"Hopefully thanks to the two carve-outs, the China NPLs have now been put behind them," says one fund manager. "What we're worried about is new NPL formation if the Hong Kong economy continues to remain weak."

NPLs have fallen from 19% to 9.5% as the result of the two carve-outs, which saw HK$21.85 billion ($2.76 billion) removed in 1999 and HK$11.4 billion ($1.46 billion) removed in June 2002. The current figure is, however, significantly higher than the 5.16% industry average and there are still a high proportion of China related loans and even higher proportion of China related NPL's - respectively 12.9% of total assets and 33% of NPL's.

In a recently published research report, Macquarie's Simon Ho says, "Bank of China's key challenge to achieving decent shareholder returns is controlling NPL's. Lowering bad debt provisions to peer levels should produce respectable ROA of 1% and ROE of 15%. But considerable risks remain due to 1) a weak track record 2) uncertainty over the quality of existing loans 3) further potential weakness in collateral values and 4) a difficult macro environment.

"Bank of China is leveraged to declines in property values," he continues. "Owing to the lack of a revaluation reserve cushion, downward property revaluations will directly be charged to earnings. We estimate that a 5% fall in property values could result in a revaluation equal to 12% of earnings."

In 2001, Bank of China reported an ROA of 0.34% compared to an industry average of 1.47% and ROE of 7.3% compared to an industry average of 15.5%. Because of its high reliance on loans to the corporate rather than retail sector (68% vs 32%), the bank also reported a much lower net interest margin of 1.87% compared to an industry average of 2.5%.

Bank of China has said it hopes to get NPL's down to 8.4% by year-end and improve its ROE to 11.5% at the end of the 2002 Financial Year and 16% by the end of the 2004 Financial Year. At the same time, it intends to maintain its CAR around the 14.5% level, while still managing a dividend pay out ratio of 60% to 70% of net income.

Its next key test will come on July 25 when it begins to trade on the stock exchange. Lead managers will be hoping that the high oversubscription and bedrock of corporate support will keep the stock steady. With a market capitalization of HK$89.87 billion, the bank will rank number as the seventh largest stock on the HKSE sandwiched between Sun Hung Kai and CNOOC.

The bank should also benefit from a relatively rapid inclusion in the world's major indices. Observers say it will be included in the FTSE indices from day one and expect it to incorporated by the MSCI within a couple of weeks as it is likely to go into the China Free index rather than Hong Kong index, which would have taken longer.

Within the next year to year-and-a-half, many also expect a second divestment by the parent in the form of a New York Stock Exchange listing. Some believe that Bank of China Beijing decided to cap the secondary share sale to 25% of its subsidiary's equity post greenshoe rather than pre-greenshoe in order to hold more stock back for a second divestment.

As Morley fund manager, Koh concludes, "The parent pumped in a lot of capital through its purchase of NPL's at book value and this is the only way it is going to get any of it back again."

Alongside the three leads, co-leads were Deutsche Bank, Merrill Lynch, Morgan Stanley, Nomura and Salomon Smith Barney. There were also eight co-managers comprising ABN AMRO, Cazenove, Daiwa, Fox Pitt Kelton, ING Barings, JPMorgan, Lehman Brothers and SG Securities. On the legal side, lawyers acting for the Bank of China comprised Shearman & Sterling in regard to US law, Clifford Chance in regard to Hong Kong law and Jun He Law in regard to PRC law. Acting for the joint sponsors were Sullivan & Cromwell for US law, Allen & Overy for Hong Kong law and Commerce & Finance Law for PRC law.