Little Sheep kicks off $116 million IPO

The Chinese hotpot chain will use the capital raised from the listing to add 150 new outlets to its restaurant network by 2010.
ChinaÆs largest full-service restaurant chain, Little Sheep Group, plans to raise between HK$656.6 million and HK$901.6 million ($84 million and $116 million) in an initial public offering that kicked off yesterday. The deal will help fund the opening of 150 new outlets by 2010.

The price range has been set at HK$2.68 to HK$3.68 a share, which will result in a market capitalisation of at least $350 million. Little Sheep is selling 24% of the company in the form of 245 million shares, of which 71% are primary and 29% secondary. There is a greenshoe of 15% that could bring another 37 million shares into the deal and raise the total proceeds to as much as $133 million.

The secondary shares come from two pre-IPO investors, 3i Investors and PraxCapital, who currently own 12.5% and 3.1% of the company, respectively. They are selling part of their shares to recoup their initial investment.

A full 90% of the shares are reserved for institutional investors, while the remaining 10% will be sold to retail investors. One source close to the deal says that they expect retail investors to be enthusiastic about the listing since the company is already a well-known brand on the mainland.

Since it was established in 1999, Little Sheep has become a major food brand in China. In the broad category of consumer food service brands, it has a 6% market share, behind only MacDonalds and Yum! Brands (which owns KFC, Pizza Hut and Taco Bell). But within the full-service restaurant category, which excludes fast food, it is the market leader.

The company has made its name by offering the same hotpot cuisine across its large network of stores. According to research by the Nielsen Company in 2007, it was the most easily identified hotpot restaurant in six Chinese cities, including Shanghai, Beijing, Shenzhen and Tianjin.

As of March this year, it had a total of 350 outlets, of which 103 were directly owned and the remaining 247 were franchised. Of the 150 new restaurants that will be opened, 40 will be finished this year. The company will also renovate 50 of its existing restaurants. The aim of the expansion will be to increase the companyÆs exposure to changing demographics relating to eating out: the amount spent on eating out in China increased at a compound annual growth rate of 15% between 2001 and 2006. This is higher than the increase in per capita disposable income in the same period, which grew at a CAGR of 11.4%.

Joy Huang, an analyst at Euromonitor International, says that the increase in disposable income plays a part but there are other factors at play as well. ôFaced with heavier work pressure and a faster lifestyle, consumers, especially those in urban areas, prefer to eat in restaurants rather than cooking at home. And for branded restaurants, better food safety control and good taste are also main attractions to consumers.ö

ôFast franchising brings problems such as a lack of management control and employee education, which does harm to the brand reputation,ö says Huang. So in 2007, more than half the outlets were shutdown or brought into direct ownership. ôThis strategic action makes it more competitive, which allows its management team to have stronger control on the franchised restaurants and to maintain and build Little SheepÆs brand,ö Huang adds.

More restaurants under direct management equals greater revenues, according to one syndicate research report. Between 2005 and 2007, Little SheepÆs revenues increased by a CAGR of 36%, ôwhich was largely driven by the growing number of company-owned restaurantsö. The report expects the growth rate to increase to 41.3% in the period between 2007 and 2009.

Based on the bookrunnersÆ average earnings estimate, the price range values Little Sheep at a 2008 price-to-earnings ratio between 18.2 and 24.9 times, putting it at a substantial discount to the company that it is being compared most to, Ajisen Ramen. The Japanese fast food restaurant, which has a strong presence in the mainland, is currently trading at a 2008 P/E ratio of 34 times.

The same report highlights a number of potential problems that Little Sheep might face as it executes its expansion plan. It may, for instance, have problems finding enough affordable sites for its restaurants. Big expansion plans could also lead to over-saturation, with outlets within the same area competing with each other.

The other main problem is food inflation: the cost of lamb saw year-on-year growth of 45% in 2007. Little Sheep is a vertically integrated company, with its own lamb processing plants in Inner Mongolia, but ôif Little Sheep cannot pass the increase in its cost of inventories resulting from rising food prices to its customers through price increases in its products, its gross and operating margins may be adversely affected,ö says the report. One source points out that since the customers cook their own food at a hotpot restaurant, it will be difficult to add value in terms of services, like cooking.

The listing is being organised by Deutsche Bank and Merrill Lynch. The institutional bookbuild began yesterday, the pricing is scheduled for June 3 and trading is expected to start on June 12.
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