Lotte shops for record breaking IPO

Korean retailer hopes to raise up to $3 billion in what is shaping up to be Asia''s largest ever non-privatization IPO.

Pre-marketing has begun for a $2.5 billion to $3 billion IPO for Korean retailer Lotte Shopping. The Goldman Sachs, Nomura and Daewoo Securities led deal was launched last Monday (January 2) and will begin formal roadshows at the beginning of next week, with pricing of the international offering scheduled for January 27 just before Chinese New Year. The domestic offering will be launched immediately after the holiday, with listing scheduled for mid-February.

The deal is a ground breaking one for Korea on a number of fronts. First and foremost, it indicates the willingness and ability of Korea Inc to return to the stock market for its capital raising needs.

Indeed, many analysts and investment bankers are expecting attention to shift to the primary market this year following a year of stellar stock market performance. Korea ranked as Asia's best performing stock market in 2005, with the Kospi rising almost 50%.

The market's re-rating should now enable groups like Lotte to secure much higher valuations for their businesses and take advantage of continuing strong secondary market momentum. In turn, this will allow the primary market to absorb far greater deal sizes.

Even at the bottom end of the range, Lotte's IPO will easily break the record for the largest ever equity deal from Korea. This was set by LG Philips LCD in July last year when it raised $2.2 billion from a secondary offering.

More significantly, if Lotte's deal prices at the top end of the range it will secure a place within the ranks of the10 largest ever equity deals from Asia ex-Japan. In doing so, it will enable the company to become the only non-Chinese entity on the list.

The deal will also rank as the third IPO from the country to seek a simultaneous dual listing. In doing so, it will follow Kumho Tire's example and list in London and Seoul.

The transaction is likely to have a similar format to Kumho, with about 80% of the deal set to be placed offshore and 20% onshore. However, unlike Kumho, Lotte Shopping will also have a POWL (Public Offering Without Listing) in Japan, which will be led by Nomura.

The Japanese securities firm is also a joint global co-ordinator of the international offering alongside Goldman Sachs, while Daewoo Securities will handle the domestic IPO. Co-leads for the international offering are ABN AMRO Rothschild, JPMorgan and Mizuho Securities.

The deal will constitute all primary shares and will have a freefloat of up to 30% of the company's enlarged share capital (pre-greenshoe). The main valuation benchmarks are likely to be Korean retailers Shinsegae and Hyundai Department Stores, both of which trade at a significant premium to the market average of roughly 10 times.

Shinsegae has a market cap of about $8.9 billion and is currently trading on a 2006 P/E ratio of about 17.5 times. Hyundai is much smaller, with a market cap of about $1.6 billion and is trading at about 12.5 times 2006 earnings.

Lotte's valuation is still a moving target given that the company has not yet fixed the exact percentage of share capital it will issue. Should it offer 30% and raise $3 billion, the IPO will be valued at about 13.5 to 14.5 times 2006 earnings. This valuation is based on syndicate 2006 net income forecasts (pre-money), which span Won650 billion to Won700 billion.

However, should the company opt for a 25% freefloat and still raise $3 billion, it will price its IPO at more like 16 to 17 times 2006 earnings.

Investors are likely to have two main considerations. Firstly does Lotte deserve a higher valuation than Shinsegae - either in the primary market or in the secondary market after factoring in an IPO discount?

Secondly, is the sector is fully valued? Answers to both questions will hinge on investors' view of the sector's growth profile and which company is best placed to capture it.

Traditionally Korean companies trade at a discount to their global comps - partly because of corporate governance concerns in a chaebol dominated economy and partly because of North Korea's dark shadow. Shinsegae, by contrast, is currently valued in line with global comps such as US retailing giant Wal-Mart, which is also presently trading around 17.5 times 2006 earnings.

A number of analysts, nevertheless, retain outperform ratings on Shinsegae because it is forecast to record strong EPS growth over the coming three years. Likewise Lotte's lead managers will argue that a mid to high teens P/E valuation looks reasonable in the context of 20% plus EPS growth. Global comps that command valuations around these levels are generally only just managing double digit EPS growth.

Analysts are forecasting a strong trajectory in sales growth. In 2004, Lotte Shopping recorded revenues of Won8.5 trillion. This figure is projected to rise to about Won9 trillion in 2005 and Won11 trillion in 2006.

About 60% of the company's sales come from its department store operations, 30% from its discount stores and the remaining 10% from a range of other businesses including Lotte Cinema (the company is the second largest operator in Korea) and Lotte Credit Card. Lotte Shopping is also the Korean franchise holder for Krispy Kreme donuts and owns 79% of listed department store operator Lotte Midopa.

Analysts say that retail sales growth in the country is being driven by two main factors. Firstly Korea is entering a new phase of consumer confidence following two major dips caused by the Asian financial crisis and more recently a credit card crunch.

This upcycle has been reflected in 10 consecutive months of retail sales growth (up to the end of November). Over the first 11 months of the year, for example, the country's department store sales rose 4.4% year-on-year and discount store sales by 4.5%.

This sales growth has also accelerated during the latter months of the year, with department stores sales rising 6% in November 2005 compared to November 2004 and discount stores sales by 5.2%. Analysts believe these revenue growth levels will continue into 2006, although individual company's growth figures will not benefit from coming off such a low base.

Instead, Shinsegae and Lotte will rely on their expansion plans. Lotte in particular has said it will primarily focus on expanding its discount store operations.

As of December 2005, the group had 22 department stores, 40 discount stores and 45 supermarkets. This gives it a leading market share in the department store sector (about 44%), while it ranks second by number of stores in the discount store sector and third by sales behind E-mart (owned by Shinsegae) and Tesco Samsung Home-plus.

In the supermarket sector, it ranks second to LG Mart and only entered the business in 2001.

Lotte, therefore, has a different profile to Shinsegae, which is highly concentrated in the discount store sector and has seven department stores. The latter is hoping to boost its number of discount stores from 75 to 100 by the end of 2007 and analysts say it will be able to rely heavily on its existing landbank to do so.

Where Lotte is concerned, they believe the group will need to buy out a rival operator to boost its store numbers since the group has a smaller landbank and new plots are scarce. They also believe Lotte is likely to go for a smaller operator since there will be store overlap with the bigger players and neither the fourth or fifth largest Korean operators - Carrefour and Wal-Mart - are likely to be up for sale.

Outside of the top five, analysts estimate that just over a dozen smaller operators account for a 25% to 30% market share.

Lotte management have said they hope to expand in this sector although IPO proceeds will initially be used to reduce the group's Won3 trillion debt. At the end of 2005, this represented a net gearing level of about 130%.

In recent years, the company has shown itself to be highly acquisitive. In 2002, it acquired Tong Yang Card and merged it with its own store card operations the following year. In early 2004, it acquired Hanhwa Stores, boosting its supermarket franchise by 25 stores.

One question investors will need to ask themselves is how well Lotte is managing these acquisitions. Going forwards, both Lotte and Shinsegaee also have plans to expand overseas, which will either prove a welcome diversification and earnings kicker, or an unnecessary distraction. Both companies are actively considering opening up in China, while Lotte has also been laying down plans to open its first overseas department store in Moscow.

The group's department store operations are considered the most mature and stable part of the group. On the plus side, there are high barriers to entry for new competitors and on the downside fierce competition from the discount store sector where overall margins are lower. Lotte's net margin of roughly 5.5% is, for example, dragged down by a net margin of only about 1.3% to 1.5% in the discount store sector.

The overhang of Lotte's mammoth deal has not, so far, had a negative effect on either Shinsegae or Hyundai Department Stores. The two stocks are already up 10% year-to-date and lead managers will be hoping Lotte can ride on the back of the sector's continuing momentum in Korea and the wider Asian market where consumer plays remain among investors' top picks.

In addition, the new IPO will enable investors to build up sizeable positions in Korea fifth largest business group. Pre deal, the Shin family were the biggest shareholders with a 45% stake, while Hotel Lotte owned 13.5%, Lotte Confectionary 12.4% and Lotte Chilsung 6.2%.