Pacific Basin plugs IPO

Will a high dividend yield and low valuation be enough to tempt investors?

Minor dry bulk carrier Pacific Basin has launched roadshows for its Hong Kong IPO, hoping to raise HK$961 million ($123 million) to HK$1.27 billion ($162 million) from a 437 million share deal.

Timing of the offering could hardly be worse given the poor performance of a recent IPO for China Shipping and a huge plummet in the Baltic Dry Index (BDI), which measures rates for dry bulk vessels and has slipped from a peak of 5,684 in early February to 2,682 late last week. Most of the bubble and subsequent drop in the index has also been attributed to China's soaring demand for commodities, followed by the government's attempts to cool the economy.

However, Pacific Basin's lead manager Goldman Sachs has been arguing that the BDI is an imperfect proxy since minor bulks account for only 37% of the overall dry bulk market, which is dominated by core commodities such as iron ore and coal. The company is also being pitched as a profitable niche player and one that is coming at a valuation, which is either flat or at a discount to all of its main comparables. As a further failsafe, the deal also has a highly defensive dividend yield of 8% to 10.5% based on a 50% pay-out ratio.

By comparison, bulk carrier China Shipping Development (oil and coastal shipping) currently yields 5.2%, while other more direct comparables such as Thailand's Precious Shipping yields 3.85% and Denmark's Dampskibsselskabet Torm yields 4.11%. Container shipping company, China Shipping, which began trading a week ago, yields roughly 4.5%.

Pacific Basin and China Shipping are not comparables although it seems likely retail investors will group them as such. The former ships dry bulk goods such as grains and fertilizer and has a pan Asian geographical spread, while the latter is the world's tenth largest container operator and has a much stronger China focus.

As Credit Suisse First Boston commented in a recent research report, "There has been little parallel in the movement of container rates and dry bulk rates. To argue that prices in one mirror prices in the other is like linking gold and copper prices and saying they are both metals."

Goldman is pitching Pacific Basin on a PE range of 4.7 to 6.2 times 2004 earnings. A price range of HK$2.20 to HK$2.90 is based on a freefloat of 34% pre shoe and a 2004 profit forecast of $65 million. The 437 million share deal has a split of 250 million primary shares and 187 million secondary shares, with the standard 90% /10% split between institutional and retail investors.

Alongside the lead, JPMorgan is joint lead manager, with Cazenove and HSBC as co-leads, plus DnB Nor Markets as co-manager and Petercam SA as placing agent. Roadshows began last Tuesday and the timetable is slighly elongated because there are a number of public holidays in Asia and the US over the next couple of weeks. Books are scheduled to close on July 7 and listing will take place on July 14.

The deal is being pitched at a discount to comps. China Development, for example, is currently trading at roughly 9.7 times 2004 earnings, while Thai companies Precious Shipping and Thoreson Thai average 4.5 to 5 times. The outlyer is Thorm at only four times, while China Shipping is now at roughly 5.5 times.

However, the whole sector has been on a downward bias since the BDI began to fall in early February. Thorm has dropped from a high of DKK214 to DKK146, while Precious Shipping has slid from Bt51 to Bt32.5 and China Development Shipping from HK$6.50 to HK$4.10.

The company's main challenge lies in persuading investors the industry is not being tugged into the downward part of the cycle. Both bulk and container shipping are highly cyclical industries.

Pacific Basin has seen shipping rates move from an average of $6,900 in 2001 to $6,100 in 2002, then soar to $9,800 in 2003. At one point in 2004, the company was reporting rates as high as $17,000 compared to a break-even rate of $2,700.

High rates mean high operating margins and syndicate research is forecasting a hike from 36% in 2003 to 56.4% in 2004. But low rates leave the company struggling to breakeven.

In 2001, the company reported net income of $3.3 million based on seven chartered vessels. In 2002, it upped the number of vessels to 13 but reported a loss of $2.02 million, largely due to an FX loss of $6.2 million. By 2003, rates were up and so were the number of ships to 15, leading to a profit of $24.5 million.

In total, the company now has 42 vessels, of which 19 are owned, 16 managed and seven chartered.

Investors will need to decide what rates are likely to do in 2005 and whether the company will see profitability plunge if they continue to fall. A number of shipping companies have argued this is unlikely.

While the BDI has slid quite dramatically, many argue it will find a floor around the 3,000 level because of capacity constraints. They argue this despite the fact the BDI average for the past 10 years has been 1,342.

Shipbuilders are currently facing huge backlogs because of the sheer amount of orders they are trying to process and analysts say they always prioritise orders for container ships because margins are higher.

Pacific Basin operates in the handysize sector of the dry bulk market and the number of vessels worldwide is declining rather than increasing. Many bulk carriers prefer to operate larger sized vessels such as Panamax, which can carry dead weight tonnage (dwt) of 60,000 to 80,000 rather the handysize vessels, which carry 25,000 to 30,000 dwt.

The lead has been arguing that Pacific Basin has forged a very profitable niche particularly in Asia where smaller, more flexible ships are more suitable for markets that have more basic infrastructure development and bigger ships often have problems docking. It operates the world's largest fleet of Handysize carriers

It has also said the lack of new supply should make the industry less cyclical. Pacific Basin also operates a much newer fleet than the Thais, whose ships average 19 years compared to Pacific Basin's six years.

"This company has a new fleet, more management expertise and is far more efficient than any of the comps," says one observer.

It is largely run by Western management and while it is headquartered in Hong Kong, its focus is pan-Asian. Only 15% of its discharge tonnage is offloaded in China and its three major customers are all Australasian - Carter Holt, Fletcher Challenge and Stratus Shipping.

Observers say the company is far more attuned to global GDP growth than Chinese demand. By product, 25% of its cargo is forestry products, 15% fertilizer, 13% grain and 12% cement.

It also has a long history since its founders previously established a company also called Pacific Basin that was listed on the Nasdaq in 1994 and later sold to Malaysian interests. Its top management - Chris Buttery, Paul Over and Mark Harris, returned to Hong Kong in 1998 to establish Pacific Basin.

Much of the company is owned by Private equity funds. Management owns 12%, while two private equity funds owned by Jefferies Capital - IDB and Dry Bulk Shipping - own 75%.

Proceeds are being used to purchase three new ships and four secondhand ships. At 60%, net gearing is fairly and explains why the company is able to sustain such a high dividend pay-out ratio.

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