Philippines equity: unblocking the tap

The IPO of one of the Philippines most successful privatization initiatives foreshadows flood of equity deals.

An IPO for Manila Water is set to provide an important test of investor sentiment towards the country's equity markets at a time when more than $1 billion in paper is expected. Of this amount, over $500 million could come from one deal alone - SM Investment Corp (SMIC).

Manila Water began roadshows in the Philippines on Tuesday, ending a drought of IPO issuance since the Asian financial crisis of 1997. In the intervening years, there have only been about six equity deals of any kind topping the $50 million mark and just three, which were able to scrape past $100 million.

Issuers' willingness and ability to tap the equity markets again follows an uptick of investor interest and trading volume on the PSE (Philippines Stock Exchange) over the past six months. However, in comparison to the rest of Asia, trading volume still remains extremely thin and currently averages just $56 million per day compared to $153 million in Indonesia, the region's second smallest market.

Thus even if Manila Water prices at the very top end of its indicative range raising $88.5 million it will equate to more than one day's trading volume for the whole exchange, while SMIC could clock in around nine days. Manila Water's own parent Ayala Corp, the country's eight largest listed stock, only trades about $1 million per day and below the top 15 listed companies, liquidity drops to more like $10,00 to $20,000.

But liquidity has increased markedly over the past year. At the end of 2003, the PSE was averaging just $11 million trading volume per day, rising to $23 million by September 2004 and $56 million by February 2005. Over the same time period, the market cap of the Philippines Composite Index has risen from $17 billion to $25 billion.

Investment bankers believe Manila Water and SMIC will offer investors opportunities to build positions in the primary market that would be difficult in the secondary. They also believe investors will be receptive to deals that enable them to capture the market's continuing momentum.

During 2004, the Philippines was Asia's second best performing market after Indonesia, rising just over 25%. So far in 2005, it remains the third best performer, hitting a five-year high late last week.

Manila Water is offering 745 million shares on an indicative range of Ps5 to Ps6.5, potentially raising Ps3.73 billion ($68 million) to Ps4.84 ($88.5 million). Of this amount, 550 million will be primary shares and 195 million secondary shares. There is also a 78.5 million share greenshoe.

UBS is leading the international offering, which will constitute two thirds of the deal and BPI Capital, the domestic offering, which will constitute the remaining one third. The international offering price will be fixed on Friday February 25, while the domestic offering will run across the following week, with listing scheduled for March 18. Bankers say the domestic underwriting agreement will be signed once the international offering is completed and that BPI already has underwriting commitments from local brokerages to cover the entire domestic offering.

As a result of the deal: the Ayala group will drop from 45.8% to 30.2%; Britain's United Utilities from 17.8% to 11.7%; Mitsubishi from 10.2% to 7.9%; BPI from 10.2% to 3.9%; IFC from 9.5% to 7.4% and employees from 6.5% to 4.2%. Post greenshoe, the deal will have a freefloat of 34.6%.

Based on the indicative range, the deal is being marketed on a P/E range of six to 7.7 times 2005 earnings, or 7.9 to 10.3 times on a tax adjusted basis. Manila Water is currently enjoying a tax holiday, but this is scheduled to finish in the middle of 2006, so investors are likely to pay more attention to the second range than the first.

The PSE as a whole is averaging a P/E multiple of 14.5 times earnings. Given there are no other water companies listed in Asia, direct comparables are hard to find.

Domestically, specialists quote First Philippines Holdings, which has a number of power plants and toll roads. It is currently trading at 10 times earnings on a tax-adjusted basis or 7.5 times unadjusted.

Globally, there are a number of comparables in Europe. United Utilities, for example, is currently trading at 11.8 times 2005 earnings and France's Suez at 15 times.

Specialists believe the deal will have a number of selling points aside from the macro exposure it will offer to the entire market. "This company has very transparent earnings and a solid growth profile," says one observer. "In the Ayala's it also has one of the most well respected management teams in the country."

Manila Water will also offer a higher than average dividend yield for the Philippines market, although a relatively low pay-out ratio. Based on the indicative range, the deal has a yield of 5% to 3.8% and a pay-out ratio of 25%.

The Ayala's successfully won a 25-year concession to run Manila Water in 1997. The Ramos government had put two water concessions up for privatization to forestall a looming water crisis, similar to the power crisis, which had caused nationwide power outages during the early 1990's. At the time, a government report estimated that the state-owned Metropolitan Waterworks and Sewerage System (MWSS) was serving only 20% of the capital, with about 80% of businesses digging their own wells to source an adequate supply of water.

The Western water concession was awarded to a Lopez group company - Maynilad, but it was returned to the government in 2002 after the group struggled with its dollar denominated debt burden at the height of the financial crisis.

Manila Water, by contrast, has been a great success story and is frequently held up as a rare example of a successful privatization exercise in the country. It has now connected 426,000 households, up from 325,000 in 1997. It serves a population of five million.

More importantly it has reduced the huge leakages and pilfering that had previously undermined the entire system. This figure has been reduced from 63% in 1997 to 50.7% in 2002 and 43% in 2004.

The only disputed area has been its ADR (Appropriate Discount Rate) - the amount it can claim as profits (ie annual rate of return) as a result of the efficiencies it is able to achieve. It won the concession by bidding only 5.2%, but was subsequently able to overturn it through the court system, much to the annoyance of the regulators and MWSS. Over the past seven years, its reported ADR has been 10.4%, but analysts estimate the real figure is more like 15% to 17%.

This has enabled the group to grow profits strongly despite its capex burden. In 2003, it reported EBITDA of Ps1.15 billion and tax adjusted profit of Ps860 million. This rose to Ps1.336 billion in 2004, or Ps1 billion on a tax adjusted basis.

In 2005, analysts are forecasting EBITDA of Ps2 billion and tax adjusted net income of Ps1.5 billion.

Tariffs are re-set every five years and have risen from Ps4 in 1997 to Ps18.5 in 2003. The next adjustment will be in 2008. Analysts say there is still considerable upside potential, quoting an ADB report that said water bills as a percentage of disposable income are still only 2% in the Philippines compared to 5% in comparable emerging market countries.

The driving force behind the IPO is raising funds for capex and enlarging the company's equity base so that it can take on more debt. The ratio between the two is currently 1:1.5.

Analysts say investors are unlikely to show many concerns about the company's operational efficiency. However, they may take issue with its ability to source water. Manila's geographical location miles away from any river system and its volatile weather patterns have always played havoc with the capital's water supply.

Indeed, the 1997 privatization was hastened by the devastating effect of El Nino, which threatened a major water shortage. Since then, the underlying problem of how to build a comprehensive and reliable indigenous water supply has still not been solved.

Manila Water operates the water system, but the underlying assets are owned by MWSS. And MWSS sources nearly 90% of its water from the Angat Dam, which was damaged by a series of typhoons in the autumn of last year.

Nevertheless, the deal is already said to be attracting considerable interest. Originally it had been thought that Philippines specialists would provide the main bulk of demand. But bankers have noted growing interest from pan Asian specialists over the past couple of weeks.

Right behind Manila Water, a second Philippines conglomerate is preparing the country's largest ever IPO in Peso terms and possibly dollars too. Macquarie is leading the IPO for SM Investments Corp, which analysts have assigned a pre-money fair value of $1.75 billion at the bottom end of the range.

The holding company of SM group will begin marketing a deal on Monday, with the international offering scheduled to price on March 10, followed by a domestic offering between March 11 and 17, then listing on March 22. The domestic offer will be led by SM subsidiary BDO Capital.

The offering terms remain fairly flexible. The company will offer a minimum of 75 million shares and a maximum of 140 million shares, of which secondary shares will constitute a maximum of 25%. It is also being flexible over the freefloat, which could span 15% to 30%.

Based on an indicative price range of Ps230 to Ps300, the company will raise Ps17.25 billion ($315 million) at the bottom end of the range if it issues 75 million shares and Ps32.2 billion ($588 million) if it issues 140 million shares. Although it could potentially raise up to Ps42 billion ($768 million) if it issues 140 million shares at the top end of the range, specialists say this is highly unlikely.

Investors will need to come up with a sum of the parts valuation based on the group's mix of retail assets, property assets and listed assets. About 70% of its revenues derive from its unlisted retail assets about 55% of its book value also derives from its unlisted retail and real estate assets.

SM investments is the holding company of the Sy family and there are three listed entities: SM Prime, SM Development and Banco De Oro.

Prior to SMIC, the largest IPO from the Philippines was Petron Corp's Ps10.4 billion IPO in 1994 (excluding the strategic stake by Aramco). Based on the exchange rate at the time, the IPO amounted to about $400 million.

Third in line behind Manila Water and SMIC is a $175 million IPO for media group GMA led by ATR-Kim Eng and Deutsche Bank. Later in the year, bankers also expect a $200 million plus IPO for First Philippines Generation. Pitches were heard last week.

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