Shanghai Forte introduces the "land factory"

The city''s largest private sector developer attempts to sell a new property concept to investors.

Roadshows for a $114 million to $149 million IPO of Shanghai's largest privately-owned property developer, Shanghai Forte, began on Wednesday under the lead management of HSBC.

While small, the 455.9 million share offering is significant on two counts. Firstly and depressingly, it is only the second straight equity offering from non-Japan Asia so far this year and as such its reception will be closely monitored. Secondly, the company represents the first in a wave of Chinese developers trying to promote the concept of a "land factory" among an investor base used to dealing with a small number of Hong Kong developers and their huge land banks.

Unlike Hong Kong, where land is tightly controlled and companies amass sizeable development portfolios, many of China's fragmented and entrepreneurial property developers maintain small land banks, which they develop as fast as possible, using pre-sales to fund completion. Similar to the manufacturing sector, inventories are kept low and returns are generated by efficiency of throughput. In Shanghai Forte's case, the residential developer maintains two to three years of supply.

On the plus side, this makes companies extremely efficient and leads to high investment returns, but on the negative side, there is little visibility over future performance and earnings. And while China is back in favour, some bankers say this latter point may be important, as investors have been looking for earnings consistency and shown themselves to be distrustful of private sector management and government policy u-turns.

Specialists say the history of the Chinese property sector reflects the fact that all land still technically belongs to the state. Developers are granted 'land use rights', with typical terms of 40 years for commercial sites and 70 years for residential sites. Until recently, land was allocated through closed-door tenders, with the Shanghai government only introducing open auctions in July 2001.

However, China's emergent middle class is starting to make its presence felt. Re-sale of state housing was only permitted in 1998, but by 2002, had already topped the level of new properties coming on stream. So too, in the space of five years, mortgages have jumped from 0.2% to 5% of banks' loan books.

Some observers consequently believe that it is difficult to value Chinese property companies on the basis of Net Asset Value (NAV) or price to book, since it is unclear what value to assign land in the unique context of a country like China. They also argue that supply/demand statistics are distorted by developers' need to pre-sell before a project can be completed.

"While the numbers might show that project A has 1,000 units coming on stream, they may never actually get built unless the developer can pre-sell them," one expert explains. "This means the threat of oversupply is often more imagined than real."

And because Shanghai Forte has such a small land bank, traditional NAV and price to book valuations make it look expensive relative to other listed Chinese property companies such as China Resources, China Vanke and Beijing North Star.

At HK$1.95 to HK$2.55 per share, the company is being marketed on a 15% to 30% discount to NAV (using an assumption that future property prices will remain flat). By contrast, comparables trade around the 60% plus level.

On a price to book basis, Shanghai Forte is being offered at roughly 1.3 to 1.7 times 2003 earnings, where comps are trading as low as 0.4 times.

The company's high earnings per share (EPS) also means that on a p/e basis it looks more attractive than its peers and is being marketed at 6.5 to 8.5 times 2003 earnings, a 20% to 30% discount to the sector average.

But as its supporters point out, high EPS is the direct result of operational efficiency. "Return on equity is huge because the land bank is deliberately kept so small," says one industry expert. "The company really sweats its assets, whereas a number of other China related property plays have underutilized asset bases, which earn them very little."

According to syndicate research, Shanghai Forte's ROE stood at 85% in 2002 and even if it falls to a 30% to 50% band, analysts say that it will still rank far superior to all its peers.

The company has also shown itself to be a master of pre-sales and recorded rates of 96% in 2000, 98% in 2001 and 96% in the 10 months to October 2002. Increasing private sector ownership means that property is accounting for an ever greater proportion of GDP and in Shanghai is forecast to grow from 6.2% of GDP in 2001 to 7% by 2005. Should these targets be met, the property market will expand by 14% per year.

Shanghai Forte recorded a gross margin of 25% in 2002, in line with the previous three years. It believes it will be able to maintain it, because the government has recently started limiting the amount of land made available for development in order to contain oversupply pressures.

Pre shoe the company is offering 30% of its issued share capital, of which 99% will be new shares and 1% old shares. Post offering and pre shoe, Fosun High Technology and Fosun High New Technology will own 26.15% and 41.41% respectively. Going some way to address fears about the reliability of private sector management in China, the Fosun was ranked seventh in revenue terms during 2001 among all private sector enterprises.

As an additional sweetener, the company has also said that it will maintain a dividend pay-out ratio of 40% to 50% of net profits from 2003 onwards.

The H-share deal will be conducted as a concurrent offering with pricing scheduled for March 1 and listing on March 6. Co-leads are BOCI Asia and Nomura.

Non-syndicate bankers conclude that the offering should benefit from an empty primary market ahead of a possible war in the Middle East. And while it remains to be seen whether the company will be able to convince Hong Kong's retail investors, Mainland property-related stocks have generally outperformed the market since the end of last year.

Beijing North Star and China Vanke have respectively risen 10.53% and 14.60%, compared to a 2.3% increase for the Red chip sector and 10.54% increase for the H-share sector.

Proceeds will partially be used to expand the company's land bank. At the end of 2002, the company had 36 development projects on stream in Shanghai covering 2.1 million square metres. It hopes to double this to 4.4 million.

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