Shanghai Prime Machinery tests the waters for an IPO

A play on China's industrial growth that hopes to copy sister company's performance.
Shanghai Prime Machinery has started pre-marketing this week an initial public offering that is expected to raise between $150 million and $175 million. It plans to list on Hong KongÆs main board towards the end of April.

The state-owned enterprise is a sister company to Shanghai Electric Group and is expected to be well-received by investors as it is essentially a leveraged play on the industrial growth of China. Shanghai Electric has gained 75% since its trading debut in late April last year.

Credit Suisse, which also took Shanghai Electric to market, is sole bookrunner for the offering with BNP Paribas Peregrine and Macquarie Securities acting as co-leads.

The total deal size has yet to be determined, but the pre-greenshoe free-float is expected to be between 40% and 45% of the company, meaning about half the issued H-share capital could be in public hands if the 15% shoe is exercised in full.

This is unusually high for Hong Kong-listed companies which typically float no more than 25% to 33% of its shares during the IPO, but one observer said the company has little choice if it wants to ensure that investors get a meaningful stake.

ôThis is a small company that will have a market cap of less than $500 million and there arenÆt that many shares to go around, especially if there is a full clawback to retail investors,ö said one observer, who noted that eight of the last 10 Hong Kong IPOs have seen retail investors walk away with half the deal as a result of heavy oversubscription rates.

All the shares will be new as the National Social Security Fund has elected to receive shares in the company instead of the usual 10% of the net proceeds, following a recent rule change. Similar to the situation with Hunan Nonferrous Metals, which is currently marketing a Hong Kong IPO of up to $227.5 million, the NSSF will settle that transaction outside the IPO process.

According to fund managers, Shanghai Prime Machinery has five divisions, the largest and most high-tech of which makes turbine blades and contributed about 55% of operating profit last year. The other divisions comprise bearings, cutting tools, electrical motors and fasteners, including nuts and bolts.

Fasteners was injected into the listing candidates as recently as November 2005, but is expected to be a major growth driver going forward. Last year it contributed a mere 3% of operating profit, but that is expected to grow to 24% in 2006.

Overall, Shanghai Prime Machinery is projecting its bottom line to improve by about 67% this year to around Rmb225 million ($28 million) from Rmb135 million in 2005, according to an investor who has been briefed on the company. It posted total revenues of Rmb1.42 billion last year.

The projections for this year is in line with the strong growth seen between 2003 and 2005 with a compound annual growth rate of more than 50% in terms of revenues and more than 100% in terms of net profits.

ôItÆs a lower margin, but high growth business and it is still at a relatively fast ramp-up stage,ö one observer said, noting that margins are typically in the high single digits.

One difficulty for investors when assessing the company is that there are no direct comparables in terms of valuation, given its diversified business.

One indication is to look at a basket of Hong Kong-listed industrial stocks, which trade at about 12 to 13 times forward earnings. Another comparable is its sister company Shanghai Electric, which is quoted at a 2006 PE multiple of about 16 times.

Investors say Shanghai Prime Machinery is being marketed at a range of 12.3 to 14.3 times its projected 2006 earnings, which at the top end would put it on par with Shanghai Electric after deducting a 10% IPO discount.

One investor said this seemed somewhat expensive, although the smallish size of the offering and the heavy demand for mainland companies (with leading positions in their industries) may allow it to get away with it.

The company has a leading position in almost all of its divisions and will spend the majority of the listing proceeds to further expand its production capacity of fasteners and bearings. Total capital expenditures are budgeted to grow to over Rmb500 million ($62 million) this year from just under Rmb200 million in 2005, one observer said.

Meanwhile, ChinaÆs industrial production grew at a rapid 16.2% year-on-year in the first two months this year, following 16.5% growth in December and is expected to remain strong.

In a comment to that data HSBC economist Qu Hongbin said: "Demand is strong, therefore production should be strong, so there's no reason for us to believe the current growth momentum is going to lose steam meaningfully in the coming months."

Hong Liang, an economist with Goldman Sachs, noted that the industrial production data confirmed the banks view that ôChina's growth is gaining more momentum.ö However, she expected inflationary pressures to build up in the near future and saw a ôneed and likelihoodö of a moderate monetary tightening in the first half.

Shanghai Prime Machinery currently exports about 15% of its blended production, but plans to materially boost that portion in the coming years.

It already counts Hitachi, Mitsubishi, General Electric and Toshiba among its customers for turbine blades, although sister company Shanghai Electric, which makes equipment for the power, electromagnetic and transport industries, is one of its major customers and last yeat bought about 38% of its total production from this division.

Among the potential concerns û or at least reasons that could prompt investors to ask for a lower valuation û are steel prices, since steel is used in most of its production and is one of its main cost items. The companyÆs reliance on fasteners as its major growth driver in the future may also take some explaining given the low barriers to entry in this business.

The company is currently 100%-owned by state-owned Shanghai Electric (Group) Corporation, which is one of China's leading industrial conglomerates within the power generation and transmission equipment industries.

The formal road show will be launched on April 6 or 7 with the listing expected to take place towards the end of that month.
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