Shenhua Energy: warming global investors?

One of the most symbolically important IPO''s from China gets the green light from the Hong Kong Stock Exchange.

The HKSE's listing committee gave its formal approval for the IPO of China Shenhua Energy Company Ltd late yesterday (May 12) paving the way for the official beginning of pre-marketing. Under the lead of CICC, Deutsche Bank and Merrill Lynch, formal roadshows will begin around May 26, with pricing scheduled for the week beginning June 6.

The $2.5 billion to $3 billion deal will have four tranches including a Japanese POWL (Public Offering Without Listing) run by Nomura. The Japanese house will also act as a co-lead in the international tranche alongside ABN AMRO, JPMorgan, Lehman and Morgan Stanley.

Because of the large size of the deal, the leads have sought and won two waivers concerning the minimum and maximum amounts they can allocate to retail. These stand at a 5% minimum allocation and 20% maximum allocation compared to the standard 10% minimum and 50% maximum.

Alongside the institutional tranche, there is also a separate tranche for strategic investors, although they are strictly defined as financial investors since the company does not want, or believes it needs, a strategic partner. This tranche will see Anglo American take $150 million and four corporates - Henderson, Citic Pacific, Chow Tai Fook and Kerry -$100 million each.

There is a possibility that one more corporate may also sign up, bringing the strategic tranche up from $550 million to $650 million.

Specialists say that a prospective A-share tranche is now effectively dead, although the company has not yet formally killed it off and has until the weekend to do so.

Shenhua Energy will offer 18% of its share capital post greenshoe. Based on a preliminary proceeds range of $2.5 billion to $3 billion and the company's own forecast earnings of Rmb14.1 billion ($1.7 billion) for the 2005 Financial Year ended December, Shenhua is currently being pitched on a forward P/E multiple of eight to 9.7 times 2005 earnings.

A number of syndicate members, on the other hand, have profit projections above Rmb15 billion, which cheapens the valuation.

Vaulation comps

On a range of eight to 9.7 times, the company will come at a premium to its closest comparable Yanzhou Coal, but at a discount to global energy giants such as Peabody Energy in the US and Australia's BHP Billiton and Rio Tinto.

Hong Kong listed Yanzhou coal is currently trading around 7.5 to eight times analysts' 2005 earnings estimates based on yesterday's closing share price of HK$10.45. Year-to-date the company is down 5.86%, but is up 35.2% on a one-year annual return basis.

The China and Hong Kong MSCI indices respectively average 10.5 times and 16.7 times forward earnings.

Some analysts believe Yanzhou has suffered from a lone company discount in the past and argue that its valuation may be boosted over the long-term by the listing of Shenhua and possibly China National Coal later in the year.

Specialists say Yanzhou is also not a perfect comparable because it is increasingly a minnow relative to Shenhua. Yanzhou has current capacity of 38 million tonnes per annum compared to Shenhua's100 million.

But the gap between the two should widen significantly over the coming five years as Shenhua is planning to double capacity to 200 million tonnes per annum by 2010, whereas analysts are forecasting volume growth of only 5% to 7% for Yanzhou over the next two.

Shenhua is not only China's largest coal producer, but also the world's second largest in terms of reserves behind Peabody Energy. The latter is currently trading at about 16 times 2005 earnings, whereas diversified mining companies BHP Billiton and Rio Tinto are trading at roughly 12 times and 10.5 times.

Such is the size of Shenhua's IPO that its market capitalization will top Peabody by a factor of nearly three upon listing - $16.5 billion at the top end of the range compared to $5.9 billion for the US coal giant.

However, specialists say the international comparables are only indirectly relevant for two reasons. Firstly Shenhua is an integrated energy play that also encompasses power stations and railways.

But secondly and more importantly, coal is far more of a domestic commodity than, for example, oil. Shenhua's IPO is, therefore, very much a China play rather than a global play and as such the company has an inherently different risk profile to energy giants in developed markets.

King Coal?

Shenhua is one of the most symbolically important IPO's to ever come out of China - on a par with the landmark listings of Petrochina, Sinopec and CNOOC.

What it does not have is the same sex appeal. Whereas oil has traditionally belonged to the world of the glamorous and the rich, coal has historically been associated with the dirty and the poor. So too, where oil prices have always been volatile, coal prices have been (until two years ago) been very stable.

Furthermore, many of the world's richest countries are reducing their reliance on coal because of environmental concerns. In China, by contrast, coal consumption and the consequent pollution it produces is soaring. Coal is the primary fuel of the country's rapid industrial revolution and lead managers will argue that Shenhua provides the perfect proxy for investors looking to play it.

Price cycle

They are also likely to argue that future earnings will be driven by capacity expansion rather than price increases now the cycle may be peaking. A big jump in prices has been the chief reason why revenues have gone from Rmb27 billion in 2003 to Rmb39.3 billion in 2004 and a forecast Rmb51 billion in 2005.

At the same time net income has jumped from Rmb2.9 billion 2003 to Rmb8.9 billion in 2004 to a forecast Rmb14.1 billion in 2005. This represents a growth rate of 200% between 2003 and 2004, followed by 59% between 2004 and 2005.

At the recent coal conference in January the government intervened to keep price increases within an 8% cap over September 2004 levels. But analysts say signed contracts show that prices have been increasing on average 15% to 17% so far in 2005.

There remains considerable uncertainty when the cycle will peak. Syndicate research is forecasting that prices will remain flat or decline slightly in 2006.

However, analysts also note that China's continuing strong growth has wrong-footed many industry participants in the past and a number of houses believe the current cycle could run on for a further 18 to 24 months. Indeed, it has been China's demand for coal that is repeatedly cited as the main reason why international prices have increased so dramatically over the past two years.

Between January 2003 and July 2004, for example, the spot price of steam coal delivered to NW Europe jumped from $36 per tonne to $79 per tonne. This price increase was further compounded by the Chinese government's efforts to curb exports in order to meet soaring demand at home.

According to "Coal Leader", China's primary coal demand is expected to increase by 2.2% per annum from 1.3 billion tonnes in 2002 to 2.4 billion tonnes by 2030. At the same time, the government has been forcibly closing down hazardous small mines and consolidating the industry under giants like Shenhua.

In 1998, there were roughly 75,000 mines in China that employed less than 13 miners. The government claims to have shut down at least 30,000 since then.

Shenhua's five-year capacity expansion plan will see it grow by the size of a Yanzhou every two-and-a-half years. Its annual capex is equivalent to the entire annual capex of the Australian coal mining industry, currently the world's biggest exporter.

An integrated energy play

Second to capacity expansion, lead managers are likely to argue that the company's earnings will be underpinned by its integrated status and the efficiencies that ensue. One of the chief costs for a coal producer is transportation and it has been bottlenecks in this area, which have kept supply overly tight and prices high.

So far this has been uniformly positive for Shenhua since it owns and operates one of only two railway lines, which cross the entire length of the country from the coal mines in the West to the ports and power plants in the East. The company estimates this enables it to reduce its operating costs by about 40% to 50%.

Its cost per tonne, for example, stands at Rmb6 compared to a China industry average of Rmb10.

In turn it runs much higher margins than global comps. Analysts say its 2004 EBITDA margin came in at 47%.

Should the bottlenecks ease, however, then prices may fall and other companies might benefit from easier logistics. The China Coal Market and Transportation Associations is predicting this will be the case, with 100 million tonnes of rail capacity scheduled to come stream in 2005 thanks to the construction of two major rail lines out of northern China.

Shenhua management also believe the company's high degree of efficiency can be measured in terms of its safety record. Specialists note that Shenhua sustains lower fatalities than both Australian and US mining companies. Only South African mining companies have a better track-record.

They say this can be partly attributed to the company's superior geological base, which enables it to employ a completely mechanized method of mining known as longwall drift. This eradicates the need for drilling and blasting. Instead a cutter ploughs back and forth along the coal face, depositing coal onto a conveyer belt.

Analysts say that roughly 76% of Shenhua's revenues derive from coal production and much of the balance from power generation. Specialists believe the power assets constitute a major selling point. This is because Shenhua is in a superior position to bid for new plants because it can always guarantee the coal supplies necessary to run them.

So too, the power assets may provide a small valuation kicker for the group. Listed power companies such as Huaneng, Datang and Huadian are currently trading on forward multiples in the mid teens.

Shenhua currently has installed capacity of just over 5,000 MW and has hopes of significantly boosting the figure. "The power assets are an integral part of this company's equity story," says one observer. "Together they are already bigger than listed companies such as China Power International."

Shenhua will be using proceeds to help boost output, but will not plough funds into E&P since it already has 50 years of proven reserves. Some money will also be used to pay down debt as the company is relatively highly geared. At the end of 2004, net debt to capitalizataion stood at 55%.

Undermined by market conditions?

On the downside, the major hurdle Shenhua looks set to face is the underlying market tone. The company is hoping to bring the world's third biggest IPO so far this year against a background of directionless markets and price sensitive investors.

As one banker puts it, "There were nine IPO's in the US last week. Three got pulled and three were priced at the very bottom of their indicative ranges."

Many investors have mixed feelings about the China market. In Spring 2004, the bottom fell out and many of the commodity stocks collapsed after the Chinese government tried to rein in the economy and the US Federal Reserve began hiking interest rates.

Some now wonder whether a similar scenario will unfold in 2005. Domestically, the Chinese government has reported stronger than expected GDP figures for the first two months of the year, prompting renewed speculation that it may adopt new austerity measures. Internationally, investors remain nervous about the sustainability of the Fed's benign interest rate stance.


A second and unquantifiable hurdle surrounds the ethics of investing in a company, whose expansion will accelerate the already dreadful levels of pollution on the Mainland and in surrounding countries.

The World Bank has estimated that up to 400,000 people die each year in China as a result of air pollution. China's industrialization is also said to account for up to 40% of air pollution assailing neighbouring countries - South Korea, Japan and Hong Kong.

According to "Coal Leader", coal fired power stations will account for 95% of the growth of global demand out to 2030, of which China and India will account for 68%. It estimates that China's power sector will acount for 73% of total domestic coal consumption by 2030, upfrom 52% in 2002.

Demand growth in OECD countries will be minimal thanks to efforts to try and slow global warming by switching to other energy sources. Some commentators point out how hypocritical Western observers are to criticize China, when their own countries only started making efforts to improve the environment once they were rich and developed.

One country unlikely to put pressure on the Chinese coal industry is the US, where George Bush is said to have adopted a pro-coal policy since his election in 2000. In a recently published book - Coal, A Human History, author and former US assistant attorney general Barbara Freese recalls the huge fundraising efforts the powerful coal lobby made in the formerly Democratic state of West Virginia, which subsequently swung Republican.

The book is reviewed in the May issue of FinanceAsia magazine.

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