Lead manager Goldman Sachs began pre-marketing a $350 million to $450 million listing of Chinese hardware telecom equipment manufacturer ZTE Corporation on Monday (November 15).
The deal is unusual because it represents the first time an A share company has sought a secondary listing in Hong Kong, rather than the other way round, which has been the norm in the past. As such, the offering presents a number of challenges, which if successfully overcome, may prompt other Mainland listed such as Minsheng Bank to follow suit.
The biggest hurdle is the fact that the 29 A-shares, which are currently listed in both centres, average a 50% trading premium on the Mainland, where the government is continually trying to think of ways to encourage better valuation discipline among local investors. Indeed, existing ZTE investors scuppered plans for an H share listing two years ago because they were so worried about dilution and the prospects of a sliding domestic valuation.
This time round, ZTE is said to have secured support from 96% of its domestic investor base after it argued that better international understanding of the complexities of its equity story would support rather than undermine the domestic valuation. Management also argued that it would be much easier to secure capital from the international markets, which would in turn support the company's expansion plans and future net profits.
Since the company was listed in Shenzhen in 1997, it has seen its share price rise about 800% and is currently trading at RMB26.70 (Tuesday's close), up 71.34% year-to-date. This represents a street average 2005 P/E multiple of 15.8 times pre money and 19 times post money.
In research reports published over the past month, domestic analysts have said they expect the H share deal to come at a 20% to 30% discount to the outstanding A share. However, the new deal is being marketed on a fairly elastic P/E range since differences between PRC Gaap and Hong Kong Gaap affect 2005 profit forecasts.
Based on PRC Gaap forecasts, 2005 net profits range from $140 million to $160 million. On this basis, the new deal is being marketed on a P/E range of 13 to 19 times. Based on Hong Kong Gaap forecasts, on the other hand, it appears much cheaper and spans the early teens.
The difference between the two accounting standards principally centres on revenue recognition. The company previously took a very conservative stance and only recognised revenue once payment was made. Going forwards (for both China and Hong Kong Gaap), it will recognise revenue as soon as a sales contract is signed.
In marketing the deal, fund managers say the lead is trying to persuade them to do their own valuation work and treat the deal as an IPO rather than a secondary listing. The offering has been structured like an IPO with a 90%/10% split between international and retail investors.
Pre-greenshoe, ZTE is offering 151 million shares and post greenshoe 162.2 million. The full amount will result in an H share freefloat of 16.7% and an A-share freefloat of 31.5% (down from 37%). Like all dual listed HK/China stocks, there will be no fungibility between the two.
Some 99.1% of the deal will be new shares and 0.9% secondary shares, proceeds of which are going to the National Social Security Fund.
Alongside the lead manager, Guotai Junan is joint sponsor of the Hong Kong retail offering. Co-leads in the international tranche are Bear Stearns, BNP Paribas Peregrine, Citic Securities and Credit Suisse First Boston.
The deal has a more accelerated schedule than most IPO's, with a formal price range to be set this Friday after only one week of pre-marketing. Pricing is scheduled for December 2.
Similar to the IPO of China Netcom before it, the deal's major macro challenge concerns the uncertain direction of China's telecom sector. At issue is how long the PHS system (Personal Handyphone System) will flourish on the Mainland given it has been adopted by the two fixed line operators - China Telecom and China Netcom - as an interim technology in the absence of a cellular license.
Analysts expect both operators to begin winding down their PHS capex, but none are sure how swiftly the gap will be filled by 3G, nor how many licenses will be issued, or which technologies will be employed. In a worse case scenario, the telecom manufacturers could see PHS revenues start to decline in 2005 at a time when there is still uncertainty about the issuance of 3G licenses, or a cautious approach to capex by the new licensees.
The second big uncertainty is what impact global telecom giants such as Ericsson, Motorola and Nokia might have on the Mainland market. Currently, they not only have sophisticated 3G products, but also invented the underlying technologies and manufacturing standards.
The global giants have historically held market shares of up to 30% in the China handset sector and currently derive about 7% to 8% of their overall revenues from the country. A basket of Ericsson, Motorola, Nokia and Lucent stocks currently span 2005 P/E ratios of about 15 to 22 times.
In its favour, ZTE and China's other home-grown giant Huawei are regarded as national flag bearers by the Chinese government. The latter has frequently made clear its determination to create a home-grown industry, to the extent that it is even trying to develop its own 3G technological standard: TD-SCDMA.
At a recent conference in Beijing, government officials indicated that different 3G standards would continue to be tested until the middle of 2005. This implies that the government will only start issuing licenses towards the end of the year at the earliest. It also said it currently favours multiple technologies in a bid to promote competition.
At the end of 2003, ZTE derived 45.9% of its revenues from wireless communication systems (base stations etc), 21.3% from handsets and about 13% each from wireline switches and optics and data. Between 2001 and 2003, it recorded a revenue CAGR of 34.3%, rising to 45% in the first half of this year. Observers say analysts' consensus forecasts are predicting a five-year EPS of CAGR of 23%.
In turn, the company had a 37.5% market share of PHS equipment supplies in 2003, ranking second to UTStarcom, which stood at roughly 55%. It also had a 17.6% market share of CDMA equipment supplies. It is China Unicom's largest supplier and has the highest market share of any domestic supplier.
Its two closest comparables are unlisted Huawei Technologies and Nasdaq-listed UTStarcom. However, the former primarily focuses on optical and data communications. It also derives a much higher proportion of its profits from international operations (40% in 2003).
The latter is a closer comparable, although observers point out that it has a far more limited product range than ZTE. Its dependence on the uncertain PHS system also means it trades on a very divergent range of 2005 profit forecasts. These span 9 to 17 times and average about 12.
Observers further note that ZTE has been increasingly diversifying its revenue base overseas. Three years ago, international operations accounted for about 4% of revenue. By the first half of 2004, the figure had increased to 13.4% and by the end of 2006 the company is targeting 40%.
ZTE has been particularly successful at winning contracts across a host of emerging market economies including Nepal, Pakistan,Vietnam, the Congo and Tunisia. Analysts say international margins tend to be higher then domestic ones are therefore providing a good buffer at a time of increasing competition.