Getting to know your ABC

After two-and-a-half months of intense work to get Agricultural Bank of China (ABC) ready for an initial public offering, bankers breathed a sigh of relief on Friday last week as the Hong Kong stock exchange formally gave the deal the all clear.

Investor education for the H-share tranche will begin today and, if all goes to plan, China's largest bank by number of customers and branches will start trading in Shanghai on July 15 and in Hong Kong the following day.

The target is to raise more than $22 billion, which will make it the largest IPO in the world. The bank itself has expressed a desire for a deal of up to $30 billion -- although the recent decline in share prices among its peers and the huge supply of Chinese bank shares expected over the next few months could make this target too big a challenge.

Sources say the deal has already attracted a lot of interest from potential cornerstone investors who are asking for a guaranteed allocation against a commitment to hold the shares for a set amount of time, typically six or 12 months. While the amounts still have to be finalised, ABC may sell as much as 40% of the deal to cornerstones, which will include strategic players in the form of other banks, as well as pure financial investors such as sovereign wealth funds and other portfolio managers, the sources say.

The investor education is expected to focus primarily on two issues: determining a feasible valuation range for the transaction that won't put off the high-quality long-term investors that the bank covets; and to get investors to understand that while ABC has more branches than the other big three state-owned banks outside the big cities, it is not a bank that lends to a bunch of small farmers and it is also no more a policy bank than its peers. That may have been the case 20 years ago, but today, the lending is done on a purely commercial basis and to a much more sophisticated customer base.

The bank is being described as having two parts: one urban banking part that is focused on the east coast areas, and which is fairly similar to the domestic businesses of Industrial and Commercial Bank of China, China Construction Bank and Bank of China; and a second part focused on so-called county areas, which include large and small towns, municipalities, suburban areas and villages as well as rural areas.

Depending on what metrics one looks at, about 65% of the bank is focused on the urban areas, while 35% is focused on the county areas. For deposits the split is 60/40 and for loans 71/29 in favour of the urban areas, according to a preliminary prospectus published in Chinese. And a further breakdown of the county lending shows that 75% is to corporates, while only 6% is to rural households. However, investors should take note of the county business, not because it is in any way "lower quality", but because of the opportunities, sources say.

"The county piece is the unique piece as the others aren't significantly involved," said one person with good knowledge of the bank, and noted that since 2000 these areas have been consistently producing higher GDP growth than the coastal provinces -- 11% per year versus 9%. And this is expected to continue as the urbanisation process moves inward and companies are moving inland to reduce operating costs. Also, the government continues to try to develop these areas through fiscal spending.

The key question for investors will be whether the bank can actually make money in these areas, though, and sceptics will note that historically the profitability has been lower here. Sources say it is catching up though and note that a key reason why profitability has been lower is that balance sheets in the county areas are a lot less leveraged. As the urbanisation process continues, that will change. Importantly, the competition in these areas is also a lot lower, which puts Agricultural Bank is a good position to benefit.

It should also benefit from the growth of the Chinese consumption story, given that it has 320 million retail customers. This is well above ICBC's 220 million customers and makes it the largest retail bank in the world.

Another key selling argument will be the fact that ABC has emerged from restructuring only in the past year and now stands to reap the benefits from that in the form of improved profitability, much like ICBC, CCB and BOC did after they were listed.

ABC is forecasting a net profit growth of 26% in 2010 and should maintain a return on equity at around 20% or just below even with the dilution from the capital raised through the IPO. This compares with 16%-17% for Bank of China and 21%-22% for ICBC and CCB.

Analysts are said to be more positive on the trajectory of ABC's ROE as its three peers all improved significantly on key metrics like cost-to-income ratio, non-performing loans and NPL coverage after they listed. The same is expected to happen with ABC as the management will shift from focusing on developing the bank's infrastructure to actually growing the business. ABC's NPL ratio was about 2.9% at the end of 2009 compared with an average of about 1.5% for the other three. Although, when the latter firms listed they had an average NPL ratio of 4.7%. And the first signs of an improvement are already starting to show with ABC's NPL ratio dropping to 2.4% at the end of the first quarter.

It is worth noting, however, that when CCB came to market in 2005, followed by BOC and ICBC in 2006, the economy was on an upward trend. The current concerns about the possibility of rising non-performing loan ratios at all Chinese banks following last year's unprecedented lending binge will obviously have a bearing on the outlook and expectations for ABC as well.

Indeed, the share prices of the other three have underperformed this year as the market has priced in these concerns. With regard to valuations, most observers argue that ABC will warrant a discount versus ICBC and CCB, which currently trade at about two times book value -- the question is how much of a discount. It is expected to come at a premium to BOC, however, as the latter gets about 20%-25% of its revenues from overseas markets, including Hong Kong, and therefore is much more exposed to a global economic downturn. BOC is currently trading at about 1.6 times.

As with all dual listings in Shanghai and Hong Kong these days, the A-share process will run slightly ahead of the H-share timetable, although in this case the difference will be only one day. Thus, the bookbuilding for the A-share tranche will start on June 23, followed by the H-share tranche on June 24 and the final price will be determined on July 5 and 6, respectively.

The A-share tranche, which will account for about 47% of the total offering, is being arranged by China International Capital Corp (CICC), Citic Securities, China Galaxy Securities and Guotai Junan Securities, while the H-share tranche, which will account for about 53%, is being arranged by CICC, Deutsche Bank, Goldman Sachs, J.P. Morgan, Macquarie and Morgan Stanley.

Despite the fact that pre-marketing is starting today, ABC has still not named any global coordinators for the offering, meaning so far all the banks are included in the deal as joint bookrunners. Expectations appear to be that CICC, which is working on both the A- and H-share tranches, Goldman and Morgan Stanley will be given an expanded global coordinator role, although the politics involved in a high-profile deal like this means that could quickly change.