Honghua to benefit from oil boom

Honghua Group, the world's second-largest maker of onshore oil drilling rigs, is expected to be one of the beneficiaries of oil producers' surging exploration and production spending.

But analysts warn rising raw material costs may squeeze its margins.

The Sichuan company is the first mainland firm to launch an initial public offering since the Lunar New Year after fears of a possible recession in the United States pummelled global stock markets and turned investors wary of new offerings.

Honghua is seeking to raise up to HK$3.75 billion by issuing 833.36 million new shares at HK$3.16 to HK$4.50 each, sources said. Founded a decade ago by a collectively owned enterprise, the firm makes onshore drilling rigs and their components for domestic and overseas customers.

The mainland is its largest market, accounting for 51 per cent of total rig sales in the first eight months of last year. North America made up 72 per cent of total sales for the same period a year earlier, its preliminary listing prospectus shows.

The oilfield services units of China National Petroleum Corp and China Petroleum & Chemical are Honghua's largest domestic customers, while United States-based Nabors Industries is its largest overseas client and a strategic shareholder.

Honghua also makes offshore rig modules and parts for another strategic shareholder, China National Offshore Oil Corp, although that division accounted for only 0.94 per cent of total sales in 2006.

Honghua plans to use about 60 per cent of the listing proceeds to build an offshore equipment plant on the eastern coast to satisfy China National Offshore's demand, especially for deeper-water operations.

It is developing offshore modules for depths of 7,000 metres and 12,000 metres, compared with the ones for 4,000 metres that it has been selling.

Honghua is expected to benefit from the rising exploration and production expenditure of the country's three state oil and gas majors.

China, the world's second-largest onshore rig market by wells drilled, is estimated to need 1,125 new onshore rigs in the five years to 2012, or 38 per cent of the global total, according to consultancy Spears & Associates.

'Honghua will benefit from its status as one of the largest rig producers in the world serving the strategically important oil industry, but one has to look at whether it can pass on cost increases to customers,' said Pegasus Fund Managers managing director Paul Pong.

Raw materials, mainly steel, account for 92.5 per cent of total production costs, up from 87.6 per cent in 2005, amid rising metal prices.

Spot market prices of medium steel plates had surged as much as 54 per cent between 2004 and last year, according to Datastream. Prices are set to rise further this year after Japanese and Korean steelmakers on Monday agreed to a 65 per cent surge in the price of imported iron ore.

However, Honghua's overall gross margin rose to 32.9 per cent in first eight months of last year from 29 per cent a year earlier, 21 per cent in 2005, and 18.4 per cent in 2004.

This came as the company ramped up production of more expensive digitally controlled rigs, especially in 2006 and last year.

Prices of such products averaged 29 million yuan in the first eight months of last year, against 11.9 million yuan for conventional rigs.

Honghua's share offer range represents a price-earnings ratio of 18.6 to 26.5 times, based on its estimated net profit for last year of at least 538.3 million yuan, and 12.3 to 17.5 times based on sponsor Credit Suisse's 813.9 million yuan net profit estimate for next year.

Both multiples assumed Credit Suisse and its co-sponsor Morgan Stanley would exercise their option to sell 15 per cent more shares than indicated.

The main domestic competitors include China National Petroleum Corp unit Baoji Oilfield Machinery and Lanzhou LS-National Oilwell Petroleum Engineering - a Sino-US joint venture between Lanzhou Petrochemical Machinery Equipment and Engineering Group and National Oilwell International (NOI).

NOI's parent National Oilwell Varco, the largest maker of oilfield equipment in the US and identified by the prospectus as one of Honghua's two overseas rivals, traded at 16.6 times last year's net profit and 13.39 times this year's estimated profit, according to Bloomberg data.

'[Honghua's] offer price range looks a bit expensive given that industrial stocks command price- earnings ratios of 10 to 15 times, but this could be partly compensated by high oil prices, which would bode well for oil drillers and their suppliers,' said Sun Hung Kai Securities analyst Eva Yip.

According to Kim Eng Securities oil sector analyst Larry Grace, while it is difficult to find direct comparables of Honghua, the market tends to impose higher multiples on China than elsewhere for oilfield engineering and services.

Honghua said it planned to distribute no less than 20 per cent of net profit as dividends.

What the analysts say

Prudential Brokerage associate director

Kingston Lin King-kam:

'The market is not familiar with Honghua's products as they are not mainstream items. I think investors are probably more interested in large-cap, easy-to-understand IPOs like China Railway Construction.'

Sun Hung Kai Securities analyst Eva Yip:

'The offer price range looks a bit expensive given that industrial stocks normally command price-earnings ratios of 10 to 15 times, but this could be partly compensated by high oil prices, which would bode well for oil drillers and their suppliers.'

Fulbright Securities

general manager

Francis Lun Sheung-nim:

'The IPO market has turned around slowly and even small-caps were being flipped yesterday. I think investors will be interested in Honghua as Chinese producers have cost advantages.'

Pegasus Fund Managers managing director

Paul Pong:

'Honghua will benefit from its status as one of the largest rig producers in the world serving the oil industry in China, but one has to look at whether it can pass on cost increases to customers and its profit margin trends.'

Kim Eng Securities oil sector analyst Larry Grace:

'It is difficult to find direct comparables of Honghua, but I think the market tends to impose higher multiples here for oilfield engineering and services.'