Commodities

David Fickling is a Bloomberg Gadfly columnist covering commodities, as well as industrial and consumer companies. He has been a reporter for Bloomberg News, Dow Jones, the Wall Street Journal, the Financial Times and the Guardian.

Ouch.

China Inc. likes its capital markets activity to go off without a hitch. State-owned enterprises, for instance, aren't allowed to price initial public offerings at less than the value of their net assets, even if their peers are trading at a discount to book.

So there'll be uncomfortable questions after shares in Cofco Meat Holdings Ltd., a pork producer in which state-owned Cofco Corp. has a 28 percent stake, plummeted 24 percent on their first day of trading on Tuesday. Even after the stock bounced back to a 15 percent decline, it's likely to rank as one of the worst first-day performances for a noteworthy Hong Kong IPO this year.

Pops and Busts
Cofco Meat has had one of the worst first-day share price performances among noteworthy Hong Kong IPOs this year
Source: Bloomberg
Note: Shows companies with IPOs on Hong Kong exchanges worth at least $100 million that began trading during 2016. Most companies show price change at close of trade; Cofco shows intraday maximum because shares were still trading at publication time.

Here are some things that investors in a significant IPO like to see: a strong history of profit; a watertight argument for revenue and earnings growth; a broad panel of similarly valued peer companies; and evidence that pre-IPO investors aren't doing too well out of the deal. Cofco Meat has a good story about why it should prosper, but it has issues on all those counts.

Take profits. As a commodity business, Cofco Meat operates on prosciutto-thin margins, with gross profit averaging just 3.5 percent of sales over the past three fiscal years. Broadly speaking, that's meant it makes profits when pork prices are high and loses money when they're low: Last year's 210 million yuan ($31 million) of net income followed two years of losses, according to the IPO prospectus.

Pigs Fly
The wholesale price of pork in China hit a record in June
Source: China Ministry of Commerce, Bloomberg

Wholesale pork prices are looking pretty healthy now, with a Ministry of Commerce measure touching a record in June. But as with any other commodity, a cycle is clearly at work. When prices are high, farmers start breeding more pigs that will most likely hit the market over the next few years just as consumers start switching to less costly meats such as chicken. Prices have been ticking down for five months, suggesting the IPO may have missed its best-before date.

Those market prices still show a long-term rising trend, but clouds are emerging on that horizon, too. From 2010 to 2015, China's pork consumption grew about 0.2 percent a year faster than production, according to analysis for the IPO by Frost & Sullivan. Over the subsequent five years, production will outpace consumption by about 0.1 percent a year, reducing a deficit in domestic production from 800,000 metric tons in 2015 to 400,000 metric tons in 2020. In commodities, smaller deficits generally mean weaker pricing.

Mystery Meat
Price-to-book valuations of global meat companies are all over the place
Source: Bloomberg

Comparable companies are also a problem. Many of the world's meat businesses are closely held. The ones that are publicly traded often focus on different animals and varied parts of the supply chain, from farming and slaughtering to processing, distribution and retail sales. Few other companies are doing exactly what Cofco Meat does, so it's hard to be confident that its focus on the farm-and-abattoir end of the industry will prove more profitable than a more broadly based rival like WH Group Ltd.

Salami Slicing
More than 85 percent of Cofco Meat's shares are already locked up by key investors
Source: Company prospectus, Bloomberg

The last issue comes from the pre-IPO investors. Temasek Holdings Pte. and funds including ones affiliated with KKR & Co. bought stakes in Cofco Meat last year for about 40 percent to 47 percent less than the price of shares to the public. Since then, about 1.4 billion yuan has been invested to improve hog production capacity by 55 percent, so you could argue the business has been transformed -- but without a longer track record of profits, investors clearly remain skeptical.

With about 86 percent of the shares locked up by pre-IPO and cornerstone investors, those doubts have been magnified by an illiquid market.

It's easy to tell a bullish version of this story focusing on China's growing hunger for animal protein and the country's efforts to professionalize its food production industry. Compare Cofco Meat's 2.2 times book value with the 5.7 multiple for Henan Shuanghui Investment & Development Co., a WH Group-controlled business focused on the same segment of the pork industry, and it looks positively cheap -- although historic price-to-earnings valuations make it look costlier, at 28 times compared with Henan Shuanghui's 17 times.

Still, the problem with any first-time sale of shares is one with which Cofco Meat should be familiar: Careful buyers often want to know how their sausage is made. When available information is scarce, the pickiest shoppers will tend to be wary.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
David Fickling in Sydney at dfickling@bloomberg.net

To contact the editor responsible for this story:
Daniel Niemi at dniemi1@bloomberg.net