With the closing of the retail offer today, the float of QR National is entering its final phase. There remains considerable confusion about how well the attempt to raise between about $3.6 billion and $5 billion in the biggest privatisation since Telstra is tracking.

From launch, the float has attracted a lot of criticism over its pricing — the indicative of range of $2.50 to $3 a share translates to a price-earnings multiple of between 21 and 25 times prospective earnings — and the perceived weak levels of retail demand. Given the post-financial crisis context, some unusual aspects to QR National’s financials and the usual practice of the market trying to talk down the value of the entry price to an IPO, that’s neither novel nor surprising. This is a big float in a brittle market of a unique and complicated business.

While the broker firm bids produced just over $1 billion of demand, QR National was, despite the massive advertising campaign, never really pitched at mums and dads, or at least those mums and dads outside Queensland, where parochialism, familiarity and some extra incentives might stimulate some demand. The expected yield of between 2.1% and 2.5% says it all.

That modest yield flows from the most unusual aspect of the privatisation, the fact that QR National’s cash flows and the bulk of a $3 billion debt facility are going to be absorbed by a $3.8 billion capital expenditure program over the next two years.

In that sense the key investment decision is whether Lance Hockridge and his relatively recently assembled team can deploy that capital efficiently and generate appropriate returns.

There is also large-scale opportunity, and risk, as a large number of the group’s long term contracts in its ‘above rail’ operations mature over the next half decade. The margins on those contracts are currently quite low — if QR National can retain and reprice them in the face of competition from Asciano there would be considerable upside.

More broadly, QR National is less efficient in terms of not just revenue yields but costs compared with Asciano and its international peers — there is another layer of long-term upside if, post-privatisation, the business is simply managed better. For the critics of the float, of course, those represents a lot of ‘ifs’.

The float promoters have some flexibility, with the Queensland government committed to retaining at least 25% of the group and willing to keep as much as 40%, which will help in creating some tension for the offer.

The international roadshows have reportedly gone well. European investors are familiar with rail and privatisations and North American investors have made a lot of money out of railroads in recent years. It hasn’t hurt the float that its roadshows have coincided with a spate of strong results by the big North American railway operators.

QR National is primarily a coal haulage business and that adds to its appeal to international institutions — it provides an indirect but very strong exposure to Asia’s economic performance within a stable and familiar jurisdiction. The currency issue is a double-edged sword, making the investment more expensive for foreigners but, given the backdrop of QE2, perhaps providing some currency upside.

The real question for the international investors, and the issue that will determine the fate (or at least the pricing) of the float will be the extent of domestic institutional demand. While the local institutions have been aggressively talking the float down and have forced QR National to deny that it would consider pricing the float below the indicative range, that is quite routine in big IPOs.

The real attitude of the domestic institutions won’t be known until they start bidding into the bookbuild late next week.

If there is decent demand that will encourage the offshore investors, who would know that unless there is significant domestic support for the float and its after-market there won’t be sufficient liquidity in the after-market and therefore they would probably be staring at material paper losses.

Thus the critical element of the float isn’t retail investor appetite, although that can create tension for the institutions, but whether the local institutions buy the capital growth and efficiency story that under-pins the float. It is going to be a nerve-wracking week for QR National, the float promoters and the Queensland government.

*This article was originally published on Business Spectator

Peter Fray

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