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5 December 2019

Landrich Holding Limited – Decision of the Listing Review Committee
 
On 20 November 2019, the Listing Review Committee heard an application by Landrich Holding Limited (the Company) for a review of the decision of the Listing Committee, set out in a letter dated 12 September 2019, rejecting the Company’s application to list on the Main Board.
 
Having carefully considered all the facts and evidence, and all the submissions (written and oral) presented by the Company and the Listing Department, the Listing Review Committee decided to overturn the decision of the Listing Committee and to allow the Company to proceed with its application for listing.
 
We set out below the Listing Review Committee’s reasons for its decision. Please note that this necessarily represents only a summary of the Listing Review Committee’s analysis, and does not purport to set out exhaustively the facts or address all of the arguments presented.
 
1.    The Company and its Group act as a contractor in the construction industry. The Group derives most of its revenue from public sector civil engineering projects, particularly in relation to roads and drainage, and site formation. The majority of the Group’s existing business involves it acting as a subcontractor, although the Group has undertaken some projects as a main contractor either in a joint venture or on a stand-alone basis.
 
2. The Group has certain licence approvals as a contractor by the Hong Kong Government’s Development Bureau (DB): Roads and Drainage (Group C Probation and Group B Probation), and Site Formation (Group B Probation).
 
3. The Company’s market capitalisation at the time of listing is expected to be $520 million based on the low-end of the offer price range.
 
4. The Group seeks to raise from listing about $70 million in net proceeds. Of that, the Group intends to apply $30 million to finance future projects as part of its expansion plan.
 
5. The Group’s expansion plan involves a strategy to undertake more projects as the main contractor, and to upgrade its DB licences from “probationary” to “confirmed” thus removing certain restrictions which may limit the projects on which the Group can be engaged. Under the DB’s Contractor Management Handbook, the Group would be required to allocate a sum of money as working capital in order to undertake a project as a main contractor. The Group calculates it would need $27 million for this purpose, in order to undertake a 2-year Group B contract and a 3-year Group C contract.
 
6. The Company notes that gross profit margins of such projects may be lower for main contractor projects than for subcontractor projects, but believes that there are good reasons for undertaking more projects as main contractor. Amongst other things, the Company believes that gross profit can be greater in main contractor projects, main contractor projects may require less resources, and main contractor projects may help to establish the Group’s reputation and/or allow the Group to diversify risks.
 
Listing Department’s concerns
 
7. The Listing Department has concerns in relation to the commercial rationale of the expansion plan, which has a focus on increased main contractor work. Amongst other things, the Listing Department notes that the gross profit margin for main contractor work is lower than for subcontractor projects, and accordingly questions whether the plan to increase focus on main contractor work makes financial sense. The Listing Department notes that the Group would have to increase the value of its main contractor projects substantially in order to maintain current levels of profitability. However, if anything, the amount of main contractor work that the Group has been undertaking has been decreasing in recent years.
 
8. The Listing Department also: (a) notes that it does not make sense to say that main contractor projects may require less resources, given the additional costs and working capital which the Company says are required; and (b) does not understand how main contractor work allows diversification of risks, given the main contractor would remain in a position of overall responsibility for the project.
 
9. The Listing Department says that the Company has not substantiated the demand for main contractor work, and does not see evidence of market demand for the work required by the Group to upgrade its DB licences.
 
10.    The Listing Department considers this a borderline case, but believes that the Company has not demonstrated the commercial rationale for listing, and so is unsuitable for listing.
 
Applicable Listing Rules and guidance
 
11. Rule 8.04 provides that both the issuer and its business must, in the opinion of the Exchange, be suitable for listing. Rule 2.06 provides that suitability for listing depends on many factors, and reiterates the Exchange’s discretion to accept or reject applications for listing.
 
12. Guidance on factors which may be relevant in the Exchange’s assessment of suitability for listing can be found in, amongst other things, Guidance Letters HKEX-GL68-13 and HKEX-GL68-13A (GL68-13A). Suitability for listing is based on a qualitative review and there is no bright-line test. However, applicants will normally be expected to demonstrate adequately, amongst other things, the commercial rationale for listing, including by reference to their proposed use of listing proceeds, and their future objectives and strategies for business operations and growth. Paragraph 4.1 of GL68-13A says consideration may be had to whether a listing of the applicant is consistent with its business strategy, including the proposed use of proceeds and whether the applicant has genuine funding needs.
 
Listing Committee’s decision
 
13. In September 2019, the Listing Department recommended to the Listing Committee that the Company’s application for listing on the Main Board be rejected on the basis that the Company is unsuitable for listing.
 
14. The matter was considered by the Listing Committee on 11 September 2019. The Listing Committee decided the Company was not suitable for listing under Rule 8.04 and rejected the application. Amongst other things, the Listing Committee noted that the Company had not substantiated demand for its services as a main contractor, and/or for its civil engineering work as a stand-alone main contractor. The Listing Committee understood that the Company only had two more years to obtain the qualifying projects required to allow it to upgrade its licences from probationary to confirmed status, and that the Company seemed unlikely to be able to fulfil the confirmation requirements to complete the upgrade.
 
Main arguments before the Listing Review Committee
 
The Company’s submission in summary
 
15. The Company submitted that there had been a misunderstanding by the Listing Department and the Listing Committee in respect of the time available for the Company to undertake qualifying contracts to upgrade its licences from “probationary” to “confirmed”. In particular, the Company said that its probationary licences were valid indefinitely. In order to upgrade, a qualifying project needed to be undertaken in the five-year period prior to the upgrade. However, there was no requirement that such a project be undertaken within five years of the award of the probationary licence.
 
16. The Company submitted that it is inappropriate to conclude there is insufficient future demand for services from the Group by reference to past performance. The Group’s actual revenue from main contractor projects increased year-on-year throughout the Track Record Period from $115 million to $199 million. Reasonable growth was expected in the civil engineering works industry in the coming years, as described in the prospectus. There are currently limits on the projects that the Group can undertake due to restrictions on its financial resources, hence its desire to obtain funds by listing, and due to restrictions relating to the Company’s probationary licence status, which the Company seeks to address by achieving an upgrade of those licences to “confirmed” status.
 
17. The Company reiterated and expanded on the reasons why, in its submission, being a main contractor, whether on a stand-alone basis or in a joint venture, may be desirable. These included amongst other things potential higher absolute gross profit, reputation enhancement, predictability of revenue and reduction of credit risk (in that the main contractor directly deals with the customer, which is usually the Government), diversification of risk (through the engagement of subcontractors), and the need for less resources, including machinery, labour, equipment and construction materials, and lower rental costs. However, the Group would continue to undertake its profitable subcontractor work. The Group does not propose to undertake main contractor work exclusively post-listing. The Company submitted that this expansion plan is in line with past strategy.
 
18. In respect of demand, it was submitted that the Group had recently been short-listed for a new project in the Roads and Drainage category, which if undertaken should be a qualifying project allowing an upgrade from “probationary” to “confirmed” in the Roads and Drainage (Group C) category. Having a listed status would also help the Group to be more competitive.
 
19. The Company submitted that no objection had been made by the Listing Department to the majority of its proposed use of proceeds, relating to other elements of its expansion plans.
 
20. One reason why the Company sought equity financing rather than debt was because bank loans were typically for no longer than 12 months, which was not long enough when the funds are needed as project working capital.
 
The Listing Department’s submission in summary
 
21. The Listing Department acknowledged that there had been a misinterpretation – arising from unclear drafting in the prospectus – in relation to whether or not there was a time limit for upgrading licences from “probationary” to “confirmed” status, and noted that the Company was not subject to a restricted time period in which to upgrade its licences. Nevertheless, the Listing Department continued to have concerns over whether there was sufficient demand for the Group’s civil engineering work.
 
22. The Listing Department noted that the value of main contractor projects had significantly decreased during the Track Record Period, and that no new main contractor projects had been awarded since December 2018. There was doubt over whether the latest short-listed tender for a project would be successful.
 
23. As to the other uses of proceeds, the Listing Department noted that 42% is intended for future main contractor projects; and 44% is intended for acquisition of machinery and hiring personnel, and that that investment is intended to complement the undertaking of more main contractor projects. The use of all of these proceeds is therefore connected and related to the proposed expansion into main contractor work, and the Listing Department had doubts over the commercial rationale of that proposed expansion.
 
24. Amongst other things, the Listing Department noted: in relation to profit, even a larger main contractor project value would not generate more profit than a higher margin / lower value subcontractor project (on average); in relation to resources, main contractor projects seem to require more resources than subcontractor projects, not less – for example there is a 10% working capital requirement for main contractor projects; in relation to diversification of risks, the main contractor would have overall responsibility for the project; in respect of rental costs, the Company forecasted spending more on equipment rental in FY 2020 and 2021, not less.
 
Listing Review Committee’s views
 
25. GL68-13A provides guidance on how the Exchange will assess suitability for listing, which is a basic condition for listing under Rule 8.04. Amongst other things, GL68-13A relates to concerns that some companies may seek a listing with a primary objective to exploit the value of the listing status, rather than to develop their underlying businesses. Companies which are unable to demonstrate a commercial rationale for listing may be more likely to invite speculative trading.
 
26. In establishing an applicant’s suitability, GL68-13A makes clear that the focus will be on a qualitative review of the applicant’s business strategy (paragraph 4.1) and whether the applicant can demonstrate it has a convincing commercial rationale for listing (paragraph 4.2). The Listing Department is accordingly required to consider an applicant’s business strategy and commercial rationale for listing. Amongst other things, this involves assessing the Company and the genuineness of its business strategy and commercial rationale for listing in the context of the commercial or industrial sector in which the applicant is engaged. This can be a difficult assessment but should be as objective as possible.
 
27. In this case, the Listing Review Committee noted that, whilst they are neither exhaustive nor a checklist, the Company only had one of the characteristics listed in paragraph 1.4 of GL68-13A which raise a question about whether heightened scrutiny should be applied in the vetting process, in that the Company’s anticipated capitalisation on listing was only marginally above the minimum required of HK$500 million.
 
28. As noted above, the Listing Committee’s rejection of the Company’s application appears at least in part to have been based on a misunderstanding that there was a time limit of some two years for the Company to qualify for confirmed licenses, and that this was unlikely to be achieved in the time available. In light of the further explanation provided by the Company that there was no such time limit, the concern about whether there was sufficient time available to achieve an upgrade of licences wholly falls away, and made a borderline case less so.
 
29. There were extensive submissions in relation to the commercial rationale of the Company continuing to develop its business as a main contractor, either on a stand-alone basis or as a member of a joint venture consortium, in addition to undertaking building works as a subcontractor. While it was accepted that the margins for a main contractor were generally lower than those earned by subcontractors, the Company believed that, as a main contractor, it could in large measure mitigate the risk assumed by subcontracting all or a portion of the main contract, control the amount of working capital needed to support the contract, and deploy its resources, including its professional resources and plant and machinery, more effectively. In addition, the ability to tender for larger contracts as a main contractor was expected to enhance the Company’s standing in its industry and benefit its business. The Listing Review Committee noted that the funds available from listing could allow a company an opportunity to invest much greater resources in activities which may have previously been comparatively modest, and to embark on entirely new initiatives. In this case, the Company’s proposed expansion into more main contractor work appeared to the Listing Review Committee a logical way for a contractor to expand and was likely to be a conventional path of expansion in this industry.
 
30. The Listing Department expressed concerns over whether there would be demand for the Company’s services as a main contractor. The Listing Review Committee noted that the Company as a holder of probationary licences was limited in the number of contracts it was permitted to undertake as a main contractor and this could explain the absence of new contracts after the end of its Track Record Period.
 
31. At the hearing, the Company described how it had been short-listed as a main contractor, as a member of a joint venture consortium, for a contract of sufficient size to qualify for a licence upgrade. The Company had been asked to provide detailed financial information in respect of the proposed project, which the Company said indicated that it stood a good chance of winning the tender. The Listing Review Committee accepts that this information may not have been available when the Listing Department and Listing Committee had considered the Company’s application in September. This development was evidence that there may be demand for the Company’s services as a main contractor. Furthermore, the Company denied that it had tendered for this project simply with its listing application in mind.
 
32. The Company was also asked how its financial performance had been after the end of the three years’ Track Record Period ended 31 March 2019. The Company confirmed that both its revenues and attributable profits for the six months ended 30 September 2019 exceeded both the comparable period in 2018 and the forecast it provided the Listing Department as part of its application for listing. This level of performance was expected to continue during its current financial year. The Listing Review Committee was reassured that the Company had sustained its revenues and profits over the period since its initial application for listing was made in November 2018.
 
33. The Listing Review Committee was accordingly satisfied that the Company had demonstrated its commercial rationale for listing. However, the Listing Review Committee had concerns about certain matters in the Company’s draft prospectus which did not form part of the basis on which the Listing Department had recommended rejection of the Company’s application. These included concerns that the cash generation of the Company on a consolidated basis had lagged behind its stated profitability. This was particularly evident in the decline in contract liabilities and the increase in the amount of contract assets during the Track Record Period. The Listing Review Committee also had questions as to how certain loans from directors and dividend payments to companies controlled by them related to each other. Unfortunately, the Company was not well prepared to answer these questions and its sponsor and auditor provided the Company little, if any, assistance on these matters at the hearing, so questions remained on how the Company has been financing its business during the Track Record Period.
 
34. For the reasons set out above, the Listing Review Committee decided to permit the Company to continue its application for listing. This will also give the Listing Department an opportunity to assess in greater detail the current tender for a contract as main contractor which, if successfully completed, may enable the Company to achieve a licence upgrade, and to consider with the Company the concerns expressed above.
 
Decision
 
35. For the reasons summarised above, the Listing Review Committee decided to overturn the decision of the Listing Committee and to permit the Company to continue its application for listing.
 
Please note that decisions of the Listing Review Committee do not represent binding precedents, and do not constrain the discretion of or otherwise bind the Exchange or other committees (including without limitation the Listing Review Committee in respect of other matters).