Screening our Calls

In this in-depth article, with an accompanying analysis of Pacific Century CyberWorks' hectic sequence of equity fundings and portfolio of acquisitions, we give our latest valuation. To the London board of Cable & Wireless we say: if PCCW is offering you paper, don't pick up the phone.

Screening Our Calls
15th February 2000

Pacific Century CyberWorks (PCCW) has made an audacious approach to Cable & Wireless plc, proposing a merger with its HK-listed subsidiary Cable & Wireless HKT. Any transaction would likely involve the issue of vast amounts of over-valued shares in PCCW, either in exchange or to fund the acquisition. How over-valued? Read this article to find out. We've gathered all the information on PCCW's nine months of hectic existence and presented it on this site. NOW that's what we call content!

PCCW has yet to publish any full-year results since it was taken over by Richard Li's Pacific Century Group, but Webb-site.com has pieced together the hyper-active company's transactions since the takeover, and you can read our detailed description of PCCW's investment portfolio by clicking here.

How much cash do they have?

Since May last year, PCCW has conducted 5 placings (including yesterday's) and raised a total of US$2,377m net of expenses. A summary of these transactions can be found here. Of the announced investments made by the company, in some cases the consideration has not been disclosed. We can assume these are relatively minor, perhaps absorbing up to US$100m. Investments with disclosed cash investments total US$273m, so we estimate that the company has spent a total of US$373m on investments.

In addition, various share swaps for acquisitions and investments have been conducted, of which by far the largest in dollar terms was the swap with CMGI, a Nasdaq-listed internet company.

So PCCW probably has a cash pile of about US$2bn. However, in its various placing announcements, US$378m was earmarked for its CMGI Asia joint venture, and US$289m to develop the broadband satellite venture, Pacific Convergence Corp. So take that away and the company has about US$1.3bn of uncommitted cash. We are assuming here that spending on the Cyber-port construction to date has been minimal and is covered by rental and sales of the company's office property in Beijing.

At the current market price, C&W HKT is valued at US$38bn, so US$1.3bn would barely scratch the surface - they could buy 3.4% with that. PCCW's net assets, which we evaluate below, consist of a Beijing Property and a collection of mostly over-valued zero-dividend internet investments. So there is relatively little cashflow or asset base against which to secure loans. Hence only a reckless banker is going to lend them the cash to make the bid alone.

That means that any major involvement in a merger or even an acquisition consortium would probably involve the further issue of PCCW shares. The only other alternatives would be to reach agreements to pre-sell or demerge the businesses of C&W HKT to reduce the size of the target, or to use issue junk bonds.

How big is PCCW really?

When PCCW acquired 60% of Pacific Convergence Corp (PCC) from Richard Li's private company, it granted an option to Intel to sell it the other 40% of PCC in exchange for 1,003m shares of PCCW. If the option is not exercised within 10 years then PCCW can require it to be exercised, so it is effectively a forward sale of the stake and we can assume that it will be exercised by one party or the other.

In May-99, in part consideration for the reversal of PCG's Beijing property into PCCW, the latter issued convertible bonds with a face value of HK$960m which convert at $0.31 per share and are therefore almost certain to convert before expiry, since they are now worth 85 times more as marketable shares than they are as bonds. Some of them have already converted, and we will assume that all do.

Taking into account the shares to be issued when the Intel Option converts, together with the shares from the outstanding convertible bonds, there will be about 13.5bn shares in issue. There are also an undisclosed number of executive share options outstanding, so we will ignore these.

Today's closing price of HK$26.35 then values PCCW at about HK$356bn (US$45.6bn). Investment bank analysts have been competing with ever higher estimates of value. Merrill Lynch in January put a price of HK$25 per share on the stock, only to be out-done by Lehman in February at HK$35 (which values PCCW at US$61bn on a fully diluted basis).

What are the net assets?

After PCCW's acquisition of PCC it had pro forma net assets of HK$2,290m (US$294m), but assuming conversion of the outstanding convertible bonds, this increases the net asset value to HK$3,250m (US$418m).

Since then, there have been 4 placings which raised HK$17,776m (US$2,285m) of net cash proceeds.

PCCW's controlling shareholder, Richard Li, was recently quoted in Jan-00 as saying that stated that PCCW had seen paper gains of some US$1.3bn on its investment portfolio so far. However, that comes mostly from investments in other internet bubble stocks.

For example, when Japanese cellphone retailer Hikari Tsushin took over HK-listed battery maker Golden Power, PCCW also took a 20% stake at the same time. It subscribed 233.4m Golden Power shares at HK$0.90 per share, and the shares are now trading at $18.55, giving a paper profit of $4,120m (US$529m). This is despite the fact that Golden Power has yet to demonstrate any internet strategy.

PCCW has about 8.12m shares in CMGI which have almost tripled in value since the September deal, and are now worth about US$937m (unless it has sold any) based on the market price of US$115.5. That gives a book profit of US$587m. So the Golden Power and CMGI stakes together account for an unrealised gain of about US$1,116m.

If we take the company's figure of US$1.3bn of gains, plus US$350m for the CMGI share swap, then this adds about US$1,650m to the asset value. We are ignoring any discount (which in some cases could be substantial) if the company attempts to liquidate the holdings.

So with the placings, the gains in the investment portfolio and the CMGI share swap, the pro forma net assets of PCCW are about US$4.35bn (HK$33.8bn). To this we add our previous estimate of the future profits from the Cyber-port property development of HK$9.3bn (US$1.2bn), bringing the total value to HK$43.1bn (US$5.54bn), or around HK$3.20 per share. Next, we have to evaluate Pacific Century Convergence Corp.

Pie in the sky

A lot of the hype surrounding PCCW relates to its planned broadband satellite network to be operated by its subsidiary Pacific Convergence Corp (PCC) covering "110m Asian cable households in 63 countries" under the leased satellite footprint. Let's put that in perspective.

PCC is still very much under development. PCC started as a 60:40 joint venture between Richard Li's private company (PCG) and Intel. According to the accountant's report issued when PCCW acquired PCC, the combined capital injection of the two shareholders into PCC by Jun-99 was only US$16.2m. Much expenditure, risk and development lies ahead of it. We'll describe some of the key risks here.

Regulatory hurdles

It is still difficult for foreign companies (and that includes HK companies) to do business in the telecommunications sector of many Asian countries, including mainland China. It will remain difficult for some time. Would-be operators who skirt the ownership restrictions in various countries by entering into "consultancy" arrangements, even with government controlled entities, run the risk of the government changing its mind when it suits its purpose and canceling contracts.

For example, this happened with China Unicom's so-called CCF (China-China-Foreign) joint ventures to operate cellphone networks. Foreign partners formed local joint ventures which in turn provided services to China Unicom. The foreigners committed capital and resources, took operational risks and were then told, as business was booming, that their contracts were illegal and void. China has basically taken the BOT (Build-Operate-Transfer) model and turned it into the BOC (Build-Operate-Confiscate) model.

WTO and the continuing progress of international deregulation will gradually reduce this problem across the Asia region, but it will take time. And with deregulation comes competition.

Competition

PCCW will not have the Asian broadband market to itself. Even before foreign-investment deregulation, domestic telecoms operators are already competing on their home turf to provide broadband connections between each country's major cities. And in cities, fixed line telecom operators (through DSL lines) and wireless local-loop providers will compete with cable TV companies to provide broadband access.

Similarly, the know-how for converting cable TV networks to 2-way broadband networks is no secret and there will be plenty of companies seeking to work on these installations. A cable TV operator in an Asian town will be able to contract-out a suitable solution. The companies who make the hardware, will be the value-adders in this process.

When that cable TV operator seeks to connect his new 2-way network to the internet, there will be multiple choices from both fibre optic and satellite networks. These capacity providers will largely compete on price to provide data capacity, the same way airlines and shipping companies compete for traffic. Shifting binary data from A to B (or B to C) is not the kind of product that gives much scope for differentiation. So competition to provide a utilitarian product will attract utility rates of investment returns - low and unexciting.

As an aside, if you think international call costs have hit bottom, think again. Costs are coming down so fast that in the next few years, companies will begin to offer unlimited international voice calls (to major destinations, not Antarctica) on a per-line basis for a fixed monthly fee.

But what about that 110m customer base? Well remember that the subscriber's main relationship is with the cable TV company, not the firm that provides the bandwidth to the internet. If the cable TV company gets a better offer to provide bandwidth between its network and the internet, then it is likely to take it. Once this competition develops, contracts to provide that bandwidth are likely to be fairly short. So don't expect PCC to wind up with 110m customers. Think of their customers as cable TV companies, which will be numbered in the thousands. The question then is how much will a cable TV company pay for the bandwidth and separately, for any content that PCC might own.

Content

When you decide to watch a movie on TV, you are not really that concerned about whether it comes to you by terrestrial TV, cable or satellite. Your choice of channel is mainly determined by what you want to see and when it is showing. That is, you want the content. Bandwidth is a commodity, but content is unique. The whole beauty of the internet is that it brings content to people. Once cable TV companies provide internet connectivity, their customers will be concerned about what content that brings them.

Here, PCCW has made a start in licensing content from groups such as IMG (the sports marketing people) for its proposed channel "Network of the World". But the key word here is licensing - they don't own it. PCCW is way behind people like Newscorp with its Fox Studios and newspapers, or Time Warner with all its magazines, record labels and Warner Brothers studios. And remember that a key aspect of the internet is that it gives content providers direct reach to end-users. For example, PCCW's content provider IMG already has an on-line presence at Sports.com, accessible from anywhere on the internet. Another example of direct content provision is Webb-site.com. You will not pay your ISP much of a premium to reach this site when it is available throughout the web.

As the market develops, content will be king. To acquire serious content providers takes serious money (or vendors who are willing to accept over-valued shares). PCCW has barely started to do this, and you cannot value what you do not have.

Valuation

Let's assume that end users are willing, in the very long run, to pay an extra US$10-20 per month for broadband access to the internet from their local cable provider. In poorer parts of Asia, traditional cable TV tends to come very cheaply, so this cost will be a lot to absorb.

Then assume that this commodity service has an operating profit margin of 10%, split 50:50 between cable TV companies and their broadband connection provider. That leaves us with profits of US$0.50-1.00 per month, or US$6-12 per year. Apply a profit multiple of around 10x to that, and you have a value of US$60-120 per end-user. Next, suppose that of the 110m homes on cable TV, the broadband market leader (which may or may not be PCC) gets 10% of them to use its cable-based system, as opposed to other access methods such as DSL or wireless. So we might be taking about 11m end-users worth US$60-120 each to the broadband provider, or a US$0.66-1.32bn of valuation.

Given all the above risks, but allowing for at least some possibility of success on a major scale, for a company which has barely let the ink dry on its business plan, we would have trouble attaching a valuation of more than US$2bn to PCC in its present state.

Value per share

So take our estimated net assets (including investment gains and future Cyber-port profits) of US$5.54bn, and add a maximum of US$2bn for PCC. That gives you a valuation of US$7.5bn (HK$58bn) or around HK$4.30 per share on a fully diluted basis. That implies that PCCW, on a market price of $26.35, is currently over-valued by a factor of around 6x.

A word on Equity Spirals

Hong Kong has been hit by repeated epidemics of investor mania and never seems to learn. We had red chips in 1993 and again in 1997, and now we have internet stock mania, jet-fresh from the USA.

PCCW has indeed been able to "create value" for early-round investors by sucking in later investors or company vendors at higher prices per share. That is how what we call "equity spirals" work.

We don't blame PCCW or other companies for using an over-valued share price to raise cash and make acquisitions - when your shares are over-valued, it is the rational thing to do and a lot of companies are doing the same thing. We certainly would. But when the last willing investor has bought in, and the last willing vendor has accepted the paper, then suddenly the Emperor's clothes will seem as transparent as the day he was born.

In this sense, equity spirals are little different from what bankers call "Ponzi schemes" which promise artificially high-interest returns and fulfill this promise to early depositors by paying them off with later depositors' money, until the number of withdrawals becomes impossible to meet from fresh deposits. The same mechanism is at work in the internet stock bubble.

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