Decision Time

As the shareholder meetings of C&W and HKT draw nearer, we take a look at the details of the takeover document. If you are an HKT shareholder, watch out for a sting in the offer alternatives. If you are a C&W shareholder, consider the real value of the huge PCCW stake your company will be getting. We also review the debt burden PCCW will be under and find a few surprises in the offer document.

Decision Time
9th June 2000

The company that has generated the highest share of media coverage in the last year in Hong Kong is Pacific Century Cyberworks (PCCW). No wonder then that it has occupied a proportionate share of our coverage. We are almost bored with speaking to the media about it, as one of the very few commentators who offer an alternative view to the many investment banks who have promoted and distributed the stock. We also broke the story on the Star TV joint venture agreement with HKT, and correctly predicted that it would collapse (Word format).

Now it is time for shareholders of Cable & Wireless plc (C&W) and C&W HKT to decide on the takeover offer, at their meetings on 13-Jun-00 and 3-Jul-00 respectively.

The Sting in the Offer

If you are an HKT shareholder, watch out. We have already explained how you can make your vote count by getting onto the shareholders' register and becoming a "member" of the company. But let's assume you don't bother, and that the scheme is approved.

You (or more likely, your broker or custodian) will receive a "Form of Election" which allows you to choose between the Share Alternative and the "Combination Alternative". Kind of like the rock and the hard place. There is also something called the "Mix and Match" (in other words, a bit of each) but you can in most cases safely ignore that because it will only make financial sense to go for one of the two alternatives, depending on the PCCW share price.

As we explained back in March, all that you need to know is that if the PCCW share price is less than HK$18.62 per share (as it has been since 31-Mar-00), then the Combination Alternative is worth more than the Share Alternative. If you elect for the Combination Alternative, then you should also make the "Increased Cash Election" in respect of all your holding. This allows you to effectively swap some of your new PCCW shares for cash at HK$18.62 per share, at the expense of those who take the Share Alternative. So you'll get fewer of those shares and more cash. That is exactly what C&W, which owns 54% of HKT, has undertaken to do (subject to its shareholders' approval of the sale).

But here's the sting: the offer has been structured so that those shareholders who do nothing will automatically get the Share Alternative.

Based on yesterday's closing price of HK$14.70 per PCCW share, the combination alternative is worth HK$17.69 per share but the all-share offer is worth only HK$16.17. So wake up and smell the offer - or you will suffer an 8.6% loss. If you snooze, you lose - and C&W (and anyone else who makes the Increased Cash Election) benefits by getting more cash and fewer shares.

The deadline for returning the Form of Election is 4pm on 8-Aug-00 (or such later time as may be announced). Your broker or custodian may set a slightly earlier deadline. You do not have to (and should not) return the Form of Election with your voting instructions for the Court Meeting of HKT which takes place on 3-Jul-00. We say "should not" because you do not know what the PCCW share price will do between now and 8-Aug. You should delay making that decision until the latest possible time, but don't forget it!

Increased placing size by C&W

With its 6,592m shares in HKT, C&W can expect to receive up to 4,691m shares in PCCW (assuming everyone logically elects for the Combination Alternative) worth US$8.84bn at yesterday's price and giving C&W 22.2% of PCCW. They plan to swap US$0.5bn of that for new shares in CMGI (some people never learn).

In the original 29-Feb-00 announcement (back when PCCW was riding high at $22.15), it was stated that C&W intended to sell "approximately 4%" of PCCW's enlarged issued share capital as soon as practicable after the merger. The merger document reveals that this has quietly been increased to 4.9% of PCCW, by means of a "supplemental letter agreement" dated 26-May-00, the same day as the merger document went out. It may not sound like much, but 0.9% of the company will be about 190m shares. That's an extra US$358m of stock to hit the market, raising the total placing size to about 1,037m shares, or US$1.95bn at current prices.

Furthermore, the placing size can be increased subject to the agreement of PCCW "not to be unreasonably withheld or delayed". The residual holding of C&W could be as much as US$6.39bn. They've undertaken not to sell that for 6 months after the deal completes, but then they can sell another 50% (US$3.2bn) in the next 6 months. China Telecom, which owns around 11.3% of HKT, is also not regarded as a long-term holder. They will get 934m shares in PCCW worth US$1.76bn. Finally, the Government of HK owns around 8% of HKT and they have stated their intention to sell down most of the stock they bought in Aug-98.

HKT's public shareholders may do well to jump the gun in this race, and take the cash in the market before the merger completes.

The Investment Portfolio

PCCW's meteoric investment portfolio has, like all good meteors, been burning up as it descends through the stratosphere. Only a few charred remains will be left when it hits the ground (or as chartists would say, "forms a bottom"). Here we take a look at the principal listed investments.

CMGI

PCCW's largest investment to date has been a share swap with CMGI in which PCCW received 8,115,942 shares in CMGI (split adjusted). That deal was done at an effective US$43.13 per share, putting a book value of $350m on the stock. The shares soared to a high of $163.50, and at PCCW's last accounting date of 31-Mar-00, the shares closed at $113.31 and the stake was worth US$920m, accounting for 85% of the market value of PCCW's long-term investment securities at 31-Mar-00.

The shares closed yesterday at $60.44, valuing the stake at US$491m, so they have lost $429m, or 47% in market value since the end of March.

On the other side of the swap, CMGI received PCCW shares at HK$6.05 per share, which are worth US$846m at yesterday's close.

SoftNet Systems

Another investment was a cash subscription of US$128.8m in 5m shares in Nasdaq-listed SoftNet Systems, Inc at US$25.75 per share. At PCCW's 31-Mar-00 period end, the shares closed at $29.25 and the stake was worth $146m.

Softnet's shares closed yesterday at $13.375, valuing the stake at US$67m, so they have lost $79m, or 54% in market value since the end of March.

Hikari Tsushin International

PCCW subscribed for 933.6m shares at HK$0.225 per share of Hikari Tsushin International (HTI, formerly Golden Power) for a 20% stake alongside Japanese bubble stock Hikari Tsushin, which took 51%. The shares shot up and reached $5.05 on 14-Feb-00 (the day the subscription was approved by shareholders) and have now crashed 90% to $0.51 at yesterday's close.

At PCCW's 31-Mar-00 period end, the shares closed at $1.81 and their stake was worth US$217m. At yesterday's close the stake was worth just US$61m, a loss of US$156m or 72% since the period end. HTI is accounted for as an associate of PCCW rather than an investment.

As you can see from the web site, HTI has done almost nothing since the takeover and is still just a battery maker with a pile of cash. Given the problems faced by its Japanese parent, there must be a fair chance that we shall see another change of control of HTI - perhaps PCCW will buy Hikari Tsushin's 51% stake in HTI, and use the company as a shell for one of its spin-offs.

Meanwhile in Japan, things are even worse. In support of the hypothesis that investment skills are not always inherited, on 10-Feb-00 PCCW Chairman Richard Li swapped US$1bn of existing shares in PCCW (then trading at HK$23.40) for US$1bn worth of stock in Hikari Tsushin, then trading at Y213,000. Now they are about Y5,400, down about 97.4%, and Li's billion has shrunk to about US$26m. Let's be thankful he didn't make that investment through PCCW.

Tom.com

PCCW subscribed for 121m shares in Tom.com at HK$1.07 per share prior to its IPO, for a total cost of US$16.6m. At 31-Mar-00 Tom.com closed at $10.80, valuing the stake at US$168m.

The shares closed yesterday at HK$5.90, valuing the stake at US$92m, so they have lost $76m, or 45% in market value since the end of March. PCCW has undertaken not to sell the shares before 1-Sep-00.

Summary

Since 31-Mar-00, the market value of PCCW's 4 biggest listed holdings has fallen by US$740m, or about 51%, from US$1,451m to US$711m.

Is the SoftNet Systems stake for sale?

It is interesting to note that, under HK accounting standards, there are now two categories of investments held by PCCW. These are "Investment Securities" meaning securities "intended to be held on a continuing basis" (these used to be known as long term investments), and "Other Investments" which is everything else. Investment Securities are held at cost less any provision for impairment, whereas Other Investments are carried at fair value (in other words, market value if they are listed).

"Other Investments" at 31-Mar-00 included only HK$5.5m of HK-listed stock at market value, so we can infer that Tom.com is held as an "Investment Security". This plus the value of the CMGI stake add up almost exactly to the quoted market value of listed stocks held as (long-term) "Investment Securities", which implies that the stake in SoftNet is held under "Other Investments". Other Investments listed overseas had a market value of HK$1.15bn (US$148m) which almost matches the value of the SoftNet stake.

It would seem that the stake of some 18% in SoftNet does not qualify as "intended to be held on a continuing basis". That is surprising given that the two companies are supposed to be working together on helping Asian cable TV stations to upgrade their networks to broadband satellite-based connectivity as described in this press release.

Since the bulk of such investment appears to be in SoftNet, that wording would imply that PCCW has bought a put option (to limit its downside) and sold a call option (which limits the upside) on at least part of the stake. The options would have different strike prices (the put being lower than the call price). This theory is supported by the fact that between 31-Mar and 5-May, the value of the SoftNet stake fell by about HK$646m, but the decline in the value of "other investments" as stated in the accounts was only HK$218m, presumably offset by the hedge.

It hardly shows confidence in SoftNet if PCCW has chosen to forego its potential gains on the stock in return for downside protection. We wonder who sold the put option and bought the call option from PCCW, and whether they have hedged their position by shorting the SoftNet stock.

As collateral for these derivatives, PCCW has pledged the shares of a subsidiary which holds investments with a carrying value of US$408m - so large that it must include the stake in CMGI and some other investments.

Expenses

The takeover document discloses that the estimated expenses of the deal (mostly on a multitude of financial advisers, lawyers and accountants as well as printing) will amount to a huge US$130m.

But wait - that figure excludes the fees relating to the US$12bn loan facility. According to the Facility Agreement seen by Webb-site.com, the loan also carries a "standby fee" of 0.1% per month (currently US$12m per month) from the end of February until the loan is drawn down around 15-Aug-00. Call that another US$66m. The reported underwriting fee of 0.35% and the front-end fee of 0.70% adds another US$126m.

Pretty soon it starts to add up to real money - some US$322m in fees and expenses, before you even start to pay interest.

That Gearing

The US$12bn loan is reported to carry an interest margin of 1.15% above LIBOR (the London interbank rate) which is currently about 6.2%. So they'll be paying interest at a rate of 7.35%, or around US$882m per annum until the loan is reduced.

Bankers will look at it as an "all-in" yield (including fees) of 2.20% above LIBOR, 8.4%, and that's the kind of cost of money you can expect when PCCW comes back to the debt market to refinance the loan, or perhaps a little less if they can complete various issues of subordinated convertible debt to reduce the bank risk.

Perhaps the weakest aspect of the merged PCCW-HKT will be the amount of debt it has to carry. In recent statements, Linus Cheung, HKT's CEO, has flip-flopped on whether the company will be willing to sell off controlling stakes in HKT's businesses, but it seems certain that they will at least have to sell minority stakes or other assets to pay back the debt.

At 31-Mar-00 PCCW had cash of about US$1.75bn and short-term bank loans and bank debt of about US$100m. At the same time, HKT had cash of about US$2.46bn and bank debt of about US$300m. The final dividend of HKT will absorb U$702m, and the payout under the takeover will absorb US$11.32bn. Expenses of the takeover will absorb another US$322m (see above).

PCCW has also previously "earmarked" about HK$2,945m (US$378m) of its cash for investment in joint ventures with CMGI in Asia, out of the proceeds of a placing conducted on 25-Jan-00. If that money is still set aside, then that increases net debt to $8.91bn.

That figure almost exactly matches the US$9bn "Tranche B" of the US$12bn loan facility PCCW has obtained. That facility expires on 28-Feb-01 and only 30% of it can be extended.

It then becomes crucial that PCCW's memorandum of understanding with Telstra actually proceeds. PCCW will borrow US$1.5bn from Telstra in the form of a convertible note, which can be used to repay part of the bank loan. It will also sell a 40% interest in the mobile phone business of HKT to Telstra for a further US$1.5bn.

That should take the bank debt temporarily down to US$6bn. But we haven't begun to talk about the cost of building the satellite broadband network or investing in third generation mobile network. The company may also have to bid for its 3G license (see today's other story). And not to mention the US1.5bn cost of building the Cyberport - whoops, we just did.

The Telstra note has a conversion price of HK$23.69 per share, and we would be surprised to see the shares trading above that level when the loan note comes up for its first (50%) redemption in 4 years' time. That price would value the company (post-HKT) at US$67bn. So think of the loan note as debt.

Hang Seng Index

It seems near certain that HKT will be replaced in the 33-stock Hang Seng Index by PCCW, so the market should already have factored that into the price. You can expect that announcement just as soon as the merger is approved. However, most fund managers do not track the HSI, but use other more representative indices such as the MSCI series. PCCW is already in the MSCI index, with a 50% market weighting. Expect that to go up to 100% after C&W has finished dumping the stock to increase the free float.

The only major fund which is known to track the HSI is the Tracker Fund, and that is not large enough to have a sustained effect on the price. Part of its necessary holding in PCCW will come from its existing holding in HKT.

Valuation

A well known US investment bank (perhaps the only one that isn't advising on some aspect of the deal) has recently restated a price target of HK$35 on PCCW, implying a post-merger valuation of US$100bn. They made that a 12-month "strategic value" target back in January. Seven months to go guys...

We maintain our previous valuation of HK$6 per share (assuming the deal proceeds), valuing the company (post-HKT) at US$17bn. That includes $21.9bn for HKT, less the $11.3bn of cash to pay out on the takeover, for a net contribution of US$10.6bn. The other $6.4bn comes from PCCW's property assets, cash, investment portfolio and future profits from the Cyberport development, and US$2bn thrown in for the net present value of future profits from Network of the World.

That's really the only major subjective part of the valuation - do you think it is worth another US$83bn? Even yesterday's price of $14.70 implies a valuation of some US$27bn on NOW.

A Generous Gift

Never let it be said that Mr Li is not generous. On 30-Mar-00, while advisers were slaving away on the Scheme of Arrangement document, his Pacific Century Group Holdings Ltd transferred 11,275,000 shares in PCCW (then worth US$27m) to an undisclosed third party as a gift.

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Decision Time 9th June 2000