End Game for PCCW
21 September 2000
OK, we can't hold it any longer - that overwhelming desire to say "we told you so" sometimes gets the better of us. The market is finally reverting to rational analysis and beginning to recognise how much PCCW has in common with British Telecom - both are former monopoly utility companies, both adapting to the internet age, both with media interests, and both highly indebted.
Back on 15-Feb-00, soon after news first surfaced that Pacific Century Cyberworks Ltd (PCCW) was attempting to buy Cable & Wireless HKT Ltd (HKT), we wrote an article entitled Screening our Calls urging Cable & Wireless plc to ignore the approach, which was bound to involved an offer of PCCW's massively over-valued shares.
That day, PCCW shares closed at HK$26.35, which turns out to be their record high, the day after a placing of 335m new shares at $23.50 - hands up all fund managers who bought that one! At that time we valued PCCW (pre-merger) at just $4.35. The merger would increase that to $6.05, as we estimated in our article on 13-Apr-00.
Our valuation has not been revised since then. Although the value of PCCW's internet holdings has fallen further, the outlook for the residential property market has improved slightly, and lets remember that the Cyberport is 75% residential and the relatively small office component has to be handed back to the government anyway. So we call it even and stick to a $6 valuation for PCCW.
In our 15-Feb article, written at the height of internet mania, we wrote about equity spirals and PCCW:
"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.
... 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."
That day has surely come, with the stock closing today at $9.05 and showing every sign of reaching our valuation. Remember, including outstanding options, there will be about 22.5bn shares in issue, so every HK$1 change in the share price means about US$2.9bn of market value. That means the company is still over-valued by about US$9bn.
What were they thinking?
Did Cable & Wireless plc (C&W) really think they could get away with selling HKT and avoid being stuck with a huge pile of bubble paper when the music stopped? This shows questionable judgement to say the least.
Recall that PCCW made two different offers for HKT - the "Share Offer" and the "Combination Offer" - a mixture of cash and shares. Based on today's closing PCCW price of $9.05, the Share offer was only worth $9.96 per HKT share, while the Combination Offer (which nearly everyone took) was worth $13.67 per HKT share. That's a 23% discount to the HKT share price of $17.65 on 10-Feb-00, the last day before PCCW announced that it might acquire an interest in HKT. In effect, C&W has sold HKT for a knock-down price which may yet decline further.
But originally, when the offer was announced, PCCW was at $22.15. PCCW was only prepared to pay US$11.3bn in cash, so the deal was structured so that the Share Offer was worth more than the Combination Offer. C&W was to opt for the lower offer in order to get as much of the fixed amount of cash as possible, hoping that everyone else would go for the higher Share Offer. The plan provided for C&W to end up with only 11.2% of PCCW, then place 4% of it in the market and swap 1% of it for new shares in CMGI, leaving them with only 6.2%. They were even offering to sell the new PCCW shares back to the other HKT shareholders at $18.62 per share.
How naive. The bubble burst, and C&W was left holding not 11.2% but 21.4% of PCCW. They then swapped about 1.2% for new shares in CMGI.
Yesterday's placing of 4.9% of PCCW at $9.88 per share has barely dented the overhang as C&W still has a stake of 15.3% in PCCW, almost three quarters of what they started with. They will be free to sell another 7.65% from about 22-Feb-01 (which is six months after dealings in the new shares commenced) while the rest is released after a further 6 months. Mark those dates in your diary.
In our article Decision Time on 9-Jun-00, we warned about the large overhang of stock that would hit the market after the deal completed and wrote:
"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."
We hope they took our advice. At least the board of PCCW was aware of this problem. On 8-Aug-00, before the HKT takeover was completed, PCCW Chairman Richard Li's private company sold 240m shares at $15.811. He did make a couple of small repurchases totaling 10.5m shares over the next 2 days, but the net result is that he sold 229.5m shares for $3.62bn (US$464m) at an average price of $15.78 excluding expenses. That's 74% more than today's closing price.
Then after the deal was completed, several directors exercised part of their share options and sold some of their shares to cash in their gains. The largest of these was Francis Yuen Tin-fan, Deputy Chairman, who exercised 21.33m options at $2.356 and sold 8m of the resulting shares at an average of $15.325, raising (net of the subscription price) HK$72.35m in cash. The options exercised represented two-thirds of the original grant of 32m options. Mr Yuen has apparently decided to go from "clicks to bricks" - yesterday's SCMP quoted sources as saying that he has purchased the former Peak residence of the Belgian Consul-General for HK$190m (US$24.4m).
A new round of PCCW options was recently granted with an exercise price of $12.024 and an exercise period of 9 years from 26-Aug-01. The largest grant was to Francis Yuen, who gets 32m options. PCCW's Managing Director, Alex Arena, gets 16m.
HMTF Convertible Gone?
When the takeover of HKT was originally announced, it was stated that CMGI would issue new shares in exchange for US$500m of the PCCW shares which C&W would receive. This duly happened on 29-Aug-00, and C&W received 4.3% of CMGI at US$37.275 per share, while valuing the PCCW shares at about HK$16.18. C&W is locked into CMGI for 6 months and must hold half the stake for a further six months.
Conditional on that share swap, and subject to the takeover of HKT being completed, a company called HMTF PCCW Investors LLC, which is an affiliate of Texas-based investment group Hicks Muse Tate and Furst Inc., agreed to subscribe US$500m in convertible securities of PCCW. All this was part of the leap-day takeover announcement of HKT.
The next day, PCCW, CMGI and HMTF announced they would each invest up to US$500m to form "@Ventures Global Partners" which would support the development of Internet companies based in Asia, Europe, and the Americas. Two days later, the PR volume was increased with a further announcement of a "Global Media Convergence Alliance" between the three partners. However, on 7-Sep-00 CMGI announced a restructuring and at the same time said:
"CMGI, Hicks, Muse, Tate & Furst (HMTF) and PCCW have agreed not to move forward with the establishment of a separate international venture fund as previously announced, preferring a more flexible model for co-investment."
PCCW has not made any formal announcement about this, leaving the proposed issue to HMTF of US$500m convertible preference shares under some doubt. Although PCCW claimed in the HKT offer document that the US$500m funding would help reduce its debt burden, we suspect the issue was conditional on PCCW putting the same amount into the venture fund. It is high time that PCCW announced whether the US$500m funding deal is on or off.
Telstra Convertible to be repriced again?
Some four months after the original 12-Apr-00 Memorandum of Understanding, PCCW updated us with an announcement on 24-Aug-00 that "agreement in principle" had been reached with Telstra.
The proposed deal includes the issue by PCCW of a US$1.5bn convertible loan note to Telstra. The debt will bear interest at 3% per annum and was to be convertible at HK$23.69 per share, being 120% of the volume-weighted average price up to and including the date of the MoU.
However, in the 24-Aug-00 announcement, the conversion price was described only as:
"120% of the volume weighted average market closing price for the sales of the Issuer's ordinary shares listed on the Stock Exchange over the 30 trading days prior to public announcement
How coy. What "public announcement" could that be? We thought we'd check the Telstra announcement filed with the Australian Stock Exchange, but this was even less helpful:
"A full copy of this announcement, which includes Convertible Bonds Key Terms Outline, is available for purchase from ASX Customer Service on 1 300 300 279. Charges apply."
It is quite outrageous that a first-world stock exchange makes information available on such a selective basis. It is not clear whether Telstra has any control over which portions of the announcement are held to ransom by the exchange.
Anyway, we got to the bottom of this and it emerged that "public announcement" meant the one you were looking at and the conversion price had in fact been cut by 18% to HK$19.52, being 120% of the 30-day average price up to that time.
Now the share price has fallen to $9.05, leaving the conversion price high and dry at 116% above the market. To get back to the conversion price, the market value of PCCW would have to rise by some US$30bn. That makes the bond look like a soft loan and makes Telstra look like the World Bank. So they will come under heavy pressure to lower the conversion price again and increase the stake in PCCW that they will be entitled to.
None of the proposed deals with Telstra have been signed, so legally speaking, everything is still on the table and Telstra could still walk away.
Missed Targets
A pungent smell of toasted research reports fills the air. Merrill Lynch in Jan-00 set a target of HK$25 on this stock, while in Feb-00 the guys at Lehman outdid them with a target of $35.
Taking account of the HKT deal, HSBC (a lender to PCCW) set a value of $21.54 on the stock (SCMP, 26-Jul-00) while Lehman came back with a new analyst and a "near-term" target of $22 (SCMP, 30-Jul-00). Prudential Bache gives it a fair value of $24 (SCMP, 28-Jul-00). UBS Warburg (adviser to PCCW) put it at $24 on 29-Aug-00 and SG Securities topped the list in a 14-Jul report with a target of $32.
Mingling with the smell of toasted research is that of toasted warrants. On the back of research like this, there has been a whole raft of covered warrants every time the price fell and the last batch of warrants went out-of-the-money. Hong Kong's gambling public keep coming back for more pain in the hope that this time, their warrants won't expire worthless.
The warrant issuers (normally investment banks like CLSA, CSFB, Macquarie and SG), some of whom also publish that optimistic research, love this because the retail investors will nearly always pay a lot more than the theoretical value of an option, allowing the banks to create or purchase the options and lock in a profit. As a result, we see a brief price surge after each major share price decline, while warrant issuers buy up stock to hedge the warrant issue, and then unwind it as the price falls again. The smart investor has been selling stock to the warrant issuers.
End Game
Webb-site.com never set out to be a stock picker or to cover a company in this depth for so long. As regular readers know, the site is primarily about corporate and economic governance, and their are plenty of other places on the net for investment tips.
We initially wrote about the Cyberport only because it represented poor economic governance - the granting by Government of a huge property development to a single party without a tender. Without the Cyberport, Tricom may never have been transformed into PCCW. Just over a year ago, that was all it was about - that and a property in Beijing injected by Pacific Century Regional Developments into PCCW.
In turn, we have written extensively about PCCW only because it represented a classic example of a speculative bubble and the way in which public perception can be manipulated in such a wholesale fashion to build vast wealth at the expense of others. It has been fun being the little boy who shouts that the Emperor had no clothes while the rest of the market marvels at the costume. The great names of investment banking played their part and the market (and C&W) bought the story lock, stock and barrel.
It was financial engineering at its very best and worst, but it appears that the game is over. In future, PCCW will have to pay a fair price for its funding.
© Webb-site.com, 2000
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