Behind the Telstra Deal
13 April 2000

PCCW yesterday announced a highly conditional Memorandum of Understanding with Telstra in which it has agreed to sell a 40% interest in something it doesn't yet own, the C&W HKT wireless business. The deal also includes a US$1.5bn convertible loan from Telstra.

The deal was billed as a "strategic alliance" but on closer inspection, the core of it is simply the HKT asset pre-sale. Telstra has only modest mobile investments in Asia, which would be contributed into the "Regional Mobile Company" (RMC) which would be 40% owned by Telstra and 60% by PCCW-HKT. Therefore the bulk of Telstra's 40% stake would be paid for by purchasing a stake in the JV for cash payable to PCCW-HKT, currently estimated to be US$1.5bn. This money will then be used to pay down part of the US$12bn of debt which PCCW will use to complete the merger with C&W HKT.

In addition, Telstra and HKT would pool their international submarine cable and related assets into a jointly held company. That's no great news because little if any cash will change hands. Most of the World's undersea cables are owned by consortia of multiple telephone companies which then lease capacity on those cables, so the "IP Backbone Company" will just be a pooling of such contractual interests along with some other hardware. Very few operators own entire major cables outright. To see what we mean, click here for information on the recent SEA-ME-WE3 cable consortium.

Other aspects of the announcement were just window dressing, for example, the forthcoming PCCW "Network of the World" channel will be made available to Australians. But that was always the case - it is on the internet, which anyone can access. Indeed it will have to be free, because Telstra is largely prohibited from being involved in pay-TV operations due to a non-compete arrangement with Foxtel, of which it owns 50%. The rest is 25% is owned by Kerry Packer's Publishing and Broadcasting Ltd and 25% by Murdoch's News Corp.

Another extraneous part of the deal was that they are going to "aggregate Australian HTML content for global distribution" which to us sounds like a search engine. And Australian content is already available globally - that's how the net works.

The entire Telstra/ PCCW deal is conditional, amongst many things, on completion of the acquisition of C&W HKT.

What does Telstra bring?

Apart from throwing cash at the deal, Telstra brings very little. The announcement was coy, saying only that "Telstra's mobile and wireless infrastructure and assets that are located outside Australia" would be included in the "Regional Mobile Company" (RMC).

In fact, Telstra's annual report (30-Jun-99) reveals that there were stakes in just two small mobile businesses. One of these is a 49%  interest in Modi Telstra Ltd, which was effectively 25% owned by Distacom (major shareholder of HK-listed Sunday) and 26% owned by Indian conglomerate Modicorp (the latter two stakes being jointly held to give Indian control). However, sources tell Webb-site.com that Telstra is in the process of selling its stake to the other shareholders, leaving it as a 51:49 Modicorp:Distacom joint venture. The operation (known as Mobile Net) had around 35,000 subscribers at the end of the 3rd quarter of 1999.

The remaining Asian mobile asset of Telstra is a 60% interest in Mobitel of Sri Lanka. The other 40% is owned by Sri Lanka Telecom, which is 61.5% owned by the government, 35% by NTT and 3.5% by employees. No information is available on that business, but we presume it is small as it is only gets a one-line mention in the Telstra annual report.

In order to count  RMC as a subsidiary (and so deny claims that it has sold control of the mobile business), PCCW will have a casting vote in the RMC boardroom and retain at least 50.1% of RMC. This gives them ultimate control, which means that Telstra is ultimately surrendering control of Mobitel.

Normally in joint ventures, neither party is allowed to transfer control of their stake without first offering it to the others. It remains to be seen whether the Sri Lankan Government will consent to a change in control of its mobile operator. 

C&W-HKT's mobile assets outside HK are not that great either. The only material business is an indirect 14.7% stake in Mobile One (Asia) Pte Ltd, which was the second mobile phone operator in Singapore. That is part of a 30% stake which is held by Great Eastern Telecommunications Ltd, a joint venture company which in turn is 51% owned by Cable & Wireless plc and 49% by C&W HKT. The rest of Mobile One is owned 35% by Keppel Group and 35% by Singapore Press Holdings. Last disclosed figures for subscribers were over 300,000, giving C&WHKT at least 44,000 attributable users. That's minor compared to the Hong Kong mobile business.

Valuation of HK Mobile Business

All in all, it's a fair assumption that the value of the stake in Mobile One and Mobitel roughly balance. We can only assume this, because amongst the many conditions of the deal is that it is conditional on each side "undertaking and being reasonably satisfied as to the results of due diligence and valuation" in relation to the others "assets and capabilities". In other words, the valuations are not yet agreed.

Assuming that these values of the Mobile One and Mobitel stakes are similar, then the US$1.5bn that Telstra will pay for its 40% interest in RMC is effectively the price of 40% of the Hong Kong mobile business. That values the whole thing at US$3.75bn for 920,000 customers, and implies a price per subscriber of US$4,076.

Subordinated Debt

Telstra has also agreed (again, conditional on many things, including the C&W HKT deal completing) to lend US$1.5bn to PCCW in the form of subordinated convertible loan notes. We say "lend" because many reports have taken this to be an investment in shares. That ain't necessarily so. The difference between you buying shares and Telstra buying convertibles is that if the PCCW shares go down, Telstra can demand its money back, but you, dear investor, cannot. So the loan is hardly an expression of confidence in PCCW's shares.

The loan note is convertible at Telstra's option at HK$23.69 per share (not, as widely reported, $19.74), a price at which PCCW shares only briefly traded before commencing their swan dive. Meanwhile they pay interest at 3% p.a. quarterly stepping up to 5% p.a. after 4 years. At Telstra's option, half the loan note can be redeemed after 4 years, and the rest after a further 2 years. PCCW can only force the note to convert after 4 years if the share price (averaged over 15 days) exceeds $28.43, or after 6 years if the share price (again averaged) exceeds $26.06.

The Telstra debt is what bankers like to call "subordinate" (they, on the other hand, are insubordinate). So it ranks behind the US$12bn loan advanced by Bank of China and colleagues for the C&W-HKT takeover. No wonder the ratings agencies have said that they are re-evaluating Telstra's credit rating.

The key thing to bear in mind here is that unless the PCCW share price ever gets back up above the conversion price (and stays there) then Telstra will want its money back.

The Internet Space...or Vacuum

Later in this article we will review our valuation of PCCW in the light of the collapsing share prices of PCCW's investment portfolio. Just 4 weeks ago, on 18-Mar-00, PCCW was crowing over US$1bn of paper gains on its portfolio as at 16-Mar-00.

Since then, CMGI has fallen 43% to US$70.4365 (at 12-Apr-00), wiping US$436m off PCCW's stake, Hikari Tsushin International has fallen 44% to HK$1.24 (at 13-Apr-00, split-adjusted), wiping US$118.8m off the stake, Softnet has fallen 49% to $16.6875 (at 12-Apr-00), wiping US$79.7m off the stake, and Tom.com has fallen only 29% to HK$7.85, wiping US$49.0m off the stake (way to go, Tom!). Add that all up, and PCCW's main listed portfolio has fallen by US$684m. Ah well, easy come, easy go....that reduces the US$1,026m of paper gains from a month ago to just US$342m.

For all Hikari's supposed internet expertise, the web site is still under the old Golden Power name.

Spare a thought for poor Richard though. Back on 11-Feb-00, in a deal tagged at US$1bn, Mr Li swapped 332,526,000 existing shares in PCCW (then trading at HK$23.40) for 510,200 existing shares in fellow bubble stock Hikari Tsushin Inc, with its Chairman Mr Yasumitsu Shigeta. Hikari's shares were valued at Y213,000 each but have since collapsed 85% to around Y32,000 (its difficult to tell, because they have been "limit down" for many days on the Tokyo Exchange - this figure is from overseas trade). Mr Li has a paper loss of around US$850m, whereas he would have lost only US$295m (29.5%) if he had kept the PCCW shares.

In its announcement of that swap, PCCW said in part:

"the two companies share similarities and complimentary strengths. Both companies place equal value on operations and investments to further their core activities..."

it continued

"in Japan, Hikari's reputation places it solidly at the forefront of the nation's IT revolution"

What a long time two months is in the internet space... or is that vacuum?

Valuation

If the C&W-HKT deal completes, PCCW will have a fully diluted capital of about 22.15bn shares. If the Telstra loan note converts, this will result in about 494m shares or about 2.2% of PCCW. Since this is a small increase in the capital, the effect of the conversion is to add only about HK$0.39 per share to the fair value of PCCW. And that will only happen if the share price reaches $23.69, so we can safely ignore that for now.

Accordingly we will treat the loan note as debt, and look at the 22.15bn shares in issue. Here's our sum of the parts valuation of PCCW, assuming the C&W-HKT deal does not complete:

The most subjective item in the above table is what you think the broadband satellite-based delivery network will be worth, and any value you attach to the future "Network of the World" channel. We think we're being generous here, since little of this has been built or paid for yet. See our previous analysis of this.

Now, if the C&W HKT deal does complete, we bring it in at our previous valuation of HK$14 per share (which is around 20x forward earnings), valuing C&W HKT at HK$170bn (US$21.9bn):

So the C&W-HKT merger, if it completes, will raise the fair value by 59% to HK$6.05 per share.

The closing price of HK$16.50 today values the enlarged PCCW-HKT at about US$47bn, which implies about US$30bn of air still in the bubble if you agree with our valuation of about US$17bn. The market value would have to rise to US$67bn in order for the Telstra subordinated loan note to convert.

Of course, some analysts will talk to you about the ability of PCCW to go on doing "value accreting transactions" but that just means issuing shares at over-valuation to buy things or raise cash. You can do that when you are small, but when you are a US$47bn company then it becomes almost impossible to find big enough targets to add much value to the shares, since you are averaging the acquired value over such a large base of existing shares. The game no longer works.

Jumping the Gun

Referring to the Scheme of Arrangement to be put to C&W-HKT's shareholders, in its latest announcement PCCW says:

"Cable & Wireless plc, which owns approximately 54% of the shares of HKT, has given PCCW an irrevocable acceptance of the Offer and an undertaking to vote in favour of or assent to the Scheme"

That's being somewhat economical with the truth, and in our opinion it omits a fact which makes that statement misleading. The fact is, the irrevocable acceptance is conditional, amongst other things, on the approval of shareholders of C&W plc in general meeting in the UK. The date of that meeting has yet to be announced but it won't be for several weeks yet. If the shareholders of C&W plc vote down the sale of the 54% stake in HKT, then the deal will be scrapped.

So this is the pivotal meeting, and it will depend on whether C&W plc shareholders really understand what they are getting. With the PCCW share price now well below the "crossover point" of $18.62, most people will elect for the cash-and-shares alternative, leaving C&W plc with about 20% of PCCW. Not quite what they hoped, and a big overhang on the market price.

Yet PCCW is still pushing the misinformation forward. Speaking on CNN after the Telstra announcement on 12-Apr-00, Alex Arena, MD of PCCW, said:

"a very positive thing happened only a couple of weeks ago, and that was that the board of Hong Kong Telecom actually voted unanimously in favour of a scheme of arrangement..."

Let's be quite clear. The board resolved only that a scheme of arrangement, rather than a general offer, should be the mode of the Offer, but they did not decide whether or not to recommend to shareholders that they accept the Offer. That fact was stated in a corrective announcement the day after the meeting Mr Arena was referring to, because Linus Cheung (HKT's CEO) reportedly came out of the meeting making the same mis-statement. They have simply formed an independent committee to review the Offer, and their views will be contained in a document to be posted on or before 18-May-00.

Hold on to your seats, the best is yet to come.

© Webb-site.com, 2000

Organisations in this story

• CABLE & WIRELESS LIMITED
• PCCW LIMITED
• PCCW-HKT Limited
• Telstra Corporation Limited

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