Why this deal changes everything: PCCW, Asiamoney, July 2000

Asiamoney, July 2000

 The takeover of Cable & Wireless HKT will crown an astonishing first year for Internet company Pacific Century CyberWorks – and it sets some interesting financial precedents. Most significantly, it shows that a start-up can swallow an old economy business many times its size if the market values the former on what it might turn into rather than what it is now. It’s a situation that gives great power to analysts; and this merger said plenty about them too. PCCW’s managing director, deputy chairman and CFO are among those who state their case to Asiamoney. By Chris Wright.

 Pacific Century CyberWorks  (PCCW) has crammed a lot in to a short space of time. Since May 1999, the company has taken on the contract to develop the Cyberport IT complex with the Hong Kong government; raised one of the largest and most frantically subscribed equity offerings in Asian history; followed it with the largest ever loan in ex-Japan Asia; and trumped all that with the largest ever Asian takeover – a deal that cleared its final hurdle on Monday, July 3, when the last required shareholder vote was passed.

And make no mistake about it: PCCWs’ takeover of Cable & Wireless HKT (C&W HKT), scheduled for completion in August, is the most influential and significant merger in Asia in recent memory. It changes the rules. There is no escaping the peculiarity of the image: one year old Internet start-up – big on potential but small on assets, controlled by 33-year old chairman – swallows 127-year-old former monopoly, whose forerunner was formed before Bell had even invented the telephone, with a significantly larger market capitalization and links to almost every home in Hong Kong. It is the ultimate old-economy/new-economy event, more extreme even than AOL/Time Warner.

Beyond all that, the merger raises the intriguing question of valuation. This is a merger that succeeded because the market assumed sufficient value in PCCW stock to support what was mainly a share-based takeover. It is also a merger in which the value of that stock changed dramatically over the course of negotiations. Yes, there was a major cash component; but fundamentally, this deal was reliant on the market believing in a high valuation of PCCW relative to what it actually owns.

That’s the case in every stock deal. But never before has there been a situation where that valuation has been so abstract and so open to interpretation. Few would claim that today’s share price valuation reflects accurately the value of what PCCW owns: the market is valuing the future. But how do you do that? And what happens if, as in this case, most of the banks best equipped to help investors make accurate assessments of value are conflicted out of producing any objective research anyway?

PCCW is a vibrant and exciting company staffed by exceptional people, and was open and cooperative in the research for this feature. But the merger itself will have broader influence beyond these companies or their sector, because when a deal like this goes through, suddenly anything is possible.

 No comment

You are an investor and you want to get hold of independent research on PCCW. You like the sound of its vision, you want to be part of its future. But how can you find out what these are exactly?

You think through the banks that are renowned for their knowledge of the Internet sector. Let’s start with Credit Suisse First Boston (CSFB) – Jay Chang knows what he’s doing. No good: CSFB is an advisor to PCCW and, although Chang produced insightful and voluminous research on PCCW early on, he can no longer comment on the company.

OK. Goldman Sachs? Tim Storey? Rajeev Gupta? Sorry – Goldman was advisor to Singapore Telecom, PCCW’s rival bidder in trying to get the C&WHKT assets in the first place. When Asiamoney called Storey in early July, he was still conflicted. “Perhaps by the end of this month,” he suggested. And so too Morgan Stanley Dean Witter – the other mainstay of Internet research. It’s advisor to Telstra, which is involved in two joint ventures with PCCW, both  dependent on the PCCW-HKT deal going through.

It gets worse. Consider the situation of UBS Warburg (advisor to PCCW), Bank of China (same – and a major lender besides), HSBC (also a major lender to PCCW), Merrill Lynch (advisor to Cable & Wireless), ING Barings (advisor to minority shareholders of HK T), and BNP Paribas and Barclays (both arrangers of the loan financing for the acquisition).

This is hardly PCCW’s fault. Banking consolidation is partly responsible. But the result of this advisory quagmire is an absolute dearth of independent research, an issue that the company’s senior management are quite aware of. “We are at a severe disadvantage at the moment because there are so many banks involved in this transaction,” says managing director Alex Arena over lunch on June 2. “The amount of analyst research and coverage in the marketplace is quite small. That’s why there is this variable.”

“This variable” refers to the staggering range of conflicting valuations from the banks that do produce research. At the low end is Dresdner Kleinwort Benson. Its June 16 note, the only sell recommendation on the stock that Asiamoney is aware of, gives a sum-of-the-parts valuation of the merged PCCW-HKT of HK$10.74 per share. At the other end is Lehman Brothers. On May 18 it re-stated a price target of HK$35. Independent commentator David Webb puts fair value closer to HK$6 per share.

Let’s think about the implications of those valuations. At that price target, Lehman’s valuation gives the combined company (see footnote) a market capitalization of US$99.5 billion. Webb’s is nearer to US$17 billion. The difference between these two figures is in itself more than double the entire market capitalization of General Motors.

In fairness, the company is unique and therefore difficult to value – part Softbank or CMGI, part Excite@home, part property developer. “We are in no man’s land,” says deputy chairman Francis Yuen. “We are the first to combine a new and an old economy company and there is no company like us to follow.” When Asiamoney first meets PCCW’s amiable CFO, Peter Allen, he admits he has just been puzzling with a colleague over a piece of research on the company. He loves the valuation, he says; he just can’t quite figure out how the analyst has come up with it. He resolves to put a call in to the analyst in question, before David Webb writes another article.

Ah, yes: David Webb. PCCW must rue the day he heard of them. Webb is a former investment banker, and was corporate finance director of BZW Asia and in-house advisor to Wheelock before throwing it all in to work as an independent, tracking the Hong Kong market and launching webb-site.com. His site promotes transparency and investor rights in Hong Kong, and frequently takes on companies he sees as being overvalued or misleading. PCCW and the Cyberport have so far attracted no less than 14 detailed articles on the site (one of them claiming he was investigated by the Kroll detective agency for his articles on the Cyberport). His articles tend to be widely influential among the Hong Kong media, partly because his analytical abilities of public data are better than those of most journalists.

Webb is by some distance the most bearish commentator on PCCW stocks, and he has little time for the more stratospheric valuations of the company. “I don’t think they are really thinking through the implications of that kind of statement,” he says of Lehman’s price target. “It is simply a momentum argument – that you should pay more for the stock because somebody else will pay even more later. When analysts start advising on momentum rather than valuation, they are not doing their job properly.”

Michael Leary, an analyst at Lehman, explains his thinking like this: “You need to look at two things. In the industry, you are seeing cheaper and cheaper access to faster and faster bandwidth. In the media, there is great interest in more and more people spending more time online. Take these together and look where PCCW is positioned – they will capitalize on those trends. Who is to say how fast this will unfold? But we expect strong momentum.”

Without commenting on any specific house, bullishness must be tempting for investment banks for other reasons. PCCW itself estimated a cost of US$130 million in legal and banking fees through the merger. Fees on the US$12 billion loan it arranged in April were similarly juicy. Banks want those mandates, and if you take the view that the Li family thinks together, the size of the pie gets even bigger. You can’t help but assume that most investment banks would be less than thrilled to see their analysts put out critical valuations that might sour relations with such a potentially lucrative client. Market rumour has it that Dresdner’s sell note was met with a frosty reception from PCCW; when asked about this, Kleinwort Benson director Niall Shiner responds with an emphatic: “no comment”.

We asked PCCW if Dresdner Kleinwort Benson will still be considered for lending or capital markets business despite its report. A spokesman for PCCW said: “As far as future business is concerned, PCCW is open to discussion with any investment banks if they can bring good ideas or value to PCCW. This means those with brilliant ideas and the brightest staff will always win our business.”

But Webb argues: “In general, without reference to any specific house, investment banks are horribly conflicted in what they say. They have an investment banking department which relies for its income on a number of very large companies in Hong Kong. You cannot afford to eliminate between a quarter and a third of your market by being very critical to one family. So any outside investors should keep that in mind when reading this kind of research.”

 NOW… and then?

In the box, “Defining PCCW”, we give a brief guide to what constitutes this complex business. Not all of it is difficult to take a view on: there are only so many ways one can value property, fixed line communications or existing investments. But it is the biggest part of the company, Pacific Convergence Corporation (including the NOW channel), which has the greatest potential – and is therefore the hardest to assess.

NOW’s basic premise is interactive television, and frankly, it sounds great. PCCW’s senior management – grown men, all of them – become wide-eyed and animated as they discuss the possibilities.

It works like this. If you are watching a news item and you want to know more about it, you can drill down and receive more information. For example, if you are watching Wimbledon (which, incidentally, was meant to be the landmark launch event for the station: for logistical reasons, it didn’t happen) you can choose which match you want to watch, find out more information about the player’s career, watch highlights of previous matches, or see archived interviews. It gives the viewer access to the cutting room floor.

The concepts are fascinating. But there is also uncertainty. For example:

 1.         Will it catch on? Time Warner spent millions trying to launch an interactive TV service in the 90s and failed.

2.         Let’s assume it will. First mover advantage is a valuable thing – but PCCW will not have a successful market to itself forever. It has fine minds working on the provision of top-notch content – notably Michael Johnson, who founded AsiaSat in 1985 after two decades in film and TV – and has signed collaborations with TWI in England, Commercial Radio in Hong Kong and Eracom in Taiwan. But they could potentially end up against forces as big as Time Warner and News Corp, with vast access to news, film libraries and TV archives.

3.         Some parts of the business’s success appear to be out of PCCW’s hands. PCCW wants to be “technology agnostic” and offer many methods of service provision, so that where broadband access is insufficient for people to receive it through the Internet, the company can rely on satellite distribution. Content is then available for free through cable TV operators all over Asia – but those cable TV operators are not obliged to provide it, and viewers who do have broadband are not obliged to watch NOW. Given the connectivity, they will watch whatever they want – that’s the Internet.

4.         For the sort of interactive experience NOW envisions, many cable operators will have to upgrade their systems to allow full two-way data flow – also out of PCCW’s hands.

5.         How much will Asian people be prepared to pay for connectivity?

 Management makes credible arguments against these claims. Allen says: “Yes, in some areas it will depend on the cable operators as to whether they will want to access the satellite signal. But we have strong indications that they will. A lot of them went into business because of Richard Li in the first place when he offered them his Star TV proposition.” On the cost issue, he points out that the number of PCs in use in China is growing faster than in the US, as is use of the Internet. “If they have got enough money to buy a PC, they will have enough money to enable the other types of access we will be providing.”

Deputy chairman Francis Yuen points to the company’s partners – its strategic link-ups, mainly built on stock swaps, include Intel, CMGI and (perhaps more of a mixed blessing) Hikari Tsushin. “Our success has been built on our ability to develop alliances and work closely with our partners,” he says.

They may very well be right. But these are predictions, and that is what causes the valuation disputes. Webb values NOW at US$2 billion; HSBC – by no means the most bullish of the analysts covering the company – puts it at US$22.9 billion. The highest valuations are from analysts who believe most strongly in the company’s positioning, and a sample of comments gives you a sense of where they are coming from:

 •           Lehman in May wrote: “We reaffirm our 1-Buy rating on the shares on the back of its cutting edge convergent content.”

•           CSFB, making a buy recommendation back in November when it could still put out research, said: “We believe that Pacific Century CyberWorks, although not without execution risks, represents the best diversified way to invest in the Internet today.”

•           Merrill Lynch, January: “We think that PCCW is well placed to dominate the Asian Internet space.”

•           Indosuez WI Carr, March: “We’re buyers of PCCW as we feel confident in management’s ability to achieve both the Interactive TV vision and a position as Asia’s leading incubator.”

•           ABN Amro, February: “Richard Li will continue to guide PCCW with a leadership and vision that will maintain the company’s position at the forefront of Internet development in Asia.”

 Vision, vision, vision.

But how do you evaluate a premium for the future? Says Webb: “Why would you pay for something that hasn’t happened yet? It’s like taking today’s share price of Microsoft and saying: I wish I’d paid the same price 15 years ago. No you don’t, you wish you had paid what it was costing then when it had all the business risk ahead of it and a big discount factor built in to the price. You can overpay for the future.”

“CyberWorks may well turn out to be one of the leading players in its field,” he adds. “But if it’s already got that valuation you are looking at no dividends to justify holding it over that period. The risks are not properly discounted in that scenario and it is encumbent upon institutional investors to look after their clients’ money a bit more thoroughly. You can’t just say: never mind what fair value is, let’s pay for the future now; fair value already includes the future at a proper discount.”

 The merger

All such forward-looking businesses face this ambiguity. But it became key with the takeover bid since so much of it was based on stock. In fact, shareholders were given two choices:

 •           The combination alternative, in which each HKT share would be exchanged for 0.7116 PCCW shares and US$0.929; or

•           The share alternative, consisting of 1.1 PCCW shares.

 The PCCW share price at which one alternative became worth more than the other was HK$18.62. Above it, the share alternative made more sense for shareholders; below it, the combination alternative would be worth more. In February, when Cable & Wireless confirmed the bid, the stock price was around the HK$25 mark (its high point has been HK$26.35 on February 15); but in March, tech stocks crashed around the globe, starting on Nasdaq but hitting Asia particularly hard. Late that month PCCW dropped below that HK$18.62 mark. It has yet to reach it again.

So two things were clear for a long time: one, that the combination offering was going to be the one that would be selected; and two, that the offer itself was going to be worth considerably less than when it was made. When Asiamoney  met Allen the PCCW share price was 39% lower than when the offer had been announced. Even allowing for the fact that HKT shares fell in the same period, that’s quite a difference – with 12.16 billion HKT shares in issue, a PCCW share price of HK$25 would be equivalent to a payout of HK$334 billion for HKT. At HK$14.45 (the closing price on the latest practicable date listed in the acquisition proposal) it works out as HK$213 billion using the more valuable combination offer. The difference between these sums amounts to more than US$15 billion.

Allen said at the time: “At the end of the day I think the shareholders will first of all look at the price of the HKT shares relative to the price of PCCW shares, and secondly they will look at our long term proposition and judge it against holding just a pure investment in a telco.” It seems they did. In the final reckoning, PCCW’s share price appears to have had no bearing on the recommendations of Cable & Wireless or HKT’s boards. Management put it down to rare synergies between the two corporate cultures and a genuine excitement on the part of C&WHKT management for PCCW’s ideas – particularly in the face of a rival bid, which was from an old generation telco and from Singapore to boot. “We can help them realize the vision senior management already have of breaking out of being a domestic telco to being something much more interesting and exciting,” says Allen.

Shortly afterwards, we asked Alex Arena about PCCW’s valuation. “I think we are developing a range of extremely exciting businesses. We are genuinely in front in many areas… What we are focused on is executing that. What we are not focused on is the day to day share price. That can be influenced by lots of things – perceptions of what the US Fed will or will not do – and you cannot have all your decisions as a manager dictated by that.” That, says Arena, is why the company embarked on its range of capital raising exercises prior to the bid. “We didn’t want to be hostage to a banking crisis or doomsday scenario. And if we hadn’t been doing this HKT transaction, which is a great accelerator of our implementation, we would be very immune to what is happening in the marketplace.” But they were doing this transaction, and so the share price did become key. Was there a point where the falling share price could have derailed the deal? “No. It made for a lot of interesting, speculative, gossipy pieces in the popular media. But anyone who sat down and anlaysed it realised that things didn’t stack up.”

 Who cares…

But, in the end, does accurate valuation really make any difference? Does an investor, and in particular a retail investor, ever really even pretend to understand the nuts and bolts of a business as complex and conceptual as this? How many people considering buying PCCW shares stop and say: “Hold on, before I commit my money, I should think hard about the fact that in 2003 underseas fibre cable will reach China, thus generating a far greater availability of international IP bandwidth and creating potential competition issues – and share price weakness – for a company that appears reliant on satellite distribution”? Or mull over the fact that, for the true inter-connectivity that NOW really requires, the company is reliant on Indian cable networks raising the money to upgrade their infrastructure to allow full two-way communication? The answer, surely, is very few. Retail investors in particular take the view that this is a company in the right space with the right people in charge – the Li factor or otherwise – and that therefore, although they won’t pretend to know exactly why, it will be a success and make them money. David Webb can dissect the small print of acquisition proposals until doomsday, but it won’t compete with the combined hype of new technology and Richard Li.

“You are talking about a big spectrum of investors from individual investor to institutional investors,” says Allen. “There is no doubt that both the individual investors and institutions will place emphasis on Richard Li’s pedigree and past achievements. But in the first analysis it’s the quality of our business proposition which will be the most telling factor.”

Asked the same question, Arena refers back to the loan. “You got 33 commercial banks together lending US$12 billion in Asia’s biggest loan. They don’t do that without asking questions. Within a few days, maybe as little as 48 hours, we got verbal commitment based on all the material we had already prepared, and within 10 days we had it all locked up in contractual form. That was an intense period of time but it says a lot about our ability to articulate what we are doing. It’s not just vision, vision, vision, it’s execution, too. You get served by banks in proportion to how well you can satisfy their questions.”

At 9.30 am on Tuesday, July 25, a court hearing will be held to sanction the scheme – a mere formality. The following Tuesday will be the last day for dealing in HKT shares before they are suspended at 10am the following morning. And on Thursday, August 10, Asia’s biggest and most significant merger will be complete and the continent’s largest Internet company – potentially its largest company – can continue its strategy to change the world.

Oh, and one other event will happen in this period: on August 3, PCCW will celebrate its anniversary as a public company. It will be one year old.