China Telecom's 16.8 billion share offering failed to price on schedule yesterday (Thursday) after the order book closed just under 75% subscribed and roughly half the demand was generated by lower quality retail orders out of Hong Kong, the US and Japan.
Having gone into the previous weekend with the deal 50% covered, the three leads were unable to generate enough momentum during the final critical 48 hour period when institutions normally come off the fence and many have been left to wonder whether they should have faced up to market reality an awful lot sooner.
In some respects, the three - CICC, Merrill Lynch and Morgan Stanley - were unlucky. China's jumbo privatizations run to a schedule uniquely their own, with little heed of wider market conditions and even less flexibility to adjust terms to fit them.
Where China Telecom was concerned, the $3.19 billion offering (should it have priced at the bottom of the range) was also handicapped by regulatory requirements, which gave the leads little room to manoeuvre. Under US SEC filing rules, for example, the deal size could not be downsized by more than 20% and under CSRC regulations it could not be priced below book value.
China Telecom went out with a price range of HK$1.48 to HK$1.71 per share against a book value of HK$1.47 per share (pre shoe). Had the leads been able to marry pricing to demand, observers say they could have either downsized the deal slightly and priced it at a slim discount to NAV, or maintained the deal size and priced at a roughly 10% discount to NAV, which was where most of the big institutional orders came in.
However as numerous bankers have pointed out, the three always knew they were operating under these constraints and many question why they did not take heed of them sooner. As things now stand, observers say there are three to four alternative options to restructure the deal and the leads are negotiating with the company and CSRC to find a way of overcoming the NAV issue. At the same time, the deal is being re-filed in Hong Kong and New York so that it can be downsized if necessary.
Re-launch and a new book build is expected early next week, but the big danger is that the roughly $1.2 billion of retail demand will fail to stick once investors realise that institutions have not supported the deal. Key will be the attitude of Japanese retail investors, since the Public Offer Without Listing (POWL) on the Tokyo Stock Exchange is believed to have generated just under $1 billion in demand on its own. By contrast the Hong Kong public offer comprising 5% of the deal was marginally oversubscribed and matched by retail demand from the US.
In many ways, specialists say that China Telecom's experience echoes a previous Chinese privatization in late 1999 when there was a similar disconnect between the issuer's and investors' pricing expectations. "The true picture always becomes very clear to ECM during pre-marketing, but often gets reversed in translation by the relationship manager," says one banker. "It's very difficult to pass on that kind of tough message to those kinds of bosses."
Bankers characterise China Telecom as a deal which struggled against the weight of its enormous size, difficult market conditions, an unappealing sector, lack of pricing leverage and more fundamentally, a lack of clarity over valuation and regulatory backdrop. Added to this, the company and one of the leads generated enormous negative publicity for themselves by trying to address investors concerns only to have to retract their comments after falling foul of US regulations concerning forward looking statements.
And at the very heart of the problem, institutions wanted a steeper discount to China Mobile and could call the shots because there were not a sufficient number of corporates or retail investors to offset their pricing demands. "Looking at the price range, I can only imagine the leads went out with a degree of moisture on their palms," says one banker.
When China Telecom first convened its analysts' meeting in late August, China Mobile was trading around HK$23 per share. By the time pre-marketing began a month later, Mobile had dropped 22% to trade around the HK$18 mark, thereby narrowing the prospective differential.
On a p/e basis, China Telecom's prospective valuation was also clouded by its treatment of up-front connection fees for new customers. Until July, the company had charged customers upfront, but will now amortize existing fees over a 10-year period. Analysts consequently argue that since part of China Telecom's 'E' is not recurrent revenue its adjusted p/e should come out a couple of points higher.
On an adjusted p/e range of 11.2 to 12.8 times 2003 earnings, the company offered a 17% discount (at the bottom end) to China Mobile, which has been trading around the 13.2 times level over the past few days. On other valuation metrics, however, the discount is already very steep even before the deal is restructured.
When, for example, China Unicom priced its roughly $5 billion IPO in the summer of 2000, investors accepted a 27% discount to China Mobile on an EV/EBITDA basis. Currently, China Mobile is trading on an EV/EBITDA basis of six times 2003 prospective earnings. At the bottom end of the range, China Telecom would have priced at roughly 2.8 times, a 54% discount.
So too, where China Telecom was proposing to price at 1.1 times book, China Mobile has been trading at 2.7 times book. And in terms of EV/operating free cash flow - increasingly the ratio used by institutions wary of capex hungry telcos - China Mobile is trading at 6.56 times 2003, whereas China Telecom was proposing 4.8 times.
In almost every respect, analysts say that China Mobile's ratios and fundamentals are better than China Telecom's and crucially the former does not have an expensive network to build for a relatively poor rate of return.
But institutions' main complaint is that China Telecom officials put their story across very poorly, and confused the market by contradicting themselves on a number of occasions. In the process they failed to provide much comfort for accounts already wary of regulatory U-turns and many seem to have concluded that the company's relationship with the MII (Ministry of Information Industry) is not as tight as it ought to be.
"We had a very long meeting with the company where they went into great detail about their capex history and future plans," says one fund manager. "Then one week later, an official gets up and says that the company's capex forecasts are double what they should be."
"There was just no clarity on a whole host of issues that should have been pinned down before the company ever set off the road," he adds. "Capex is one, the issue of whether they will get a 3G license is another and then there's the Universal Service Obligation Scheme and so on."
Others suggest a lack of clarity reflects a political vacuum ahead of the 16th party congress, which begins in early November. A number suggest the deal should not, therefore, have gone ahead when it did.
But on a more fundamental level, investors say that they do not believe the company's growth story. "China Telecom cannot have it both ways," says one. "They can't say they are going to cut their capex and maintain the same revenue growth. And likewise if they do maintain the capex, I don't see how they can maintain their margins since new subscribers will be even more low-end than the ones they have already. We think this is a low growth company and it has to be cheap."
One of the ways observers say it may be possible to restructure the deal is by increasing the dividend pay-out ratio. Having initially indicated a 2003 yield of about 2.9% the figure was increased to 4.4% (at the bottom end of the range) during roadshows and some believe it may now be pushed up to 6%.
However, as the investor concludes, "What bankers fail to realise is that the yield itself is not important. It's the type of company that pays it. What's the point of investing say $100 in China Telecom now in order to get back $3 next year? I might as well just pay $97. Investors are looking for companies with secure cash flows and predictable earnings. These typically are the type of companies which pay high dividends, not China Telecom which has a fixed line network to build and more provinces to buy off its parent."
