All are agreed, however, that Cable & Wireless had little other option in disposing of its 14.7% stake in the telecoms and internet company. "On the sell side, getting rid of PCCW at this time and at these levels says everything about what Cable & Wireless really thinks of it," says one telecoms analyst. "On the buy side, institutions don't want to go anywhere near the stock either, having got badly burnt the last time C&W sold down part of its stake at HK$9 [$1.15] per share. Any form of placement would have just sent the stock crashing further downwards and made C&W's remaining equity even more worthless than it already is."
For lead manager UBS Warburg, underlying problems concerning investors' tarnished view of the company look as if they have been further compounded by an overly aggressive structure on the $1.5 billion exchangeable. Sector specialists comment that the bidding war, which took place in London last week, has left the bank in the unenviable position of trying to place a bought deal on terms that are far too tight for such a large issue size.
"When you are dealing with a stock that has such a toxic track record as this one, it's very dangerous to win a large bought deal on tight terms," says one. "You could end up with a good chunk sitting on your own balance sheet."
Indicative terms comprise a $1.5 billion issue size with a June 2003 maturity and a par in, par out structure, equating to a zero coupon and zero yield. The conversion premium has been set at 17% to 23% over Friday's closing share price of HK$3.075 (the stock was suspended in Hong Kong on Monday). The company can also call the deal immediately subject to a 120% hurdle.
Underlying assumptions include a bond floor around the 88.9% level, representing a credit spread of 60bp over Libor and fair value at par. Investors are being offered 11 option points for the equity based on an implied volatility spread of 23% to 32%, against historic (100) day volatility of 56%. The stock borrow fee has been set at 1%.
For specialists, the main problem with the structure is its equity orientation at a time when investors want defensive protection and greater bond content. Specifically, a number of experts have taken issue with the lack of yield and the call feature, which removes much of investors' upside. In turn, these structural problems have been attributed to the fact that Cable & Wireless knew that it would be unable to dispose of its PCCW stake through a share placement. Instead, it is now trying to offload the stake as quickly as it can through an exchangeable structure and in the process, potentially denying investors the opportunity to ride the deal for more than a few months.
"Cable & Wireless wants a structure where it can force conversion as soon as it can," says one banker. "But investors, and particularly outright accounts, just hate transactions that have immediate call provisions, because it means a deal can be pulled away from them at any time. At 120%, this one also has a very low hurdle. If as an investor you believe the stock is near its bottom, then the likelihood of it rising 20% and conversion being forced upon you, is high. After the volatile ride equity investors have had with PCCW this last year, they now want the comfort of coupon payments."
Where fixed income investors are concerned, critics also argue that they will be turned off by the credit spread and low bond floor, which most agree should be in the low 90s rather than the high 80s. "Terms are at the market, but there is no meat and therefore little incentive for investors to buy," comments one head of Asian fixed income research. "A credit spread of 60bp is reasonable enough for an A2/A-rated credit like Cable & Wireless, but there are plenty of other comparables out in the market at similar levels. Vodafone, for example, has a similar rating and is offering the same spread over five years on its recent exchangeable."
A second adds: "For a deal half this size, it might be possible to get away with a zero coupon and yield. But trying to push out $1.5 billion worth of paper at this levels is very optimistic."
For the same reasons, critics argue that fair value should come above par and question how much option value investors want from PCCW and are likely to get should the share price drop further on the resumption of trading. "If the share price falls to HK$2.80, then the equity option falls with it to about eight points, pushing implied volatility into the low 40% range," one banker argues. "This is getting too close to historic levels to please many investors. We also believe that the underlying assumptions are based on an unrealistic stock borrow fee of 1%, when 4% would be more appropriate."
The impact of hedge fund activity on the stock and ADR has also raised concerns. Says one banker: "PCCW trades about $30 million a day and is liquid by Asian standards, not by European standards. This deal is large and to make sure that hedge funds can delta hedge, Cable & Wireless has put stock borrow in the market. But who are the hedge funds going to sell these shares back to?"
UBS Warburg estimates that there are three possible scenarios for the share price. Scenario one sees the share price move up, should investors believe that the overhang has been removed, and secondly, that it can weight the book towards outright accounts with no interest in shorting the stock. Scenario two also sees the stock rise under the influence of hedge funds trying to cover short positions by purchasing the underlying stock. Scenario three, however, sees the stock fall, should a greater number of hedge funds be in the market placing short positions to hedge the volatility.
On balance, UBSW believes that $500 million in hedge fund activity will create $250 million in buying pressure. This is based on the fact that half of the shorts will be covered by purchases in the underlying equity.
With little time and opportunity to benefit from any defensive exposure to Cable & Wireless' credit, the key assumptions all concern PCCW. And as Standard & Poor's analyst John Bailey explains, trying to pin any valuation on the latter is difficult.
"Historic results offer few pointers," he says. "What an analyst or investor needs to look at is the ability of the cash flow to service the debt, and further, to examine the business model for future earnings drivers. But with the dynamics of the industry changing so quickly, this presents a number of difficulties. What can be said with some certainty is that revenues from voice are going down and data up."
Credit analysts tend to assign PCCW a rating either marginally above or below the investment grade threshold. There is a general consensus that the fixed line business of Hong Kong Telecom on its own would still command a BBB rating despite the debt which has been ring fenced round it. At the holding company level, however, many analysts believe that the company struggles to stay in the BB category.
As one puts it: "A debt to EBITDA ratio of 7.6 times prospective 2001 earnings and an interest coverage ratio of 1.75 times are not the hallmarks of an investment grade credit. In fact, they make PCCW look more like a single-B credit."
In its sales memo, UBS Warburg has assumed EBITDA of $858 million for 2001 incrementally rising to $899 million in 2003. Having been able to re-finance the syndicated loan used to purchase Hong Kong Telecom (HKT), PCCW's debt load has been significantly eased, however. With total debt of $6.5 billion, the peak year for principal re-payment falls in 2006 when $3 billion is due. Before this, $1.5 billion is due in 2004 and $1.1 billion in 2005. The remaining $0.9 billion falls due in 2008.
The secondary market performance of PCCW's existing convertible, however, underlines a highly pessimistic credit view despite its illiquidity. With a conversion premium of 118.10%, the December 2005 transaction is now trading as straight debt, with a bid/offer price of 84/85 and a yield to maturity of 11.15%.
"It's going to be a long time before PCCW is restored to financial health, given the large debt now sitting on its balance and the declining margins and increasing competition it faces across all its businesses," an equity analyst argues. "We estimate NAV at HK$2.85 and never believed that Hong Kong Telecom was worth HK$18.62 in the first place. At the time it was worth more like HK$10 and since then, PCCW has come in and destroyed a lot of wealth."
In its sales note, UBS Warburg argues that operationally the worst is over for PCCW, and most analysts do tend to agree. The curtailment of the company's B2C activities, the goodwill write-off for its $29 billion acquisition of HKT and the hefty $667 million provisioning for its internet investments, have given the company a cleaner slate on which to balance the need to de-leverage with an ongoing requirement to fund capex in a non-dilutive manner.
As the note also points out, PCCW has breathing space until 2004 before principal repayments become a more pressing issue and three years in the interim to sell non-core assets such as Hong Kongs Cyberport development, the companys stake in Singapore wireless operator MobileOne and Reach, its 50/50 IP backbone joint venture with Telstra.
For Cable & Wireless, the aggressive terms the company hopes to achieve on the exchangeable may also, in some small way, mitigate the massive loss in value of PCCW shares, which have fallen 83.15% over the past year. PCCW itself will be principally hoping that the removal of the share overhang from a Cable & Wireless placement will enable the stock to find its feet again pending a few days of hedge fund induced volatility.
So too, while PCCW is technically insolvent under Hong Kong GAAP, with negative shareholders equity of $1.8 billion, it may post a positive US GAAP figure should it amortize the goodwill write-off over a 20-year timeframe.
Yet as Nomura concludes in a research report published this week, PCCW is a company that has given investors first degree burns and most are not prepared to cut it any more slack.
An investor must ask whether he wants to invest in a business or in a concept, the report states. In our view, if he wants to invest in a business, he will, as things stand, be paying too much if that business is PCCW. If he wants to invest in the PCCW concept and believes that concept will become a reality, we wish him well.