China Mobile and PCCW assail convertible market

Differing credit perceptions have led China Mobile and Pacific Century CyberWorks (PCCW) to take radically different approaches to the structure of their debut equity-linked bonds.
Keen to keep dollar-denominated off its balance sheet, China Mobile has adopted a highly equity-oriented approach to its $600 million deal. PCCW, on the other hand, fighting to reduce its massive debt load and rebuild some credibility with investors, has targeted mainstream convertible accounts with its $1.1 billion offering.

The sudden appearance of the latter on the day the former announced indicative terms, initially left some observers wondering whether overall demand would be cannibalised. However, most agree on reflection that as the two are attempting to attract completely different investor bases, this is unlikely to be the case. Some further argue that China Mobile's deal may even be given an additional push, since its terms now appear far more attractive in the light of PCCW's more aggressive stance.

China Mobile

Under the lead management of Goldman Sachs, Merrill Lynch and China International Capital Corp, A3/BBB-rated China Mobile will price its five year transaction early next week. Terms comprise: a coupon of 2.5% to 3%; a conversion premium of 18% to 23%; par redemption and; two year hard no call, thereafter subject to a 120% trigger. There is no put option.

Market participants say that the structure has been devised to take into account investors' preference for cash paying, par redemption structures. "It's the sweet spot of the market right now," says one specialist. "Investors like par in par out structures with higher coupons and lower yields because they feel more comforted.

"It's a global trend, but one that's particularly applicable to Asia where investors got badly burnt during the financial crisis," the specialist adds. "Traditionally, this region has given us low coupons and premium redemption structures that lead deals to be sold on the basis of their bond floors. Unfortunately, most floors failed to hold once the financial crisis hit and now investors want more current interest income, rather than letting it all stack up at the back end."

Based on a bond floor of $77 to $79 and an equity option value of $24 to $32, the transaction is said to have a theoretical value of $105 to $106.

The fixed income value has been determined by using China Mobile's outstanding 2004 bonds as the main reference point. A discount rate of 8.06% has been applied, based on the current 5.66% trading level of five year Treasuries and the 220bp bid price of the 2004 bonds. An extra 20bp has also been factored in to account for the convertible's one year longer tenor.

"Additional supply has led China Mobile's spreads to widen recently," says one analyst, "but we believe they will narrow again once the effect of oversubscription to the convertible bond kicks in."

Where the equity option is concerned, an implied volatility rate of 24% to 32% has been used, although the stock has actually averaged 53% over the past 100 days. China Mobile has also never previously paid a dividend, but the structure contains clauses to cover for the payment of an extraordinary dividend.

"Should the company pay an extraordinary dividend, then there will be an adjustment to the conversion price," says one observer. "If, for example, the company pays one extraordinary dividend of over 2% during the lifetime of the bond, then the conversion price will be adjusted by any amount over 2%."

In a first for an Asian equity-linked deal, Hutchison Whampoa recently incorporated extraordinary dividend protection into its $3 billion exchangeable. In a further new twist for the region, China Mobile has incorporated credit protection in the form of a change of control put.

"If the company is de-listed, or the Chinese government sells down below 51%, then investors can put the deal at par plus accrued interest," says one market player. "This was felt to be necessary to appease European investors, many of whom have seen their own region's convertibles suffer because of heavy M&A activity that has resulted in ultimate ownership on some deals being transferred to weaker credits."

China Mobile's transaction is also unique in being the first from Asia to be fully registered with the US SEC and, therefore, able to tap retail investors. Some bankers believe that they will prove receptive.

As one states, "This is a company with a phenomenal growth story. Following the injection of the additional seven cellular networks, China Mobile will have a subscriber base of 35.42 million and rank second to only Vodafone worldwide."

"You are getting principal protection insurance from an investment grade issuer with a double digit growth story. It's pretty compelling," he concludes.

Bankers argue that comparisons with outstanding Chinese convertibles are fairly meaningless, however, and offer European wireless transactions as a more valid point of reference. "Outstanding Chinese deals tend to fall into two categories," one banker remarks. "They are either very small, or have been issued by the unlisted parents of companies like Beijing Enterprises. All are unrated and in the latter instance, there has been no follow-up information, or updated financials. Most are out of the money."

By comparison, A3/A-rated Hutchison Whampoa, albeit backed by a three notch higher credit rating from Standard & Poor's, priced its recent deal with a slightly higher yield (2.875%), significantly higher conversion premium (32%) and two year shorter maturity.

For China Mobile, it is a case of wanting to force conversion and therefore adopting a low trigger and earlier call option than might usually expected for a five year deal. "The company does not want a lot of dollar denominated debt on its balance sheet, because its revenues are entirely denominated in renminbi and hedging the currency is difficult," one banker highlights.

Fund managers agree that the deal will be predominantly bought by pure equity accounts. Says one fixed income manager, "This structure is not attractive to bond holders at all. For asset swappers, there is very little value. It's quite difficult to short the underlying shares and there's little arbitrage profits to be had if you deduct 3% to 4% hedging costs from a 105/106 theoretical value."

"But for equity investors," he notes, "the low bond floor means that there is more equity option value and far more sensitivity to the underlying equity."

PCCW reins in debt

PCCW's accelerated deal, launched today (Monday) and scheduled to close before the end of New York trading, has surprised and divided the market. Led by BNP Prime Peregrine and HSBC, the company has launched a $1.1 billion deal, of which $500 million will be purchased by PCCW head Richard Li.

Indicative terms for the BVI registered transaction comprise: a coupon of 3% to 3.5% payable annually; a conversion premium of 21% to 26% over Friday's HK$6.50 close; hard no call for three years and thereafter subject to the 120% trigger and; premium redemption at 6.5% to 7%, equating to a yield-to-maturity of 85bp to 135bp over Treasuries. There is no put option.

Key to any valuation of the deal lies with an investor's credit assumptions about PCCW, which is currently unrated. In its short history, the internet and telecoms venture has always provoked strong opinions and nowhere more so than over its underlying financial health.

According to those close to the deal, the successful completion of the convertible bond and simultaneous rights issue will result in debt on the company's balance sheet falling to $3.84 billion. Indeed, if this is the case, success will be viewed as a remarkable achievement for a start-up internet venture, whose initial growth was almost entirely fuelled by a stock market frenzy and its recent performance dogged by a 65% share price collapse.

The company's acquisition of Hong Kong Telecom (HKT) was financed by $12 billion in debt, of which $1.5 billion was almost immediately paid down by cash off PCCW's balance sheet and $1.5 billion in cash from HKT. The company's recent completion of a joint-venture agreement with Telstra has seen this figure further reduced to a net debt position of $6.195 billion.

As a result of the agreement, net debt will fall again to $5.445 billion, since about $750 million is being pushed down into the joint-venture internet backbone owned by the two companies, yet operated on a stand-alone basis. With an additional $1.1 billion from the convertible and $500 million from the rights issue, a final net debt position of $3.84 billion will be achieved.

Taking into consideration PCCW's own EBITDA of $1 billion, bankers say that the company's gearing levels are far less onerous than most market participants have frequently assumed. In valuing the convertible, the two leads have consequently worked on the basis that PCCW has an implied investment grade rating of about BBB-/Baa3, equating to an asset swap level of about 200bp to 250bp over Libor.

At these levels, the transaction has a bond floor of between $87.4 and $89.4 and backed by an equity option value of $19.9 to $25.6, a theoretical value of $107.3 to $115. Since the company has a historic volatility of 90% to 100% and its covered warrants volatility of 60% to 70%, bankers state that the transaction offers convertible accounts attractive arbitrage potential.

"True convertible accounts, particularly in Europe, are very keen on the structure because they have a cheap volatility play," comments one observer.

Some equity accounts are also believed to have participated, taking the view that the stock has reached a historic low, but want some upside protection in the form of the coupon payments.

Asset swappers are said to have stayed away, however, since most commercial banks in the region already have full credit lines to the group.

Yet, some bankers maintain that PCCW simply continues to hoodwink the market with outrageous financing plans that only see themselves through to completion because they have the Li family name behind them.

Most convertible analysts canvassed by FinanceAsia were valuing the transaction on the basis of a bond spread in the low to mid 500bp area over Treasuries, while some fixed income specialists argued that a straight five year bond by the credit would need to be priced in the mid to high 700bp area.

All were starting from the assumption that PCCW should command a low BB to high single B credit rating based on its heavy debt load and the fact that all the debt has been ring fenced by creditor banks. Indeed, at the time of takeover, arranger banks were very keen to emphasise that they were not lending $12 billion to PCCW, but to HKT. The entire amount was, therefore, parcelled out on a non-recourse basis through an SPV that owned the HKT shares.

"What you have to remember is that the banks had to give their permission for the convertible bond to go ahead and they wouldn't do that unless they couldn't see future cash flows coming through," one banker retorts. "And since proceeds will be used to pay down bank debt, running costs will be dramatically reduced."

Others, however, contend that as most of the assets have already been pledged to the banks, the credit is extremely weak. As one puts it, "The banks have the most senior claim on Hong Kong Telecom and if you strip out its earnings, there is basically nothing left but a lot of debt. Personally, I think that you can shave off quite a few basis points because of the Li name, otherwise the company would have to pay the same kind of levels Asia Global Crossing did a few weeks ago."

Rated B+/B2, the telecoms group raised $408 million in 10 year debt in early October on an issue price of 97.99 and launch spread of 793bp over Treasuries to yield 13.75%. Other benchmarks cited by fixed income specialists include the outstanding pool of Korea sub debt, which have similar single-B ratings and trade in the mid 600bp area on five year maturities.

However, as one convertible analyst concludes, "Whatever premise you attach to the bond doesn't really matter at the end of the day because no one is going to buy this paper on the basis of credit. It will all come down to equity upside."

Success will see the Li family set more new records in Asia's capital markets. The syndicated loan still ranks as the largest ever from Asia by a huge margin, while the current convertible will rank second only to Hutchison Whampoa as the largest equity-linked transaction on record.

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