China Netcom IPO: smooth operator?

Company takes realistic view of valuation at (yet another) uncertain juncture in China''s telecom history.

China Netcom began pre-marketing a $1 billion to $1.4 billion Hong Kong and New York Stock Exchange listing on Monday via its three leads CICC, Citigroup and Goldman Sachs. Most of the big China and Hong Kong IPO's so far this year have had a fairly rough ride and at first glance many would expect Netcom to follow suit.

However, a number of equity specialists believe Netcom should run relatively smoothly, barring any unforeseen surprises. This belief is founded on the extensive efforts the company and its lead managers have made to avoid falling into the same traps that China Telecom did when it completed its IPO in autumn 2002.

The latter came unstuck when investors demanded a valuation below book value, which is forbidden under CSRC regulations. China Netcom has got around this by cutting its book value through a series of asset write-downs.

The company initially wrote off Rmb25.8 billion ($3.12 billion) of fixed asset value at the end of 2003. It then transferred a further 12% of fixed asset value back to its parent in June 2004 - Rmb18.6 billion ($2.25 billion). The parent also assumed 21% of the company's debt - Rmb15.3 billion ($1.85 billion), which reduced its net gearing level to 89.8%, in line with China Telecom's 84.7%.

Secondly, the company has not been ambitious with its freefloat. China Telecom initially aimed for a 20% freefloat, but ended up cutting it to 10.05% (both figures pre greenshoe).

China Netcom is planning to issue16.2% of its enlarged share capital pre greenshoe, which would give it a market capitalization of $6.17 billion to $8.64 billion.

Thirdly and most importantly, Netcom has a clear benchmark to price against - China Telecom. Sensibly it has set off with a wide discount range in the hope of enticing investors at the bottom, building momentum and pricing close to Telecom at the top.

Based on syndicate consensus profit forecasts of Rmb8 billion ($970 million) for 2005, Netcom is being pre-marketed at 6.36 to 8.9 times 2005 earnings.

By contrast, China Telecom is trading at 8.5 to 9.5 times 2005 earnings based on its current share price of HK$2.50.

Netcom's pre-marketing range also represents a wide 40% to 20% discount to the syndicate's consensus fair value assumption around the $10.7 billion level. Likewise China Telecom is trading at a 20% to 25% discount to fair value and at a similar P/E discount to China Mobile.

The company's supporters believe Netcom has considerable long-term upside potential even at the top end of the range. Primarily this stems from the company's vision of becoming a bundled operator of both voice and data services.

But it also reflects the fact that China's fixed line sector is undervalued. After loosely tracking the performance of the Hang Seng Index for much of the year, Telecom has underperformed over the last three-and-a-half months thanks to supply pressures generated by Netcom.

More fundamentally, it remains undervalued relative to other Asian telcos because of the considerable uncertainty surrounding the future structure of China's telecoms industry. Asia's fixed line operators (ex Japan, ex Australia) are currently trading on an average 2005 P/E multiple of 12.5 times.

Regulatory haze

Analysts often re-iterate that rapid technological advances and regulatory changes make the future of the global telecoms sector difficult to predict. This difficulty is magnified in China thanks to the lack of a telecoms law (in the final stages of being drafted) and opacity of the industry's regulator, the MII (Ministry of Information Industry).

Telecom specialists say the Chinese government has not yet come to a decision about what direction the industry should be moving in. Until it does, most believe Telecom and Netcom will not be re-rated out of their current valuation band.

At issue is what to do about granting additional cellular licenses and how much to charge for them. Presently, Telecom and Netcom are the only incumbent operators in Asia that do not own a "proper" cellular business and have been penalized as such.

The lack of a cellular business means both face huge issues with mobile substitution - declining fixed line revenues as mobile operators poach existing fixed line business and grab most new business. So far the two have successfully negated the issue through their Personal Handyphone System businesses (PHS).

PHS is a technology, which allows both operators to offer wireless services via a long-standing local loop license and 10Mhz of spectrum. Since starting the service in 2002, Netcom has seen usage grow swiftly - subscribers were up 285% to 9.2 million in 1H04 and usage up 366.7%.

This growth enabled the group to maintain revenue growth of 7.5% in its core local telephony business during 1H04. Local telephony accounts for 52.4% of overall revenues.

The chief advantage of the service relative to GSM and CDMA operators is that is cheap. It is run under the basis of calling party pays, whereas the cellular operators are beset by a two-way charging system. They pay an interconnection fee to the fixed line incumbents, which do not pay anything in return.

However, analysts say PHS is an inferior and at best an interim technology at risk from cost cutting by rival operators such as China Unicom, which has pushed hard into the low end of the market that PHS occupies. This is because the higher frequency of the PHS spectrum and its lower power equates to poorer coverage. Furthermore the system cannot roam and operators are running out of bandwidth, limiting future growth potential.

Both operators need a mobile license, but telecom specialists say the government remains divided whether to issue four or two. Its decision requires a delicate balancing act.

Given it owns all four listed operators, it is not in its interests to harm any one operator. However, it also has to keep in mind its need to create requisite competition to satisfy end consumers.

Investors, therefore, need to decide what impact two or four licenses might have on the four listed players. Specialists say the government is aware that if it only issues two licenses and they go to the fixed line players, this will have a disastrous impact on Mobile and Unicom.

As such there is a powerful body within the government, which believes the ideal solution would be to merge Mobile with Netcom and Unicom with Telecom creating two giant and competing integrated players.

Others believe that the two mobile operators could be granted the licenses, leaving Netcom and Telecom to develop alternative technologies.

"The government has seen what a mess other countries have made of 3G and is no hurry to follow suit," says one observer. "If there is a killer application that can replace 3G at a lower cost, why not go for that instead?"

WiMax

That killer application may be called WiMax and would partially explain Netcom's former interest in forming a joint-venture with/or buying a large stake in Hong Kong's PCCW.

PCCW is applying WiMax in the UK and its more experienced management would be able to help Netcom establish the technology in China. For Netcom, WiMax could have two chief advantages.

Firstly it could help realize its ambition to become a full service communications provider using its proprietary broadband network to offer data and voice services. Secondly, it could potentially reduce the country/company's huge capex burden - installing telephone lines to remote provinces where the return per user is very low.

This is because WiMax offers an alternative to the hugely costly last mile access that fixed line operators have so jealously guarded. With WiMax, all a service operator needs to do is install a WiMax transmitter at a base station and a receiver into a PC. The technology will then transmit voice and data to the end user without the need to lay expensive cables or telephone lines into every last residential and business address.

At the moment, there is only an industry standard for point-to-point broadband - ie a user cannot roam around. However, an industry standard for mobile is expected to be ready by the middle of 2006, allowing service providers to marry the bandwidth capabilities of their broadband networks with the flexibility and mobility of cell phones.

China Netcom hopes investors will price some of this vision into the company's valuation. The company prides itself on its entrepreneurial skills - from its founding by Edward Tien in 1999 through to its 2003 acquisition of the "distressed" Asia Global Crossing, which had built a pan-Pacific fibre optic network.

Cost efficient?

However, in the absence of regulatory clarity to underpin the company's long-term strategy, investors are likely to place far more focus on the Netcom's current balance sheet, its cost cutting efforts and capital management skills.

In particular, they will be looking for direction as to what will be funded on or off balance sheet. The parent has already said it will compensate the list co if the government imposes Universal Service Obligations (USO's) on operators in order to provide telephone lines to remote areas.

It has not yet said which part of the Netcom group would be responsible for funding capex associated with a potential 3G license.

Investors are also likely to ask a lot of questions about the company's high capex to sales ratio - the worst of any listed Asian incumbent as capex is tied to system growth rather than maintenance. While most other Asian operators range from 10% to 20%, Netcom reported a ratio of 51% in 2003 compared to 44.1% at China Telecom, which was only marginally better.

Netcom forecasts that the ratio will drop to the mid 30% level within a year as it cuts capex.

Investors are also likely to focus on what Netcom is doing to reverse a declining trend in revenue growth. While broadband revenues are growing quickly, they are doing so from a low base (3.2% national penetration rate) and are not growing quickly enough to offset declining fixed line revenues that are being cannibalized by VoIP (Voice over Internet Protocol).

In 2002 revenue was up 11.9% over 2001. In 2003 it was up 10% over 2002 and in 2004, analysts are forecasting growth of around 9.5%.

In the first half of the year, the group recorded $3.87 billion in revenue and $1.07 billion in EBITDA over its coverage area of six northern provinces and municipalities and two southern provinces and municipalities. It had a market share of 94.6% for its fixed line services (77.6 million subscribers) and 92.9% for broadband (4.2 million subscribers).

By contrast, China Telecom had 178 million fixed line subscribers as of 1H04 and 10.9 million broadband subscribers over its coverage area of 21 southern provinces and municipalities. Its ARPU was also slightly higher - RMB75 versus Rmb70 - as it has slightly more higher paying business users.

Local telephony accounted for 52% of Netcom's overall 1H04 revenue ($2.058 billion), up 7.5% on the same time last year.

Long distance revenue amounted to 13.9% or $545 million (up 5.1%.), International revenue 1.9% or $81 million, (down 10.5%), business/data about 5% and broadband/internet services 8.1% or $297 million, (up 50%).

Some critics have pointed out that while long distances revenues were up this is because VoIP rose so strongly (47.6%), while the traditional network was down 7.2%. Tariffs on the fixed line network are still regulated by government, whereas VoIP (telephone calls via the internet) are completely de-regulated and have been subject to fierce price competition.

In order to win customers, both Telecom and Netcom are said to be routing calls through their traditional networks but classifying them as VoIP in order to charge customers less and defend market share. VoIP now accounts for 48% of Netcom's long distance traffic.

But supporters add that the key area is local telephony since this accounts for the bulk of the group's revenues. Because broadband penetration is low and ARPU levels in this segment are so much lower, they argue it will be more difficult for VoIP to have much of an impact.

They also note that cash flow generating abilities of fixed line operators make them an ideal defensive play. Because telecom revenues are so far removed from commodity prices, they also believe the sector is a good proxy for those looking for defensive China exposure in the face of a hard or soft landing.

Other selling points of the deal include its dividend yield, which will range from 4% to 4.8%. This is based on a pay-out ratio of 35% to 40% and will rank above both China Telecom (2.8%) and most other Asian fixed line operators (with the exception of Korea Telecom and Chunghwa Telecom).

So too, there remains some asset injection potential given there are still four provinces housed by the parent. Even though these are lower margin businesses, analysts say they will still offer some EPS accretion.

IPO structure

The structure of the company's IPO has the standard split between old and new shares of 90.9% and 9.1%. Post deal, the China Netcom group will own 76.9% in aggregate, the public 16.2% and other existing shareholders including Goldman Sachs and News Corp the remaining 6.9%.

The IPO will have three tranches - US, international and Hong Kong public offering, plus a Public Offering Without Listing (POWL) in Japan run by Daiwa SMBC and Nomura.

Co-leads in the US and international tranches are CLSA, Deutsche Bank and Morgan Stanley, with Cazenove and CIBC as co-managers. The Hong Kong public offering will account for 10% of the deal pre clawbacks and numbers BOCI, Citic Capital and ICBC Asia as co-leads.

Pricing is scheduled to take place on November 9, with listing in New York on November 16 and Hong Kong November 17.