China Telecom begins pre-marketing

The fixed line incumbent acknowledges difficult markets by offering investors a compelling valuation.

Pre-marketing begins today (Monday) for China Telecom's 16.7 billion share Hong Kong and New York Stock Exchange listing under the lead of CICC, Merrill Lynch and Morgan Stanley.

The three bookrunners have gone out with a very wide range of $3 billion to $4 billion ahead of formal roadshows starting October 7. Most market observers, nevertheless, expect the deal to come in towards the bottom end of the range given that non-lead syndicate members have internally assigned pre-IPO DCF valuations ranging from $15 billion to $20 billion and the market is expecting pricing at a discount to DCF.

Success will make China Telecom the third largest IPO and equity offering this year behind CIT Group and Travelers Property. According to figures supplied by Dealogic, the flotation will also rank as the world's sixth largest telecoms related equity offering since the sector fell out of bed in early 2001.

To some, China Telecom might seem the worst possible IPO candidate given the current state of the 3G ravaged telecoms sector and volatility of global equity markets facing the prospect of war against Iraq. Yet most of the market, right through from non-lead syndicate bankers and their analysts to the fund management community, expect it to be a success. Many believe the Chinese government has taken a sensible approach to what can be achieved and have been heartened by the success of Bank of China's $2.67 billion IPO, which had a fundamentally far less appealing equity story.

What the company does not have in its favour, however, is the ability to leverage different investor communities to seek a pricing advantage. Bank of China very skillfully called in political and lending favours from Hong Kong's influential corporate investor base and relied on retail discounts and customer loyalty to secure a high price. In doing so, it was able to largely bypass global institutions demanding hefty discounts.

China Telecom, on the other hand, is not only a much larger deal, but that depends upon securing widespread institutional support. As an SEC-registered transaction, it also means that local investors cannot be offered any form of discount.

The leads have consequently followed Petrochina's pioneering example and sought a waiver from the Hong Kong Stock Exchange to offer 5% rather than 10% to retail. This should ensure that the HK IPO does not end up being too unwieldy with a lot of loose paper flying around in the critical few days as deal begins to trade. It also gives the leads flexibility to upsize the deal if domestic demand allows.

Similar to Bank of China, there will be a Japanese Public Offer Without Listing (POWL) and like Bank of China, demand is expected to be strong. "Japanese investors bought Bank of China because they like the China growth story," says one observer. "And this company is far more closely aligned to GDP growth than its predecessor."

Nomura will run the POWL and is also a co-lead in the international syndicate, which also includes Bear Stearns, Cazenove, Deutsche Bank and UBS Warburg. In the US syndicate, co-leads are Credit Suisse First Boston, Goldman Sachs, JPMorgan, Lehman Brothers and Salomon Smith Barney, while the Hong Kong IPO has BNP Paribas Peregrine, BOCI, CLSA, HSBC and ICEA.


Pre-greenshoe, China Telecom is offering 20% of its equity, of which 90% will be sold via primary shares and 10% secondary shares. Subject to a 15% greenshoe, the company will sell a total of 23% of its equity, with pricing scheduled for October 23.

In terms of valuation benchmarks, specialists have quoted a number of different ratios, although all emphasise that post 3G, funds are most concerned with bottom line figures adjusted for capex. However, no matter whether the company is priced on a P/E, EV/EBITDA, DCF or price to cash earnings basis, it is set to come at a discount to China Mobile, its main comparable. Hence, a renewed decline in the latter's share price over the past week means that China Telecom faces the prospect of being priced off an increasingly lower base.

Year-to-date China Mobile is down 34.24% compared to an 18% decline in the Hang Seng Index and closed Friday at HK$18.05 per share, having been traded at HK$23 only a month ago. However, supporters say that while China Mobile has lost half its value over the past two years, the decline is nowhere near as steep as most European telcos burdened with 3G debt.

Towards the end of last week, China Mobile was trading on 2003 ratios of 11.2 times (P/E), 6.1 times EV/EBITDA and 5.9 times (cash earnings or operating cash flow). Putting these figures into the context of Mobile's trading levels when the last Chinese telecoms company was floated shows just how far the sector has fallen from grace.

In June 2000, China Unicom raised $5.65 billion in what still stands as Asia ex-Japan's largest flotation. Priced at HK$15.57 per share, the company came flat to its DCF valuation and on an EV/EBITDA multiple of 19.8 times 2000 earnings. At the time European wireless companies averaged 19.2 times, while China Mobile was trading up in the stratosphere on an EV/EBITDA multiple of 27 times 2000 earnings or a 40% premium to DCF. China Unicom closed Friday at HK$4.925.

In terms of global comparables, a large but low growth company such as Verizon in the US is trading on respective 2003 multiples of 9.2 times (P/E), 4.5 times (EV/EBITDA) and 3.6 times (price to cash earnings). A high growth company like Spain's Telifonica, on the other hand, is trading on respective 2003 ratios of 18.8 times, 5.5 times and 4.5 times.

Based on Asian comparables, analysts say that China Telecom should come on a high single digit P/E, giving an EV/EBITDA ratio of three to four times and a price to cash earnings ratio straddling either side of five times.

And as one observer puts it, "As a rule of thumb, experience shows that anything that comes on an EV/EBITDA ratio of four times or under is very cheap." Malaysian cellular operator Maxis by contrast recently completed its IPO on an EV/EBITDA ratio of 6.6 times 2002 earnings.

Fund managers also add that China Telecom should come at a discount to Asian cellular operators such as Mobile and Maxis because fixed line networks typically have a higher capex burden. Some also highlight that part of China Telecom's 'E' is not recurrent revenue and that the price should consequently be lower. This is because until July China Telecom charged new customers an up-front connection fee, but has now stopped doing so and will amortise existing fees over a 10-year period.

Selling points

China Telecom's key selling point is its blend of defensive and growth characteristics. Lead managers are likely to argue that China Telecom fits the bill at a time when investors are looking for stability of earnings, visibility of earnings, quality of earnings and some form of yield. Two years ago, when investors were looking for growth stocks, trying to sell an incumbent fixed line operator would have proved challenging. Now it is simply seen as the kicker to the kind of defensive utility style play a wireline company offers because it controls the local loop (last mile).

Yet similar to when Mobile listed in 1997, analysts have been preparing a dizzy array of impressive statistics. Not least of these is China Telecom's size and its almost complete monopoly over its service areas. The China Telecom group, which operates across 21 provinces south of the Yangtze river, is the world's largest wireline company overtaking Verizon of the US.

Three provinces and one municipality have been included in the listing vehicle - Jiangsu, Guangdong, Zhejiang and Shanghai. Between them they had 48.5 million fixed line subscribers at the end of 2001 (63.5 million for the remaining 17 provinces) and analysts estimate the figure will top the 57 million mark by the end of the year. Indeed, China's overall fixed line connections grew by a CAGR of 27% from 1996 to 2001 compared to a global average of just 7%.

Analysts expect the strong growth to continue because penetration rates remain low, averaging 22.7% for the four provinces in the listing vehicle, compared to a 57% global average. Fixed line installations are also forecasted to beat GDP growth, which has averaged a high 11.5% in China Telecom's service areas over the past three years.

Many also point out that business line penetration is still low but should grow strongly, particularly after WTO leads to the presence of greater multinationals and Sino-foreign joint ventures. Currently it is just 16% in the four service areas.

Analysts say that roughly 50% of China Telecom's revenues presently derive from local calls, with about 25% from long distance and international calls, 15% from data and 10% from managed data and other value-added services. Going forwards local call revenue is expected to increase as long distance falls away, with analysts forecasting the former to hit about 58% of overall revenues within the next two years.

So too, data is expected to grow strongly, as the government tries to connect 200 million users by 2005 (15% penetration rate) up from 33.7 million at the end of 2001 (2.6% penetration). Analysts are predicting a CAGR of over 40%.

All this translates into very strong earnings predictions, with a number of houses forecasting operating revenue growth in the high single digits and net profits in the low teens for the next three years at least.

A second selling point is that China Telecom is very lightly geared compared to virtually any global comparable. At the end of 2001, for example, it reported a debt to EBITDA ratio of 0.68 times compared to 1.4 times for Korea Telecom and 2.8 times for Singapore Telecom.

Like nearly all of its predecessors, the third selling point concerns potential asset injections from the parent. A number of China Telecom's top officials previously worked for Mobile and are expected to follow its practice of completing one acquisition per year at a discount to DCF. Yet while each acquisition should be EBITDA positive, some analysts point out that a number of the provinces in the Centre and West are loss making.

The lack of a cellular license is also viewed as a positive in the current market environment. As one fund manager comments, "3G is a long way off in China and no one would relish the prospect of watching China Telecom build an increasingly outdated 2G network from scratch based on zero market share."

Finally, China Telecom will offer investors a yield play (just below 3%), although all concerned argue that it could have been more generous given the company's large free cash flows ($483 million forecast end 2002). EBITDA forecasts for the year stand around the $4.5 billion mark. Neither Mobile nor Unicom currently pay a dividend.


For all China stocks, the key concern surrounds policy risk and the opaque regulatory regime under which various sectors operate. In the telecoms sector an unexpected tariff re-balancing in 2001 unsettled the market and continuous rumours (such as plans to introduce calling party pays) have repeatedly pummeled the cellular stocks.

Supporters say the creation of a super commission, which will speak with one voice, should negate the constant flow of confusing and unfounded rumours emanating from the Ministry of Information Industry (MII). Many also argue that the changes implemented by the Chinese government to date have done little harm to the cellular companies.

"The Chinese government is steadily moving towards a more transparent regulatory regime," says one country expert. "People tend to forget that China Mobile has delivered pretty much everything it said it would from the word go. They also ignore the fact that Western governments have been far more efficient at decimating their domestic telecoms sectors with misguided policies."

A second issue voiced by fund managers concerns China Telecom's growth statistics - their reliability and how realistically they can be translated into improved earnings. As one explains, "You can't have it both ways. It's not possible to argue that the mobile sector is facing competition and declining tariffs and then not apply the same scenario to the fixed line sector. There has to be some impact on fixed line tariffs."

And he adds. "I also find it hard to believe that a Chinese fixed line operator with a network and heavy capex to maintain can sustain higher operating margins than a Chinese cellular company."

Some also question statistics relating to penetration rates and believe that mobile companies will steadily eat into potential market share gains by fixed line operators. Says one, "Mobile substitution is a big issue. When analysts compare China to developed Asia, they seem to forget that fixed line growth in these countries was driven at a time when mobile services were not as cheap or as efficient as they are now."

Analysts counter argue that while mobile substitution is an issue, overall telecoms growth should negate the issue over the medium term.

Excluding interconnection fees, China Telecom's operating margin stood at 50% in FY2001, compared with a 37% margin for Korea Telecom and 46% margin for SingTel.

One of the ways the company intends to maintain its current margins is through improving capex efficiency. Having set itself an internal return-on-investment hurdle of 15%, it intends to bring down capex as a percentage of sales from 56% in 2001 to 30% by the end of this year. Globally the average stands in the low 20% range. It partially intends to do so by centralising financial and operational management.

Some fund managers remain unconvinced, however, citing China Telecom's revenue return per dollar spent. Average usage per line stands at only about $15 per month, at least 50% less than global wireline comps. A of investors number also highlight the government's plans to roll out lines to remote rural areas and create a Universal Service Obligations Fund (USO) to compensate those companies which fulfill the government's agenda. But analysts estimate that even when the fund is set up some time next year, it will probably only trim China Telecom's revenues by 1% to 2% per annum.

A final concern stems from China Telecom's H share status and its exclusion from the Hang Seng Index, which retail investors track. Again, however, supporters say that international accounts are far more interested in the MSCI, in which the company should rank as the second largest stock in the MSCI China Index and number 20 in the MSCI Asia Free.

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