China Telecom: by hook or by crook

Provisional allocations suggest that China Telecom''s IPO may not have been quite the disaster it has been portrayed.

Having been forced to cut the size of China Telecom's proposed New York and Hong Kong Stock Exchange listing, lead managers CICC, Merrill Lynch and Morgan Stanley priced a 7.556 billion share offering after US trading hours on Wednesday. The revised deal was 55% smaller than originally intended and raised $1.437 billion after being priced at HK$1.48 per share, the bottom end of a HK$1.48 to HK$1.71 price range.

However, early indications show that the final institutional order book was marginally bigger than last Thursday when the deal was postponed because the leads could not close it within the size and price range allowed under US and Chinese securities laws. The institutional book (including corporates) is said to have closed at the $1.7 billion level, with a further $1.2 billion to $1.3 billion of retail demand still pending as the Hong Kong public offer does not close until Monday.

At roughly $2.7 billion in total, the deal is heading towards a final oversubscription rate of about 1.9 times. In the run up to pricing, the three leads attracted enormous criticism for their handling of the deal, but after the re-launch on Tuesday, they may have partially redeemed themselves with their strategy towards re-building the book.

This appears to have been a case of downsizing the deal below the size of the original order book to make sure that if orders were lost, it would still prove possible to close. At the same time, the three hoped a smaller offering would attract new orders and result in a comfortable level of oversubscription that could buoy the deal through its first few days of secondary market trading.

Pending the completion of the Hong Kong public offering, the order book is believed to have the following splits: institutions 43%, corporates 25% and retail 32% of which US retail comprises 15%, Japanese POWL (Public Offer Without Listing) 12% and Hong Kong retail 5%. This breakdown is broadly similar to that of Bank of China in late July, which saw 35% allocated to retail, 30% to corporates, 23% to institutions and 12% to the POWL.

One of the main differences is that Bank of China was able to leverage its many lending relationships into a $4 billion corporate order book containing 242 individual investors. By contrast, China Telecom is said to have attracted roughly half a dozen corporate orders, of which some were only $5 million to $10 million. One order for roughly $45 million is known to have come from a Li ka-shing group company, although rumours that Shanghai Bell submitted a $100 million order have been flatly denied.

Similar to Bank of China, Japanese retail demand is said to have been extremely strong and like US retail stayed firm throughout the deal's re-launch. Demand for the POWL is said to have come in around the $600 million to $800 million mark, while US retail closed around the $500 million mark, but was cut back 60% during allocations.

As one non-lead banker explains, "US retail got ticketed out last week and was basically done ahead of the deal's re-launch. All the US brokers needed was a re-confirmation from investors and most came through. The feeling we got was that US investors liked the yield and they liked the China growth story."

Where Japanese investors are concerned, observers say that the China story was the primary attraction and the yield secondary. Investors also felt that a smaller deal size would benefit secondary market trading and hence an opportunity to realize greater profits.

The institutional order book is said to have contained about 150 accounts and had a rough geographical breakdown of 45% US, 43% Asia and 12% Europe. Observers comment that one of the chief reasons the lead were confident a revised deal would work was because of about eight to 10 anchor accounts (orders more than $50 million), of which the largest came in for just under $100 million.

Some of the anchor orders came from global funds based in Asia, but the key to getting the deal across the finishing line was the more favourable view of relative value funds in the US. While Asian fund managers compared China Telecom to China Mobile and generally found it wanting, observers say US funds were much more focused on domestic comparables such as Verizon and SBC Communications, otherwise known as the RBOC's (Regional Bell Operating Companies).

The RBOC's tend to offer dividend yields of 3% to 5%, similar to the 4.4% offered by China Telecom. But the chief difference lies in EPS growth. One specialist says that while the former will only average EPS growth of 0.9% between 2003 and 2005, China Telecom is forecast to achieve a 14% ratio over the same time period.

But in return for the regulatory and operational risks of an emerging markets play, accounts expect a pricing discount. Many were initially said to have thought the 10% discount offered by China Telecom not enough. But, as a result of the re-sizing and reduction in issued share capital from 20% to 10.05% (pre shoe), a number changed their minds as the p/e ratio became more favourable.

The original deal size was marketed on the basis of an adjusted p/e range of 11.2 to 12.8 times forecast 2003 earnings. The revised deal was priced at about 9.6 times according to one analyst's estimates. This also meant that Telecom was priced at a more attractive discount to Mobile, which has been trading around the 11.3 level over the past few days.

In terms of EV/EBITDA, China Telecom was priced at 3.2 times forecast 2003 earnings according to one specialist and in terms of price to cash earnings, 3.4 times. China Mobile, on the other hand, is trading around six times EV/EBITDA and 6.56 times cash earnings.

Some Asian equity bankers have a few words of congratulations for the three lead managers who have ultimately been able to push out a lot of paper in a very bad market. They have also done so operating under a PRC-imposed constraint that no domestic company be sold below book value. China Telecom's book value falls at HK$1.47 per share, HK$1 below the final issue price.

But the vast majority of bankers conclude that the deal's execution and management of China Telecom officials was a complete shambles. Syndicate members castigate the information vacuum, which existed as being one of the worst they have ever seen and a number highlight the lack of a cap on the bookrunners' selling commission, a typical feature of Morgan Stanley-led deals.

"It's also the case that the prospectus nearly had to be re-printed for a third time after yet another disclosure issue cropped up the morning of the re-launch," says one. "I have never known a deal where there was so little control over the issuer and what they could or could not say."

And a second adds, "This deal is a long, long way from being a work of art. It could hardly be described as a Botticelli. More like Edward Munch's The Scream."

For China Telecom, one of the next steps will be to build its free float so that it can be included in the MSCI indices tracked by institutional fund managers. Over the past few days the company has tried to dismiss the notion of an equity overhang by saying that it will look to debt financing first in order to raise funds to finance acquisitions from its parent. Many believe it will return to the equity markets within the next year.

In the meantime, the next key date in the deal's timetable will be Monday when the domestic retail offer closes. Trading will then commence in New York on Thursday and Hong Kong on Friday.

Laywers to the deal include Shearman & Sterling as underwriters' US counsel, Slaughter and May as underwriters' Hong Kong counsel, Haiwen & Partners as underwriters' PRC counsel, Sullivan & Cromwell as issuer's US counsel, Freshfields as issuer's Hong Kong counsel and Jingtian Law Firm as issuer's PRC counsel.