Chunghwa ADR stumbles on the starting blocks

In a pattern familiar to many Asian privatizations, a government''s inability to countenance discount pricing has resulted in the collapse of a key divestment.
The abrupt withdrawal of a debut ADR for Chunghwa Telecom has surprised few given the large gulf between what international investors were willing to pay for the stock and what the Taiwanese government had been expecting to receive for it. Since early autumn, when the first stage of the privatization was launched at NT$104 ($3.24) per share, the company's share price, and with it the government's ambitions, have suffered a long and painfully sharp fall to current trading levels around the NT$77 mark (Tuesday's close).

For a government that had clearly found it hard to come to terms with such a harsh adjustment over such a rapid timeframe, the prospect of having to price an IPO at a discount for foreign investors proved too politically unpalatable to bear. Market observers consequently report that while it was willing to accept parity pricing to Chunghwa's NT$77 share price, it would not accept the indicative price range of NT$65 to NT$75 per share proposed by the deal's three lead managers Goldman Sachs, Merrill Lynch and UBS Warburg.

At current levels, the company would have raised NT$102.564 billion. In total, it had made an SEC filing for 1.158 billion shares (115.8 million ADRs) and a 174 million share greenshoe. In terms of the company's 9.647 billion share equity base, this represented a 13.8% stake. Alongside the three leads, ABN Amro, Credit Suisse First Boston and Deutsche Bank were named as co-leads, with CLSA, Daiwa, ING Barings and Soc Gen as co-managers.

At the heart of the problem lies the fact that Chunghwa has attempted to go public at a difficult point in its corporate history and at a difficult point for the telecom sector as a whole. Unlike the many other telecom-related stocks simultaneously attempting to access the international equity markets, the company has also been constrained from showing more flexibility by both its government-imposed timetable and the structure of its offering. The government's divestment schedule may have matched its own budgetary requirements, but it failed to take into account deteriorating sentiment towards global telecom stocks.

With the straight equity and debt markets saturated with paper from a sector estimated to need $300 billion to purchase and fund 3G licenses this year, prospective issuers have increasingly turned to the equity-linked market in search of new investors. Hutchison Whampoa set the ball rolling in early January with its second exchangeable into Vodafone. Orange, Telecom Italia and Olivetti have all followed suit since then, or announced their intention to do so.

Chunghwa, by contrast, had no such leeway, partly because of the inflexibility of its schedule, but largely because the country's Byzantine securities laws make exchangeable offerings difficult and time-consuming propositions.

"Privatizations can often be painful learning curves for all concerned," one observer concludes. "But with this one, the situation was compounded by the inexperience of a government whose last attempt to privatize a state-owned asset in 1997 ended equally ignominiously."

A second adds: "Few transactions are more politically sensitive than a privatization. With Chunghwa Telecom, the lead managers were having to deal with a stock which had been sold at a very high price to domestic investors and had come down sharply in a very short period of time. How then could the government turn round and justify selling one of its more valuable domestic assets to foreigners at an even more substantial discount?"

Inaccurate valuation

For many observers, if fault can be assigned anywhere, it lies with the initial NT$104 valuation and the NT$140 share price some bankers allege the ADR mandate was originally won at in September. Neither price has ever been in line with any Discounted Cash Flow (DCF) valuation compiled by either international investor or syndicate banker. Consensus opinion gives the company a DCF valuation around the NT$60 to NT$80 mark.

As one banker explains: "A bear case valuation would assign Chunghwa Telecom a DCF as low as the mid NT$50s, and in a bull market up to nearly NT$100. Most banks have come out somewhere in the middle. Whether you would then need to apply an IPO discount depends on your view of the country's telecoms sector. We would argue that Taiwan's strong dynamics means that it should not necessitate one."

And as one of Taiwan's largest domestic investors adds: "We were absolutely amazed when the government came out with its NT$104 issue price and thought it was completely ridiculous from the word go. Our own analysis of the company put fair value at more like NT$80. We have always treated Chunghwa as a utility play, assuming low growth of less than 10% per annum and consequently a low price/earnings ratio of about 10 to 15 times 2001 earnings."

Had the government been able to adopt a different structure for the privatization process, many bankers argue that the end result could have been very different. The success last year of privatizations from China, Hong Kong and Singapore can in part be attributed to their simultaneous global offer structures. By targetting domestic and international investors at the same time, pricing momentum can be generated by playing the demands of one investor base off against another. In Hong Kong and Singapore, in particular, domestic investors were not penalized for any over-optimistic assumptions on the part of their respective governments, but rather incentived with slightly discounted pricing.

"In some Asian equity markets, principally Korea and Taiwan, there is either restricted access to stock, or a lack of internationalization in the IPO market that has led to a noticeable bifurcation," one banker comments. "This makes it very difficult for any bank to get an international equity offering away. There is a real inability for foreign investors to participate in the initial domestic offering and then an unwillingness on the part of the government to sell them international stock at a market price which may necessitate a discount to the local price."

In Taiwan's case, the auction style rather than book build style of domestic IPOs ruled out any possibility of a simultaneous offering structure. "General capital market practise dictates that in a privatization, a government should try and access the widest possible investor base and be very careful about what it says in relation to timing," a second banker adds. "The danger of a multiple tranche approach is that you may end up with each investor base assigning a very different valuation to the company in question."

ADRs always come at a premium!

The Taiwanese government was also said to be labouring under a misapprehension that an ADR offering could achieve premium pricing to the local stock price. "This is really embarrassing for our country," says one local banker summing up the general mood in Taipei. "ADRs always come at some sort of premium."

A banker replies: "One of the main problems dealing with Taiwan is that there is an almost mythical belief that ADRs should trade at some kind of premium to the local stock. The fact is that only two do: TSMC and UMC. Both are global leaders in their field, not a purely domestic operator with a declining market share."

Merrill Lynch faced a similar problem when it attempted to meet government demands for parity pricing on a 5% sell-down of China Steel in early 1997. It was only finally able to do so after scaling back the offering size from $250 million to $183 million, keeping books open in the hope of persuading funds against a discount and managing to secure what was rumoured to be a $100 million order from one Swiss bank, which subsequently went on to win a convertible mandate from the company.

Once a failure...

Getting Chunghwa away was always going to prove a tall order, and while the decision to postpone now rather than immediately before pricing has been praised, many believe that the deal has nevertheless been tainted by an association with failure. After watching the company's domestic privatization unfold into a public relations disaster, the three leads had always known that one of their most important tasks was to overturn the prevailing negative tone and quickly.

With roadshows cancelled the day before management was to set off for Hong Kong, Chunghwa's story has yet to be given a public airing. As a result, a perception that the company may be a bloated state-owned monolith fighting to maintain market share lingers. As one banker jokes: "The comic story is that when a third of the staff went on strike and marched against the company last year, the country's telephone system continued to work just fine."

Yet as one banker argues: "The fact is that you can make a fantastic case for the telecoms industry in Taiwan and particularly the wireless sector. Teledensity is staggering and penetration rates could easily surpass the 100% mark when non-human use by fridges and vending machines, for example, starts to kick in."

A second continues: "Recent growth levels in Taiwan have been exceptionally high. Mobile penetration has jumped from 7% to 65% to 70% in the space of only a few years. One of the most positive aspects of the pre-marketing was, therefore, in being able to change key investors' opinion of the company. Originally, we had expected that some accounts would say definitely no and were mildly surprised that hardly any did. They are much more interested in the company now and Chunghwa will find it easier to re-present to them when it comes back."

In benchmarking the company against international comparables, it was decided to pitch it on an EV/EBITDA level of about six times 2001 earnings, mid-way between the levels of its nearest comparables, Singapore Telecommunications and Korea Telecom. Pre-marketing feedback confirmed that this was indeed the level that investors would accept the company, despite the fact that its growth prospects are not viewed as strong.

"Chunghwa Telecom is at an unfortunate juncture in its history with regards to the public offering," one specialist notes. "Singapore Telecommunications has already made the move to seek growth by diversifying into the international markets, while Korea Telecom has aggressively made itself the largest high-speed broadband service provider in the Republic. Chunghwa is not at this stage yet."

Cash or stock dividend

Ironically, the company's large free cash flow has also counted against it in one regard. Since earnings are easily able to cover annual capex requirements of about NT$50 billion, the company had planned to give some back by enticing investors with a high dividend yield around 8%. At these levels, it would park itself in the ranks of a utility stock, attracting international investors looking for a defensive play on the telecoms sector and Taiwanese economy.

However, as one domestic fund manager explains, for local investors, a cash dividend has virtually no appeal at all. "In any market, it's retail investors that are most often driven by dividend assumptions," he explains. "And in Taiwan, investors are only interested in stock dividends.

"This is partly because our market is dominated by tech companies which need to conserve cash to continue growing their businesses and so offer stock dividends which investors have become used to. But it is also because of a quirk in our tax regime, which uses a stock's face value rather than its market value as the basis to determine capital gains tax."

How culpable were the lead managers?

In any fiercely competitive mandate situation, investment banks are often tempted to make promises that are subsequently hard to live up to. In Chunghwa's case, the award of a mandate to lead an ADR offering almost perfectly coincided with a sharp fall-off in favour towards the whole telecoms sector.

It rapidly became clear that sticking to the government's original timetable and rushing a transaction to market before Christmas was not a wise option. Over that period, the government appeared to make the hard adjustment towards acceptance of a more realistic price for Chunghwa. Postponing the transaction only one day before roadshows would also suggest, however, that it was still hoping for some form of market salvation right until the end.

"The banks had all prepared their research and investors had done their preliminary homework, but the government kept ploughing on even though no-one had made a positive revaluation of the company," one banker remarks. "Sometimes it seems that only when it comes to the crunch, can an issuer finally accept what everyone else has known all along."

A second affirms: "Sometimes people do need a slight shock before they are mentally able to get to the point where they accept the reality of a situation, decide to step back and consider what is the best option for all concerned."

An exchangeable?

Where this now leaves the transaction remains open to debate. Over the past few weeks, a number of houses have proposed that the government consider an exchangeable bond as a means of disposing of the stock at a premium to its current share price. Such a strategy is flawed for a number of reasons, experts say.

"Firstly, the company has an extremely small free float and an ADR transaction in exchangeable format would leave the stock price continuously at the mercy of delta hedgers," states one market player. "Secondly, any form of government-related debt instrument in Taiwan needs Legislative Yuan approval, which is a very cumbersome procedure. The company needs to expand its equity base. The only problem is how to do so effectively."

Those close to the transaction remain confident. "The whole point of the pre-marketing is to conduct a final check and it is far better to undergo the catharsis now," one concludes. "The privatization remains intact and the SEC filing open. We're confident that when it comes to valuation, investors and the government will be able to meet in the middle sooner rather than later." 

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