Lead manager UBS Warburg's protestations that a full order book has been secured for the Cable & Wireless exchangeable into PCCW have been met with considerable scepticism by the rest of the market, which believes that up to two-thirds of the deal may remain unplaced.
As one rival banker puts it: "We all bid aggressively for these deals and there's a very fine balance between winning a deal and still being able to provide something that investors will accept. Sometimes when the balance is tipped a little too far the wrong way, a lead manager can find that everything starts to work against it and then it has a big problem on its hands and particularly when it is a bought deal."
For most participants, the 2.2 year deal was too aggressive for its size and for a market where sellers considerably outweigh buyers of a company that currently everyone loves to hate. Marco Bernardis, a convertibles fund manager at Bank Armand von Ernst in Switzerland sums up the general feeling when he says: "PCCW is not a stock we would want to invest in. It's far too speculative and the fundamentals are not very good.
"Aside from the stock, the structure is not very attractive to us from a technical point of view," he adds. "Of course the call option is a problem and there is also no coupon, but at least the premium is adequate, I suppose. We would have preferred to see a little bit of a coupon, and so no, we didn't purchase the deal."
A second convertibles fund manager in New York, who wished to remain anonymous, agrees that the limited call protection and lack of coupon were the two main negatives to the structure. "First of all, the fundamentals of the underlying stock are not good, and secondly, the convertible is not that attractive because it was too aggressively priced," he reports. "We don't know anyone who has bought the deal and would not be surprised at all to learn that most of the paper is still with the lead. Had the terms been a lot, lot cheaper, only then might we have participated."
This fund manager also cites the lack of stock borrow and the resulting high cost of what remains, as a further barrier to entry. "It's very difficult and expensive to set up new shorts at these levels," he comments. "The demand for borrow has been high for a very long period of time and the only viable option now is to go through UBS Warburg to get it. However, a number of hedge funds don't like the idea of setting up though the same broker they've bought the exchangeable from."
A UBS Warburg official affirms that the stock "has been the biggest short play on the planet for the last year, with some investors shorting it all the way down from the HK$18 level. It's been an interesting market dynamic," the banker comments, "and begs the question, at what point will they start looking to cover their positions?"
Convertible specialists say that with brokers now charging stock borrow fees of 4%-5%, any new investor would have had to participate through UBS Warburg, which had borrowed stock from Cable & Wireless and is said to have been charging 1%.
"We participated this way," reports a third fund manager based in London, who also wished to remain anonymous. "We bought a little bit of the deal and intend to watch it quite closely to see if there's an opportunity to accumulate some more."
He concludes that while the transaction has been controversial and its impact on the stock price heavy, it could yet prove to be a good investment. "Although the earnings on the stock are very bad at the moment, it may be possible to extract value six months from now," he states. "The equity option is definitely worth something and even if it's not worth the full 11%, no-one goes out of business for losing this amount. They would go out of business, on the other hand, if the credit proves to be worthless. But in this instance, the credit of Cable & Wireless is excellent. The bigger problem lies with the earlier PCCW convertible, where the underlying credit is very poor."
This deal, launched in October 2000, raised $1.1 billion and has had an abysmal trading record. With a five-year final maturity and hard no call for three years thereafter subject to a 120% trigger, the offering has seen its conversion premium widen out as the stock price plummets, closing yesterday (Tuesday) at 144.5%. Currently trading as high yield debt, the yield has spiked up to 11.163% from 7% at issue price.
The new June 2003 transaction closed its first day trading in Asia (Tuesday) at a bid/offer price of 99.125%-99.375%. In line with the falling stock price, which dropped 11% from Friday's HK$3.075 ($0.39) close to HK$2.725 at Tuesday's close, the conversion premium has widened out from 17%-30.1%. The deal was launched with a zero coupon, zero yield and an immediate call option subject to a 120% trigger. Conversion into shares is mandatory.
The bond floor stands at 88.41% based on a credit spread of 60bp over Libor for A2/A-rated Cable & Wireless.
The softening of terms in the secondary market has also pushed out implied volatility, which was marketed in the mid 20s and closed yesterday at 45.3%. For some investors, this is still felt to represent value compared to historic (100) day volatility of 56%.
"The volatility is the only way to play the deal," says the London-based fund manager. "Even with the stock down to HK$2.70 and the implied volatility up past 40%, it's still cheaper than buying a covered warrant on PCCW, which I doubt we would be able to get for volatility of less than about 50%. Some investors aren't happy because the stock is very heavy, borrow is very short and it obviously hasn't reached its bottom yet. But we see the upside beyond this."
UBS Warburg officials also argue that once the stock stops being driven down by speculators, it will start to find a solid platform. "Not many commentators are arguing that this stock is a rip roaring buy," says one. "But at these levels, some believe that it is starting to looking interesting."
Lead bankers also argue that traditional EV/EBITDA calculations are pretty meaningless for a company in the process of undergoing such massive restructuring. At HK$3.075, PCCW was trading on a high 16 times level (ex associates) against regional comparables, but a more acceptable 12 to 13 times level at HK$2.70, where it falls in line with the historic levels commanded by Singapore Telecommunications.
Where debt ratios are concerned, PCCW's nearest comparable among the region's major fixed line players is Ba2/BB+ rated PLDT, which reported a similarly weak EBITDA to interest coverage ratio of 1.7 times and debt to EBITDA of 6.3 times as of June 2000. In its sales note, UBS Warburg computed that PCCW had an interest coverage ratio of 1.75 times during 2000 and believes that this will rise to 2.2 times by 2003.
"Because you have $200 million in negative EBITDA from the B2C business, I don't think you can look at PCCW on a straight EV/EBITDA basis," the banker argues. "If you use a 16 times multiple, then you are assigning a negative net worth of $3 billion for this side of the company. Really, you should zero this figure out. The best way to assign an overall valuation is by stripping out the fixed line business and assigning a SingTel-type multiple, take a view on the value of Reach [PCCW's IP backbone JV with Telstra] and then factor in the 40% holdings in the mobile business.
"PCCW realizes that the world has changed and that equity is no longer free," the banker continues. "It has said that it will come up with a business model for the B2C business that is either cash flow neutral or positive."
Bankers further believe that with much of the company's future capex de-consolidated from the balance sheet and a number of assets available for sale (including a $400 million to $500 million property portfolio), the company's financial health is much better than its critics give it credit for.
Few would also doubt that PCCW and Cable & Wireless have got the best possible terms in the current climate. The former has finally been able to remove the share overhang from C&Ws 14.7% stake, while the latter has secured an interest free loan and divested itself of an embarrassing investment.
A UBS Warburg official defiantly concludes: PCCW and Cable & Wireless have got what they wanted and weve delivered what we promised. The vendor is happy, the company is happy and everyone stands to gain.