Taiwan government privatizes Chunghwa Telecom

Government completes country''s largest ever equity offering.

The Taiwan government acting through the Ministry of Transport and Communications (MOTC) sold a 17% stake in Chunghwa Telecom (CHT) on Tuesday (August 9), reducing its stake in the company below 50% and freeing management from restrictive operational procedures.

The $3.113 billion offering was split into two, with 289.4 million shares sold via a domestic auction and 135.068 million units in ADR format. There is a ratio of one ADR per 10 common shares.

Under the lead management of Goldman Sachs, Morgan Stanley and UBS, the $2.56 billion ADR offering was priced at $18.98 per unit, representing a 3% discount to the ADR's $19.57 close in New York on Tuesday and a 0.5% discount to the stock's close in Taipei earlier the same day. The domestic offering was priced at NT$56.30 per share, representing a 7.7% discount to spot.

Year-to-pricing the stock had traded down 2.40%, but had had a far more volatile run in the week after launch. News that roadshows were being launched late last week immediately sent it tumbling down from its 52-week high around the NT$66 level. The premium between the ADR and local spot price also contracted from around 8% level to about 2.5%.

Initial guidance on the ADR was set at a 5% to 10% discount to spot. This wide range marked a deliberate ploy on the part of the lead managers to try and build early momentum for what represented a large deal at a slow time of year for the equity markets.

The strategy worked and by Tuesday, the leads were able to narrow the range to between 3% and 7%, before pricing at the tight end. During New York's trading on Tuesday, the ADR also rose marginally from $19.42 to $19.57 in a reflection of the domestic deal's success.

The Taiwanese government is likely to be extremely pleased with the result - the more so because of the opposition it faced trying to bring it to market. Indeed, on the day of pricing the company's powerful labour union had mobilised its members to try and jam the phones lines in the capital and it has called a one-day strike for the day the stock goes ex-dividend on Friday.

As a result of the deal, the government has dropped from a 65.3% stake to 48.3%. Ultimately it has said it wants to reduce its holding to 33%, but has not set out a timetable for future sales.

Foreign investors, however, are now very close to the 49% foreign shareholding limit on the stock. Pre-deal, analysts estimate that QFII's held about 22% through the domestic market and 11.5% in ADR format.

This is likely to have been one of the reasons behind the deal's success, since it will now be more difficult to build big positions in the secondary market. Observers say that the international order book minus the POWL (Public Offering Without Listing) in Japan was roughly seven times covered.

For POWL manager Daiwa SMBC, the deal was particularly lucrative since Japanese retail investors were allocated 23% of the total deal. By demand, observers say the rest was split 50% Asia, 30% US and 20% Europe. Over 400 investors placed orders.

Specialists believe the strong demand was driven by two major factors. Firstly telecom bankers note an increasing global re-weighting of the telco sector.

As one comments, "Investors are becoming a lot more positive, although buying activity has mainly come from Europe and Asia so far. There's a feeling that the debt problems are now behind the telcos and the technology risks associated with 3G are more manageable.

"I don't think EV/EBITDA valuations will shoot back up to the 13 level, but there's plenty of scope for them to trade up to the six to eight band."

CHT is currently trading at about 5.9 times on a 2005 basis compared to a 5.2 times average for integrated telcos from non-Japan Asia (NJA), 4.4 times for US integrated telcos and four times for European integrated telecoms.

On a P/E basis, it is also relatively rich and is trading around 13 times 2005 earnings, compared to a 14 times NJA average, 16.5 times in the US and 14.7 times in Europe.

However, this valuation is counterbalanced by the stock's strong dividend yield - the main selling point of the deal. The company was initially supposed to pay its 2004 dividend on July 18, but the date was moved to mid-August in order to try to get the ADR completed so investors could enjoy the pay-out.

Based on a dividend per share of NT$4.7, ADR investors will receive a yield of 7.8% based on the sale price. On a forward looking basis, the NJA average currently stands at 3.7%, compared to 4.4% in the US and 4% in Europe.

One of the key criteria for investors thinking of purchasing CHT (and holding it beyond the ex-date) is the sustainability of that dividend yield and their belief in management's ability to continue maximising shareholder returns.

Observers say company officials are under no illusions about this. Says one, "They fully realise their major asset is the company's cash flow. They told investors they have no concrete plans to start making overseas investments and are committed to bolstering shareholder returns."

And he adds, "Investors realise that top line growth will be slow (1.5% revenue growth in 2004), but they hope bottom line growth will be boosted by cost cutting measures and balance sheet management."

One thing the company will not be able to do is boost the pay-out ratio since it is already at the 90% limit - the Taiwanese government stipulates that 10% of net earnings be held in a legal reserve.

Taiwan Mobile and Far EasTone have room to do so, however, and both are currently yielding more than CHT. The former is yielding roughly 8.3% based on a 78.7% pay-out ratio of net income and the latter 7.5% based on an 83% pay-out ratio.

Instead, CHT hopes to boost its dividend yield by buying back shares and improving ROE. It has plenty of room to leverage up since it runs a net cash position. At the end of 2004, it reported an ROE of 16.3% versus an NJA average of 20.4%.

During roadshows the company did not outline a specific timetable for buying back shares. When it last tried to do so in 2003, moves to buy-back 7% to 10% of its equity were blocked by the union.

Should it succeed this time round, some analysts believe there will be a negative impact on the dividend yield over the short-term. This is because share cancellations have to be written off against unappropriated earnings and will, therefore, have to come out of the same 90% pool the divided is paid from. Some analysts believe the yield could drop to 5% the year following a 6% buy-back before jumping to 8% the year after.

The company's other big initiative is to improve its operational efficiency and earnings through cost cutting. Unsurprisingly, company officials were loathe to make public statements about cost cutting measures during roadshows for fear of stirring up the unions even further.

But local newspapers have reported that up to 8,000 employees could be shed from the 28,000 strong workforce over the next couple of years. About 800 of this number will also automatically opt into the company's voluntary retirement programme now the privatization has been completed.

How fiercely this efficiency drive will be resisted by the union is one imponderable hanging over the share prices. The other major uncertainty surrounds the changing dynamics of the competitive landscape in Taiwan.

Most analysts agree the telco sector is poised to undergo a period of rapid change. Over the next year, Taiwan will witness the establishment of a new independent telecom regulator, the introduction of MNP (mobile number portability), the introduction of 3G, VOIP and at least one new competitor.

Over its recent history, CHT has been able to successfully withstand competition, but analysts worry its margins will be pressurised by competition at the margin. In a country of 22.69 million people (end of 2004), CHT had a 97.9% market share in fixed line, a 36.6% market share in mobile and 80% in broadband.

Overall, penetration rates in Taiwan stood at: 59.6% fixed line, 98.5% mobile and 51% broadband.

Where the regulator is concerned, Taiwan is in the process of establishing a National Communications Commission (NCC) to replace the Directorate General of Telecoms (DGT), presently headed by CHT's former parent the MOTC. Most analysts believe the NCC is unlikely to suddenly adopt an intensely pro-consumer stance like that of the Hong Kong regulator. But, a number point out that it may yet adopt a more competitive policy, which will disadvantage an incumbent like CHT.

Analysts are more sanguine about the impact of MNP and 3G. The former is scheduled to be implemented on October 15, but CHT's strong market share across the whole industry means that it can offer the best discounts to clients that opt for bundled services.

As one telco banker explains, "Customers will only get big discounts if they stay within CHT's network. This will severely curtail the impact of MNP."

Likewise, most analysts believe it will be difficult for new 3G operators like VIPO to gain much traction, although the latter has strong backers - Kinpo and Compal - plus equally forthright ambitions to capture 20% of market churn within its first year of operation.

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