UMC sets new benchmark for Taiwan

Pricing of a $200 million exchangeable into AU Optronics underlines the incredible strength of the Taiwanese equity-linked market.

The foundry manufacturer took the first steps yesterday (Thursday) towards monetizing a 4.3% stake in Taiwan's leading producer of large size TFT-LCD panels with one of the most aggressively priced equity-linked offerings to date. However, while the majority of market participants believe the deal has set the kind of tight benchmark which others can only hope to emulate, some argue that terms could have been pushed a lot further given the current trading levels of recent transactions.

Where none would disagree is that the valuation hinges on the prospective launch of a $770 million ADR offering for AU Optronics, which will give investors a stock that can be hedged. Without the ADR, terms become prohibitively expensive because there is no stock borrow. With the ADR, convertible experts say the deal offers a relatively attractive volatility play, although those investors which take that bet would have wanted some compensation to cover the uncertainty of the Salomon Smith Barney-led New York listing, which has also provisionally been scheduled for May.

The lead manager of the exchangeable is Lehman Brothers. Terms for the $200 million deal (pre-greenshoe) comprise a five-year final maturity, zero coupon, zero yield, par redemption and a conversion premium of 17.5% to Thursday's NT$50.5 close.

There is also hard no-call for three months subject to a 120% hurdle, although UMC has said that it will endeavour to extend this to March 2003 in the event that an ADR does not take place. The put option is set at two years and nine months.

Alongside the lead, ABN AMRO is joint lead, with co-managers comprising Daiwa, Deutsche, Chinatrust, National Securities and UBS Warburg.

Underlying assumptions comprise a bond floor of 86.1%, theoretical value of 102.4% and implied volatility of 31.9%. This is based on a credit spread of 130bp over Libor, zero dividend yield, 2% stock borrow cost (in the event of an ADR) and 40% volatility assumption. Historic volatility stands around the 60% mark.

The deal was formally executed under a rapid timeframe with books launched at London's open and closed about six hours later four times oversubscribed. Distribution for the Reg S deal was said to have been almost equally split between Europe and Asia.

Participants note that the bond floor is the lowest on record for a Taiwanese deal, with UMC itself coming in second last December with a $302 million deal that had a bond floor of 88.5%. Other observers also highlight the exceptionally aggressive call, which incorporates a structure that investors almost universally loathe because their upside is limited to 20% and there is a high probability of the deal being called away from them before they have a chance to ride the equity story. The last time a similar call structure was used in Asia was April last year when Cable & Wireless monetized part of its stake in PCCW.

UMC, on the other hand, would have wanted the short call to force conversion of a stake, which it is trying to sell towards the high point of the market. Pending the completion of the greenshoe, the company will have divested 138 million shares and reduced its stake from 14.8% to 10.5%. It also recently completed a domestic exchangeable, which reduced its stake from 17.2% to 14.8% through the divestment of 80 million shares.

But the counterbalance to the aggressive call structure is the level of implied volatility. Investors have paid 14 points for the equity option in return for a 28.1 point differential between implied and historic volatility, although this has been discounted to eight points in the valuation model. When UMC completed its deal in December, investors paid 11.5 points for a 12 point differential based on implied volatility of 50% and historic volatility of 62%.

The UMC transaction is currently the most expensive Taiwanese deal in the secondary market on a volatility basis, trading on implied volatility of 60.71%. Other recent Taiwanese deals, which have some form of stock borrow, have also seen implied volatility levels shoot closer to historic levels, with Macronix, for example trading on implied volatility of 45.1% against a 260 day level of 63% and Siliconware at 40.3% based on a 260 day level of 63.5%.

The combination of the recent removal of Taiwan's cumbersome Entitlement Certificates, the underlying performance of the domestic stock market and confident projections for the tech cycle, have conspired to push all of this year's CBs well above par. At Asia's close yesterday, for example, Macronix was bid at 109% and Siliconware at 110%, with UMC at 115%.

But as one participant argues, "Just because a couple of previous deals have performed well in the secondary market, does this mean that investors will be happy to pay 14 points for a new deal, whose fortunes are linked to an event which may or may not happen?"

A second adds, "Investors are taking a big bet on the ADR taking place. But it's a relatively small deal so it wouldn't have been that difficult to find investors that would. When you've got a great credit like UMC, a great equity story like AU and a red hot market like Taiwan, a deal like this will fly."

Since December, when BBB rated UMC launched its 2.25-year deal based on a credit spread assumption of 200bp over Libor, spreads have tightened considerably. In the equity market, AU has also been one of the better performers returning 55.38% on a one-year basis and 35.03% year-to-date.

The stock is, however, down from a mid February high of NT$62.5 when it hit a price to book valuation of just over four times. Currently it is trading at just under three times. Analysts say that the share price has been weighed down in recent weeks. Partly this derived from the prospect of the UMC exchangeable. But mainly, it came from a realisation that a previous NT$10 billion convertible launched last November at a conversion price of NT$15.8 per share (becomes convertible in June) and a prospective new share ADR offering will be highly dilutive to the company's existing equity base.

AU Optronics was formed in September last year from a merger of Acer Display Technologies and Unipac Electronics. It is now Taiwan's largest manufacturer of flat screen panels and analysts believe it is well positioned for the jump to 5G fabs. AU and a smaller rival HannStar also represent the only two pure plays globally for a sector which has caught the imagination of investors and provides the upside potential of the DRAM sector.