What made Netcom buy PCCW stake?

Chinese telco enters the Hong Kong market. Good luck will be the verdict of many.

The worst-kept secret in Asian M&A was finally announced yesterday when China Netcom declared its intention to buy 20% of PCCW. In doing so it is dipping its toe in what many will regard as one of the world's most difficult telecoms markets - indeed, a market so difficult that the operators and the regulator (OFTA) frequently take pot shots at each other in the media.

Hong Kong's mobile phone market is highly fragmented and contains six operators whose ARPUs (average revenue per user) have been progressively declining thanks to price wars. The local fixed line and IDD business is under massive pressure from new technologies, primarily VoIP (voice over internet protocol) - with PCCW fighting a strong rearguard action against competitors such as City Telecom.

In summary, Hong Kong's telecom market is a pretty good one if you are a consumer, but as a shareholder there are few in the analyst community who would describe it as stellar. It lacks the growth of an Indonesia or a Vietnam and as stated above, there are too many competitors while new technologies are wreaking havoc.

All of which makes you wonder why Netcom had any interest in taking a 20% stake in PCCW? The Chinese telco paid $1 billion (in stock) to become the second largest shareholder in PCCW, and did so at a price of HK$4.74, which amounts to about a 20% premium.

The $1 billion is being injected as new equity and bankers say the best Hong Kong benchmark for the trade was BT's capital injection into Smartone in 1998. A similar premium was paid on that occasion, although it was obviously a much more bullish period for telco stocks.

This transaction will see major shareholder, Richard Li diluted from 32% to 25.5% and face a 12-18 month lock-up on further stock sales. The deal will also see HK$5 billion committed for new investment in China, although the exact details have been left vague.

So what does Netcom get? And why did it do the trade?

The answer to the second question is potentially easier to field than the former. It is evident that PCCW - the old Hongkong Telecom - is regarded as a strategic asset for policymakers sitting in Beijing and its acquisition by a Chinese telco is part of a bigger process that began with the 1997 handover.

Netcom, whose telecom assets are all located in the North, immediately benefits on a geographical level by stretching its footprint to the South - thus giving Netcom the strategic satisfaction of flanking China Telecom from both the North and South. A push into Guangdong province will be regarded as the logical next step.

PCCW also brings human capital. In recent years PCCW has grown adept at savvy marketing thanks to the very cut-throat nature of the Hong Kong market. Even more importantly - after selling its CSL mobile business - it has become much more aggressive at experimenting with new technologies and expanding into new areas.

Indeed, in many respects PCCW is one of the strangest beasts in the telecoms world. On the one hand it is an old-style incumbent that is defending its IDD and fixed line turf tooth-and-nail and attacking new technologies (ie VoIP) with a luddite zeal. On the other hand, it is itself the proponent of some seriously disruptive technologies.

The most evident of these to consumers has been its aggressive push into the pay-TV business via NOW. NOW has come along way since Richard Li's original vision of a 'network of the world' and is now just a standard distributor of content, via PCCW's broadband network.

As such, it has become a massive thorn-in-the-side of dominant cable TV operator Wharf, especially after it poached ESPN-Star Sports from the latter. Wharf's iCable was the entrenched cable TV operator and PCCW's move into its turf via its own internet-delivered service (the customer, by the way, can't tell the difference) is just as disruptive as what City Telecom is doing via VoIP to PCCW's own fixed line business.

Then there is PCCW's drive into Wi-fi. This is a technology that most people will associate with Starbucks and hotel rooms, but taken to its logical conclusion is very disruptive - particularly to 3G.

At the moment most people use Wi-fi (if at all) to surf the net using their laptops while sipping a latte in Starbucks or some similar place. The service has been rolled out aggressively in Hong Kong (by PCCW) to try and match what is happening in the US. (PCCW has also been investing heavily in Wi-fi in the UK).

However, Wi-fi gets more interesting when you see the next wave of technology, called WiMaxx. The Koreans are the leaders at rolling out WiMaxx and what they are promising is a system that will let you surf the internet at broadband speeds while traveling at up to 70mph (ie sitting on a train). This will be considerably quicker than the current 3G experience - and considerably cheaper to roll out than the billions spent by major global operators on 3G licenses and networks.

The only issue about WiMaxx is how regulators will treat it and allocate spectrum to it. What is not in doubt is that many in the telco industry recognize that WiMaxx has the potential to aggravate 3G network operators. New age PDAs will be able to do everything that a 3G phone can do (and more) and roam between WiMaxx base stations.

When you hear people talk about the coming convergence of broadband and wireless, WiMaxx and its derivative technologies are basically what they are talking about. Thus PCCW is useful to Netcom because its people are already entrenched in these areas.

Discussion of new technologies is particularly relevant in China right now, and indeed this may also explain Netcom's zeal to get a deal done. It is an open secret that Chinese policymakers - probably just after the National Peoples' Congress in March - will make some fairly definitive statements about the telecoms landscape and how they wish it to evolve.

The Chinese government remains the controlling shareholder in all four Chinese telcos (China Mobile, China Unicom, China Netcom and China Telecom). And it is particularly keen to make sure that good infrastructure is put in place ahead of the 2008 Olympics and that includes in the telecoms space.

This has led to intense speculation about the four players consolidating into either three, or ideally, two players. The government knows it will take up to two years to build nationwide 3G networks and that the cost of each network will be $8-10 billion. As the controlling shareholder of all four companies it makes little sense to give out four 3G licenses and spend up to $40 billion, when it could avoid duplication of cost if only two high quality 3G networks were built.

The telco that is most often talked about as an M&A target is Unicom, and what is clear is that all the telcos are now jockeying for position ahead of the new regulatory regime. By embracing new technologies, Netcom is clearly putting itself in a neatly hedged position. How Wi-fi and WiMaxx will fit into the overall picture should also become clear this year. At the very least, WiMaxx will become the favoured option for rolling out broadband services to China's rural areas, because it leads to huge cost-savings on the so-called "last mile".

Netcom has displayed considerable political clout, even aside from getting this PCCW deal done. According to bankers it has gained a license to broadcast TV over its broadband network. Obviously the PCCW deal will bring the technology and expertise to capitalize on that license thanks to its NOW service. However, what makes this license so significant is the fact that historically the Chinese TV industry has been closely controlled through state-owned cable companies, with the obvious intention being to restrict what people watch. Netcom's license - if it manages to follow through and roll out a TV service - will be a major crack in media policy and a huge potential earner for Netcom.

What looks clear about the PCCW transaction is that it is probably much less about Hong Kong (an awful telco market) than it is about China: the evolution of new technologies and Netcom's desire to bring PCCW's human capital to the party in employing these technologies. And given all the face issues and approvals that will have been processed, it may also give Netcom a degree of comfort that it will be a survivor in the coming reorganization of the Chinese telecoms landscape.

Netcom was advised on the transaction by Goldman Sachs, while PCCW was co-advised by JPMorgan and Morgan Stanley.

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