Telstra's New Deal
13 October 2000
After six months of negotiation, PCCW and Telstra today announced final terms of their deal in two separate and different press releases.
Convertible Bond
As predicted, the convertible bond has been repriced in Telstra's favour. The size of the loan has been cut in half to US$750m, and the conversion price has been cut from the original HK$23.69 per PCCW to share to a 15% premium over the average price in the next 45 trading days (or about 2 months). So based on last night's price, if that were to be maintained for two months, the conversion price would be $8.80 per share.
The original conversion price was a 20% premium on the average price up to 12-Apr-00 when the deal was first announced. The new formula could work in Telstra's favour if markets continue to deteriorate. As PCCW's share price has now collapsed to HK$7.65 yesterday (close to our valuation of HK$6 per share), the downside for Telstra is far less than it was originally.
Importantly, the Telstra press release also discloses that the interest rate on the bond has been raised from the original 3% to 5% for the first four years, and from 5% to 7% for the last two years. That's one of several things the PCCW press release omits to mention. At the time of writing, the PCCW release was still not on their web site - so much for the speed of the internet.
Also not mentioned is the fact that the status of the bond has been raised (originally it was subordinated, ranking behind the banks) to give Telstra security over half of PCCW's interest in the IP Backbone Company (IPBC) which is a 50:50 joint venture to hold the two companies' international infrastructure. So if the loan defaults, then Telstra could end up with control over IPBC as well as the HKT mobile business (see below).
The Mobile Sale
Telstra will now acquire 60% of HKT's mobile business for US$1.68bn, valuing the whole thing at US$2.8bn or around US$3,000 per subscriber. The original deal was for 40% for US$1.5bn, or around US$4,000 per subscriber. So PCCW gets an extra US$180m of cash.
As we explained in our article What Price Mobile, that puts a big premium on the business, compared with Smartone, which trades at around US$600 per subscriber, and Sunday, now around US$800 per subscriber. You always pay a premium for control, but not on that scale.
The price for PCCW is that it surrenders control over the mobile business, but it's still a very generous price and they needed the cash. Telstra's shareholders must be wondering just what their board's strategy is with HKT Mobile, which faces a new round of expenditure on a third generation (3G) mobile network (if they win a licence) starting in 2001. They are competing with 5 other 2G licensees in a market with some 60% penetration.
The good news for HK consumers is that Telstra's takeover of the mobile business should reduce the risk of a cartel breaking out in the local market, as the Li family will only control the biggest player, Hutchison, rather than have 59% of the market through Hutchison and HKT. So we can expect continued fierce competition in the near-saturated market place.
The IPBC
There's a subtle change in the terms here which favours PCCW. Needless to say, Telstra didn't want to highlight this in its press release. In the 24-Aug-00 announcement, it was proposed that the 50:50 joint venture would take on debt and use that to pay partly in cash to its two shareholders for the international infrastructure assets being acquired from them.
The cash payments were described as being US$625m to Telstra and between $1,000m and $1,125m to PCCW. In other words, the PCCW backbone assets were worth between US$375 and $500m more than those of Telstra.
Now in the new deal, that figure has gone up to US$750m, which is the additional amount of cash that the IPBC will pay to PCCW. Since IPBC will be 50% owned by PCCW, it's debt will not appear on PCCW's balance sheet. But that does not make it disappear in economic terms - it is pure smoke and mirrors to ignore the debt load in your off-balance-sheet associates. The debt represents a real economic encumbrance on your cashflows.
So in effect, the economic debt reduction by PCCW as a result of the IPBC venture is US$375m (50% of the US$750m) not US$1,125m as mentioned in the press release.
Valuation
The other day an Australian investment house put out a US$23bn valuation on the IPBC. However, if you look closely at this deal, you can deduce a much lower figure in the minds of PCCW and Telstra. The previous announcement disclosed that the revenues of the two sets of assets (assuming they haven't changed) were US$1,097m and US$832m respectively for the year to 30-Jun-00. The difference of US$265m is valued by the two companies at US$750m, being the extra cash that PCCW will receive compared with Telstra.
That is 2.83x the revenue difference, so assuming a dollar of Telstra revenue is worth the same as a dollar of PCCW revenue, it values IPBC at US$5.46bn on an ungeared basis. The earnings before interest, tax and depreciation of IPBC were US$493m, so that implies 11.1x EBITDA. Depreciation reduces EBIT to US$361m, so the deal values the business at 15.1x EBIT. That's far more realistic than the Australian house's valuation of around 64x EBIT.
Now it is proposed that IPBC will take on US$2bn of debt, of which $1.5bn will be paid to the two shareholders and $500m will be kept for working capital. The cash pay-out reduces the equity valuation to about US$4bn, meaning that PCCW's 50% share would be worth about US$2bn.
A further aspect which supports this valuation is that following an IPO of IPBC, Telstra's bond security over half of PCCW's shareholding in IPBC would be adjusted 6-monthly to maintain security at twice the amount outstanding on the convertible note. Currently the security is 25% of IPBC, so if the two sides expect that to be worth $1.5bn (twice the bond principal) in an IPO, then they think IPBC is worth US$6bn when floated.
PCCW's debt reduction
Although PCCW has billed the deal as a debt reduction of US$3,555m, one cannot ignore the debt in IPBC. That means there is a net debt reduction of US$750m for the convertible bond, $1,680m for the mobile sale, and just $375m from IPBC (as explained above), taking the total to $2,805m. And remember, if the PCCW share price does not recover beyond the conversion price, then half the bond is repayable in 4 years' time and the other half in 6 years. If you treat that as debt then the overall debt reduction is just $2,055m.
PCCW has until 28-Feb-01 to repay the bulk of its bridging loan taken out to buy HKT. Current debt stands at about $9bn. The Telstra deal will allow that to be repaid down to about $5.5bn, so we can expect PCCW to be looking for a new $6bn long-term loan facility, principally on the basis of cashflow from the domestic fixed-line and IDD business (but excluding the international portion which belongs to IPBC).
Banks in the new loan syndicate will have regard to the fact that IPBC's assets will already carry $2bn of debt, and that the Telstra bond has security over part of PCCW's shareholding. They will also take into account the fact that PCCW no longer controls HKT's mobile business, so they are not able to direct any cashflow from that unless Telstra agrees. However, mobile is not a strongly cash-generative business and if anything, it will be calling on its shareholders to finance 3G mobile expansion.
IPBC will take out $2bn of debt to finance the cash payout to its shareholders and capital expenditure. And besides all that, PCCW is reportedly looking for funds to finance the US$1.5bn construction of the Cyberport. Some of that will come from pre-sales of flats once the project gets going, but they may need to raise up to $1bn before the project becomes cashflow positive.
The profit-sharing formula in the PCCW-Government joint venture means that the more PCCW can fund it (rather than requiring the JV to borrow the money directly), the greater PCCW's percentage profit share in the project. It is based on the deemed value of the land (for the Government share) versus the capital contribution by PCCW (for its share).
So combining the 3 facilities, the debt market might need to advance a total of US$9bn to PCCW, IPBC and for the Cyberport - in effect rolling over the existing $9bn bridging loan. The bankers are going to be busy...
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