Fears that equity investors were on a buyer's strike diminished somewhat yesterday (May 19) when China Telecom successfully pulled off the largest placement of the year, raising $1.725 billion. The fixed line telco placed 5.85 billion shares at HK$2.30 each - a 3.15% discount to the stock's HK$2.37 close Wednesday lunchtime when it was suspended.
The whole market could clearly understand why joint leads Morgan Stanley and UBS would choose to launch a deal on a day when share prices were suddenly spiking upwards and momentum briefly returned. But, many bankers were unable to comprehend why investors would buy into such a large deal given that underlying sentiment remains nervous, negative and volatile.
A number assumed that since the deal had been so well flagged, hedge funds had more than enough time to get short positions in place. But those close to the deal say the final order book was split 75% long only accounts and 25% hedge funds.
As one explains, "Usually with a placement of this size you'd expect to see hedge funds driving demand and pricing. But in this instance they were pretty thin on the ground because they've been badly burnt in recent weeks. There had been a lot of short positions against the stock, but most had already been covered since there have been so many days when the markets got beaten up."
On the contrary, long only accounts are said to have come into the deal because they believe China Telecom's valuation has now fallen far enough to promise 20% to 30% upside on a medium-term view. On this basis, the placement offered interested investors an opportunity to build a position in a stock, which previously had a fairly limited freefloat of only 10.62%.
The stock has recently been trading about $40 million a day, which means the new deal equates to about 43 days trading volume and will expand the freefloat to 17.15%. The listed vehicle issued 90.9% of the shares and domestic shareholders the remaining 9.1%.
The strong showing by outright accounts meant the order book had a very stable core. About half the $3 billion demand generated came from 50 accounts placing orders for at least $20 million.
"There were no super jumbo orders," says one observer. "They were all below the $100 million range and the deal had a long tail."
Having monitored the market for a couple of weeks, the leads waited until a day when Asian equity markets rebounded. By Wednesday lunchtime when the stock was suspended, the H-share sector had already risen 4.5% on the day.
To ensure the deal continued to engender positive momentum, the leads decided to allocate the first $1 billion on a first come first served basis. Within about 45 minutes, this portion of the deal was covered. They then built a book for the remaining $500 million and this went on to close about three times covered.
Given there was leeway to raise the deal by 15%, the transaction was upsized to the maximum $1.725 billion. This fell short of original expectations for a $2.5 billion plus offering but, nevertheless, represented a considerable achievement given the poor state of market conditions.
"I think everyone was very clear about where the deal should price," says one specialist. "The many uncertainty was how big it should be."
Just over 200 investors are said to have participated, with an overall geographical split that saw 47% placed into Asia, 28% into Europe and 25% into the US. The book built part of the deal had a split of 35% Asia, 33% Europe and 32% US, while the first come first served book was split 55% Asia, 24% Europe and 21% US.
At the time of pricing, China Telecom was trading at about nine times 2004 earnings, compared to a global fixed line average of 11 times. It is this discount, following the stock's poor performance year-to-date (down 25.78%), which is said to have encouraged accounts to take a longer-term view.
Analysts say it makes no sense for the stock to trade below the global average when it has far superior top line growth and highly defensive cash flows.
But the main uncertainty is when it will get its long coveted mobile license. As Deutsche Bank wrote in a recent research report, many are assuming negative revenue growth from 2006 because of intensifying competition and mobile substitution. The company needs the license to keep maintain growth at a time when it will no longer be able to boost future earnings through asset injections.
The current deal was prompted by the listco's Rmb67.8 billion ($8.2 billion) acquisition of 10 southern provinces from the parent (including Rmb40 billion in assumed debt). The acquisition was valued at 8.9 times 2004 earnings, assuming a profit forecast of Rmb3.1 billion for the 10 provinces.
China Telecom is funding the purchase through a mixture of cash (via the placement) and a shareholder's loan. After accounting for the placement, the acquisition will enhance EPS by 11%.
The listco's last acquisition of six provinces was valued at 11.5 times forward earnings and enhanced EPS by 21% to 23% in 2003.
Yet as CSFB wrote in a recent research report, "In the previous acquisition, the market was so impressed with its 23% EPS accretion that very few investors cared about how much of that was due to the heavy asset-write down at those six acquired provinces (we estimate the EPS accretion would have been only 14% without such depreciation savings)."
It went on to add that the smaller EPS accretion this time round (because the earnings base is now larger) has only been possible, "with a big help of lower depreciation (Rmb3 billion) as a result of a Rmb14.8 billion write-down."
Yet, as company supporters argue, the company has a successful track-record in reducing costs and improving margins. The 10 new provinces, for example, are currently loss making because of high capex and a high cost structure.
Analysts note that in the three months following China Telecom's last acquisition in 2003, the company's share price rose about 35%. However, they also highlight that incumbent listed stocks normally come under selling pressure when a large IPO by a competitor approaches. One of the guiding principles behind the timing of the current deal, for example, is the knowledge that China Netcom is planning to list in Hong Kong early in the autumn.
Whether the success of China Telecom's deal will significantly lift the prospects of other China deals in the pipeline remains unclear. What it does show is a market that remains open for the right deal in the right window.
