Since the first convertible from Asia was launched by Thailand's Land & Houses in November 1993, equity linked deals from the region have had an extremely poor track record. The first wave of deals issued at the height of a stock boom that year collapsed the following year, with a second wave of issuance by second tier Thai corporates in the latter half of 1996 coming unstuck during the Asian crisis.
Overly ambitious offerings that have tried to come to the market since then have consequently suffered from a deeply rooted investor wariness, no matter how strong the underlying credit. The Singapore Government's exchangeable into DBS, in early 1999, has been the most notable example to date. Attempting to raise $1.3 billion from a three tranche multi-currency exchangeable, the government was subsequently forced to settle for $765 million, despite the backing of its triple-A credit.
KDIC has opted an exchangeable structure to sell a 5.1% stake in Kepco because it hopes to maximise the funds it can raise at a time when the electricity utility's share price is trading at depressed levels. Deutsche Bank, LG Securities and UBS Warburg are joint-lead managers for its five year deal which will open presentations in Singapore and Hong Kong on Friday.The Singapore team will then move to the US and the Hong Kong team to Europe, with pricing to take place the following Thursday (5 October).
Indicative terms
The indicative range will be formally announced on Friday, although term sheets circulating around Seoul show that the deal is likely to have: a 1% to 3% coupon, payable semi-annually; a 20% to 30% exchange premium over Kepco's common shares and; a yield to maturity of 50bp to 120bp over five year Treasuries.
To be issued at par, there will also be a hard no call for three years and thereafter subject to the 140% trigger. Rated Baa2, the deal will also be listed in Luxembourg and Belgium. Local bankers comment that the terms have been modified slightly from last week, when it was suggested that the transaction was likely to have a 1% coupon and be exchangeable at a 25% premium to spot.
Convertible analysts and fund managers describe the terms as fairly punchy and hope that the government will forsake its traditional pricing sensitivities for final pricing terms that work for the market. "My initial reaction is that this is a deal which is gunning for an extremely high exchange premium, particularly at the top end of the range, where it is ambitious even by European standards," says one London-based sector specialist. "Even triple-A credits like Allianz haven't been able to breach 30% this year. It is also exchangeable into Kepco's common shares, which opens investors up to foreign exchange risk. Previously, it was thought that it might exchange in Kepco's ADRs."
And an Asian fund manager adds, "Pricing does look fairly tight. According to my models, the Hutchison deal offered investors an 8% to 9% discount to breakdown value. This deal looks like it will come flat."
No guarantee
What premium will KDIC pay for the lack of an explicit government guarantee?
For fixed income investors, analysts calculate that they will be protected by a bond floor of 86 in a worst case scenario and 91.5 in a best case scenario This latter level is fairly standard for Asian deals and should cap investors' downside risk at comfortable levels. Key to investors' yield assumptions, however, will be the level at which KDIC would trade relative to other state-owned entities were it to issue straight fixed rate debt.
The most comparable benchmark is the Korea Development Bank (KDB), which has an outstanding 2006 bond currently trading at a bid/offer spread of 215bp/203bp over Treasuries, equating to a yield of 8.03%/7.9%. Since KDIC does not have an explicit government guarantee, analysts believe that it would need to offer at least 20bp above these levels.
Indeed, although KDIC has crucially secured the deal a Baa2 sovereign ceiling rating from Moody's, it has notably not applied to Standard & Poor's. The latter has traditionally taken a stricter approach to its rating methodology of quasi-sovereign borrowers. Many observers believe, for example, that the only reason why the Industrial Bank of Korea (IBK) remains one notch below the sovereign ceiling is because the English translation of the IBK Act suggests that the bank has a different level of support to other state-owned development banks. In Korean, the wording is exactly the same.
In terms of valuing the exchangeable's equity option, one Asian fund manager canvassed by FinanceAsia.com used an implied volatility of 47.62% based on a 100 day historical average of Kepco's trading performance. Convertible specialists, on the other hand, argue that a greater haircut is needed because of difficulties shorting the local stock.
Says one, "In a worst case scenario we calculate that this deal will have a fair value of 102.5 based on a bond floor of 86 and implied volatility of 35%. This assumes that there will be a 1% coupon, a 30% exchange premium and a yield to maturity of 6.4%.
"In a best case scenario," he adds, "fair value will come to 110, based on a bond floor of 91.5 and implied volatility of 20%. This assumes a 3% coupon, a 20% exchange premium and a yield to maturity of 7.1%."
Equity upside
To date, most Asian equity linked deals have averaged conversion premiums around the 10% to 15% mark. That KDIC might be able to get investors to cross a higher hurdle largely stems from the fact that the company is presently undervalued across all analysts' measures, but is not expected to stay at these levels over the medium term.
Indeed, news that the deal was to launch this week initially surprised some market players given that Kepco's share price has recently taken a new battering in tandem with the intensifying global oil crisis. Having been fairly range-bound at the W33,000 ($29.49) level for some months, the counter slipped to W25,000 just over a week ago, for instance, on concerns that the oil crisis would affect its earnings.
It has since recovered slightly to a current price of W29,000 and analysts agree that the market has misjudged the situation. As one analyst explains, "The impact of rising oil prices on Kepco is actually rather low because its generating units use mainly coal and nuclear power. Oil only accounts for 10% of output, against 80% for coal and nuclear power."
This misjudgment was further compounded by reports that the government was considering compensating the company by allowing a tariff re-balancing by up to 50%, compared to a weighted average hike of only 4.7% last November. Again, however, analysts says that an increase in rates is more a function of helping the company to meet its large capex needs and that the 50% level will not be applied across the board.
Rather, it will only be applied to those industrial consumers that use more than 300 kilowatts per hour and above - about 10% to 20 % of Kepco's users. "Korea is the world's six largest importer of crude oil and the government wants large industrial concerns to curb the amount they utilise," comments one analyst.
Merrill Lynch utilities analyst Jay Choi further comments, "In the past the residential and commercial sector has effectively subsidised the industrial sector, since electricity tariffs have amounted to about 120% of the former's operating costs, compared to 90% for the latter.
"We think that if crude prices average out to about $25 per barrel over the next year, there will be negligible impact on Kepco," he adds. "It's only if prices stay over $33, that there will be negative implications."
And he concludes, "Kepco needs a tariff re-balancing because it requires about W7 trillion to W8 trillion in capex per annum to fund a forecast power consumption growth rate of about 8% per year over the next decade."
Shares trading at a discount
Over the longer term, Kepco's share price has remained depressed because of the government's failure to pass a restructuring bill to split off the company's generation and distribution units into separate subsidies. Just prior to the National Assembly's refusal to discuss the legislation last December, for example, the stock was trading as high as W49,900.
At its current levels, however, it commands a TEV/EBITDA multiple of 4.4 times compared to an industry average of 5.6 times and a Korean blue chip average of just over 5 times. Says Merrill Lynch's Choi, "Taking the restructuring and privatization aside, we think that Kepco has a NPV (net present value) of W34,500. This means that it's current share price is trading at a 19% discount."
Most analysts are also optimistic that when the company's restructuring bill is passed to the National Assembly this year, it will be approved. "We believe that the bill will go through this time," affirms one. "One of the main problems last time was with the labour unions, but since then, Kepco has set up retirement funds for its employees and allayed fears about mass redundancies."
"The next couple of months will be crucial," a local analyst concludes. "If the bill goes through and this does seem likely, then the stock has plenty of upside. We have a buy recommendation."
For market players, KDIC's deal will mark a critical test of investor sentiment. Yet many question whether current conditions augur well for such an ambitious issue size and some believe that the deal may be slightly downsized before roadshows start at the end of the week. As one banker concludes, "Whether the market is prepared to put this much money to work will be the key question. But we all want to see the deal go well. The Asian equity-linked market has been in the doldrums for some time and it would be great to see it get some confidence back again."
