SIZING THE X-FACTOR
Government sweeteners to market the China Telecom IPO only raised investors' sense of political risk.
By Jasper Moiseiwitsch

When China Telecommunications went out to market its multibillion-dollar dual listing on the stock exchanges of Hong Kong and New York in mid-October, investors flinched. Sources close to the deal described demand as "soggy" and pricing often approached the NAV floor - a deal breaker, as the government will not sell assets below book value. Roadshows were postponed for a week for suspicious-sounding "technical reasons".

If investors cast a baleful eye on the deal, they had reason. Overseas markets had in recent years absorbed about US$20 billion in PRC telecoms assets, and were perhaps approaching saturation point. Most importantly, investors had become ever more wary of the mainland regulatory risk, and were increasingly mystified as to how policy shifts emanating from the all-powerful Ministry of Information Industry (MII) might affect their investments.

"You can do your [risk] forecasts based on various assumptions, but there is a real risk that these assumptions can be blown apart by political actions," said Julian Mayo, managing director of the Hong Kong hedge fund iRegent, around the time of China Telecom's marketing.

A Mobile Feast

The deal effectively marked China Telecom's second IPO. In 1997, the organization spun off the richest part of its mobile assets in a well-received US$4.5 billion Hong Kong-New York listing. The listed company, originally known as China Telecom (Hong Kong) was rebranded as China Mobile. Thus encouraged, the PRC government returned to markets with more and more cellular offerings. It listed China Unicom - a former also-ran that was helped by the transfer of a CDMA network from the People's Liberation Army - for US$5.56 billion. And, just to squeeze every little drop of interest in the mainland mobile story, China Mobile followed up with a US$2 billion share issuance in 1999, and then with a US$7.59 billion stock and bond sale in 2000.

And now, in 2002, with Unicom's and China Mobile's share prices well off their highs, China Telecom has returned to markets with a new multibillion dollar listing. It brings to the table the PRC's dominant fixed-line/long-distance network. The listing spins off China Telecom's three richest provinces and Shanghai municipality, which collectively hold about 53 million subscribers served by a national fiber-optic network/satellite communications/digital microwave network.

It is a strikingly modern system that was built with all the gusto and government dollars that a 'pillar' industry can summon. In the formulation of its current five-year plan, the PRC government deemed telecoms a strategic state industry, and has poured billions into building out its fixed-line and mobile networks. The plan has very specific government targets for fixed-line and mobile capacity: it, expects, for example, that by 2005 there should be 360 million mobile phone subscribers and 2.5 million kilometers of fiber-optic cable.

Amazingly, the government, through oversight via the MII, seems on track to meeting these numbers. But in so doing, it has continuously intervened in the market. It meddles with tariffs, it continuously redraws market boundaries between faux state competitors, and it reallocates assets among various telcos. For example, early this year the MII handed half of China Telecom's northern assets to China Netcom.

Political Risk

The toing and froing has rattled investors of the listed companies. Publicly held enterprises are supposed to operate according to a single mandate - shareholder returns - and not to fulfil state goals of transforming China into an IT hub. Yet mainland telcos still need government approval to change rates on their basic fixed-line and mobile services. Last summer, for example, the MII fined China Mobile and China Unicom US$100,000 for cutting rates without permission.

This squirrelly aspect of mainland regulation has contributed to share price declines of China Mobile and Unicom of 71 percent and 75 percent, respectively, from their summer 2000 highs. And, as international investors have wisened up to this regulatory risk, it seems that both Unicom and China Mobile have retreated to domestic markets for their capital raising. China Unicom listed on the Shanghai exchange in October, and at about the same time China Mobile began marketing a US$966 million domestic bond sale.

MII fingerprints were also seen all over the China Telecom IPO. Reports surfaced amid marketing of that deal that the MII would raise the tariffs charged by mainland telcos (principally China Telecom) to Hong Kong operators on connections for calls into China. News of the measure was ideally timed to give a boost to the China Telecom IPO, which was still searching for a price. However, while this fee adjustment is good for China Telecom and its investors, it also underlines the capricious nature of China's telecoms regulatory regime. "There is a higher level of risk in China that the rules can be changed," says iRegent's Mayo.

The Effort to Reassure

Merrill Lynch, one of the deal's joint global coordinators, thought investors were sufficiently concerned about this risk to address it in an email to investors. The email said that deregulation and tariff adjustments reduced China Telecom's regulatory risk, and that its risks were far lower than that seen, for example, in the PRC wireless sector.

China Telecom's defenders says that the MII has promised the company that it would not interfere with its tariff policies for three to five years after listing. And, while China Telecom carries the heaviest burden in meeting the government's five-year goals in fixed-line penetration rates, these sources note that these goals have largely been achieved and will not have a big impact on the telco's upcoming operations. Further, the burst of government intervention in telecoms markets in recent times was needed to get China's telcos in shape for liberalization and privatization - now the government will largely leave it alone, say the defenders.

Full Circle

Nevertheless, investor feedback during the marketing phase of China Telecom's IPO dwelled on this regulatory risk, as it did on related matters such as capital expenditure and whether the company will re-enter the wireless market.

China Telecom's capex reached its highest level in the first six months of 2002, with spending reaching about US$7 billion on an annualized basis. This spending has coincided with ambitious government targets for increasing fixed-line (phone and Internet) penetration rates, as outlined in the Tenth Five-Year Plan.

In the prospectus, the company projects that capex will fall off post-listing, running to a forecasted US$3.25 billion in 2004. But Pyramid Research, a telecoms consultancy, expects that China Telecom still has big expenditures to come. For example, the company wants to install next-generation 'soft switches', which are software-based telecom switches that are much more efficient than traditional electronic switches. "Capex is not going to shrink while the company is still upgrading," says Connie Hsu, a Hong Kong-based manager of Pyramid Research. "I don't believe China Telecom - and this includes the listed company - is going to lower its capex costs."

The listed China Telecom has promised that any future capex will generate a return above its weighted cost of capital: about 13 percent. That's sound financing but it is also a high threshold, and it's questionable whether the company could resist pressure to meet state goals on infrastructure build-out even if expected returns fell below this figure.

China Telecom is also expected to re-enter the wireless market and will, accordingly, have to take on the huge costs of building a new cellular network. All expectations are that the company will jump straight to 2.5 generation technology or higher - no one knows how much it will cost, but it will be expensive.

The MII has made clear that it will award more mobile licenses, and at least one of these licenses should go to China Telecom. This fits the government's plan to create four fully integrated mainland telephone companies (China Telecom, China Netcom, China Unicom and China Mobile). Apart from what this would mean to China Mobile's investors, who might think that China Telecom already has a listed cellular operation, China Telecom's latest investors would have all profit and capex projections upset by a re-entry into wireless.

China Telecom was marketed as a defensive investment with stable returns and generous dividends. Instead investors may find that they have taken a stake in Asia's latest 3G experiment. "I don't think that would be the most prudent use of shareholder funds," says Henry Lee, managing director of Hendale Advisors, of a possible wireless build-out.

For investors, this deal may be the beginning of a long, strange journey.

Jasper Moiseiwitsch is a contributing editor of CFO Asia based in Hong Kong.