UNTANGLING THE NET
China Netcom is trying to improve corporate governance and financial management to survive and thrive in the mainland’s cutthroat telecom market. Can this state-owned enterprise make it?
By Yang Jian

Li Fushen is CFO of China Netcom, the smallest of the mainland’s four major phone companies, but it seems he cannot count. At his company, he says, “1 + 1 + 1 did not equal 3, it was far less than 3.” Li is referring to the merger in 2002 of the three state-owned enterprises – China Telecommunications, China Network Communications, and Jitong Communications – that created Netcom. Decreed by state fiat, the union did not make much business sense on paper, as the three SOEs had overlapping assets, networks, customers, and markets.

The integration problems were indeed a nightmare. “We were an old-fashioned SOE, with different entities that had different cultures,” recalls Li. Internal tension was perhaps inevitable. Last year, Fan Xingcha resigned as CFO and became an advisor to the board. In May this year, Tian Suning stepped down as CEO “for personal reasons”, but remains board vice-chairman. “I dread board meetings,” says the candid Li. “Sometimes, our decisions are rejected repeatedly.” But he hastens to add that the 13-person board, now with five independent directors including former Goldman Sachs president John Thornton, needs to be “troublesome” in order to be effective.

Four years after it was formed, Netcom appears to be getting some of the math right. The Hong Kong-listed company reported solid operating profits of 20.5 bn renminbi (US$2.6 bn) last year, up 17% from 2004, although revenues rose only 4.5% to 87.2 bn renminbi. “Netcom’s management should be stable now after several rounds of restructuring,” reckons Zhang Yu, a telecom analyst with technology consulting services provider BDA. “At least people are working together.” With Thornton and other outsiders outnumbering insider directors, corporate governance is also regarded as having become far stronger at Netcom than in most other Chinese enterprises.

But the company still faces formidable challenges. Earnings in the first half of 2006 fell 7.7% to 7.1 bn renminbi compared with the same period last year. The slowdown had been expected. Netcom’s core business is in fixed-line networks, and that is a moribund market in China, forecast to expand only 4% to 5% to around 425m users by 2009. In contrast, wireless networks currently have 400m subscribers, a number expected to leap to 640m in three years. And Netcom has exclusive operations in only ten jurisdictions, only two of which are among China’s top ten telecom markets (see chart, page 31). Fixed-line rival China Telecom has a monopoly in 21 provinces, eight of them among the richest in China.

Netcom wants to engage in the mobile phone business, currently allowed only to China Mobile and China Unicom, and in yet-to-be-awarded third-generation (3G) wireless services, as well as expand overseas. It bought a 19.9% stake in PCCW, Hong Kong’s leading phone company, in 2005. But these ambitions require top-notch management, especially in the financial arena, given the huge sums that must be raised. Good corporate governance is also key. “Of China’s four big telecom companies, we are the one with the biggest difficulties,” Netcom chairman Zhang Chunjiang recently told the Asian Wall Street Journal.. “So we wanted to develop a corporate-governance system that could let investors relax.”

School for survival

Can an enterprise with deep SOE roots really transform itself inside and out? Netcom is certainly trying. It was Zhang, says Li, who pushed for a comprehensive financial training program for all senior executives at Netcom and its subsidiaries. “I was shocked that the number-one guy at the group asked for it,” says the CFO. In April this year, the group’s entire senior management decamped from Beijing to far-away Shanghai. To avoid distractions, Netcom held the training program at the Shanghai National Accounting Institute. The sessions focused on financial statements, budgeting management, and internal control.

Li was initially worried that the 20 participants, all top honchos in their respective organizations, would get bored. But he says they were all receptive and eager to learn. “They are mostly former technical and business people,” he says. “It was the first time they learned financial theory systematically, and analyzed and judged issues from a financial perspective.” Li says the executives have become noticeably more financially literate. “The way they study and think of problems has changed,” he adds. “They ask more about financial status, asset structure, and risks.”

Li himself learned a lot from the interaction. After assessing the daily training results, he decided to copy everyone on all company financial data. “In future, all internal decisions on resources allocation will be transparent,” says the CFO. “All budgets and objectives will now be shared with the entire company.” Four training sessions have been scheduled for deputy general managers, after which Li hopes to get most of the group’s 200,000 employees involved. The goal is to make everyone in Netcom take responsibility for good financial management, especially internal control.

An internal control mechanism is already in place in Netcom, started two years ago as part of the company’s preparations for going public in Hong Kong and New York. Unlike other Chinese enterprises, which scuttled their plans to list shares in the US because of the strictures of the Sarbanes-Oxley Act, Netcom insisted on going ahead in October 2004. “We decided to list in the United States to face up to the challenge,” says Li, who was internal auditor at that time. “Only by facing up to challenges can the mechanisms and perceptions of a major state-owned enterprise (like Netcom) be transformed.”

The Sarbox Stick

With the stick of Sarbox and the looming Section 404 certification as spur, Li joined then CFO Fan in leading close to 50,000 people on a massive project to document procedures and other systems, and worked with outside consultants to institutionalize best practices. As CFO today, Li is intent on strengthening internal control for the long term. “We are not doing 404 for the sake of 404,” he says. “Section 404 is just the minimum requirement. Our purpose is to change traditional behavior and habits, and drive basic management by building up a responsibility transmission mechanism at different levels.”

The new Netcom initiative is formally called “China Netcom Group Information Quality Assurance and Accountability Mechanism,” but is referred to within the company as CNC-Sox. At the corporate level, the heads of all subsidiaries, general managers of finance departments, and other senior financial executives sign letters of commitment that detail what they need to know about internal controls in their company and what they need to do to implement them. At the functional level, responsible officers in Netcom’s eight business units sign internal control and management commitment letters and submit them to their general managers.

“With such a horizontal and vertical grid responsibility system, I’ll know where problems occur – at which subsidiary and function,” says Li. “We will investigate all cases and impose punishment, including dismissal of any person who does not live up to his or her promise.” Having worked in internal audit for ten years, Li feels such draconian measures are the best way to deal with the internal weaknesses of SOEs. “A simple matter can easily go wrong in the execution,” he says. “Rules of the game have been created by several generations. But since the business chain is too long, and people’s understanding, judgment, ideas, and perception are so different, it is still very difficult to enforce the right degree of control.”

This is not to say that Li has centralized control and financial management, which is impossible anyway given the size of the Netcom group. The CFO has delegated many financial functions and responsibilities to offices in the ten northern provinces where the group operates. Only budget management and investment and procurement are done in Beijing, along with financial management of units in the south, where Netcom has a small presence. China Telecom has a monopoly on fixed-line services in the country’s more prosperous south.

To optimize financial management, Li is drawing up a financial development strategic plan for the next five years. “The financial person in the past wore a big pair of glasses and says “no” when you ask for reimbursement of expenses,” he observes. “What is finance today? It is an important division that underpins decision-making.” Li says 70% of the people at Netcom’s financial departments now support decision-making. Accounting reconciliation and other transactional services are now done by a shared services center.

And Governance Too

With Netcom’s shares traded overseas now for two years, Li often feels pressure from international investors and regulators regarding corporate governance. But the CFO says he understands where the markets are coming from. Effective governance, says Li, is necessary to reassure investors at a deeper level. In this, everyone in the group is taking the cue from chairman Zhang, who has declared that Netcom should “introduce world-class corporate governance and be a model for large SOEs.” Early this year, the company engaged management consultant McKinsey and local governance experts to help strengthen corporate governance.

In May, Li accompanied Zhang on a global road show. “Our purpose was to further understand the demand for corporate governance of Western capital markets,” says Li. They met with more than 70 institutional investors and solicited their opinions on Netcom’s thinking on corporate governance. Li says the company’s initiatives were praised by some quarters. But other investors asked sharp questions and expressed doubts that an SOE like Netcom, still owned 75% by the state, can really have an independent board of directors.

“In London and Boston, I was asked who were on our board,” Li recounts. “I said there was John Lawson Thornton, the former chairman of Goldman Sachs. I was told that was reassuring.” On the board since 2004, Thornton has functioned as a mentor to Netcom on Western notions of corporate governance. Last year, for example, he objected to the way the company planned to acquire assets from its parent, which Zhang also headed (and where Li is chief accountant). Netcom had formed a committee comprising independent directors to oversee the deal, but then took upon itself the selection of the investment bank to act as advisor. Netcom backed down after Thornton said the choice should be made by the committee, which hired the same bank anyway.

Corporate governance has been a hot topic in China for several years, but Li says people still do not understand the concept well. “When we talk about corporate governance, we mean simply (the composition of) the board of directors,” he says. “This is not correct. The key is how to make the board play a significant role.” On paper, at least, Netcom’s board looks impressive. It has more independent directors, which include Thornton and Qian Yingyi, a respected Chinese corporate governance expert, than market leader China Mobile.

Zhang Chun, a professor at the China-Europe International Business School, says that not many Chinese companies are doing as much as Netcom in improving corporate governance. Even so, Netcom still has a long way to go. Like other SOEs, the company has a Communist Party committee, headed by chairman Zhang Chunjiang, which is tasked with ensuring that communist policies are alive and well within Netcom.

Zhang argues that the party committee is there to make sure that the company’s decisions are good for the country, and is therefore also working for the interest of minority shareholders. The arrangement was reportedly a source of heated discussions with McKinsey, which struggled to balance the party structure with global best practice. McKinsey and its local counterparts presented their recommendations in June, which Li says are now being implemented. One result has been more frequent meetings by board committees.

The CFO says the new procedures will include performance assessments to ensure board effectiveness. “The nomination and governance subcommittees will assess the directors – how many times a director makes a comment at the meeting, how many questions he or she raises, and whether these questions are significant,” he says. “If a director doesn’t make any comment in many meetings, the committees will show him or her a yellow card. Directors will be dismissed if this behavior continues.”

Three Strategies

The real test, of course, is the company’s financial performance, which in turn will depend on how well the board sets strategic directions and how effectively Netcom executes them. Early this year, Netcom disclosed three major initiatives: broadband, sponsorship of the 2008 Beijing Olympics, and internationalization. These new directions are necessary, says Li, because voice-over IP, the internet, and mobile phones are gnawing away at Netcom’s traditional business. “This is a common issue for the fixed-line business worldwide,” he adds. “Companies need to transform themselves urgently.”

Broadband is the core strategy. This segment, which allows fixed-line subscribers to have always-on connections to the internet and surf at high speed, already accounts for 11.6% of Netcom’s revenues. Capex costs are substantial, but Li says the group should recoup its spending on infrastructure and services in the next three years. The investment on broadband is partly funded by earnings from minor value-added services such as fixed-line short messaging services and ring tones.

Part of the plan to boost the broadband business is to market it via the Olympics. Netcom is spending 480m renminbi in cash and 520m renminbi in equivalent-value services to become the exclusive provider of fixed-line voice and broadband services at the Games. “The 2008 Olympic Games will be the first broadband Olympics in history,” says Li, who is confident that the sponsorship will bring gains to Netcom. “We know the Olympics is short-term, but the long-term effect is enhanced brand awareness.”

But some analysts doubt whether broadband by itself can save the fixed-line business. China’s wireless and cable-TV companies can also offer broadband services. “To change the situation fundamentally, it is very important for Netcom to obtain mobile licenses,” says BDA analyst Zhang. In China’s 2001 telecommunications system reform plan, the State Council specified that all four phone companies will eventually be allowed to operate all services. Netcom set up a mobile division in 2003, but the government has yet to issue new licenses. “We will get one soon, I hope,” says Li.

A 3G license will allow Netcom to offer cellular services that combine voice with speedy internet access and other multimedia communications, which it hopes will help it catch up with China Mobile and China Unicom, currently the only two companies allowed to offer wireless services. China Telecom will presumably be issued with a 3G license as well. Given its larger size, it too will be a tough competitor for Netcom.

Some analysts are not sure about Netcom’s 3G hopes. Because of the need for massive investment and lack of experience in the mobile business, Norson Telecom Consulting predicts that the two fixed-line operators between them will be able to sign up only 5% of the addressable 3G market, equivalent to just 13m renminbi in 2007. That’s when Norson expects 3G licenses to be given out. Their share may rise to 617m renminbi in 2009, but Norson reckons that China Mobile and China Unicom will still get the lion’s share of the 3G segment.

Can Netcom find enough money to build a 3G network? Its debt-to-equity ratio shot up to 50% last year after it acquired networks in four northern provinces from its parent. On the urging of independent directors, the company is looking for ways to bring debt leverage down, which closes off new borrowings. The company can possibly raise new funds from the stock market, hoping its focus on corporate governance and other reforms would open many purse strings. Extra money may be freed up if operating costs can be controlled, and non-core assets may be monetized, such as the sale of unprofitable marine cable company Asia Netcom earlier this year.

Stepping Out

The third initiative, internationalization, is also a potentially capital-sapping exercise. Netcom had to shell out HK$8 bn (US$1 bn) for its stake in PCCW, for example (see box, below). Analysts are cautious about this strategy too. It is not realistic for Chinese operators to go international, argues BDA’s Zhang, given the competition posed by such giants as Vodaphone. Netcom and other Chinese companies should instead focus on the burgeoning local market.

Norson analyst Liu Jun notes that Netcom’s international business, which includes Hong Kong, Macau and Taiwan, accounted for just 3.7% of total revenues in 2005. “Based on Netcom’s current profit-making capability and capital levels,” he concludes, “it is more important for the company to focus on domestic business spending, rather than go to other countries and regions to lay the groundwork for future business.”

CFO Li says Netcom is not really stepping out, but bringing in foreign funds and expertise. “We started as an old SOE and got listed in Hong Kong and New York,” he points out. “We diversified our capital structure and brought in some strategic investors. All of these are in fact part of our internationalization strategy.” There is an element of going out, as shown by the PCCW investment, but the more important part is actually bringing in foreign know-how.

Netcom is set to get some cash with the sale before the end of the year of a 4.9% stake to Spain’s Telefonica, which currently owns 5% of the company. Li is mum on the selling price, opting to focus instead on the business advantages a stronger alliance with the strategic investor will bring. “Telefonica will share with us its international operations and mobile business experiences,” says Li, noting that the Spanish company also has extensive experiences in call centers. Netcom plans to enter this business in 2008.

Can Netcom pull it off? There are no guarantees, but it at least deserves credit for trying. If it succeeds in transforming itself into a well-governed, transparent and profitable business, it may well blaze a trail for other SOEs to follow.