Description

PCCW (0008.HK) - $6.30 as of 2/9/04

This is a once high-flying Internet bubble stock turned into a solid telecom and real estate development business. It is listed in Hong Kong as one of the most liquid stock and so should be pretty easy to buy. In the heyday of the Internet bubble, PCCW traded as high as HK$131 split-adjusted. It had then made a timely acquisition of the then fixed line telecom monopoly in Hong Kong, Cable & Wireless HK (more well-known as Hong Kong Telecom then). Along with the real estate assets PCCW already had then, they made up the majority of the value the company has today. The stock price has taken a tumble and has reached a low of HK$4. Ever since the former owner of Hong Kong Telecom (HKT) sold its last 14% stake, the stock price has recovered to around $6. Once again the removal of the overhang coincides with the bottom. Yes, unfortunately you missed the bottom, but there is still plenty of upside left.

I believe the stock is worth at least HK$9, representing a 50% upside. The valuation involves analysis of one of the biggest real estate development project and a dominant telecom business in HK. While the real estate assets are pretty analyzable, analysis of the telecom business could require a lot of regulatory reading. But fortunately you won’t need to be a regulatory expert to appreciate the merit of this investment. As a starter, the telecom business generates HK$0.60/share of free cash flow, after capex, interests and taxes. If you take out the HK$3 real estate value from the HK$6 share price, you’re buying the telecom business at 5x FCF. Even if you assume the cash flow will run down 10% a year to perpetuity, you can still get above 10% IRR. And if you are like me who is bored with the fully-valued US markets, feel free to spend more time to understand the prospect of their telecom business. Then you might or might not agree with my opinion that the telecom business is stabilizing. You will also find it hard to ignore the robust rebound of the depressed Hong Kong real estate market. In summary there is plenty of upside in the story built upon a solid downside.

Rental Investment Property
The company’s real estate assets include a multipurpose complex in Beijing called Pacific Century Place. This is one of the landmark commercial, retail and residential development in Beijing. Vacancy rate is about 10% and the commercial space is mostly occupied by two big tenants, IBM and Nokia. The company also holds other investment properties throughout Hong Kong and China. Rental income runs about HK$600M per year. Using a 7% cap rate you get about HK$8.5B of value.

Cyberport
PCCW also is the sole developer of the Cyberport project in HK. This is a complex development agreement between PCCW and the HK government, in which PCCW and the HK government share the future cash flows from 2004-2007 in a 36/64 ratio. If you go through the actual Project Agreement signed in May 2000 you will know I have oversimplified here. But the gist of it is PCCW should share about HK7.5B cash distribution in the next 4 years under the assumption that average sale price of the residential units would be ~HK$7250/sq feet and average future construction costs would be ~HK$1700/sq feet. PCCW has invested HK$4.4B in this project over the past 4 years. I personally am very bullish on the HK real estate market and expected positive surprises to the future sales. This is also basically the ONLY luxurious residential primary sale in the HK Island region in the next 4 years. You should be able to get a download on this project from an English-speaking real estate broker in HK. (Hint: try http://www.centanet.com/ehome.htm) Just pretend you’re interested in buying high-end apartment units for investment purposes and ask for supply/demand insight.

Venture Portfolio
Of course, PCCW also had an infamous venture portfolio that was stated at HK$1.3B as of 12/31/02. Most of the pipedream businesses have been divested or shutdown. Given the substantial markdown (over HK$6B in the past 2 years alone) already taken I recognize HK$1B of value there (Among the major pieces are MobileOne at about HK$440M, PCCW Japan at about HK$300M and Data Access over $300M).


The above 3 components (investment property, Cyberport project and venture portfolio) give us HK$17B of value, slightly over HK$3/share.

Core Telecom Business
The core telecom business consists of local exchange, long distance services, internet service provider and even cable TV services. Think Verizon without a wireless unit. Since the HK telecom deregulation ended its monopoly in 1995, PCCW has lost about 25% of its local exchange lines market share. The market is competitive but its EBITDA trend shows only a 3-5% annual decline due to responsive cost cutting and restructuring. At the end of the day, it is still the dominant market leader with complete broadband coverage of all businesses and 95% of homes. No other telecom providers in HK get anything near that. Most carriers merely lease lines and connections from PCCW at wholesale rate. The company has introduced many new products over the last year to stop the decline in revenue. A lot could be done to leverage off the existing state-of-the-art network with little incremental investments. There are also favorable regulatory changes that help PCCW to be more competitive.

Without factoring in these positive trends, the future cashflows from this core telecom business is still worth well more than HK$3/share. The Core Telecom operations generated EBITDA of HK$4.4B in 1H03, HK$9B in 2002 and HK$9.3B in 2001. For simplicity and conservatism let’s use HK$8B. Capex was HK$1.6B in 2002 and we’ll use HK$2B for similar reasons. Pro forma for the equity offering the company has about HK$30B of net debt at an average cost of debt of about 5%, which gives you HK$1.5B of interest expense. Lump in about HK$1.5B of taxes would give you HK$3B of free cash flow. Historical analysis of cash flow statement would get you to the same answer as well. So 5.4B shares outstanding, this is about HK$0.56/share of FCF.

On an unlevered basis, the telecom business trades at 5.8x EBITDA (on HK$8B EBITDA). Due to the leverage (almost 4x), you can argue this is the better way of looking at the valuation. However if you take out capex and taxes then it comes out only about 10x unlevered FCF. Is it cheap? That depends on what you think the cost of capital for this business is. I think it is cheap for a business with pretty stable cashflow and can borrow 4x at 5% cost of debt. More importantly I think FCF is still the right way of looking at it and it is unfair to use the leverage argument against the cheap FCF multiple. First, with over HK$3B of FCF generated a year and HK$7.5B coming in from Cyberport presale this company is going to get down to 2x leverage in 3 years. Second, we’re talking about HK$4.5B of unlevered FCF vs. HK$1.5B of interest today and there really isn’t that much inherent leverage built in to the cashflow. If anything the company would probably start paying dividends as soon as it achieves A credit rating, which should only requires deleveraging up to 2.5x. At that time the 20% FCF yield would translate into a dividend yield. That is of course if the real estates get spun off. But either case the dividend yield would be attractive.

One last thing I want to mention is that the equipment plants located throughout HK that PCCW owns represent a very valuable real estate portfolio. Should they be redeveloped, substantial hidden value would be unlocked.

Realization of real estate value
You might ask how the value of the investment rental property could be realized in the share price. Well, the Cyberport project will eventually generate hard cold cash presale proceeds over the next few years, paying down debt to reduce interest expense. As to the other rental property in Beijing and Hong Kong, the company has always stated that property operations are non-core but has determined the real estate market in the past few years too depressed to divest. Over time I expect the company to either divest or spin off the real estate portion of the business.

Management
The CEO of the company used to be Richard Li, the son of the richest man in HK, Li Ka-shing. Richard Li owns 31% of the company and is the Chairman of the Board. Although Li Ka-shing has never explicitly helped his son, PCCW is understood to have benefited from time to time from Li family’s connection with the Chinese and HK government. For example the Cyberport contract was a very controversial contract awarded to PCCW, offering attractive economics despite substantial public opposition.

Richard hired Jack So as the new CEO in July 2003. Jack had tremendous experience dealing with the government, which would likely help in obtaining regulatory relief. He also is a world-class executive previously running another public service in HK (the Mass Transit Railway, the “subway” in HK).

Apart from that, the whole management team is star-studded. Robert Lee, who had the reputation of being the “master of real estate” in HK, was known for his creativity in marketing new apartment sale. Other team members such as Francis Yuen, Linus Cheung are all household names in HK that need no introduction. COO John Butcher is a solid world-class executive with unmatched industry experience.

Catalyst

- Rapid Deleveraging Story
This company currently is slightly under 4x leverage, extremely high for an Asian company that usually averts capitalizing with debt. With the cash from Cyberport apartment sale and core telecom FCF, the company could reduce debt by over HK$15B in the next 3 years (about HK$2.80/share). Coupled with the credit rating increase, interest savings would be very substantial. Chances are you would see a nice recurring dividend in a couple of years, which is the stated goal of the company. Since a lot of the debt were assumed in the LBO of HKT in 2000, a lot of the interest expense were not tax deductible. Weird tax laws? But wait, the strangest part of the HK tax laws is the 17% corporate tax rate. Anyway, my point is most of the interest savings would drop right down to after-tax FCF eventually. The imminent rating agency upgrade would certainly be a catalyst itself too.

- Real estate value poised to be unlocked
The HK real estate market has gone through a very depressed period since 1997. Substantial pent-up buying demand has been accumulated. With the limited supply in the higher-end HK Island region, there should be a period of boom in the next few years. The first 2 phases of the Cyberport residential presale has gone very well. As the presale continues, the value of the entire Cyberport residential project should be highlighted. In any case, given the nice run-up of the real estate market, PCCW should be able to reap a nice profit from the HK$4.4B it has invested thus far. In the medium-term, I also expect the company to realize value of the other non-core real estate assets.