Tuesday, February 13, 2007

PCCW (8): Now is the Time?

Now or i-Cable, PCCW Mobile or CSL, 0060 IDD or another carrier, there's a lot of reasons not to pick PCCW. Now is cumbersome to install, PCCW Mobile is Sunday in disguise, 0060 is costly. To many the time to buy PCCW is never. But there's also apparently sophisticated people foolish enough to chase for its assets, or even offer to buy shares at $6. So who's dumb and who's dumber? Now share price is back to around $4.6, a level where it's been stuck since 2003 when it was in much worse shape. I'm curious to know if there's something special inside PCCW which can only be seen by the 'gweilo'.

You may not like PCCW overpaying for the English Premier League broadcasting right, or Now and PCCW Mobile never making a profit, or IDD keep losing customers, I thought about these too. But they actully matter less in the bigger financial picture. A look at PCCW's turnover breakdown will help understand why PCCW isn't gonna screwed in any significant way.

(excluding PCPD)
Telephone & broadband & services $7.5b (IDD $1.1b) -> PCCW solutions $737m -> Mobile $585m -> Others $364m -> NOW $303m

No matter how PCCW pretends otherwise it is still the same old fixed line behemoth with a 68% market share in HK, reaching 2.6m household and businesses. And it's proven resilient against challengers in all fronts. It isn't growing but ain't going down either. Telecom revenue (excluding PCPD) is over $16b with an EBITDA of $6.5b and operating margin even showed improvement in 2006 1st half. This cash generating ability and market penetration is certainly attractive to an outside buyer.

You may ask 'what about all that haunting debt incurred from the takeover of HKT back at year 2000'? Good question, and to answer, net debt was halved from $41b in 2001 to $20b in 2006 interim (I'll stick to management's figure although I calculated $18b), but still overwhelming against net assets of only $3.1b (or only $750m if MI is taken out!). Normal capital expenditure in an year appears to be in the region of $2b, but PCCW is buying new assets too, recently spending ~$1.5b on EPL license and last year ~$1.6b on REACH undersea cable right. It is possible that ~$4b can be used to repaid debt each year and in 5 years all debt will be gone. As debt is progressively repaid PCCW's bond rating will improve and this will reduce future interest cost too. This scenario is however with the shaky belief that the management can keep their composure and confidence in check and won't try to pull another stunt to impress.

One peculiar feature about PCCW is its high profit tax rate, at ~37% of income over the last 2 years. And taxes were paid too during loss making years in 2002 and 2003. The explanation in the 2005 annual report was that certain expenses ($348m) were not deductible and some tax losses ($444m) were not allowed to offset profit. I guess it's the interest associated with the HKT acquisition debt that contributed to the bulk of the non-deductible expenses and that taxes losses were from Sunday, NOW, and other new ventures PCCW undertook in these few years. This can be a bad thing now but a good thing for the future, because future interest savings (from paying down acquisition debt) will translate 100% to bottomline improvement. Similarly, any turnaround of the new businesses will enjoy tax advantage.

Profit excluding PCPD should be roughly $1.25b. Add back amortization of $200m (which was mostly trademark) and optimistically assume* $200m interest saving and $200m savings from merging Sunday operation, we have 2007 profit of $1.85b. P/E works out to be ~15x excluding the market value of PCPD, which is about fair for a pseudo utility. Profits will grow marginally for the years afterward but if NOW and PCCW Mobile can trim their losses it'd be a major plus. On the contrary if there's no improvement these can be sold off so there's no further drain on resources.

A takeover is always a possibility, as it's in the blood of Richard Li, like father like son. Francis Leung's deal was at $6 and I gathered from press that the competitive bids worked out to be roughly the same** too. There may not be a lot of upside but I'm confident downside is really limited since PCCW today is a much stronger company than it was a few years ago, but its share price has only gone sideway. It may actually be a good defensive play in a correction with a 4% yield.

* $3b repayment x average yield of 6.5% / Sunday cost saving is more or less a guess
** market rumoured USD7.3b x 7.8 for telecom assets less $2b net debt plus market value of 62% interest in PCPD work out to be ~$6 a share

DISCLOSURE: I don't hold 8 at time of writing.

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