Sunday 26 April 2009

Time for caution on PCCW’s bargain-basement shares

The price looks right, but this stock carries a lot of baggage

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Guanyu said...

Time for caution on PCCW’s bargain-basement shares

The price looks right, but this stock carries a lot of baggage

Stephen Vines
26 April 2009

The market is not always right, but the 3.4 per cent fall in the PCCW share price on Friday, which followed a 13 per cent slump the day before, suggests Hong Kong investors may have given up on Richard Li Tzar-kai’s company. Even at the modest price of HK$3.60, do not be surprised if PCCW shares fall further.

Leaving aside that the shares are trading on a price-earnings multiple in excess of 18 and that the company intends to pay a dividend that will all but wipe out its cash reserves, PCCW is rightly assuming pariah status among Hong Kong investors.

The Court of Appeal last week stopped Mr. Li’s Pacific Century Regional Developments (PCRD) and its partner China Unicom Group privatising the company. Under the deal, shareholders would have got a modest HK$4.50 for their shares and Mr. Li and his partners would have received a special dividend to cover the costs of buying out the minorities. Now that the deal has failed, Mr. Li has decided to pay a special dividend of HK$1.30 per share, which will cost HK$8.8 billion, swallowing up almost 95 per cent of the company’s cash.

Mr. Li will be the major beneficiary, pocketing some HK$2.4 billion.

The price on offer was HK$4.50 per share, which was indeed a premium to the trading price but hardly reflected the value of the company he was proposing to acquire for HK$15.93 billion. PCCW had net assets of HK$39.8 billion last year. By virtue of the telephone business, there is healthy cash flow and profitability, hardly to be taken for granted in these troubled times.

When Mr. Li wanted to sell his stake in PCCW back in 2006, he valued it at around HK$6 per share. China Netcom (now China Unicom) bought its 20 per cent stake in January 2005 for HK$5.90.

Three years on, PCCW directors decided the company was worth 25 per cent less, yet profits for last year, although somewhat lacklustre, came in at HK$1.27 billion - just a shade above the HK$1.25 billion in 2006. This hardly suggests a diminution of value as reflected in the price offered to minority shareholders.

It is hard to think of any other Hong Kong company that has shrunk so dramatically in value in the space of just nine years. In early 2000, Mr. Li launched a successful bid for what was then Hongkong Telecom. Back then, PCCW shares peaked at HK$121.50. Allowing for the effect of share-splitting, the peak was as high as HK$131.75 in February 2000.

Flush with funds, PCCW splashed out on lavish projects to create an interactive television and internet network with fancy production centres overseas. Stakes were taken in a number of dotcom companies, all of which dwindled into dust.

The current Now Broadband network that supplies a cable television service carries the name of these failed projects. Even today, according to PCCW’s recently published results for 2008, Now does not make money.

The only real profit generator is the boring old telephone company laboriously established by Britain’s Cable & Wireless. Aside from that, the only other time that PCCW made any money from new ventures in these past years was when Mr. Li secured the last major slice of prime property on Hong Kong Island to create Cyberport. It became a vast and highly lucrative luxury property development and, in 2004, Mr. Li took it out of PCCW, alongside a clutch of other valuable property assets held by the former Hongkong Telecom, and placed them in a new entity called Pacific Century Property Developments (PCPD). PCCW tried to privatise it also last year, without success.

So what are the prospects for PCCW shares? The analysts who were cheerleaders for PCCW are now scrambling to put a “sell” or at very best a “hold” on the stock. But are things really that bad?

Because PCCW attracts so much attention for its wheeling and dealing and its court cases, the actual business of the company tends to be overlooked. Take a look at the fundamentals. Net earnings last year declined by 15 per cent, but in current circumstances this is hardly dramatic and there are reasons to argue that the underlying business is healthy.

What PCCW describes as “core revenue” rose 7 per cent last year to HK$22 billion. In essence, this comes from the old telephone business, which accounts for around three-quarters of this revenue.

The Now television service and the mobile phone service are picking up but remain modest contributors to the overall business. Moreover, the PCCW Solution division, which supplies IT services to major corporations, has become a money spinner, though it is relatively low-profile and has the kind of complex business that confuses analysts and others trying to get a sense of its real worth.

Meanwhile, PCCW still retains a majority share in PCPD, which holds the bulk of the former property portfolio. It had revenue of HK$9.9 billion last year, mainly from property development at Cyberport. But the property market is declining and PCPD has already completed most of its major sales in this development, so this lucrative revenue stream is likely to diminish.

PCCW has also done much to reduce its notoriously large level of indebtedness, but the payment of the special dividend could see debt levels rise to HK$30 billion from a current level of around HK$21 billion.

So investors who see PCCW as a bargain with its share price dwindling need to be very brave to take a punt on a company that repeatedly disappoints, especially at a time when the market is awash with other bargains carrying a lot less baggage. As for existing shareholders, they really do not have much option but to sit out this saga, hoping that someone will come along and take them out of their misery.