PCCW's trust spin-off is nothing but a cash grab

PUBLISHED : Thursday, 10 November, 2011, 12:00am
UPDATED : Thursday, 10 November, 2011, 12:00am


In early 2000, just before Richard Li Tzar-kai's PCCW made its takeover bid, Hong Kong Telecom boasted a market capitalisation of HK$215 billion. Adjusted for inflation, that would be HK$232 billion in today's money.

Now PCCW is hoping to spin off HKT in a deal that values the business at between HK$29.1 billion and HK$34.5 billion.

In other words, under PCCW's control, HKT has seen 85 per cent of its value evaporate in less than a dozen years.

Admittedly, in early 2000 stock markets were approaching the height of the technology stock boom, so perhaps the comparison of capitalisation then and now is unfair.

But even so, Li's purchase of HKT included an HK$88 billion cash payment, which is three times the minimum valuation he now hopes to obtain for the company.

With a track record of value destruction like that, potential investors should ponder very carefully whether or not Li's latest plan is an attractive proposition.

The benefits for Li are obvious. He has been trying to extract cash from his holdings of HKT for years. At a rough count this is his fifth attempt either to sell, spin off, or take private HKT since 2006. All failed.

Now his chances of success look stronger. This time, Li has structured the spin-off as a trust which will be managed by PCCW.

Investors in the deal will be offered units in the trust, each of which will be 'stapled' to a preference share in the underlying business of HKT.

The reasons Li has opted for this convoluted structure is that it allows him to retain full control over HKT's management, while extracting additional cash from the company in the form of increased dividends.

Under Hong Kong regulations, trusts can pay dividends straight from cash flow rather than from profit, and PCCW is pledging to pay out at least HK$2.6 billion in dividends next year.

At first that sounds like a spectacularly good deal for investors. It equates to a dividend yield on units in the trust of between 7.5 per cent and 8.9 per cent.

Certainly Li is hoping such high returns will catch the eye of investors at a time when the dividend yield on the benchmark Hang Seng Index is a relatively meagre 3.4 per cent and 10 year government bonds are yielding a paltry 1.4 per cent.

But dig a little deeper and the offering starts to look less enticing. According to the deal prospectus, HKT is expected to make a net profit of HK$1.4 billion next year. In other words, PCCW is planning to pay out HK$1.2 billion more in dividends next year than it expects HKT to make in profit.

It can do this because HKT is sitting on HK$5.7 billion in cash reserves which it will be able to disburse.

However, anyone considering an investment in the spin-off might like to reflect that the high dividends they have been promised will effectively be paid not out of the company's earnings, but from their own capital.

And in future years, PCCW is promising to distribute HKT's entire earnings before depreciation and amortisation as dividends. That might sound like a grand idea, but it allows for no accumulation of reserves against hard times to come. In effect the high yields PCCW has promised will have been purchased at the cost of running down HKT's capital, which in the longer term must weaken the company's business prospects.

Viewed like that, the proposed spin-off of HKT as a trust doesn't look so compelling after all.

And valued in conventional terms, it looks downright exorbitant.

PCCW's expected HK$29.1 billion to HK$34.5 billion capitalisation for HKT, coupled with projected net profit figures for next year of HK$1.4 billion equates to a price-to-forward-earnings multiple of between 21 and 25 times.

Compared to PCCW, which trades at 12 times estimated earnings for 2012, and the Hang Seng index, which is on 10 times forward earnings, the pricing on PCCW's trust is looking dear to say the least.