David Riedel of Riedel Research Group recently sent follow-up comments to a note he released to clients on June 26.
Riedel recently wrote:
As we predicted in this note from June 26th, the PCCW deal did not take place.
We would still be buyers of China Netcom (CN), which we see as a very inexpensive play on growth in Internet use in China. The shares are up 20% over the past 4 weeks but we believe that the interim results will surprise the market (again) and the shares will have more upside.
David Riedel's note of June 26:
Recent developments in CN's international strategy reinforce our view that the company is content to focus on domestic priorities. The company has indicated that they are not interested in approving any change of control in the PCCW assets and are dismantling the international legacy of departed CEO Dr. Tian. CN announced CEO, Dr. Edward Tian, left to start his own business. We believe this will not impact CN much, because actually Dr. Tian has been distanced from core management since last March. With Dr. Tian's departure, CN focused on domestic operations and decided to sell Asia Netcom. We believe the sale is good to shareholders, because Asia Netcom suffered losses and had proven costly to maintain. PCCW is a different case as it is strategically important for CN. Taking into consideration recent volatility in equity markets, we lower CN's target price to $37. The target price is 15% over the current market price, therefore we maintain our BUY rate for CN.
Dispute on Sale of PCCW Major Assets
On June 19, PCCW (PCW) announced that it received a proposal about acquisition of all telecommunication and media related assets. PCCW believe the proposed transaction is "In the best interests of the PCCW and its shareholders". Proposed acquirers are Macquarie bank and Newbridge Capital. However on June 20 CN's parent company, China Network Communications Corporation [CNC] stated that they got to know the proposal "from PCCW's announcement" and would not like to see any asset ownership change. CNC's statement suggests that the largest shareholder of PCCW, Richard Li (Li Tzar Kai) launched his asset sale plan without the agreement of the second large shareholder, CNC. (Exhibit 1)
CNC believes Richard Li has no right to sell these assets because CNC obtained veto when acquiring 20% interest of PCCW. CNC opposes the transaction because CNC has interest in PCCW's fixed-line telephone market share of 68% in Hong Kong, while if the traction come true, PCCW will be empty except for cash. However in an announcement on June 21, PCCW argued that CNC's veto is on voting interests rather than assets.
We believe the dispute seems close to an end, when a seven-member team arrived in Hong Kong, which consists of CNC management and officials from Ministry of Information Industry and State-owned Asset Commission. On CNC side, government official do not want to be fooled. Government officials were lobbied by someone in Hong Kong to acquire 20% interest of PCCW at a high price premium and now they are trying to use the deception that "assets are not voting rights." On Richard Li's side, we believe Li Ka Shing, Richard Li's father, the richest Chinese, businessman would not like to suffer a significant conflict with China government.
Some Hong Kong government officials believe Richard Li's introduction of second asset bidder aims to allure CNC to start acquisition defense, therefore they also began to investigate the event. We believe the dispute will not make much impact on CN. Since Beijing intervened in, any rational acquirer should give up. Even though acquisition defense is necessary, CNC can deal with it with its own cash.
On 16 May CN announced that Vice Chairman Zuo Xunsheng replaced Dr. Edward Tian as CEO from 17 May. Dr. Tian left to start his own venture capital business, China Broadband Capital. It is a sudden change without an interim or transition, but we are not surprised at the event and believe there will not be any negative impact on CN for the following three reasons.
* The departure of Dr. Tian was rumored for long and CN management were asked about that many times.
* Shortly after the IPO of CN, Edward Tian, as CEO of CN, was sent to Hong Kong and appointed Vice Chairman of PCCW rather than stationed in Beijing Headquarters. We believe he was distanced from the core management from that point, so there will not be negative impact on CN's operation.
* Dr. Tian taught CN management how to manage a company and helped CN go public on Hong Kong Stock Exchange and New York Stock Exchange. However, his internationalization strategy like acquisition of Asia Netcom is not very successful.
* Sale of Asia Netcom -- On June 2, CN announced to sell all of its equity interest in Asia Netcom to Ashmore Emerging Markets Liquid Investment Portfolio and Spinnaker Global Opportunity Fund Limited for USD169 mn. At the same time, CN's parent company, China Netcom Group, sell Asia Netcom's stake for USD233 mn. We believe the deal is good to CN investors.
* Strategy after Dr. Tian -- Acquisition of Asia Netcom in 2003 is a case under the former CEO, Edward Tian's overseas expansion strategy. Recently CN announced a strategy of focusing on domestic opportunities just after Dr. Tian's departure. We believe the native focus strategy might be conservative, but it is at least much better than blind expansion like acquiring Asia Netcom, where there is no profit and little synergy.
* Unprofitable in Fact -- CN and its parent company, Netcom Group bought Asia Netcom for USD181 mn and sold Asia Netcom for USD402. It seems CN did a good deal, which made profit of more than USD200 mn. But actually Asia Netcom has experienced loss since CN acquired it, for example, Asia Netcom suffered a loss of USD45 mn in 2005. Further, we estimate the annual maintenance cost should be close to USD20 mn. Therefore the premium over the capital invested is merely reimbursement for losses and fixed costs. We conclude the transaction as unloading a burden.
Proposed Merger with China Unicom
Recently CN actively push to merge with China Unicom (CHU). CN submitted a merger proposal to the State Council China. CN Chairman, Zhang Chunjiang visited Netcom's Chairman, Chang Xiaobing, at Netcom's headquarters. The preferred plan is to set up a holding company to hold both CN and CHU's parent companies. All information of these activities came from the reputable China Business News and was confirmed by middle managers of both Netcom and Unicom, not merely hearsay. If the proposal is supported and approved by the State Council, the China telecom market will be more concentrated and there will be more monopoly profit for CN.
Preferential Price for IPTV Promotion
CN began to promote IPTV in Beijing and Northeast China. The initial installation fee is set at RMB 1,000, while the monthly fee is RMB 60. But during the promotion period, subscribers can take a 50% discount in initial installation fee and exempt monthly fee for half a year. The original charges are not very high and further discounts suggest CN is not very optimistic to the market. When the license problem seems to be solved gradually, IPTV still faces two obstacles. One is lack of content; the other is competition from digital TV.
We maintain our profit and loss projection, because PCCW dispute will not impact on CN directly (or will not impact CN at all as we believe it will not take place), while loss of Asia Netcom of USD45 mn in 2005 is not significant to total profit. But we update asset disposal in cash flow projection from $100 mn to $169 mn, which is the cash inflow from the sale of Asia Netcom. The most significant impact on the target price is the beta parameter, which rises from 0.74 to 1.01. In other words, the depressed equity market raises systematic risk. According to the updated model, we calculate a target price of $37, which is 15% over the current market price. Therefore we maintain our BUY rate for CN.
CN 1-yr chart: