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A Telecom Giant Gets with the Program

By David So Until very recently, PCCW, Hong Kong's largest telecommunications-services provider, spent little time trying to boost revenue in its core fixed-line business. Instead, it has focused on reducing its heavy debt load and improving its balance sheet (through debt refinancing, selling shares, and disposing of assets) since its highly leveraged takeover of Hong Kong Telecom from Cable & Wireless (CWP) in February, 2000. But as competition in Hong Kong intensified, PCCW's market share in fixed-line operations eroded to 77% as of June, from 82% at the end of 2002 and 89% in 2001.

However, following the appointment in July of its new group managing director, Jack So, PCCW (PCW

; ranked 4 S&P STARS, or accumulate) launched two major services designed to attract and retain customers: pay-TV and the first phase of its new generation fixed-line (NGFL) services, which are built on top of its copper network, while pay-TV runs on its existing broadband Internet network infrastructure. PCCW hopes that these will increase average revenue per user (ARPU) and counter its loss in market share -- both key drivers of its stock price.

The first-phase rollout of NGFL, launched in July, is largely based on short-messaging services (SMS), which represents the majority of the data-related revenue for the cellular players in Hong Kong, or about 5% of ARPU. The fixed-line SMS provided by PCCW requires new handsets that can read and write SMS. They would be given to customers without charge (the retail price of the handsets is about $88) who sign a 12-month contract.

MESSAGE TOLL. Although we at S&P believe that SMS is best suited for mobile as opposed to fixed-line users, it's a compelling service that could help prevent customers from switching to a competing fixed-line phone company. In particular, PCCW is offering fixed-line-to-fixed-line SMS free of charge to customers as part of its basic telephony service. Given that PCCW is currently hamstrung to compete on price due to regulation, we think the key strategy of this move is to attract new customers to its fixed-line network.

However, PCCW is charging customers who send SMS messages from a PCCW fixed-line phone to a cell phone in Hong Kong, which could potentially increase ARPU. PCCW expects its new NGFL services to penetrate 10% of its existing customer base -- or 300,000 subscribers -- this year and grow to a 20% penetration rate in 2004.

PCCW's pay-TV service that was launched in September -- called NOW Broadband TV -- will initially carry 23 channels and has the technical capability to carry 400. The technology, content, and business model of NOW Broadband TV was better than investors originally anticipated. In our view, it overshadows the failure of PCCW's previous iTV offering and the old NOW format.

PICK AND CHOOSE. The new pay-TV service runs on the asynchronous digital subscriber line (ADSL) network, and the content is displayed on TV, not a personal computer. Importantly, the service operates under a revenue-sharing model with content suppliers. According to management, PCCW was able to secure these content providers because PCCW received a patent on the encryption technology that would prevent piracy, a serious problem for the pay-TV industry in Hong Kong.

PCCW's flexible pricing plan lets customers choose the channels they want. Each channel costs between $1.15 and $2.70 per month. We prefer its "a la carte" menu of channels to the "buffet" of channels offered by incumbent pay-TV operator i-Cable (ICAB

; ranked 1 STARS, or sell). We believe PCCW's offering is perfect for customers who only watch a few channels. And as more compelling content is added to PCCW's pay-TV menu in the next few months, we believe more of i-Cable's subscribers could switch to PCCW's service.

What's more, we believe PCCW has the competitive advantage over other pay-TV competitors in terms of geographic coverage. PCCW can reach more than 95% of Hong Kong households. With its pay-TV offering, it aims to capture 20,000 customers per month, reaching 300,000 subscribers by yearend 2004.

KEEPING IT NEW. We at S&P figure pay-TV revenue could represent about 2% to 6% of PCCW's total projected revenue of $2.7 billion in 2005, based on ARPU of $13 to $38. However, the beauty of this offering is that PCCW is able to generate a new stream of revenue with little incremental capital expenditure, since the service is running on the existing ADSL broadband network.

Management expects its spending to support the pay-TV services to represent about 10% of overall capital expenditures (or 1% of an estimated $2.6 billion in total revenue in 2004). PCCW's expense is mainly related to customer acquisition, since it pays about $100 for each digital decoder when a customer signs up for NOW Broadband TV.

Based on a closing price of $7.20 on Oct. 30, PCCW shares (which trade on the New York Stock Exchange as American depositary receipts) carry a price-earnings ratio (using 2004 projected earnings) of 12 and an enterprise value to earnings before taxes, depreciation, and amortization (EV/EBITDA) of 7. That compares with a p-e of 13 and EV/EBITDA of 8 for its peers, which we derived by averaging the 2004 earnings multiples for Singapore Telecommunications, Telstra (TLS), and Telecom New Zealand. In our opinion, PCCW is reasonably attractive given its earnings growth profile of 3-year compound annual growth rate of 11%. Plus, the stock trades at a 30% discount to the forward p-e ratio of 17 for the Hang Seng index.

CORPORATE APPEAL. We believe PCCW will continue rolling out new services to capitalize on its existing network infrastructure. In particular, we expect it to launch its second phase of NGFL, which will be running on its convergence Internet protocol-virtual private network (IP-VPN) by yearend. We think the offering will be compelling for corporate customers (especially for the white-collar workforce), as the services integrate the voice/data calls (with speech recognition, text to speech, and voice XML) to Microsoft Outlook, an e-mail application commonly used in offices.

PCCW's primary objective for these new products is to increase subscribers, and its second objective is to maintain and increase APRU for its fixed-line services. Given our belief that current valuations don't reflect these potential achievements, we believe the stock could move higher, assuming PCCW meets its objectives without any related overblown costs and capital expenditures. Analyst So follows telecommunications and technology stocks in Hong Kong for Standard & Poor's

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