Asian Pay Television Trust - Can it ever make a profit with these interest and hedging costs?

1/6/2013 – If at first you don't succeed, list on the stock market.

The controversial IPO of Asia Pay Television Trust, and its main asset Taiwan Broadband Communications (TBC), closed its first week of trade on the Singapore Exchange at 93 cents, down from an issue price of 97 cents.

It had dipped to 91.5 cents on May 29.

After being unsuccessful in divesting the company, Macquarie International Infrastructure Fund (MIIF) and Macquarie Korea Opportunities Fund (MKOF) sold it to retail and institutional investors through the Singapore Exchange, in the form of Asian Pay Television Trust.

It is the second-biggest offering this year after Mapletree Greater China Commercial Trust raised S$1.4 bln in February.

The sale was part of MIIF's planned delisting from the SGX, after pressure from shareholders over its low valuations.

But the prospectus raises several questions that need to be asked.

First, the company seems to be in a straight-jacket of debt and hedging costs – so much so that current liabilities are greater than current assets, and it has been publishing net losses, despite operating profits and positive cash flow.

The interest payable on some of this debt seems very high – not least because the money was partly loaned by Macquarie Capital Group, its own parent company.

Second, the greatest assets of the company are not its physical network, but the cable TV licenses, which are intangible.

Third, the tax authorities are disputing restructuring charges, which have forced TBC to make provisions for a tax bill running up to more than a hundred million dollars.

Fourth, the operating environment in Taiwan is difficult.

TBC's two direct competitors are ahead of TBC with their network upgrades, and there are price caps on some of the services set at both local and national levels.

Fifth, it also disclosed it is in breach of certain competition regulations, which the authorities could take action over.

Sixth, we can't account for IPO proceeds of S$22 mln. The total sum allocated to debt repayments is S$22 mln more than the line items which spell out the details.

And in among it all, senior managers are making an incentive payment to themselves, partly funded by IPO proceeds.

BACKGROUND

The sponsor of the trust is Macquarie Capital Group which owns MIIF and MKOF.

The complex structure of the trust is provided on page 26 of the prospectus.

It will hold just 3% of the trust while 31.9% will be held by cornerstone investors.

The remaining 65.2% stake will be held by public and institutional investors.

TBC is the third-largest cable television operator in Taiwan operating in the northern and central part of the country with 15% market share.

It operates through five system operators in Taiwan.

It competes with China Network Systems (CNS) and Kbro in the cable TV segment, which have a market share of 26% and 23% respectively.

In the broadband segment, Chunghwa Telecom (CHT) has 80% market share.

After reading the 500-page prospectus, it appears TBC's problems outweigh its prospects due to regulations and its financial liabilities.

However, before the listing DMG OSK Research recommended investors SUBSCRIBE to the IPO with a fair value of S$1.10.

According to the house, it will pay a dividend yield that is the highest in the business trust sector.

Further details about the background of the company can be found on page 13 of the prospectus.

FINANCIALS

The company disclosed these results for the most recent financial year:

Revenue: +1.3% to S$308.7 mln
Profit: (S$26.3 mln) vs (S$4.5 mln)
Cash flow from operations: S$174.8 mln vs S$185 mln
Dividends: S$89.6 mln vs S$64.3 mln
Cash & cash equivalents: S$52.5 mln vs S$66.9 mln

The obvious question that arises is:

Question

1. Why did it post a net loss, despite higher revenue, positive cash flow and an EBITDA profit?

The top line seems to be growing.

TBC generates revenue from three business segments: basic cable TV, premium digital cable TV, and broadband.

Its revenue in FY11 and FY12 grew mainly due to an increase in subscribers of premium digital cable TV services.

The growth came on the back of higher premium subscriber numbers, growing 63% in FY11 and 21.7% in FY12.

But the higher growth in FY11 was due to a low base after the re-launch of this service in 2009.

While its EBITDA margin has stayed at 62% for FY10, 59% for FY11 and 55.4% for FY12, TBC made losses for all three years.

Why?

The answer can be found in the cost and complexity of financing its business.

Just by glancing at Asia Pay TV's balance sheet, you can see that its current liabilities exceed current assets.

In addition, the total financial liabilities of S$1.4 bln in FY10, S$1.4 bln in FY11 and S$1.5 bln in FY12 exceed total financial assets of S$39 mln, S$76.7 mln and S$64.5 mln respectively.

This liquidity risk is disclosed in the prospectus on pages 140, A-45 and C-57.

It indicates that there would be insufficient resources to meet TBC's financial liabilities as they fall due.

But the management believes that the liquidity risk is mitigated by positive operating cash flow (OCF).

Let's dig a little more into its financial liabilities.

TBC's income statement has a line item called "Interest and other finance costs".

This line item amounts to S$170.2 mln for FY10, S$77 mln for FY11 and S$122.3 mln for FY12.

These numbers, which are higher than its available cash in any given year, are a combination of interest expense, hedging cost, amortisation of expenses incurred in financing the debt, and others.

A detailed break up of this line item is given on page C-26 of the prospectus.

Question

2. Why is it being charged such a high interest rate on its debt?

These hedging costs, or let's call them losses, are largely related to a US$135 mln new debt facility it arranged in 2010 at an interest rate of 8.25% above LIBOR to refinance its older debt.

What is remarkable about this is not just that this is a substantial premium to benchmark interest rates.

You could even finance a Zimbabwe gold mine for a lower interest rate than that.

But also, that the financier of one-third of this debt facility was the ultimate parent company.

Out of the US$135 mln, US$45 mln was financed by Macquarie Capital Group.

Now, we're not alleging any malfeasance, but it seems to the reasonable observer that the lenders didn't cut the company much slack.

At the very least it suggests that they see TBC as a credit risk, which is why they are demanding such a high premium for the money they have lent it.

Question

3. Why is even the parent company earning such high interest from it?

The cash flow statement highlights that TBC has borrowed additional money to run its business.

Not to forget, it refinanced its debt as well, and it plans to do so in future, too.

Its debt-to-equity ratio stood at 2.8 times as at December 2012.

It has been paying interest of more than S$50 mln each year.

Question

4. What went wrong with its hedging policy?

But it lost money in hedging its interest rate exposure via interest rate swaps and cross currency interest rate swaps.

Historically, TBC has incurred an arrangement cost for debt which was capitalised against the bank borrowing and is amortised over the terms of the credit facilities.

For FY10, this cost amounted to S$26.2 mln which also includes a one-time write-off of former arrangement costs.

For FY11 and FY12, the cost was S$5 mln each year.

So, all up, it seems the bankers are earning a lot of money from the company.

Question

5. Why did TBC opt for a US Dollar loan, instead of borrowing in the local currency?

On the balance sheet, a line item called "Other liabilities" in current liabilities section also attracted our attention.

Digging deeper, on page C-41, other current liabilities include "Accruals" which amount to S$27.7 mln for FY10, S$39.5 mln for FY11 and S$44.4 mln for FY12.

These amounts include a provision for a long term incentive plan for senior management (LTIP) of S$8.4 mln in FY10, S$13.7 mln in FY11 and S$26 mln in FY12.

In fact, S$26 mln vested on the listing date and will be partly paid from the IPO proceeds.

It is worth noting that TBC's cable TV licenses are valued at S$1.1 bln in FY12.

This is the biggest item on the assets side of the balance sheet, yet it is an intangible asset.

So, the value IPO investors are actually getting is largely for assets which they cannot pick up in their hands, to the tune of S$1.8 bln.

Another item that increases its liability is income tax.

TBC is in dispute with the tax authorities in Taiwan due to expenses claimed with respect to a series of corporate restructuring from 2006 to 2010.

The amount provided for so far is S$122.4 mln.

Further details in the "Key Risks" section of the prospectus.

Question

6. Given that this amount has been provided for, can we assume the Taiwanese tax man is going to win this dispute?

Separately, TBC has also provided forecast financials for FY13 and FY14.

Revenue is expected to grow 0.7% to S$310.8 in FY13, and 4.2% to S$323.8 in FY14.

From this year it expects to make a profit of S$54.1 mln in FY13 and S$75.8 mln in FY14.

The total planned capital expenditure is S$49.4 mln in FY13 and S$40.5 mln in FY14.

It will spend S$16.7 mln and S$7 mln of this for upgrading the Hybrid Fiber Coaxial (HFC) network to 870 MHz in the same corresponding period.

It says it will fund its planned capital expenditures through bank borrowings and cash from operations.

Further details can be found on page 98 of the prospectus.

GROWTH DRIVERS

TBC was the first cable TV operator to offer free digital upgrades to cable TV subscribers in Taiwan.

Further, it also became the first operator in Taiwan to launch 120 Mbps broadband services, which was the fastest broadband speed available in the residential market in Taiwan till 2012.

While these initiatives have certainly helped grow TBC's revenue in the past, it has laid down more startegies for its future growth.

Investment in advanced HFC Network

To provide high quality serivces for all three business segment, TBC has made investments to build advanced HFC network.

It will spend S$24 mln to upgrade of HFC Network from 750 MHz to 870 MHz by 2014.

But page 233 of the prospectus gives us the impression that TBC is lagging behind its competitors.

It higlights that Kbro has already upgraded its network in 2012, while CNS aims to complete its upgrade in this calendar year.

Question

7. Can it compete effectively with its bigger rivals?

Increase take-up of premium digital cable TV Services

TBC aims to increase the conversion of basic cable TV subscribers to premium digital cable TV as the latter is considered to be a key growth driver.

To achieve this, it began to offer free promotional set-top boxes to selected basic cable TV subscribers to promote the take-up of premium digital cable TV services.

By the end of 2012, 25.6% of the group's basic cable TV subscribers had a digital set-top box, compared to 15.5% at CNS and 19.4% at Kbro.

The group expects to achieve 55% digital set-top box penetration by the end of 2014.

Media Partners Asia (MPA), an information provider on the media industry in Asia, says in a report quoted in the prospectus that premium digital cable TV penetration in Taiwan is underdeveloped relative to the United States, Korea, Singapore and Hong Kong.

Therefore it offers a significant upside opportunity for Taiwan's cable TV industry.

Increase in broadband subscribers

TBC intends to leverage its existing cable TV customer base and infrastructure to increase its broadband subscriber base.

But here are some facts provided by MPA in the prospectus.

Government-owned CHT continues to dominate the broadband market with a market share of more than 80% revenue generating units amid intense competition in the mobile segment.

The fixed broadband market in Taiwan had 5.9 mln revenue generating units (RGUs) by the end of 2012, which is equivalent to 72.1% household penetration.

The cable broadband industry has increased its share of the fixed broadband market from less than 10.6% in 2007 to 18.5% in 2012.

It is expected to reach 19.8% by 2017, with RGUs growing at a 4.3% from 2012 to 2017.

In addition, cable broadband RGUs as a percentage of basic cable TV RGUs is expected to grow from 21.9% in 2012 to 25.8% by 2017.

TBC's current broadband penetration rate in its franchise areas is 23.3% of basic cable TV RGUs, implying headroom for growth.

But Kbro has the highest number of broadband RGUs.

It had 300,000 broadband RGUs, with growth largely due to network quality and lower pricing versus CHT's fibre based (FTTx) products.

CNS has lost its lead as the fastest growing cable broadband operator due to delays in upgrading its network.

Question

8. Given its small scale, is TBC actually still in this race?

It had 175,000 broadband RGUs, adding 10,300 RGUs during the year.

Focus on cost management

TBC will focus on cost management to drive operational efficiencies through improved processes and automation.

It has started using electronic receipts for its subscribers, as well as online billing and payment reminder services.

It is also developing a remote help desk for the 24-hour customer service call centres to provide off-site customer service and thus efficiently manage unexpected peak call volumes.

Acquisitions

The trustee-manager intends to acquire assets with the objective of delivering strong returns to unit holders.

Question

9. Are there any prospective deals on the table?

Expansion in Taiwan

According to MPA, CNS and Kbro face more stringent growth limitations than TBC as their subscriber base is nearing the one-third national cable TV subscriber cap imposed under the Cable Radio and Television Act (CRTA).

But TBC is below this cap and is well-positioned to acquire independent system operators with the capacity to take on an additional 911,659 cable TV subscribers, which would more than double its existing basic cable TV subscribers.

In addition, TBC has applied to the NCC for an expansion of one of its franchise areas after NCC announced the re-zoning of franchise areas.

But we couldn't find in the prospectus which area it has applied for.

Question

10. Which franchise area has it applied for?

However, this application will not oblige TBC to invest in or implement the expansion.

If the application to the NCC is approved and the trustee-manager decides to implement the expansion, it would increase the number of homes covered by its HFC network and therefore its number of RGUs.

Further details can be found on page 181 of the prospectus.

MANAGEMENT

The management team is composed of the CEO, Mr Robert Neale Thorpe, and the CFO, Mr Brian McKinley.

They have more than 20 years of experience in operating infrastructure and private equity fund businesses, including international telecommunications companies.

Mr Thorpe is currently a managing director of Macquarie Infrastructure and Real Assets (MIRA) and led the establishment of the Macquarie SBI Infrastructure Fund, a billion-dollar private equity fund that invests in infrastructure projects and businesses located in India.

Mr McKinley was previously the CFO of the Richard Chandler Corporation, a private Singapore-based investment company.

He has extensive experience in managing the financial operations of investment and financial services companies and telecommunications companies.

Further details can be found on page 274 of the prospectus.

KEY RISKS

TBC's risks revolve around Taiwan's regulation for doing business in this sector.

Restriction of foreign ownership in Taiwan

In Taiwan, foreign shareholders can't own more than 60% of the system operator's total outstanding shares.

As a result, TBC holds an effective ownership interest of 59.3% in four of its system operators, and an effective ownership interest of 8.9% in a fifth system operator.

However, through various shareholder loans and dividends on equity, it receives substantially all of the economic interests in TBC system operators.

Question

11. What if the Taiwan government changes the current laws on foreign ownership?

Any such changes could render the current shareholding and ownership structure of TBC ineffective and require changes to the current corporate structure of TBC, including forced disposals of the group's assets.

Re-zoning of franchise areas

The NCC, the central authority responsible for issuing cable TV licenses, announced in 2012 that it will the re-zone and adjust Taiwan's franchise areas.

This will reduce the number of franchise areas for new system operator entrants or current system operators applying for extension of existing franchise areas from 51 to 22, corresponding to Taiwan's 22 administrative areas.

For example, Taipei City went from being subdivided into five franchise areas to only being one franchise area that geographically matches its administrative area.

Following the announcement, a number of licensed cable TV system operators aiming to expand their franchise areas submitted their applications to the NCC for newly re-zoned franchise areas.

This includes TBC's franchise areas.

If these applications are successful then competition will increase for TBC.

Possible impact on group's corporate structure for violating Article 21 of the CRTA

Article 21 of the CRTA places certain restrictions on the number of system operators held by other system operators or affiliated entities in the same administrative area.

As a result, TBC could be considered to own a system operator that is affiliated to the only other system operator in the Miaoli administrative area, in contravention of Article 21 of the CRTA.

However, the NCC has not opined on this issue and the trustee-manager has no indication that it will do so in the future.

But there is a risk that the NCC may determine that it has violated Article 21 of the CRTA.

Group may have to rectify the situation within a specified period either by divesting its interest in affiliates or applying for an expansion.

In addition, NCC may also impose fines of NT$100,000 to NT$1 mln for such violation.

If TBC does not rectify this situation within the specified period of time, the cable TV licenses of Shin Ho and/or Chi Yuan may be revoked by the NCC.

However, a revocation of the cable TV licenses of either Shin Ho or Chi Yuan or both would not result in the termination of the cable TV licenses of the other TBC system operators.

But because Chi Yuan and Shin Ho accounted for 7.3% and 6.4% of the TBC's total revenue in 2012, a revocation of one or both of the cable TV licenses could adversely affect TBC.

On a positive note, following the announcement of re-zoning of the franchise areas, either Shin Ho or Chi Yuan may apply for a cable TV license that covers the entirety of the Miaoli administrative area.

But Shin Ho is better positioned to apply for an extension of its franchise area.

This is because TBC has an effective ownership interest of 59.3% in Shin Ho, as opposed to an effective ownership interest of 8.9% in Chi Yuan.

If the NCC were to approve the application, the operations of Shin Ho and Chi Yuan would be subsequently merged to form a single system operator in the Miaoli administrative area.

The merger of Shin Ho and Chi Yuan would eliminate the risk of violating Article 21 of the CRTA.

However, there can be no assurance that TBC would be able to successfully merge Shin Ho and Chi Yuan.

Question

12. Why did it violate the Article 21 of CRTA at first instance?

Pay-TV and broadband business is highly competitive in Taiwan

Competition will increase for TBC after the re-zoning of Taiwan's franchise areas as system operators have begun to submit applications for cable TV licenses in its franchise areas.

In providing fixed Broadband services, TBC faces significant competition, both in terms of pricing and the speed at which its competitors upgrade their respective networks.

Wireless broadband has historically not been a substitute for fixed broadband in Taiwan.

But it may become a viable threat to TBC with the expected launch of Long-Term Evolution (LTE), marketed as 4G LTE, by the end of 2013, according to MPA.

TBC's current or future competitors' pricing policies could significantly affect the prices TBC charges for its products.

This will lead to a decline in such prices and/or an increase in subscriber churn, resulting in a net loss of RGUs.

Risk of further reduction basic cable TV rate caps

Basic cable TV pricing in Taiwan is regulated by the NCC nationally and by the local governments in each administrative area.

It means that basic cable TV subscription fees cannot exceed the national cable TV rate cap set by the NCC, which, since 2000, has been NT$600 per month.

On 24 April 2013, the NCC announced a preliminary proposal to replace the national cable TV rate cap with an alternate rate cap model.

It says the applicable rate cap for each system operator could be reduced below NT$600 per month if the system operator is not able to meet specified digital penetration rates over the next four years.

While local governments can impose rate caps, these cannot exceed the national cable TV rate cap.

Currently, local government cable TV rate caps range between NT$480 and NT$600 per month.

Local governments have reduced cable TV rate caps in the past and may do so again in the future.

In 2011, for example, local government cable TV rate caps were reduced by NT$10 per month in four of TBC's five franchise areas.

Most recently, in 2013, the local government cable TV rate caps for the same franchise areas were further reduced by NT$10 to NT$15 per month.

This implies lower average revenue per user (ARPU) in future, which is already falling for the cable TV and broadband segment.

Currently, MPA estimates the weighted average local government cable TV rate cap across TBC's franchise areas at NT$560 compared to the national weighted average rate of NT$530.

This places TBC at the top end of cable TV pricing range in Taiwan.

MPA believes this reflects the higher than national average household disposable income levels and household disposable income growth levels in the TBC's franchise areas.

Separately, premium digital cable TV services are not subject to a price cap.

Upgrade of the HFC Network to 870 MHz

TBC's will upgrade its HFC network in order to stay competitive.

During 2013 and 2014, it intends to allocate up to NT$567 mln or S$24 mln to fund the upgrade of the HFC Network to 870 MHz.

But if the group does not receive the expected returns from its capital expenditures it will have an adverse effect on the business.

Substantial additional income tax liability

TBC Group's had claimed for deductible expenses in its tax filings from 2006 to 2010 arising from a series of corporate restructurings.

But Taiwan tax authorities rejected the claim.

Hence, TBC has challenged the Taiwan tax authorities' assessment of its tax categorisation with the National Tax Administration of Northern Taiwan, which is currently reviewing its claims and relevant income tax returns.

The Taiwan tax authorities have assessed the income tax filings for 2006 to 2010.

But the 2011 and 2012 tax filing assessments have not been confirmed by the authorities.

If the authorities find that TBC improperly classified its applicable tax deductions, it could be liable for up to NT$2.91 bln or S$122.4 mln.

However, TBC has provided for this amount in its financial accounts as at December 2012.

In fact, this was one of the reasons for TBC recording negative working capital.

Further, TBC says that it may be required to continue to pay such tax expenses in the future.

While the settlement outcome and amount is not currently known, page 162 of the prospectus highlights that TBC expects to reach a settlement with the Taiwan tax authorities by the end of 2013.

The estimated maximum tax settlement amount anticipated by the TBC and its tax adviser amounts to NT$1.1 bln of S$46 mln.

And this figure is reflected in FY13's forecast figures.

Also, there is in place a revolving facility to fund up to NT$1.2 bln S$50.2 mln for tax settlement or any other future tax liabilities.

However, the group's cash flows may be insufficient to pay any tax settlement amount or any future tax liabilities which exceed the estimated maximum tax settlement amount.

As such, it may have to borrow money thereby increasing its debt and financing costs.

Further details can be found on page 55 of the prospectus.

ONGOING LITIGATION

TBC's tax dispute is not restricted to restructuring charges.

Some of TBC's properties are subject to a tax lien, pending resolution of the ongoing tax dispute with the Taiwan tax authorities.

But the trustee-manager is of the view that the tax lien does not have a material impact on the group.

Further details can be found on page 219 of the prospectus.

DISTRIBUTION POLICY

The Trust's will distribute 100% of the trust's distributable free cash flows, with first distribution of S$69.1 mln announced for H1 FY13.

Page 154 of the prospectus highlights that the trust expects to pay a yield of 7.51% for FY13 and 8.51% for FY14.

Further details can be found on page 92 of the prospectus.

IPO PROCEEDS

S$ 1.1 bln for settlement of the acquisition amount
S$ 252.8 mln for repayment of debt and associated costs
S$ 13.9 mln for cash awards to senior management of TBC
S$ 0.5 mln for working capital
S$ 52.7 mln for listing expenses

As mentioned earlier, S$26 mln will be paid to the senior management on the listing date, which will be partly paid from the IPO proceeds of S$13.9 mln.

And S$252.8 mln will be used to repay US$135 mln or S$164.9 mln of the loan facility, outstanding interest of S$157,000, and S$64.9 mln for cross currency interest rate swaps.

Curiously, these amounts only add up to S$230 mln.

We can only guess where the remaining S$22 mln are going to go.

We see a foot note on page 85 of prospectus which says "Assumes S$252.8 million required for the repayment of the outstanding Subordinated Facility and the termination cost of the cross currency interest rate swap…."

Question

13. Perhaps there are additional costs? But for what? The investment bankers?

Further details can be found on page 85 of the prospectus.

ISSUE DETAILS

Total Offer Size: 936.2 mln units
Price per unit: S$0.97/unit
Placement units: 866.2 mln units
Public units: 70 mln units

APTT had initially marketed the IPO in an S$0.92-S$1.00 per unit price range, but tightened it S$0.97-S$1.00 a week before the IPO.

Question

14. What demand for shares did it see before the IPO that prompted it to tighten the price range?

Because after the IPO that demand seems to have waned.

Separate from the offering, up to 525.9 mln units will be delivered to MIIF to pay for part of the assets.

The consideration units will in turn be distributed by MIIF to shareholders of MIIF, who have not elected to receive cash.

However, the number of consideration units will be determined after the shareholders of MIIF have completed their election and the number of units to be offered in the placement will be reduced by such number of units.

KEY FINANCIALS AT LISTING

Key financials at listing

Market cap: S$ 1.4 bln
Price/Book: 1.04x
Price/Earnings: 25.8x

There are only four (4) reasons companies list:
1. Raise fresh capital for expansion. This is the most virtuous reason, because new shareholders can take part in the growth of the company.
2. Allow existing shareholders to (partially) exit. Frequently this means the best growth days of the company are behind it.
3. Change in laws and regulations. Such as when revised foreign ownership restrictions force existing shareholders to pare down their stakes, even though they might not want to do so. While this gives you the opportunity to buy into companies, you must ask yourself whether how the company is impacted by excessive regulation.
4. Raise the company's profile. New shareholders must ask themselves whether an ego-trip by existing shareholders is a good enough reason to buy into a stock.

"Sharing the growth" is frequently stated in the IPO's publicity material as the reason for listing, but that's just the marketing pitch.

The real reason is only ever one of the four stated above.

Download the prospectus here.

We have sent these questions to the company to invite them for an on-camera interview, and/or seek their written response.

Sofar, we have not had a reply (which is why you are seeing this message).


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