Hutch’s Big, Big Bet

In a monumental gamble, Hutchison Whampoa CFO Frank Sixt is rolling the dice on 3G technology. The outcome has global implications.
Jasper MoiseiwitschMarch 28, 2002

Frank Sixt believes in 3G. Really — he does. And not just believes, but bubbles. He says this of videophones, which he expects will be 3G’s main consumer hook: “The first time that I used the p2p (peer to peer) video application, I just found it astonishing. I was overwhelmed by that experience.” And this is not the effusion of a misty-eyed entrepreneur, but the elan of a gamesman who can look the full risk of 3G square in the eye and still back his horse.

A little faith helps, because as gambles go, this is one of the world’s biggest. 3G, standing for third generation, promises to be the technology that lets consumers download high-speed multimedia — voice and video — onto their mobile phones. And Sixt is the CFO of Hutchison Whampoa, the US$32 billion (net assets) giant that no one in Asia can afford to ignore. He is betting the horse, not to mention the company. And for the first time he has spoken at length to a financial magazine about his — and his boss Li Ka-shing’s — rationale for the investment.

It’s no wonder why he’s opened up now. Hutch is launching 3G operations in Hong Kong, the UK and Italy this summer. It has spent US$10.2 billion on seven spectrum licenses (five in Europe, plus Australia and Hong Kong) and it has further interests that reach as far as Paraguay and Israel. Lehman Brothers analyst Phil Tulk estimates the company’s total exposure — proportional equity plus debt — will be US$15 billion for the next five years on its European 3G operations alone.

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Hutchison, controlled by Hong Kong magnate Li Ka-shing, is taking this gamble on the back of an old-economy property company, which has been cosseted by the Hong Kong government’s protectionist policy toward the real estate industry. Profits, in other words, have rarely been a problem. In fiscal 2000, for example, the company reported a robust US$4.4 billion in profits on top of US$7.3 billion of turnover. Hutch owns ports in Korea, Hong Kong and China, an oil company in Canada, real estate all over the world, retail food chains and hotels. It expanded into telecommunications in the early 1980s, making many stops and starts. Now chairman Li and CFO Sixt will lean on the companies developed along the earlier evolutionary tree of its businesses to fund its 3G uberbusiness. They feel it’s worth the risk, according to Sixt, because Hutch’s comparatively conservative balance sheet allows it to grab this market while competitors in Europe are on the ropes. And they believe in the technology.

The NAVigator

Pause for a second and mull what it means if Li and Sixt are right. They will have succeeded in the last remaining technology gambit still in play in world finance, and they will be dominant in Europe. Hutch, remember, is a Chinese company — its chairman’s connections with Beijing are legion — and it can either spin off the 3G assets or use the proceeds to develop 3G closer to home, in perhaps the greatest growth market for technology of all — China. The rewards, of course, will be great for shareholders — Li and minorities alike. Equally important, Hutch will have transformed itself from a traditional, asset-based conglomerate into a technology firm with much of its income stemming from the sale of information. Hutch will, after all, own the delivery channels for the data. Remember when Japan’s companies offered business models to the rest of the world? Count on hearing the same about Hutch if the game goes their way.

But the risk is huge. Some 37 percent of Hutch’s net asset value (NAV) is now tied up in telecommunications, largely 3G. This vulnerable slice is weighing on the stock price, down about one-third over the past year, and is the reason the stock is trading at a 2.8 percent discount to NAV. Within that discount abides a horde of nagging doubts. No one knows the costs involved in maintaining the enterprise, or whether Hutch will be able to spin off its 3G assets in an initial public offering. No one knows the timing or size of Hutch’s various 3G revenue streams. No one even knows whether the technology works or if consumers want it. And Sixt, universally regarded as a wizard with numbers, told CFO Asia he doesn’t know how he will amortize the billions in spectrum purchases that Hutch made in Europe for 3G. But make no mistake. Hutchison will rise or fall on the commercial success of this technology. Says Julian Mayo, managing director of the investment house iRegent: “If you don’t believe in 3G, you shouldn’t hold [Hutchison] stock.”

Few have the guts to say Hutch can’t do it. A certain portion of analysts and investors believe that there’s magic — a kind of sixth sense for business — in Li Ka-shing’s boardroom. It has a talent for making telecom investments and pulling out billions. It converted a US$1.5 billion investment in Orange Plc, a UK mobile operator that it built from scratch, into about US$20 billion in trading gains. It likewise reported US$9 billion in profit from the sale of its stake in the US wireless operator VoiceStream (to Deutsche Telekom, in 2001). And it famously backed away from the German 3G auction in the summer of 2000, sensing that the price tag had gone insanely high.

But not all Hutch deals smack of such sagacity. In the excitement over Hutch’s recent bid for the telecom assets of bankrupt Global Crossing, many have overlooked Hutch’s likely US$400 million write-off on a convertible bond it holds on Global Crossing.

All of this is on Frank Sixt’s plate. The man in charge of Li’s big bet is a modest, enthusiastic and razor-sharp tax lawyer, with a creative streak that belies the dryness of the profession.

Until recently, Sixt kept up his membership in the Canadian songwriters guild, left over from an early stab at a career as a tunesmith. (He penned a torch song called Heartaches that was used for a 1981 movie starring Margot Kidder.) He arrived in Hong Kong from Toronto in 1983 and practiced law for the Canadian firm Stikeman Elliot until he joined Hutchison. Eventually he won the trust of Hong Kong’s canniest investor, first as an attorney and then as a financial executive.

From his office in Hong Kong’s Hutchison House, he straddles two worlds. Hutchison is an old British hong, and its boardroom — all wooden paneling, subdued lighting and leather-bound antique books — has the clubby, colonial look of a Pall Mall gentleman’s establishment. Yet the company is now chaired by a Hong Kong local. Not just any local — KS Li is the territory’s richest and most savvy businessman, and he boasts connections that reach deep into the Beijing politburo. Although a publicly listed company, Li’s control of Hutch is so absolute that it is criticized, widely, for lacking accountability. But — if not totally au fait with the investor fashion for transparency and disclosure — there is no doubting that this is a modern firm with shrewd financial sense. For example, it pulled off the biggest block trade ever when Hutch sold US$5 billion of its Vodafone stock in March 2000. This well-timed sell-down in the wireless sector anticipated the broad TMT market collapse.

Sixt is confident Hutch can parlay equal savvy into its 3G investment. Where Hutch has been different, Sixt says, is in how it has finessed the risk of 3G. Hutch’s telecommunications assets, including 3G, represent 22 percent of the company’s total. Sixt is counting on that 22 percent as a “growth base” (the telecoms assets contributed 6 percent to earnings last year).

The remaining three-quarters are all earning, performing assets, he reminds us. Its competitors in 3G — Deutsche Telekom, British Telecom and Vodafone — have no such cushion. These second-generation operators bought into 3G licenses to build businesses off the back of their 2G earnings. But they have dramatically encumbered their cash flow to finance the growth into 3G, and their options are limited.

Hutchison is in a much more healthy position. Thanks to its cushy property business and remarkably well-timed and profitable trades in the wireless sector, it has enough retained earnings to comfortably finance its 3G gambit. So, Sixt takes pains to say, unlike its 3G peers, Hutch has not risked everything on the technology.

“Hutchison, by design, has not done that,” says Sixt. “We will not reinvest significantly more [in 3G] than the value that has been derived from the telecoms division itself. None of this growth will be financed by having put at risk, or having leveraged in any way, off the back of the rest of the conglomerate.”

But saying an investment won’t bankrupt a company is different from saying it will be profitable. And not profitable in the sense of some breathless reckoning of a wireless utopia, but profitable in a CFO’s ultra-conservative, discounted cash flow sense. Even the most expert and analytic stumble here. Tulk says there is an economic argument generally for 3G, based on his DCF model. But when asked what numbers he bases these projections on, he says: “Lots of willy-nilly things.”

Amortize This

And when asked how Hutch might handle basic issues such as the amortization treatment of its license costs and customer acquisition costs, he answers: “I actually don’t know.”

One might pause here to consider the full implications of that. The CFO, the custodian of the finances of one of Asia’s biggest conglomerates, has not decided how the company will amortize its billions in expenditures in its biggest area of investment. Third-generation wireless is just too nebulous, too unknowable to make such a precise commitment of numbers.

With many of the largest companies around the world being hit by investor fears of hazy accounting in the wake of Enron, Sixt needs to address this matter. The Hutchison 2000 annual report makes passing reference to this amortization issue, saying that “3G license costs are capitalized at cost and amortized over the periods of the licenses from the date of commencement of commercial operations.”

Of course, the questions become what is the life of the license, and what is the date of commencement of commercial operations? DoCoMo didn’t have such a precise starting date. It eased into UMTS, one standard of third generation technology, beginning with a trial group of about 4,500 users, and then slowly expanded into something properly ‘commercial’ as technology permitted a wider rollout.

Sixt’s numbers are likewise lost in the fog of 3G. For example, he says Hutchison’s Italian 3G license, for which it paid US$2.7 billion, “has just been extended from 15 to 20 years [and] we are still discussing the starting point for the extension.” So the beginning and end point of this amortization period cannot be decided and cannot be fully accounted for as yet.

Then there is the other matter of Hutchison’s P&L. The company has historically reported steady profit growth — its principal earners, its ports and energy properties, are not known for gyrating income streams. Shareholders have also benefited from a series of extraordinary gains off of telecom sales. For example, in 1999, the company booked an anabolic US$15 billion net profit following the disposal of Orange. And then, in 2000, it reported a further US$4.3 billion in gains, likewise related to the sale of various wireless assets.

Now analysts say Hutchison’s 3G build could put the firm, operationally at least, into loss. Lehman Brothers research estimates that its European 3G operations alone, when accounting for interest, depreciation and amortization, will lose US$443 million in 2002, and US$891 million in 2003.

Sixt counters qualms over possible shortfalls by pointing out that the company has billions of trading profits ‘in the bag’ ready to offset any such bleed. For example, in May 2000 Hutchison bought a UK 3G license for US$6.3 billion, and then sold 35 percent of that license to Dutch-based KPN and to Japan’s DoCoMo in a transaction valued at US$8.5 billion. Hutchison still has about US$1.4 billion in retained earnings from that transaction, which it intends to use to offset losses in its UK operations through to 2003.

Investment bank Salomon Smith Barney in Hong Kong reports further that Hutchison’s interests in Vodafone and Deutsche Telekom are trading at about US$1 billion above book, and that the company could use these numbers to reduce reported losses in 2002.

All well and good. But again, the broader concern for investors is that Hutchison, for a number of years upcoming, will be largely plucking its earnings figures out of thin air. What profit the company will report in 2002 to 2005 will depend on Sixt’s accounting treatment — how he will amortize the firm’s 3G expenditures and to what extent he will offset losses from previous trading gains.

“Hutchison has been aggressive in its accounting. For instance, it will take losses up front, so there is scope to offset massive losses,” says Edmund Harriss, a portfolio manager at Investec Asset Management. “There is enormous scope for Hutchison to apply perfectly acceptable accounting rules but to engineer all sorts of outcomes,” he adds.

Speed Trap

Meanwhile, there are plenty who don’t believe 3G will add up to anything at all. Bill Rojas, co-author of A Brave New Unwired World and contributing analyst for the telecoms consultancy Pyramid Research, labels the technology a “scam”. He hones in on the application about which Sixt waxes so euphoric: the videophone. “Three-G cannot offer a videophone … A videophone would require a transmission of 1 megabit per second [mbps], upload and download. The cell can’t handle it,” says Rojas, saying that UMTS base stations can only manage 4 to 5 mbps capacity, limiting usage to four or five users per base station.

The issue, as it is framed by Rojas, hinges on transmission speed. Sixt says Hutch’s service will transmit at “64 kbps (kilobits per second) on the uplink (the speed at which the handset transmits data) and 383 kbps on the download, at a minimum, at full mobility.” Whether that is fast enough for a decent video service depends on who you ask, but it bears looking at how NTT DoCoMo’s 3G experiment has fared.

The Japanese telco (and Hutchison partner) launched the world’s first UMTS network in May 2001. It has not lived up to expectations, says investment bank CSFB conglomerates analyst Joanne Wong in Hong Kong. According to Tokyo-based specialists that Wong has spoken to, the DoCoMo 3G has excellent voice quality but is riddled with bugs, has poor coverage in its central Tokyo service area and has only about one-third of subscribers that it forecasted.

Perhaps more relevant to Hutchison is the quality of DoCoMo’s wireless video. DoCoMo’s 3G transmits at about 100 kbps on download. For that users — or the few that have one of a small number of video-enabled handsets — get a jerky, grainy image.

It is user experiences such as these — plus those old 3G bugbears: handset supply, network engineering mystifications (“It is rocket science,” says one analyst) — that have everyone, including the most 3G-hopeful such as Vodafone, Qualcomm, British Telecom, Japan Telecom and South Korea Telecom warning of delayed UMTS operations. Everyone, that is, except for Hutchison, which has never wavered from its promised second-half rollout.

That Vision Thing

In the end, what may matter most is how Sixt leverages Hutch’s most valuable intangible asset — investor confidence in management’s judgment — to get through the uncertainty before the performance of 3G becomes clear. With so much of Hutch’s asset-base at stake, Sixt is under pressure to deal with an old problem: improve Hutchison’s disclosure.

The Asian Wall Street Journal went as far as to compare Hutchison to Enron, claiming in mid-February that Hutchison “sweeps billions in contingent liabilities under the rug.”

At issue was about US$13 billion in contingent liabilities detailed in Hutch’s 2000 annual report, which the Journal complains is not sufficiently explained. “We know that Enron had way more debt than was reflected on its balance sheet, but what about Hutchison?” it asks.

Sixt calls any Enron comparison “outrageous” and notes that US$12.3 billion of these liabilities are fully reported on Hutchison’s balance sheet. The other US$700-odd million of contingent liabilities — which are not explained but could be something as simple as warranties extended on company goods — do not belong on the consolidated accounts. Says Sixt: “There is no way that (Hutchison chairman) KS Li is going to reward me for sticking losses off the balance sheet, or liabilities off the balance sheet, or for trying to hide something from shareholders, because he is one.”

But Hutchison is guilty of the Journal’s broader charge that it does not give enough detail to explain its complicated finances. Although Hutchison’s annual report ranks as one of the best in Asia, investors and analysts want more. When asked to rate the company’s investor relations, one analyst joked: “It’s improving — at a prehistoric rate.” Of all the senior management at Hutchison, Sixt is seen as the most progressive and most in favor of improved disclosure. And one happy outcome of Hutchison’s 3G efforts is that the company will be working harder to explain itself. Says Sixt: “We will be doing everything we can to make sure that the performance of our investments in the telecommunications division will be fully understood.”

Investors confirm that Hutchison is getting more transparent, and the company retains the enormous faith of this community. Even after a difficult 2001, in which Hutch’s share price fell about 22 percent (it almost perfectly tracked the declines in the Hang Seng Index), it continues to trade at a 30 times PE multiple. This is double or triple that of the best of its regional peers.

And, upcoming, if the company finds success with its many 3G ventures, it will once again be praised for its brilliance of strategy, vision and timing. But 3G’s murkiness — both as a technology and as a commercial venture — and the fact that it will drain billions from Hutchison in the near term, might soon make Hutchison like all the others: scrambling to explain itself to a skeptical investor audience. Sixt, in his modernizing way, may just be anticipating Hutch’s future.

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