FOOL ON THE HILL

Chinese Checkers

China Telecom's IPO, scheduled to launch today, got shelved when investment bankers realized it was in danger of failing due to the size, or perhaps to the price per share. We think this deal is inherently flawed for potential investors. China Telecom is but a part of the giant Ministry of Posts and Communications of the Chinese government, and investors should have no doubt that this and other components of the MPT are run by the government, for the government's benefit. This IPO is just another cynical way to bring billions of foreign investment dollars into its coffers.

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By Bill Mann (TMF Otter)
November 1, 2002

In the summer of 2000, when pundits were loony with anticipation of the boon to American companies that would come with the passing of normal trade relations with China, I issued a warning: "It should be remembered that in China, there is only one Rule Maker: the government."

Having experienced the difficulties of operating a company in China firsthand, I was skeptical that the government would allow foreign companies or individuals to make one red cent more than the absolute minimum.

Companies still flood China, looking for its nearly limitless, cheap, skilled labor for production and salivating over its burgeoning economy and 1.2 billion inhabitants as a market. And investors continue to look to China as the next big thing, in terms of a developing economy. They're not wrong, but the question is whether the benefit of the economic growth will accrue to international investors, or whether each investment opportunity is nothing more than a scheme by the communist Chinese government to separate gullible foreign investors from their money.

The latest element of the Great 10-Year Plan is an initial public offering of China Telecom (NYSE: CHA), which the company hopes will generate about $3.6 billion for its coffers. China Telecom was due to launch today, but it was pulled yesterday due to "weak demand in a tough environment." A spokesman for the company says its IPO, expected to price in Hong Kong and in New York, will be delayed until the beginning of next week, at the latest.

This morning, the investment bankers bringing China Telecom public claim the deal stalled due to its size, the environment, or because the shares were priced too high or the dividend offered was insufficient. All of these are more than likely true. But one doubts that investment bankers, who stand to rake in millions for bringing off such a massive IPO, would care to share the central truth: The company is flawed, and the deal is a mess. Still, the Chinese government knows very well that a large number of investors will be unable to resist placing a bet on the world's fastest growing economy. This IPO is going out, and soon.

When it does come, run. Run far, far away. Too many times, investors, it seems, are under the impression a company trading on the New York Stock Exchange must follow American corporate governance statutes, accounting requirements, and shareholder protection standards. They don't. In no way should an investor get a sense of safety because a company is listed on the Big Board. China Telecom is a Chinese, state-run company, beholden to Chinese law and little else. Your level of recourse, should something go wrong, would be little more than to bay at the moon. This isn't the first Chinese telecommunications company to IPO in western markets, and it won't be the last.

David Webb, a Hong Kong-based former investment banker who now runs a corporate governance website called, of all things, Webb-Site, broke down the elements of this particular offering in a recent column. It's fascinating (and a little scary) how the Chinese government seems to be taking several bites at the same apple using multiple classes of shares, nesting ownership (a company majority-held by another, which is majority-held by yet another...), controlling owners, even confusing names. David Webb's missives are an absolute necessity for anyone interested in investing in Hong Kong- or China-based companies. He is a tireless advocate for minority shareholders in a region where neither corporate governance nor class-action law have much strength. Even if you have no interest in investing in Asia, Webb-Site is a fascinating read. It might even make you appreciate just how good things are for American shareowners.

So, let's take a look at China Telecom, the company offering shares. One would think a company named China Telecom offers telecommunications services throughout China. Wrong. It actually only holds licenses in four Chinese provinces, plus Shanghai. Even more confusing, it's not even the first "China Telecom" -- another company, now called China Mobile (Hong Kong) (NYSE: CHL) has traded since 1997, and was originally called China Telecom. That company, though it has Hong Kong in the name, offers no service in Hong Kong. It's a mobile carrier, providing service in 13 provinces, and was split off from the same ministry as the current iteration of China Telecom.

Like China Mobile before it, China Telecom will be spun out from the Ministry of Posts and Telecommunications (MPT). MPT has yet to decide whether to grant mobile licenses for China Telecom, although that information isn't useful in prejudging the value of an entity in an IPO.

Here's the issue, though. The MPT controls, in one way or another, all of the publicly traded telecom companies in China, of which China Telecom, China Mobile, and China Unicom (NYSE: CHU) trade in the U.S. If MPT grants mobile licenses to China Telecom (and whatever future companies it will bring out from the remaining 17 provinces the MPT still directly controls), it will harm the values of Unicom and Mobile. Investors have no control over this. Neither do the various "managers" of these companies. MPT does. And MPT is going to go about its business in a way that most enriches the government of China.

Since the days of the Silk Road, China has represented an irresistible market opportunity to generations of traders. Except during the 19th century, when western military might humiliated China, it seems the Chinese have always gotten the best of the trade. Currently, there's no such advantage, and we're playing in the Chinese house. The deck is stacked against us, and we're playing a game with our cards face up, whilst the government's are shielded.

My hat's off to you if you win. But you'd have to be an idiot to play.

Fool on!

Bill Mann, TMFOtter on the Fool Discussion Boards

Bill Mann owns no shares of the companies mentioned above. Bill is the managing editor of The Motley Fool Select, where you can find his best Foolish stock ideas you won't find anywhere else. The Motley Fool has a disclosure policy.