Business overview, segments



EXECUTIVE SUMMARY

We carefully investigated the risk factors in investing Chinadotcom and employed two different valuation methods to work out the intrinsic value of the company. The notes will go through each step of our analysis of the company and will reach a conclusion for investment purposes. The article consists of four parts:

Part 1: Investment risks and concerns. The major risk factors, from economic risks to company specific risks, were carefully investigated to provide essential information for valuation.

Part 2: Valuation with DCF model. We used this conventional valuation method to get the intrinsic value of the company, based on careful assumptions in cost of capital.

Part 3: Valuation with multiples. We chose more than ten comparable companies to get a reference valuation multiple for Chinadotcom. The multiple indicated a price.

Part 4: Conclusion. What are the pros and cons of investing in Chinadotcom? Should we invest in this company? We will reach the conclusion in the final part.

INVESTMENT RISKS AND CONCERNS

Economic Risks

Economic Climate in Asia is volatile. Beginning in mid-1997, when the Thai Baht first depreciated substantially, many countries in Asia have experienced significant economic downturns and related difficulties. As a result the decline in the value of the region’s currencies, Many Asian governments and companies had difficulties servicing foreign currency-denominated debt and many corporate borrowers defaulted on their payments. As the economic crisis spread across the region, governments raised interest rates to defend their weakening currencies, which adversely impacted domestic growth rates. In addition, liquidity was substantially reduced as foreign investors curtailed investments in the region and domestic banks restricted additional lending activity. The currency fluctuations, as well as higher interest rates and other factors, have materially and adversely affected the economies of many countries in Asia. The economic crisis and its effect on the Asian economies described above has had and is likely to have an adverse impact on spending levels by both Asian and international companies for advertising in the Asian markets, on spending by companies in Asia for web solutions. Moreover, payments on Chinadotcom’s accounts receivable may be deferred and may be difficult to collect or uncollectable and Chinadotcom’s ability to access line of credit or other financing may be restricted.

Economic risks associated with doing business in Greater China.

Peoples Republic of China. The PRC economy had experienced significant growth in the past decade, but such growth had been uneven across geographic and economic sectors and had recently been slowing. The can be no assurance that such growth will not continue to decrease or that any slow down will not have a negative effect on Chinadotcom’s business. The PRC economy is also experiencing deflation which may continue in the future. The current economic situation may adversely affect Chinadotcom’s profitability over time as expenditures for advertisements may decrease due to the results of slowing domestic demand and deflation.

Hong Kong. A significant part of Chinadotcom’s facilities and operations are currently located in Hong Kong. The Hong Kong dollar had remained constant due to the U.S. dollar peg and currency board system that had been in effect in Hong Kong since 1983. Since mid-1997, interest rates in Hong Kong had risen significantly, real estate and retail sales have declined and Hong Kong dollar had slipped into a recession. Hong Kong also had suffered deflation, the speculation and the SAR government had substantially supported the market for the Hong Kong dollar, both directly and indirectly through the large-scale purchasing of securities listed on the Hong Kong Stock Exchange. There is no assurance that the Hong Kong economy will now worsen and that the historical currency peg of the Hong Kong dollar to the U.S dollar will be maintained. Continued recession in Hong Kong, deflation or the discontinuation of the historical currency peg could adversely affect Chinadotcom’s business.

Taiwan. A significant part of Chinadotcom’s future revenues may be derived from the Taiwan market. Taiwan had a unique international political status with both Taiwan and the PRC asserting sovereignty over all of China, which included Taiwan, other islands and all of mainland China. Since late 1997, the NT dollar, the currency of Taiwan had experienced considerable volatility and depreciation of the NT dollar could adversely effect Chinadotcom’s business, results of operations and financial condition. Taiwan had recently experienced a recession primarily due to a reduction in exports due to weaken demand for import goods in many Asian countries and a continued recession in Taiwan may materially affect Chinadotcom business.

Country Risks

Government Laws and Regulations.

Because many Chinese laws, regulations and legal requirements with regard to the Internet were relatively new and untested, their interpretation and enforcement of what was deemed to be socially destabilizing by Chinese authorities might involve significant uncertainty. In addition, the Chinese legal system was a civil law system in which decided legal cases had little precedent value. As a result, in many cases it was difficult to determine the type of content that may result in liability. We could not predict the effect of further developments in the Chinese legal system, particularly with regard to the Internet, including the promulgation of new laws, changes to existing laws or the interpretation of enforcement thereof, or the preemption of local regulations by national laws. Periodically, the Ministry of Public Security had stopped the distribution of information over the Internet which it believed to be socially destabilizing. The Ministry of Public Security had the authority to cause any local ISP to block any Web site maintained outside of China at its sole discretion. Web site that were blocked in China included many major news-related Web sites such as , , etc. The Chinese government had also expressed its intention to closely control possible new areas of business presented by the internet, such as Internet telephony. If the Chinese government were to take any action to limit or eliminate the distribution of information through portal network or to limit or regulate any current or future applications available to users on our portal network, such actions could have a material adverse effect on Chinadotcom business, financial condition and results of operations.

The Chinese government also regulated access to the Internet by imposing strict licensing requirements and requiring ISPs in China to use the international inbound and outbound Internet backbones. Though Chinadotcom did not currently require that it obtain any license to operate in China. There was no assurance that it would be able to obtain any necessary license required in the future or that future changes in Chinese government policies affecting the provision of information services, including the provision of online services and Internet access, would not impose additional regulatory requirements on company or its service providers, intensify competition in the Chinese information industry or otherwise had a material adverse effect on its business, financial condition and results of operation.

Currency Exchange Rate Risks

Historically, substantially all of Chinadotcom’s revenues, expense and liabilities were denominated in H.K dollars. Chinadotcom also generate revenues and expenses and liabilities in U.S dollars and Chinese Renminbi. In the future, Chinadotcom might also conduct business in additional foreign countries and generate revenues, expenses and liabilities in other foreign currencies. As a result, Chinadotcom are subject to the effects of exchange rate fluctuations with respect to any of these currencies. It had not entered into agreements or purchase instruments to hedge its exchange rate risks.

Although Chinese government policies were introduced in 1996 to allow greater convertibility of the Renminbi, significant restrictions still remain. There was no assurance that the Chinese regulatory authorities would not impose greater on the convertibility of the Renminbi. Because a significant amount of its future revenues might be in the form of Renminbi, any future restrictions on currency exchanges might limit its ability to utilize revenue generated in Renminbi to fund its business activities outside the PRC.

Company risk

Chinadotcom has only a limited operating history as it was incorporated in Hong Kong in mid –1997 and has reported cumulative net losses of over US$ 13 million from January 1996 though December 1998. Increasing competition in existing markets and ongoing capital expenditures as new operations are established in new markets raise the risk that Chinadotcom might not be able to reach profitability positive cash flows in the future. Going forward, revenues and cash flows could disappoint in the vent of a drop-off in web development or advertising client growth, of if the start-up costs associated with new markets or new businesses turn out to be significantly higher than current expectations.

The Internet industry is extremely competitive and the competition in Chinadotcom’s existing and new markets to intensify in the future. Rapid changes in technology, marketing, and pricing present significant ongoing challenges. In particular, well-capitalized U.S. Internet firms, while not yet well established in Asia, could pose a significant competitive treat in the future.

Chinadotcom’s growth, in common with Asia’s entire Internet business, depends on its ability to develop and maintain its presence on-line, and the reliability and security of its network connections. The company’s future growth profile depends on an increasing on-line customer base as Internet services become increasingly widespread. New customers get on-line through local ISPs, which in turn rely on local telcos and other companies to provide to provide server capacity and other network hardware via local telecommunications line and lease long distance and international lines. The success of Chinadotcom depended on its ability to operate in markets with differing levels of telecom network efficiently and coverage.

VALUATION BY DCF MODEL

Our DCF model leads to pre-split per share price of around $51, which implies a total market capitalization of Chinadotcom of US$1.1 billion. Main assumptions are as follows:

• Revenue will grow at over 100% till 2001, and 80% till 2004. We believe the company can easily achieve this based on the huge opportunity in the Asian internet in the coming years, the company’s superior business model and competitiveness, as well as its aggressive acquisition activities. We project that the percentage of revenue from on-line advertising will surpass that from web solutions in the future.

• We don’t project the company will break even till the end of 2001. SG&A will continue to account significant part but will decline and stay stable at 30% of the total cost. Staff will also account around 20% of the total cost going forward, a slight drop from current 25%. R&D expenses will see significant increase from now on, up to 15% of total cost from current 7%. These assumptions are based on the business development strategies of the company and the management forecast.

• For working capital requirement, we assume it will stay same as the current one. We believe the capital expenditure will drop significantly over the years since the company passed the start-up stage. However, we assume that the company will spend average $2 million each year for fixed assets derived from acquisition activities.

• The company is in net cash position since its inception. We set our target debt-capital ratio to 10% over the long run.

• From year 2005 to 2009, we forecast the company will enter into a relatively fast growing but stable period. We assume the growth rate will be around 60%, which we believe to be quite achievable supported by the strong growth that mainland China and other economies in the region will show.

• Our implied FCF to perpetuity growth rate is 9%, which in our view is achievable given the long-term potential of the overall internet market in Asia.

This valuation incorporates a 25% cost of capital and 9% perpetuity growth rate, which are far more conservative than what internet analysts use in general. We believe it is fair to go with more conservative assumptions at the current stage, though we see great possibility to adjust our assumption to reflect Chinadotcom’s potential value upwards. Our sensitivity analysis shows that if we use 20% cost of capital and 10% perpetuity growth rate, the implied price will be above $100 per share. However, we suggest a combined valuation arrived at from an EV/Sales multiple to get our final price range.

Cost of Capital

Traditional approach. The traditional approach to the cost of equity is using the Sharpe, Lintner and Black Captial Asset Pricing Model. Beta was the factor to measure systematic risk. The study shows the beta approach has some merit when applied in developed markets. One might consider measuring systematic risk the same way in emerging as well as developed markets. Harvey's (1995) study of emerging market returns suggests that there is no relation between expected returns and betas measured with respect to the world market portfolio. A regression of average returns on average betas produces and R-square of zero. Harvey documents that the country variance does a better job of explaining the cross-sectional variation in expected returns.

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Chinadotcom is a company traded in NASDAQ market with business focusing on Asia. When we calculate the cost of capital for this kind of company. Should we use the traditional CAPM model or Harvey's ICCRC? To answer this question, we started to investigate the relationship between beta and expected returns for those companies listed in US with business in emerging market.

We checked 30 companies listed in US market but with business in emerging markets. Again, we did not find positive relationship between beta and respected return. A regression of average returns on average betas produces negatively correlated results as chart shows above. Using CAPM will result in a misunderstanding of expected returns for these kinds of companies.

International cost of Capital and Risk Calculator. The ICCRC model is a better approach to the expected returns in emerging market. The model specifies an external ex ante risk measure. Harvey applied the risk measure to all 135 countries and available in a timely fashion. This eliminates risk measures based solely on the equity market. According to the ICCRC, there are three steps to reach the cost of capital.

Step1: calculate country risk. Using ICCRC excel version, the first step is to choose China, Taiwan and Hong Kong from the 135 country database. We took a risk model based on Institutional Investor’s Crediting Ratings and anchored the cost of capital to the current US rate. The anchoring is important because the model has been fit over the 1979-1996 sample. The average returns during this sample may be higher than the historical average over longer samples.

The cost of equity for China, Hong Kong and Taiwan is 14.8%, 18.5% and 19.9% according to the calculation from ICCRC. Since Chinadotcom diversified its business through these three regions, we weighted-averaged the number and got a hybrid cost of capital of 18%.

Step 2: Identify the Beta adjustment. Chinadotcom is an internet information service company with core business in three regions: China, Hong Kong and Taiwan. To obtain the beta adjustment for this company, we ran regression on Chinadotcom’s weekly return against MS Great China Region Index. The slope of the regression =1.67; this is a measurement of the company’s beta adjustment of the country cost of capital we get in the Step1. Using the formula:

Cost of equity (Chinadotcom)=Beta Adjustment * Country cost of equity.

The cost of equity of Chinadotcom is about 30% according to ICCRC approach.

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Step 3: Weighted Cost of Capital. Intuitively, the cost of capital is the weighted average of the costs of the different components of financing, including debt, equity and hybrid securities. The weighted average cost of capital is defined as the weighted average of the costs of the different components of financing used by a firm.

WACC=cost of equity*equity/(debt+equity)+ cost of debt*debt/(debt+equity)

We assumed the company’s target D/V ratio is 15%, with a tax rate around 15%. The cost of debt is equal to 12%, which is common for the small business borrowing cost in Hong Kong. The result is we get the WACC at 27%.

VALUATION BASED ON MULTIPLES

We chose Price/Sales multiples to compare the company to other firms within the internet information service companies. The reason we use P/S multiples is that this method enables cross-border comparisons, as traditional price/earning and EV/EBITDA analyses are not applicable due to the high number of EBITDA-negative Internet companies.

As Chinadotcom is engaged in three different internet businesses, we picked up those comparable companies across the internet navigation, internet content and internet services industries. We also added up some Hong Kong listed Internet companies as comparables. The table below shows the trading multiples for these firms.

|Symbol |Company Name |Mkt Cap. |52-W Hi |52 Low |EPS |Rev/Share |Price |Sales 00'|P/S 00' |

|CNET |CNET, Inc. | 4,615| | 27.50| 0.84 | | 61 | 145| 31.8 |

| | | |80 | | |1.26 | | | |

|EWBX |EarthWeb Inc. | | | 25.38| (3.78) | | 31 | 50| 6.0|

| | |302 |89 | | |3.19 | | | |

|EXDS |Exodus Comm. | 21,136 | | | (0.78) | | 121 | 437| 48.4 |

| | | |145 |9.05 | |1.42 | | | |

|IVIL |iVillage Inc. | | | 13.44| (5.58) | | 21 | 81| 7.5|

| | |605 |130 | | |1.51 | | | |

|LCOS |Lycos, Inc. | 7,340| | 28.56| (1.00) | | 73 | 300| 24.5 |

| | | |94 | | |2.02 | | | |

|MKTW | | | | 26.13| (4.68) | | 43 | 38| 15.4 |

| | |584 |107 | | |1.80 | | | |

|MMXI |Media Metrix, Inc. | | | 31.00| (1.34) | | 36 | 33| 22.1 |

| | |718 |74 | | |1.04 | | | |

|STRM |StarMedia Network | 3,187| | 24.00| (1.91) | | 56 | 40| 79.7 |

| | | |70 | | |0.34 | | | |

|TFSM |24/7 Media, Inc. | 1,052| | 21.75| (1.51) | | 45 | 128| 8.2|

| | | |70 | | |2.81 | | | |

|YHOO |Yahoo! Inc. | 85,915 | | 55.00| 0.10 | | 162 | 756| 113.6 |

| | | |250 | | |1.12 | | | |

|ZDZ |ZDNet Group | 2,303| | 13.44| NA | NC | 32 | 123| 18.8 |

| | | |56 | | | | | | |

|1186HK |Pacific Century Cyber | 230,303 | | | (0.14) | | 25 | 5,531 | 41.4 |

| | | |29 |0.10 | |0.61 | | | |

| | | | | | | | |Average: |35 |

Within these companies, the leading portal stocks such as Yahoo! (110x revenues) or StarMedia, Latin America’s leading portal (80x revenues), trade at premium to the sector average, reflecting their perceived revenue growth potential in the future and their current market leading position. Investors have given these companies premium valuations because of the substantial e-commerce and advertising revenues that they are and will be able to generate.

If we use the average P/S ratio across the comparable companies, Chinadotcom will be valued at US$ 49. But if the market has interpreted that the company has a greater potential market, cross-border operations, and first-mover status in Asia, we assume that Chinadotcom deserves a premium over the average number we got above. Combined with DCF analysis, if we further assume a P/S ratio similar to Latin America’s Starmedia at 80x P/S on revenue of Year 2000, the valuation of Chinadotcom will be around US$ 112 while the NASDAQ is trading at 4400 points above.

CHINADOTCOM’S 1999 ANNUAL EARNINGS REPORT

On February 15, 2000, reported a sales increase of 500% for its first year as a public company.

The most rapid growth was in the second half of the year, as the scale of the business grew in step with demand.

``The (fourth) quarter saw nearly 1,000 percent growth year-on-year in terms of revenues and over 100 percent quarter-on-quarter,'' chief financial officer Peter Hamilton told a results briefing. ``But as the scale of our business grows, you should not be anticipating growth at this continued rate,'' he said. He added that because of seasonality in advertising and slower growth in demand from e-business clients, the company was experiencing slower first quarter growth in revenues this year.

Total revenues were US$20 million for the year ended December 31, 1999, a 483% percent increase over the previous year's US$3.5 million. The company had a net loss of US $18.7 million for the year and did not provide comparative loss figures for the previous year.

The company achieved quarter-on-quarter growth of 117% in the third quarter and more than 100 percent growth in the fourth quarter.

Y2K concerns drove demand from e-business clients of the Web solutions division who wanted

projects completed in advance of the year 2000.

In the fourth quarter of 1999, revenues from web solutions rose to US$6.2 million, up from US$798,000 in the year earlier quarter. Revenues from advertising rose to US$4.54 million in the fourth quarter, up from US$218,000 in the year-earlier period. This was due to a 44 percent increase in repeat advertising customers.

The company will be focusing on improving gross margins in the coming year, said CFO Peter Hamilton.

CONCLUSION

Chinadotcom’s second IPO was very well received on January 21, 2000. The company sold a total of 4,975,500 shares at an initial price of US $85 per share for gross proceeds of more than US $422 million. The offering was 10 times oversubscribed. The company offered 3,487,500 of the new shares, and 1,162,500 shares were offered by selling shareholders. Even though the company had no earnings, the price rose 8.7% to close at 94 1/8. corporation used the proceeds of this offering for capital expenditures, acquisitions, and expanding its sales and marketing operations.

The company is riding a tide of euphoria over internet firms, and the stock price reflects that. The company’s integrated business model of “Build, Distribute, Sell” gives it unique access to diverse facets of the internet business. It has the flexibility of relying on its web consulting services for revenue while building the business from its portals and from advertising. The growth potential of Chinadotcom is immense, but the growth relies on the Communist government of China allowing the internet and ecommerce to develop with little interference. The country risk can be considered to be low since the company is headquartered in Hong Kong, an international center of trade and finance that experiences relatively little interference from the Chinese government. The company has an aggressive dealmaking personality that American investors like. They witness Chinadotcom executing the same “landgrab” strategy as or Yahoo! by partnering and creating alliances, and they show their approval by sanctioning a stock price that reflects the multiples of the internet market leaders in the U.S. and Latin America.

Chinadotcom can be considered a risky investment from the standpoint that it has not shown any earnings yet. The company has been public for less than a year and an institutional investor or a conservative investor may not feel comfortable with the limited amount of financial data the company has generated so far. The country risks are substantial, since much of China remains undeveloped and few of its inhabitants have access to the internet. The infrastructure to reach much of the population with the internet simply does not exist. The government regularly continues to control the flow of information within the country and holds internet firms liable for content that it might find offensive, though no specific guidelines are available. Asia has just emerged from a deep recession that highlighted the weaknesses of its economy and the negative side of Asian business traditions. If such a recession were to occur again, businesses would eliminate their internet efforts to cut costs and the Asian consumers with access to the internet wouldn’t have money to engage in ecommerce or act on internet advertising. Chinadotcom is subject to the economy of the region in which it operates, though it has sought equity capital in the U.S.

The choice to invest in Chinadotcom’s second public offering is a matter for class discussion and speculation. This case is intended to bring out the various risks of investing in an emerging market company, the different valuation techniques, and cost of capital.

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Teaching Notes

20 Feb 2000

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