China Telecom Sector

1) Penetration levels and remaining industry growth
As of 31 December 2006, China had over 460 mn mobile subscribers, and the rate is
growing at around 20% CAGR (FY03-06). The national mobile penetration rate in China is estimated at 33%. We believe that there is still plenty of growth opportunity and forecast mobile penetration to double by 2016 (i.e., 66%). Our forecast could also be accelerated by the introduction of new entrants into the market via 3G licensing or industry restructuring that will allow the fixed-line operators to enter into the mobile business. In addition, there also seem to be promising growth from the rural market in which penetration is estimated at only 12% to 13%.
According to China Mobile.s management, there is huge demand for the mobile service in the rural market. With an estimated population of around 745 mn (including rural towns and villages) by the National Bureau of Statistics of China (NBS), the rural market already accounts for 50% of its newly net additions. Apart from falling costs in mobile service, the rural market in China is also experiencing rapid economic development with double digit GDP growth and strong per capita growth in annual net income of rural households. For example, in 2005, the net income per capita for rural residents reached about RMB3,200 and assuming that the average rural households is 3.77 persons per family (per NBS), this translate to net income of about RMB12,000. Therefore, we believe that strong mobile growth is well protected by a strong economy.


Delay in 3G licensing and industry restructuring has helped China Mobile extend its lead. We forecast China Mobile.s net additional subscribers to remain strong in FY07 at 54 mn(or average of 4.5 mn per month) compared to 53.2 mn last year. Moreover, we believe that more production of low-cost handsets similar to Motorola.s (MOT, $18.52,
OUTPERFORM, TP $24.00, MW) Motofone at around US$30 is a definite advantage to help operators expand into the rural market.
That said, we note that our current forecast of 4.5 mn per month for China Mobile is
slightly below the January-to-March average of 4.96 mn per month. The main difference is caused by our expectation of an increase in competition from China Unicom as it improves growth at both the GSM and CDMA businesses. This is also evidenced by the 1Q07 net additions improvement at 20.4% QoQ to 4.5 mn (or average of 1.51 mn per month).


In fact, a main reason why China Mobile has been posting record breaking monthly net
additions is the relatively low competition from China Unicom and the PAS operators. Until recently, China Unicom management has focused on improving profitability by avoiding heavy CDMA handset subsidies. In addition, ever since the reshuffling of CEOs in late 2004, the fixed-line operators have decided to stop competing for market share by cutting back on PAS promotions as well as capex. The rationale is to preserve capital in favour for 3G licensing that has been delayed, as well as waiting for the decision on industry restructuring, which should allow them to acquire a mobile network.
Therefore, we maintain the view that China Mobile.s monthly net additions market share of over 75% is not sustainable. We expect downside risks could come from; 1) a rejuvenated China Unicom, which is focusing on restoring subscriber growth following success in improving profitability, 2) the adoption of TD-SCDMA technology by China Mobile(0941.HK, HK$74.65, N, TP HK$88.00), which could slow down net additions and
decrease its high-end subscriber base and 3) potential asymmetric regulation, which is granted to the fixed-line operators to speed them into mobile business as well as to restore competition in the mobile market.


2) Competitive landscape
The Chinese telecom sector has gone through a period of intensive competition during
2001-04, driven by rapid capacity expansion and the need to create growth, even though at the expense of long-term returns, to compete for funds in the capital markets. Although such competition was value-destroying, there was no mechanism to discourage management from continuing in that direction. This is until the government decided to clamp down on unhealthy competition in the market. On this front, we believe that the change in the competitive landscape has mostly been driven by the State Asset Supervisory and Administration Commission (SASAC).
The SASAC was set up in 2002 after the new administration took over from the formerpremier, Jiang Zemin. The objective of setting up the SASAC is for the government to play an active role as the largest financial shareholder of large-scale state-owned enterprises(SOE), in order to .protect and increase the value of such SOEs.. All large-scale and strategic SOEs, including all major telcos, now report directly to the SASAC.
Managements are also evaluated by the SASAC on the basis of profitability, return, growth and efficiency, rather than merely adding on subscribers.
This has been a significant positive change as the telecoms operators had previously
reported directly to the Ministry of Information Industry (MII) whose main objective was to increase the industry.s size (i.e., penetration) and look after consumers. interests, rather than protect the operators. profitability. The SASAC was probably the first government body to examine the financial performance of all telcos in detail, both individually and collectively. Therefore, its observations prompted the awareness of excessive competition at the most senior government level, which led to a rethinking of what industry structure would be sustainable and how management could be led to behave rationally.
In hindsight, it seemed that the telecoms sector has received high priority at the SASAC.
We believe the major drivers are that: 1) the sector.s returns are falling, 2) the sector is considered large and highly strategic and, 3) the government has been actively studying the issue of 3G licences and the appropriate structure. Thus, the potential industry restructuring and the issue of 3G licences are likely the most important triggers for the government to be taking over the driver.s seat for the sector. It is because 3G build-out will easily require investment of hundreds of billions of dollars and presents the opportunity to nurture the telecom equipment sector to compete at a global level by developing its owned 3G technology (i.e., TD-SCDMA).
In addition to the SASAC, we believe the other highly influential administrative body in the government involved in managing the telecoms sector is the National Development and Reform Commission (NDRC). The NDRC.s role is to formulate industrial policies for key sectors of China, including industry structure and policies supporting implementation of reform. Driven by the SASAC and NDRC, the Chinese government has started actively managing the telecom sector by introducing Document 204 (introduced in July 2004) that states out strict guidelines and approval process for tariffs promotions and CEO reshuffling (November 2004) that aimed to rationalise competitive behaviour in the industry.
The competitive landscape soon improved following the CEO reshuffling especially at thefixed line side. China Telecom and China Netcom shifted their focus and began cutting back PAS promotions and investments. For example, China Telecom.s annual capex has fallen by RMB24.6 bn or 24% from RMB61.6 bn in 2003 to its current budget of RMB47 bn in 2007, and with an emphasis on broadband, value-added services and IPTV services expansion as opposed to PAS. As a result, its total fixed-line net additions have also declined by 54% to 12.9 mn in FY06 compared to 28 mn in FY03 (based on 20 operating provinces).
At the same time, China Unicom began focusing on enhancing profitability at its GSM and CDMA divisions by avoiding aggressive handset subsidies, especially at the CDMA front.
Due to this, total CDMA net additions declined from 12.3 mn in FY03 to just 3.8 mn in
FY06. This combination of less aggressive fixed-line operators and a profitability focused Unicom meant that China Mobile was left unchallenged to reap in the rapid growth of the Chinese mobile market. China Mobile had also extended its gain by increasing capex to gold-plate its GSM network and introduced tariffs promotion to attack the rural market.
This allowed the company to post record breaking monthly net additions and we believe
that management is being more aggressive to build its subscriber base in preparation for 3G mobile business.


Having built an incredible subscriber base of over 316 mn as of 1Q07, and with over 65% market share, it is hard to imagine that China Mobile.s dominant position will be seriously challenged. However, we believe that it also does not mean that things will remain smooth for China Mobile as was the case in for the past two years. In particular, there is growing expectation that an industry restructuring and 3G licensing is approaching. This should see new entrants including the two incumbent fixed-line operators to come in and grab a slice of the fast-growing mobile market. We also believe that China Mobile.s longer-term risk has risen significantly from the likelihood of having to build out TD-SCDMA. This could trigger a lose of its high-end customers that may see better service on other 3G standards, or be attracted by the triple play services offered by the fixed-line operators.
Due to this, we score China Mobile 4 out of 5 and China Unicom 3 out of 5 on the
competitive landscape measure.


3) Scale advantages
China Mobile dominates in this category and this is no surprise given that it had an earlier start to build and improve its network and to develop a strong brand name. On the other hand, its rival, China Unicom was given the task to operate with two networks. We believe the building of the GSM network as well as trying to allocate resources between the GSM and CDMA businesses have hindered its growth. In addition, we believe that China Unicom.s market position was also squeezed in the middle as China Mobile became more aggressive in attacking both the high- and low-end market segments. Also the two fixedline operators have been aggressive in the past in fending off mobile substitution through offering heavy subsidies on PAS services. Thus, it is not surprising to see that Unicom has the lowest EBITDA margin and ROIC amongst the four listed telcos.
As China Mobile is clearly leading the pack, we score it a 5. For China Unicom, although its earnings is recovering from a focus on profitability as opposed to growth, juggling and allocating limited resources between the two networks will remain difficult. Also, we expect Unicom to be more directly affected by the introduction of new entrants following the industry restructuring and the awarding of 3G licenses expected in late 2007 or early 2008.
Therefore, we give it a lower score of 3 in this category.


4) Competitive structure
As previously explained, the competitive landscape of the Chinese mobile market has
been subdued recently, due to the anticipation of 3G licensing and potential industry
restructuring. As a result, China Unicom, China Telecom and China Netcom have all been focusing more on cost control to enhance profitability and preserve capital. This has allowed China Mobile to extend its market share.
In terms of pricing differentiation, China Unicom.s tariffs packages have always been at a slight discount to China Mobile (as approved by the regulator) as it tries to narrow the market share gap with China Mobile. However, this was not effective as tariff was largely determined by provincial managers and that made monitoring the counter offers by China Mobile.s provincial manager difficult. This situation has improved with the introduction of Doc 204 from the SASAC which required all tariffs reduction and promotional packages to firstly be approved by central management and then to seek approvals from the relevant regulatory bodies before launching into the market.


5) Revenue growth and ROIC development
We expect double digit growth in mobile industry revenue over the next two years as
China Mobile and China Unicom continue to enjoy strong subscriber growth with a
relatively benign competitive landscape. That said, the rapid expansion into the rural market or lower end subscribers is expected to pressure mobile ARPU. While pricing elasticity and continued growth in data revenue should offset some impact, the evidence so far (4Q06 and 1Q07) suggests that ARPU is still trending downwards. This together with the introduction of calling party pays package and a reduction in domestic tariffs as encouraged by the regulator, is expected to continue to place pressure on revenue per minute. For example, sina.com has recently reported that the MII will cease approval of new tariff plans that are not based on calling party pays. Moreover, operators are not allowed to adjust outgoing call rates to compensate for the free incoming call rates. Also, the MII plans to reduce the domestic mobile roaming tariff cap currently at RMB0.80 for pre-paid and RMB 0.60 for post-paid.


We expect China Mobile to still dominate in terms of subscriber numbers and expect its revenue market share to remain at the high 70% level. However, the risk is that if 3G and potential industry restructuring is accelerated it would enable more competition into the market. On the other hand, we expect to see continual improvement in China Unicom earnings and ROIC profile, but the speed of the turnaround is harder to predict. Therefore, we score China Mobile with a mark of 4 and China Unicom with 2.


6) Valuation
Our order of preference within the Chinese Telecoms sector, based on DCF models
incorporating 3G scenarios, is China Netcom, China Telecom, China Unicom and China
Mobile. Our bullish view on the fixed-line operators and China Unicom is driven by our view that the chance of a potential industry restructuring has increased substantially and could happen in 3Q07 followed by 3G licensing expected in 4Q07 or early 2008.

7) Score summary
As expected, China Mobile scores the highest in terms of growth, scale and competitive position. Versus China Unicom, which trades at more expensive P/E multiples and a lower cash flow yield, we do not believe that China Mobile.s advantages are fully captured in the valuation differential.
Thus, China Mobile scores much better than Unicom, with a score of 30 versus a score of 24 for Unicom. However, we believe China Mobile.s near term share price performance is more likely to be influenced by other factors such as its involvement in the home grown TD-SCDMA technology and news flow over increase in competition should M&A occur.
Although China Unicom does not score as well based on the metrics of scale and
competitive advantage, we believe that its share price performance will continue to
outperform that of China Mobile in the near term from increasing news flow relating to a potential break up. Indeed, within the Chinese telecom sector, our top pick is China Netcom followed by China Telecom, China Unicom and China Mobile. Our bullish view on the fixed-line operator is based on the belief that they should benefit the most from the higher chance of M&A that is expected to happen in 3Q07 followed by 3G licensing in 4Q07 or early 2008. Finally, the fixed-line operator also trades at attractive valuations.