Chinese telecom sector:The strongest being left behind

Solid 1H17 performance for all but no credit given for CM

    The Chinese telcos delivered solid 1H17 results, although this has not been equally reflected in share prices, with CT outperforming the HSI by 3% following the results and CM underperforming by 2% (adj. for dividend) despite a slightly better operating performance. The reception to the mixed ownership reform has also been underwhelming, however, we believe the change is positive for CU and potentially for the sector as a whole (as some elements of the reform may be introduced to other operators in the future). We continue to see solid growth prospects for the sector and have CM as our top pick as we believe sentiment and not fundamentals has been driving its share price.

    Sentiment not fundamentals driving CM’s share price

    CM delivered the strongest underlying 2Q results, with EBITDA up 6.2% YoY, supplemented by a substantial special, which should take its full-year payout to ~100%. However, the market seems to have largely moved on, giving no credit for the operational performance and potential future payouts, leaving its year-to-date total shareholder return of 5.5% worse than the appreciation in RMB (~7% vs. HKD). CM now trades at 12.3x FY17 P/E, 1.3 P/E points below CT (9.3x adj. for cash), which is too cheap vs. the regional incumbents. We do not see CM as a value trap given its strong market position and retain it as our top pick, followed by CU and CT.

    Data monetization may become harder but this won’t derail sector growth

    Despite the introduction of unlimited data plans at the beginning of the year, mobile revenue remains robust, with growth actually picking up to 6.6% in 2Q from 5.4% in 1Q. Regional experience suggests that ARPU improvement generally becomes harder two to three years after a 4G launch. However, China’s large data plans remain priced highly enough (60-70% above ARPU) such that based on other telcos’ experiences, blended ARPU may still rise if the current pricing structure continues. We have taken a more cautious approach and assume that ARPU will be broadly flat going forward, which will still see the sector deliver 5-6% p.a. revenue growth in the next three years due to increasing subscriber growth and growth in ICT-related businesses.

    Mixed ownership could be beneficial to all

    We discuss in detail our take on the impact of mixed ownership reform on CU in the note “Testing the Buy thesis”. From a sector perspective, the change could be beneficial for all as: 1) elements of the reform could be introduced to other operators over time, particularly in respect of board composition change and employee share schemes, and 2) new business opportunities, e.g. around enterprise services and cross-sector cooperation. Furthermore, the impact of CU’s recovery should be relatively manageable, with each 4% increase in CU’s revenue taking off only 1% of revenue for the other two operators.

    Valuation and risks

    We base our sector valuation generally on a DCF approach, which we apply due to the relatively predictable cash flow profiles of Chinese telcos. We use a 7.5% WACC for China Telecom and China Mobile, and an 8.4% WACC for China Unicom. We use 0-0.5% perpetual growth rates to reflect population growth. Upside risk: cost cuts. Downside risk: lower ARPU from competition.