Chinese telecom sector:Thought experiments on mixed ownership
Looking at CU beyond mixed ownership
Given its thin profit margin, valuing CU is a challenging task, and this is made more so given the uncertainties associated with mixed ownership. In this report, rather than speculating on what mixed ownership could entail, we look beyond it and attempt to value CU based on the fundamental cash flows under various scenarios (bull and bear). We also explore the available options to CU and the implications for CM and CT. We draw on experiences from T-Mobile and Sprint in the US, APT in Taiwan and Vodafone in Australia to understand the dos and don’ts and the financial implications.
What could CU be worth under mixed ownership?Our bull case values CU at HKD18.70/share (81% upside potential), where we assume mixed ownership delivers on returning CU’s revenue growth to around the industry average through additional distribution channels and deeper cooperation with strategic partners on value-add services, with some margin improvement (+2ppts over four years) and slightly lower capex intensity vs. peers, as the alignment of employee interests improves efficiencies. Our bear case values CU at HKD6.60/share (36% downside), where we assume mixed ownership fails to deliver, with CU’s revenue growth remaining 1% p.a. below peers permanently, its EBITDA margin falling 2ppts over four years and capex remaining high (in line with our current forecasts, i.e. no efficiency gains).
But do not forget the option valueUnder the bear scenario, we expect CU to deliver ~2.5% p.a. EBITDA growth in 2018 and 2019, with capex averaging RMB70bn p.a., higher than the current company guidance. We believe this is unlikely to be an acceptable scenario for CU and that the right course of action for it, before 5G capex looms, is to significantly reduce its mobile prices and cut its SG&A. In this case, if we just assumed that CU improved its EBITDA margin by 4ppts, without any revenue benefits or capex cuts, this would return its valuation to HKD9.70/share, hence providing some valuation support to current levels.
Implications for CM and CTIn the bull scenario, we assume competition to remain orderly and rational, and hence the impact to be manageable for CM and CT - every 2% of additional revenue growth from CU would take off only 1-2% from peers’ EBITDA. We believe the right course of action for CM and CT would be to not pursue CU too hard on pricing. At RMB47, CU’s mobile ARPU is RMB8-10 below peers; it would make it very painful for the peers if CU dropped standard package pricing to such levels. We believe this is a remote risk at this stage but one that CU may have to pursue if its performance continues to linger.
What have the overseas experiences taught us?The overseas experiences have shown that, for a turnaround, telco share prices run faster than revenue and EBITDA improvements. The EBITDA margin improvements for the US telcos we reviewed were also more significant than we had assumed, suggesting further upside should CU get this right.
Valuation and risksWe base our sector valuation on a DCF approach. We use 7.5% WACC for CT and CM, and 8.4% for CU. We use 0-0.5% perpetual growth rates to reflect population growth. Upside risk: cost cuts. Downside risk: lower ARPU.