Chinese telecom sector:Addressing investor concerns on today's sell-off

Investors concerned about 5G capex, competition and mixed ownership.

    We have fielded a number of questions from investors on today's share pricedeclines over concerns around 5G investments, competition, and mixedownership. In this note we summarise our key thoughts on each of thesetopics.

    Will 5G investments be significantly higher than 4G investments.

    Investors were concerned about the higher 5G capex outlined in the 5G WhitePaper released by CAICT (a think-tank for MIIT). While the White Paper alsoenvisaged a significant increase in revenue from 5G, this was dismissed bysome on the view that capex spend is more certain than monetization. Wenote the following: 1) it is too early to say much on 5G capex spend with thestandards yet to be set; 2) some of the 5G capex should be offset by lowerwireline spend as the fiber rollout completes; 3) the government is likely to beless intrusive and more accommodative of the sector over the next three yearsin preparation for 5G; and 4) if sector profitability continues to be weak andCM is the only operator with the financial capacity to roll out 5G, this would bedetrimental to competition and hence unlikely to be accepted by the regulator.

    Will unlimited plans significantly impact industry profitability.

    With sector revenue growing at 5.8% YTD, the impact of the drive forunlimited plans has so far been slight and our channel checks suggest thatpromotional activity has been fairly orderly so far. The concern is that thecurrent situation may spiral out of control with CM and CT closely followingCU’s more aggressive pricing plans. We believe that CM has ultimate controlon industry pricing and it is not in CM’s long-term interest to suffocate CU’sgrowth. CU needs to gain subs and scale to recover, and preventing it fromdoing so would only make CU reduce prices further. In our view, if CU doesreduce prices to the same level as its ARPU, it would be more painful for CMand CT given CU’s ARPU is RMB10/month lower. We think a price war wouldbe the last resort from CU but if the current situation continues, this could beits only option.

    CU: mixed ownership and FY17 results likely to be disappointing.

    Investors have also inquired as to whether CBN’s 700MHz asset injection willoccur. While this is not our base case, our conversations with investors to datedo not suggest that this upside is being baked into current expectations and ifthe asset injection were not to occur, the internet companies are likely to bethe sole strategic investors, with the ownership structure better aligned. On theupcoming results, we do note that, given CU’s thin profit margin, it can bevolatile. However, in the medium to long run, as CU’s top line recovers – as weenvisaged – the upside reward potential remains significant.

    Valuation and risks.

    We base our sector valuation generally on a DCF approach, which we applydue to the relatively predictable cash flow profiles of Chinese telcos. We use7.5% WACC for CT and CM and 8.4% WACC for CU. We use 0-0.5% perpetualgrowth rates to reflect population growth. Risks relate to capex and sectorcompletion. Please see pages 4-5 for specific company risks.