ZTE-A and -H:Caution,speed bump ahead;initiating ZTE-H with Hold,ZTE-A with Sell

Leverage to 5G and market share gains mostly priced in.

    ZTE is well leveraged to grow in telco capex from 5G build-out starting in 2020.

    That said, current global appetite for large 5G capex is limited; while there isstronger political support for 5G tech in China, with limited applicationopportunities, we expect Chinese telcos to tread a middle path in the 5G buildout.

    Short term, global telco capex is set to fall 5-7% p.a., although ZTE'scompetitors struggle with profitability, providing some room for share gains.

    With ZTE's share price doubling YTD against a tough market backdrop, upsidepotential appears mostly priced in; Hold ZTE-H and Sell ZTE-A.

    Limited applications to support a widespread 5G rollout.

    Global telcos have expressed reservations about 5G, which likely reflect acombination of: 1) failure to monetize 4G, 2) reduced profitability and 3) limitedviable applications requiring nationwide 5G. For many applications, e.g., videostreaming and IoT, existing technology suffices; for others, e.g., robotics, needscan mostly be met by regional 5G rollout. For most global telcos around theworld, we expect 5G networks to be deployed like islands in a sea of 4G.

    Stronger political support in China should see ZTE better placed.

    There is stronger political support for a 5G build-out in China, with thegovernment aiming to make the nation a networking powerhouse. Hence,Chinese telcos spend on 5G capex will likely be more than their internationalpeers. Our bottom-up build suggests a total 5G capex in China of ~RMB1.5trnto be spent from 2020 (twice the estimated 4G spend), which would lead toc.RMB1.9trn in total capex spending between 2020 and 2024. This would drivea 30% lift in ZTE’s China carrier revenue in 2020 and a further 15% in 2021.

    Opportunities in the near term, but it is a tough environment.

    In the near term, operating conditions for equipment vendors remain tough,with our global team expecting a 6-7% p.a. decline in telco capex (ex US) overthe next two years. Issues at its major competitors present some opportunitiesfor share gains for ZTE, i.e. teething integration issues and potentiallyexcessive pricing discipline at Nokia and poor profitability at Ericsson. We haveassumed a 2-3ppt p.a. market share increase for ZTE in the Asia Pacific andEMEA regions over the next three years to reflect these. In China, we seelimited opportunities for ZTE to gain further material share prior to 5G, given itsalready dominant position with a 30-35% market share in wireless equipment.

    Many of these factors are priced in, with close to no upside potential for ZTE-A.

    While ZTE has put the litigation issues in the US behind it, significant executionrisks remain, given the competitive threat posed by Huawei. With ZTE-Htrading in line with its peers (albeit expensive vs. its own long-run average12mth PE), and with ZTE-A valuation already implying a bullish scenario ofshare gain, margin lift and significant capex blowout in China (leaving little freecash flow for the telcos), we rate ZTE-H a Hold and ZTE-A a Sell.

    Valuation and risks.

    PT based on mid-point of SoTP and DCF valuations (WACC 8.7%, TGR 1%).

    Upside risks: 1) keen 5G applications and 2) govet push to drive 5G spending.

    Downside: 1) share loss and 2) delays in formalizing 5G. See pp. 36–7.