China Telecom Services：Attractive valuations but earnings risks persist

Equity Research25 March 2014 Barclays Capital Inc. and/or one of its affiliates does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. This research report has been prepared in whole or in part by equity research analysts based outside the US who are not registered/qualified as research analysts with FINRA. PLEASE SEE ANALYST CERTIFICATION(S) AND IMPORTANT DISCLOSURES BEGINNING ON PAGE 16. China Telecom Services Attractive valuations but earnings risks persist Valuations appear tempting, especially for CU and CT, given our forecasts incorporate healthy earnings growth as well. However, two clear risks are persisting – potential VAT implementation and intense 4G competition. Until these subside, we struggle to see a sustainable rerating case for the stocks. The cheap valuation case tempers our cautious stance, but we continue to see little reason for investors to get involved in the sector right away. Thus, our order of preference remains CU, CT (both rated EW) and then CM (rated UW). We see two risks to earnings on a six-month view: (1) VAT – we think implementation is likely into the year. Timing and specifics are unclear but the potential impact to sector profitability appears negative. Associated impacts are not in our or, we think, consensus estimates as yet. (2) potential aggression on 4G: we see CM as incentivised to push TD-LTE at the cost of (rather than with) profits – its aggressive network build-out plan and terminal sales targets are reflections of that. Against this background, we think CT and CU have no choice but to speed up on 4G network build-out and spend more on handset subsidies and marketing costs to defend against an aggressive CM. Key takeaways from the results: (1) CT and CU surprised positively on (lower-than- expected) capex guidance into the year but both caveated views with potential escalation if FDD-LTE licensing were to come earlier; (2) We see flattish margin profiles into 2014 for CU and CT and margin shrinkage as continuing for CM – this is despite healthy top-line growth – overspending continues to be a risk into 2014 estimates, in our view; (3) Wireless data growth is still in its infancy and should see rapid development in 2014 – solid monetisation platforms augur well as a potential longer- term value driver, in our view. Inexpensive valuations, but for a reason: CU and CT are both trading below book value, but with worsening competitive stress and a consequent overhang on 2014 profit estimates, we struggle to see the stocks performing till earnings risks subside and we think we are not there as yet. Our HK$4.10 PT for CT and HK$11.50 PT for CU reflect 0.9x P/B (2014E) – we think appropriate in a historical context into a period of intensifying competition. Our HK$61 PT for CM is based on 10x P/E. Our pecking order in China – CU, CT then CM: We see FCF inflexion as a positive for CU – Rmb5bn of FCF generation in 2013 was after many years of negative FCF and we see this expanding into 2014; CU’s estimated 50% profit growth into 2014 is also the highest in its peer group in China. CT’s valuation looks attractive as well with 17% profit growth in 2014, on our estimates. We just see it as unfortunate that concerns around intensifying competition and VAT impacts are material enough overhangs to offset these positives. For CM, it is 2016E before we expect EBITDA to be back at 2013E levels and 2017E for profits. We struggle to recommend the stock till profit focus returns. INDUSTRY UPDATE Asia ex-Japan Telecom Services NEUTRAL Unchanged Asia ex-Japan Telecom Services Anand Ramachandran, CFA +65 6308 3895 anand.ramachandran@barclays.com Barclays Bank, Singapore Alicia Yap, CFA +852 2903 4593 alicia.yap@barclays.com Barclays Bank, Hong Kong Wen Du +852 2903 4582 wen.du@barclays.com Barclays Bank, Hong Kong Joyce Zhou +852 2903 2512 joyce.zhou@barclays.com Barclays Bank, Hong Kong Barclays | China Telecom Services 25 March 2014 2 FIGURE 1 China telecom service – valuation summary Source: Barclays Research estimates. Price is as at market close of 24 March 2014. 4G push, higher spending, and competitive dynamics continue to concern us... I. EBITDA margin outlook – CM and CT point to declining margin trends, CU is more cautious than upbeat on margin trends as well • CT/CU: We estimate that CT and CU can benefit from a net saving on interconnect rate of cRmb3.1bn and cRmb4.4bn respectively. Despite this materi