The how and why of SOE reform

Deutsche Bank Markets Research Asia China Telecommunications Industry Chinese Telecoms Date 2 July 2015 Industry Update The how and why of SOE reform Plenty of reasons for structural reform... CU and CT to benefit the most ________________________________________________________________________________________________________________ Deutsche Bank AG/Hong Kong Deutsche Bank does and seeks to do business with companies covered in its research reports. Thus, 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. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MCI (P) 124/04/2015. Peter Milliken, CFA Research Analyst (+852) 2203 6190 peter.milliken@db.com James Wang Research Analyst (+852) 2203 6145 james-z.wang@db.com Alan Hellawell III Research Analyst (+852) 2203 6240 alan.hellawell@db.com Top picks China Telecom Corp ltd (0728.HK),HKD4.55 Buy China Unicom (0762.HK),HKD12.20 Buy Source: Deutsche Bank Companies Featured China Telecom Corp ltd (0728.HK),HKD4.55 Buy 2014A 2015E 2016E P/E (x) 15.0 8.6 13.3 EV/EBITDA (x) 3.7 3.9 3.3 Price/book (x) 1.0 0.8 0.8 China Unicom (0762.HK),HKD12.20 Buy 2014A 2015E 2016E P/E (x) 18.7 5.9 17.1 EV/EBITDA (x) 3.5 3.4 2.5 Price/book (x) 0.9 0.9 0.8 China Mobile (0941.HK),HKD99.25 Hold 2014A 2015E 2016E P/E (x) 12.2 9.0 14.1 EV/EBITDA (x) 5.4 5.7 5.1 Price/book (x) 1.7 1.6 1.5 Source: Deutsche Bank We see compelling reasons for the government to consider major reforms in the Chinese telecom sector with better efficiency and proliferation of broadband coverage being key outcomes. A merger of CU and CT and conversion of the TowerCo into InfraCo we consider the two most likely scenarios. We estimate that these scenarios would both provide a 10%+ upside to the market cap of CU and CT should they eventuate and believe that these are not currently incorporated in the market’s valuation for these stocks. BUY CT and CU for the upside from these scenarios and improving fundamentals. A number of factors point to further major reforms of the telco sector We believe the telco sector will be reviewed for a round of major reforms once the TowerCo is bedded down. We expect action as: 1) a sector with three SOEs being an unusual construct; 2) efficiency has declined, 3) the TowerCo is likely to be the pilot program of future major undertakings; 4) the government is looking to improve broadband coverage and reduce product prices; and 5) government looking to lift profitability and accountability of SOE’s. Our channel checks also suggest that the government is considering the need, or not, for such reform. Four scenarios considered to lift sector efficiency and profitability We have considered four possible scenarios: 1) a merger between CU and CT; 2) consolidation of CM and the national cable TV network (both of which were previously speculated in the media); 3) convert TowerCo into an InfraCo which would operate, maintain and construct both the broadband and mobile assets; and 4) full privatization. Whilst not exhausting, we think the future framework of the sector may well contain elements from each of these scenarios. CU and CT merger most likely... creation of an InfraCo also a sound possibility We consider the CU and CT merger to be the most likely given the significant synergy benefits involved which would improve fixed line profitability and could in turn encourage fixed line investments into the remote regions of China. While the reduction in competition may be a concern, we believe solutions include structural separation, regulated pricing and spinoff of the mobile business. An alternative would be to expand the TowerCo’s mandate to house both the fixed line and mobile infrastructure assets. This measure would also improve the accessibility of fixed line assets to new entrants. 30% value uplifts possible The two most likely scenarios mentioned above could both lift CU and CT’s valuation by 10% each. In a CU and CT merger, most of the value would come from synergy benefits and lack of asset duplication, while in the InfraCo scenario, the uplift would comes from gain on sale of fixed line assets to the InfraCo. We also estimate 10%+ value gains from the TowerCo for CT & CU. Given the potential upside, over-and-above our estimates, we retain our BUY on CT and CU with CT being the top pick on better ST momentum. Valuation and risks We value the Chinese telcos using DCFs with WACCs of 8.5% to 8.9% and terminal growth of 0%. Key downside risks include: 1) competition and 2) delays in the Towerco. Key upside risks for CM include market