Description

Valuation

The valuation disparity between CHL and CHU arises mostly from multiple expansion for CHU ever since the 3G growth story started to take off in 2009. Until that point, both companies traded at roughly the same P/E multiple, and we don't believe there's any reason they shouldn't do so again.

In fact, even the sell-side is slowly recognizing that CHU's growth isn't really that profitable. Estimates for 2012 EBITDA for CHU are actually down 6% from where they were in Jan 2010. Estimates for CHL are up 4%. The chart on the URL below provides a compelling illustration of the senseless multiple expansion that's taken place here (rolling NTM consensus P/E, CHL in white, CHU in red).

http://tinypic.com/view.php?pic=efky7t&s=7

Even if we look out into 2013 and factor in consensus expectations for rapid earnings growth from CHU, the valuation disparity is still huge (see below).

You can pay 10x today's earnings for the boring, slow-growth, high-margin dominant player in the market, with $47bn of net cash (no typo) on the balance sheet and earn a 4%+ dividend yield. Or you can buy into aggressive growth and margin assumptions for CHU at 16x 2013 earnings, and hope for the best. The choice is obvious to us, and while you can't be totally sure about timing in these situations, the signs of deceleration and lost momentum in CHU's story are definitely starting to show. As they are confirmed, we believe that multiple conversion is inevitable. If both stocks trade at parity on a 2013 P/E basis, the trade should earn 25-30% over gross exposure, excluding the 4% divvy yield.

Background

The Chinese telecom industry is controlled by only 3 players (CHL, CHA, CHU) that represent 100% of the mobile business and 90% of the fixed-line and broadband market (the balance of fixed-line/broadband is made up of local cable providers).

Fixed-line penetration of about 22% of the population is much lower than mobile (65%). Fixed-line subscriber numbers continue to fall (-7% in 2010), while mobile subscriptions continue to boom, up 16% in 2010.

China Mobile (CHL) is the clear incumbent in the industry, holding 78% market share in mobile (100% of its sales are from mobile services). It has the widest and most recognized marketing, service and distribution network. CHL has historically had the highest-ARPU customers, as it was the first player in the industry and thus the early adopters became its customers.

CHL's scale, higher-end customers and focus on the mobile business drives its margin advantage over its peers CHA and CHU.

China Unicom (CHU) is more balanced company in terms of mobile-fixed mix (52%-48% in 2010, up from 47%-53% in 2009). CHU has experienced strong growth in 3G mobile (it currently has 30% of the 3G subscriber base, vs only 20% of overall mobile subs). CHU's main advantage is technology-based, which allows it to support the most popular global handsets (CHU is currently the exclusive operator of the iPhone in China).

Investment thesis

With the fixed-line part of the business shrinking and with no portability of existing mobile phone numbers, most of the trading activity in Chinese telecom stocks has been driven by mobile subscriber additions. Importantly, CHU's high growth rates are based on temporary advantages. While subscriber growth is a relevant metric, we believe it has become too much of a distraction, to the point of trumping profitability and valuation. These two market inefficiencies provide the opportunity to put on this trade.

• There has been a lot of enthusiasm over CHU's fast growth in the booming, high-ARPU 3G segment (CHU is guiding to 78% 3G subscriber growth in 2011, vs CHA at 38% and CHL at 21%) . CHU's advantage is technology-based: it was granted by the government the exclusive license to use the leading WCDMA 3G technology, which supports the widest range of smart phones and the fastest data transfer speeds. CHL was left with the TD-SCDMA technology, which supports a much narrower offering of handsets and delivers slower/poorer data transmission. While CHU's advantage is meaningful, it will only hold until the 4G generation rolls in, likely around 2013-2014.

• CHU provides a seemingly appealing equity story as the only operator to carry the iPhone in the largest mobile market in the world. Given Apple's history of entering markets through an exclusive agreement with a particular mobile carrier and later support other carriers, CHL and CHA will likely both carry the iPhone 5 when it is released (there has been plenty of news in the past few months about Tim Cook meeting with CHL). It still hasn't been disclosed whether CHU will also hold exclusivity for the iPhone 4S, but it is probable that CHA will carry the phone (meaning more competition for CHU for iPhone customers), and perhaps even CHL as well (iPhone would need to be modified into compatibility with the TD-SCDMA standard).

• In spite of its fast growth, 3G in China grows from a small base (it accounted for less than 15% of total mobile revenues), and growth will slow meaningfully once China's large cities are penetrated. Meanwhile, nearly 70% of voice-only subscribers subscribe to CHL and are likely to remain loyal, as number portability and thus real competition is not expected to be mandated in the medium term.

• The market seems to overlook that many of the new subscribers signed by CHU are not necessarily profitable. In an effort to increase network utilization rates, CHU heavily subsidizes handset purchases (by around 30% of revenues for new subs, implying 5%ish of total sales vs 3% for CHL). As subsidies got out of hand earlier this year, CHU reduced its promotions for iPhones and high-end smart phones and switched the focus toward more entry-level smart phones (low-margin accounts) in order to sustain subscriber growth rates. In spite of these efforts, CHU's 3G subs growth rate continues to slow: if we annualize net adds YTD we get to 21mm adds for 2011, well below guidance of 25mm. All along this process, the thesis drift from the sell side has been absurd. At first it was a great thing to capture the top-end of the market (iPhones), then it was better to penetrate the lower-end and save on subsidies. Eventually, it will become apparent that CHU can choose between high rates of growth or profitability, but not both, and at that point its valuation premium should vanish.

• China Mobile (CHL) is the lower-growth, boring 800-lbs gorilla in the Chinese telecoms market, but there are advantages that come with that. It has by far the largest distribution network in the country, the highest brand recognition, and the best customer support. CHL would not be losing relative market share at these rates if it weren't for the heavy subsidies CHA and CH are giving out, and for the government-driven technological disparity. The government was aware that it was putting CHL at a disadvantage with the TD-SCDMA technology, but it also entrusted CHL with developing the home-grown 4G TD-LTE technology. Chinese officials want the local technology to be commercially viable, so they are unlikely to push further towards reducing CHL's market share.

• The different ownership model of the cell phone tower networks leads to higher capex intensity for CHU, which the market seems to overlook: while CHL pays a leasing fee to its parent company, which owns the towers, CHU owns the towers itself and thus has to foot the bill up front for rolling out its network. With CHU spending nearly 130% of its EBITDA in capex, its free cash flow profile is much worse than CHL, which only spent 53% of EBITDA in capex. Note that CHL's margin advantage holds even after incurring for the network-leasing fees it incurs.

Key Risks

• CHU regains momentum in subscriber adds. Likely more headline risk than a real earnings driver, as subscriber growth acceleration would likely be driven by subsidies again (CHU just re-instated its 286 subsidy plan again in September after having withdrawn it).
• Delays in the roll-out of CHL's 4G technology could extend CHU's window of opportunity a bit longer and allow it to capture a larger relative share of the market.
• CHL does something dumb with its huge cash pile (in the past it's put $6bn into buying a stake in SPD Bank, or $2bn into the mobile business in Pakistan).

Catalyst

• CHU subscriber growth continues to slow/misses 2011 guidance
• CHL or CHA announce deal with Apple to distribute the iPhone
• CHL makes progress with TD-LTE technology