Description

Continuing my series of Chinese Telcos write-ups. China Mobile/China Telecom/China Unicom have been amongst the best stock performers in China last 2.5 years since they were put on the entity list and booted from US market, as investors started to appreciate the improving industry competitive dynamics and shareholder returns. China Tower checks the same boxes, is arguably higher quality (70% EBITDA margin), and recently has resolved the biggest bear case/overhang since its IPO back in 2018. Yet the stock languishes near all time low, and trades at 4x trailing FCF with a balance sheet that should be close to net cash in 2 years. Stock does not screen well on P/E (15x) and P/B (0.7x), but true EPS power is greatly under-stated due to over depreciation that will go away in two years (2022 FCF is 3x reported net income). If mgmt. simply keeps the current dividend payout ratio (72%), stock will sport a 15%+ dividend yield in 2026, not bad for a super stable unlevered asset.

Global mobile tower companies have some of the best business models and generally carry a high multiple. China Tower is the world’s largest tower company by # of towers and revenue. It was formed in 2014 and the three Telcos injected all their tower assets into 788 in 2015. Similar to many other Chinese SOEs, it is a government mandated “monopoly” with no pricing power, with its customers also its largest shareholders. This difference explains why 788 always traded at a significant discount to global peers – AMTs of the world have price escalators in their contracts, while 788 has none, and there was widespread fear that it could see negative pricing when it renews the contract with the Telcos every 5 years. This overhang was resolved late last year when the contract was renewed with much better terms than feared. Pricing remains largely the same, and 788 gave some small concessions on shared towers, so 2023 revenue and margin guidance remains largely flat vs. 2022 level. Stock initially spiked on the news, but has since given it all back.

Now the crux of my thesis. When CM/CT/CU injected their tower assets into 788 in 2015, 788 paid 203.4B RMB, and these assets were depreciated using a 6 year and 10 year schedule. This compares to ordinary useful lives assumption of (10-25 years) for China Tower, and up to 20 years for global peers like AMT. I compared the assumptions used in the depreciation schedule between China Tower and AMT, and they all came in more conservative. The upshot is reported D&A is consistently much higher than capex, even during peak 5G construction years in 2020. 2022 D&A was 49B RMB vs. capex of 26B. So operating cashflow is consistently higher than reported net income, but the two will converge at end of 2025 when the acquired assets are fully depreciated. 

Mgmt was asked this particular question on the Q4 result call, and this is their reply.

In terms of capital allocation, mgmt. is probably just above average for a SOE. The excess FCF has been used to rapidly pay down debt (down 22B in 2022 to 79B) despite very low interest rate (3% cost). At this rate, the company should be almost debt free by year end 2025, which is overly conservative for a tower company. They have boosted dividend payout ratio almost every year, which hit 72% for 2022 and may well be the highest payout ratio of all SOEs. Of course, shareholders should demand payout ratio based on true FCF, not the reported net income. Mgmt. gave some lame explanation that it is due to accounting reasons, but this excuse should go away after 2025.

So my rough math is 10B+ reported net income plus 15-20B excess depreciation going away after 2025 gets me close to 30B RMB reported net income in 2026, or 33B HKD, vs. current market cap 150B HKD, or 4.5x. At 75% payout ratio, that is almost 18% div yield, which feels too high for a stable tower asset. If re-rated to 8-9% div yield (above where telcos trade at), stock is a double. Valuation on any multiple is at a steep discount to global peers, even acknowledging 788 is an inferior asset with no pricing power. The improving balance sheet and FCF should provide downside support.

I should mention that I am glossing over the fact the company does some capital leases, which could understate true capex, but it is not too significant a number. Also there is some option value of the company actually figuring out adding more monetization/services on their existing towers. While NIMBY is not as severe in China vs. in US/developed economies, many of the tower sites are increasingly irreplaceable assets, especially in Tier 1/2 cities. The company has developed some rapidly growing ancillary service revenue streams, accounting for almost 10% of overall revenue, but likely still loss making. I am just ascribing 0 value to it.

In terms of what will rerate the stock, I have no idea. The over-deprecation thesis is not new or unique insight, and company fundamentals/results have been predictably boring. Depreciation came down YoY for the first time in 2022 albeit just slightly, and should come down more in the next few years., so the story will become clearer in the P&L. The three telcos were similarly left for dead in 2020, before the significant rerating. China Telecom went from arguably the lowest multiple telco to the highest multiple telco in just 2 years. Also US investors cannot invest in the three telcos as they are on the entity list, but to my knowledge, 788 is not.   

Catalyst

Time? Convergence of reported NI and FCF