Description

Summary: I started with China Mobile (CM) as a technical trade against forced selling created by Trump’s executive order in January. I picked CM because I knew next to nothing about the industry, and CM’s fortress balance sheet and leading market share gave me confidence about the downside. As I did more digging, I got more intrigued by the industry, as this appeared to be the classic Peter Lynch category of “bad getting less bad”. In particular, China Telecom seemed interesting as it consistently gained mobile subs in a saturated/no growth market, similar to TMUS in the US market, and it is the largest IDC player in China. That business (less than 5% of CT’s sales) would have fetched a big chunk (if not most) of CT’s market cap, using public comps like GDS and VNET (written up on VIC). So I switched the majority of my CM position into CT. I had largely ignored China Unicom (CU) until their earning call recently. Frankly, the results are just blah, but I was somewhat struck by how cash generative the company is and how cheap the stock is -- market cap is $135B HKD with $20B RMB net cash, and they generated $140B RMB FCF last 4 years. CU remains the lowest quality of the three, but it is also the clear price laggard and presents interesting risk/reward – the industry backdrop has clearly turned for better, yet investors can buy CU near the early Jan puking low and historical trough valuation at 0.35x BV. Even re-rating to CT’s 0.5x BV (which itself has catalyst/room for expansion) would lead to a 50% return. 

Industry Turning: As one can see, the three telcos have been value traps largely as a result of persistently low (CT and CU)/declining ROE (CM). Arguably CT and CU are both destroying value as their ROE is lower than their cost of capital. This low ROE was caused by two issues – declining ARPU as mandated by government, and heavy capex incurred during 4G and 5G rollout periods. 

On capex, China will finish the 5G build-out by 2022. One salient feature about the 5G cycle is that CT and CU are co-building and sharing a large number of base stations. CT has indicated on the 2020 call that the co-building initiative had saved both parties 60B+ RMB capex in 2020. All three players have given 2021 capex guidance representing low single digit growth over 2020, which itself has come in below guidance. Also important is that the 5G component of capex are essentially flat YoY for CT and CU, a clear sign that 5G spends are plateauing. 2022 will be the last year of the heavy spend, and mgmt teams have indicated capex will drop significantly in 2023 and FCF will improve further from a healthy level currently. 

On mobile ARPU, the government had stopped mandating significant price cuts in 2019, and the most recent government report for 2021 is the most benign in recent years, with only a very minor price cut on corporate accounts, and no mention of consumer pricing. This is just flowing through the P&L with contracts repricing and ARPU turning positive for CU in 2020. Both CM and CT have also seen a similar trajectory and guided for flat to up ARPU in 2021. In fact, the industry just posted the strongest revenue growth in Jan/Feb 2021 at 5.8% vs. around 3% for most of 2020, and CT will likely post the highest topline growth due to positive ARPU trends and higher revenue mix from faster growing Industrial Internet business. As with any businesses with high fixed costs, any improvement/stabilization in pricing should lead to improving margins. Yet another potential source of margin improvement will come in 2022, when the three telcos renew their contract with China Tower (consensus is for a rent reduction).   

Valuation: Valuation on any metric (P/B, EV/FCF, EV/EBITDA) is the cheapest in industry history and compared to global peers. As a SS analyst put it in his recent note, “We challenge anyone to find A rated credits trading on sub 2x EBITDAs – as is still the case with China’s telcos”. CU is actually under 1x EBITDA. CU’s cheapness is readily apparent just looking at the FCF generation and balance sheet improvement over the last 4 years. It is debateable whether capex consistently below D&A is the right way to run a telco, but savings from co-building/sharing base stations is real, and Unicom is largely holding share in the mobile and broadband market. CT is demonstrating the strongest momentum in mobile subs, but that appears to be mostly at the expense of CM and the result of aggressive bundling with broadband offering. CU’s 5G penetration is actually ahead of CM’s. 

Unicom 2017 2018 2019 2020

Net Income $1,828 $10,197 $11,330 $12,493

D&A $77,492 $75,777 $83,080 $83,017

OCF $85,054 $92,387 $93,678 $105,551

Capex ($61,489) ($52,176) ($56,187) ($53,981)

ICF ($47,336) ($61,179) ($59,053) ($92,018)

FCF (NI + D&A - Capex) $17,831 $33,798 $38,223 $41,529 

EBIT $6,860 $11,631 $14,285 $15,399 

EBITDA $84,352 $87,408 $97,365 $98,416 

Cash $38,362 $33,780 $38,661 $35,074 

Investments $160 $770 $202 $24,189 

ST Debt ($49,861) ($32,520) ($14,996) ($9,158)

LT Debt ($5,000) ($4,172) ($6,865) ($5,479)

Net Cash ($16,499) ($2,912) $16,800 $20,437 

The stock is even cheaper after making adjustments for investments on the B/S. CT owns a $40B HKD stake in China Tower (788.HK). It also has a 50/50 consumer finance JV called ZhaoLian with China Merchant Bank (widely recognized as the best run bank in China). China Merchant Bank just announced that they are exploring an IPO of the JV. Based on the disclosed financials (15% ROE, growing at 20%, 1.66B net income in 2020), I think this could be worth another 15-20B RMB for CU.

Price $4.4

# shares 306.0

Mkt Cap (HKD) $1,349.4

RMB/HKD $1.19

Mkt Cap (RMB) $1,133.9

Cash $350.7

Debt -$146.4

Net Cash/(Debt) $204.4 

Gross Cash/share $1.1 

Net Cash/share $0.67 

zhaolian JV equity $207.50 

788 equity $336.13 

Adjusted EV $385.92 

EV $929.6

EV/EBITDA 0.9x

EV/EBIT 6.0x

EV/FCF 2.2x

Catalysts: There are a few interesting catalysts. First, CT is conducting a IPO relisting on A market. One feature of A market listing is all companies are priced at 20x+ earnings, and CT as a SOE cannot be priced below book value (or else it is a “loss of state asset”). So before any IPO pop, CT on the A market will be trading at a 100% premium to the HK shares (same economic interest). Now there are many other companies with similarly wide A/H price discounts, so I am not arguing that H shares will re-rate to the A shares, but any convergence will help CT H shares and CU by association. Secondly, CU mgmt commented on the earning call that they could potentially spin off some divisions. Zhaolian (mentioned above) is clearly one. CU also has a meaningful cloud/enterprise/IDC division that represents 16% of sales and growing at 20-30% YoY. Comps trade at much much higher multiples. I have learnt that both CM and CT had explored spinning out and listing their IDC businesses. Lastly, all three companies will report Q1 results this month, and I suspect results will be strong across the board – the government had already posted topline data of the industry through Febuary, which accelerated further from Q4, and all three players played games with accounting and “hid” profits in 2020 – CU openly acknowledged that they overbooked AR reserves in 2020, and a meaningful chunk of that 3B RMB charge will be released in 2021.

Risks: The biggest risk is corporate governance. These SOEs have a history of mis-aligned interest with minority shareholders – the three telcos bore the brunt of building out expensive infrastructure for the greater good of society. Shareholder fatigue is palpable when I talk to other investors much more experienced with these entities. As a relative new comer to this area of the market, I take solace in a few points. First, this fear or apathy is partially reflected in the valuation. Secondly, actual capital allocation does not appear irrational or harmful to shareholders. In fact, CU has raised dividends by 10% in each of last 2 years (a respectable 4.5% currently), and mgmt hinted that they could boost payout ratio post 2022 as capex ramps down. Thirdly, there are meaningful incentive plans in place at all three telcos, and perhaps more meaningfully, the government entity overlooking these SOEs have just added “market capitalization management” to the annual review process. As I hope is obvious by now, there are plenty of options CU could puruse to boost its sagging stock price. 

Catalyst

1) CT relisting on A market

2) CU spin-off of divisions

3) Strong earning reports