Chinese Telcos:Signs that profit growth is a target

Why a positive era may be upon us.

    Bloomberg reports that SASAC has ordered SOEs to make profits. While thismay not seem targeted at already profitable telecoms, it does align with a farmore commercial message we received from telcos at Access China than themarket seems to believe. Notably we took away: 1) 5G capex should becontained due to a lack of use cases, 2) Operators appear cautiously optimisticon adding subs and the market expanding, and 3) Operators appear more opento cooperation than in the past. These are positive signs, for a sector withaccelerating FCF. We recommend investors to BUY.

    Profit growth case appears stronger than market believes.

    The government’s top priority appears to be debt sustainability, and related tothat, SOE reform, and “quality growth”. All of this suggests to us constrainedcapex and greater profit focus at SOEs. There is a valid question though overwhether reform is focused on heavy industry, with the digital economyinvested in aggressively (at telecom’s expense) to transition the economy. It’sbecoming clear to us, that telcos are somewhere in the middle of these twodrives, rather than being used as martyrs for 5G network builds, as almost allinvestors we talk to expects. Operators talk of not building too far ahead ofdemand. As such, while telcos are being priced as though profit growth andFCF will remain elusive, a more commercial story is starting to show through,more aligned with broad SOE and SASAC initiatives.

    Other reasons to believe a more commercial era is upon us.

    With mobile packages as low as RMB18, or RMB99 for “unlimited” data,pricing has become affordable, and the government message now is as much“people are playing too many mobile games”, as it is “prices should comedown”, so state-directed price cuts seem unlikely to be strong. Additionally,headwinds that have held back the sector are ending, e.g. OTT impact onlegacy revenues and network roll outs of FTTH and 4G driving up costs.

    Service revenue growth accelerated to 9% in October and November,suggesting a better market is upon us.

    Valuation & risks.

    Our China strategy team’s data suggested large China funds were 38%underweight telcos at the end of 3Q, and we think little has changed since.

    Extreme underweights in Chinese telecoms suggests when better newscomes, they could rebound sharply, as investors scramble to position. Wethink investors should take the risk of being in early, to avoid the bigger risk ofmissing out. Relative value is unusually attractive as well. We believe there aremultiple catalysts ahead, from a laggard SOE rally, telco sector rotation beingoverdue, a possible bond-to-high-yield equity switch, IoT based growth, a FCFupcycle that is driving double digit FCF yield in 2018 and possible sectorrestructuring. James Wang has Unicom as his top pick, but CT and CM arepreferred for our regional model portfolio, as they have very strong valuestories, and CT a rapid mobile growth story, that can resonate ahead.