Description

Pair Trade

Long China Mobile (941 HK) and short China Unicom (762 HK) – all numbers in RMB unless stated otherwise

Thesis Summary

Both companies operate in an oligopolistic market that is also highly regulated.  Due to the need for continuous capex deployment (5G rollout only 2 – 3 years away), China Mobile’s superior scale and stronger balance sheet to Unicom should warrant a valuation premium.  The current valuation discount to China Unicom provides an attractive trade for hedged investors.

Background

The telecom industry is considered “strategic” in China and as such the government maintains a tight grip on the industry.  The 3 telcos – China Mobile, China Telecom and China Unicom – serve the entire market and are in effect State-owned Enterprises (SOE).  All major decisions (e.g., strategic, personnel, M&A) require government blessing.  Recently a 4th telecom license was issued to another SOE – China Broadcasting Network – but the impact is expected to be negligible as the big 3 incumbents are well-entrenched.

Weighted by 2016 revenue, China Mobile is the leader with 53% market share and Unicom has 20% market share.

Mobile Market

In mobile, subscriber growth is limited as the market is saturated.  Penetration rate is over 100% with the number of subscribers slightly over total population.  Growth, if any, will have to be driven by ARPU.

As in elsewhere in the world, two trends are apparent.  First, fixed-line is in secular decline as consumers substitute with mobile.  Second, voice is losing market share to data.  Mobile data is the sweet spot and the vital battleground.

In order to capitalize on these 2 trends, the telcos are heavily investing in LTE networks in order to drive customers into higher ARPU products.  China Mobile is the dominant player in mobile.

Broadband Market

The broadband market is also dominated by the big 3.  They have been aggressively investing in fibre to keep pace with demand.  The independent operators that lease infrastructure from the big 3 are not real competition because their broadband speed significantly lags the big 3.  The difference in speed is especially striking when one visit a non-mainland Chinese website.

Geographically China Unicom dominates the Northern provinces and China Telecom dominates the South.  China Mobile, through its Tietong acquisition, mainly competes in urban cities.

There are 4 reasons why China Mobile is a better quality business and thus should trade at a premium to China Unicom

1. China Mobile has far better economies of scale

China Mobile generated 2.6 times revenue and 3.2 times EBITDA of China Unicom in FY 2016.  Telecommunication is a capital intensive business with high fixed cost.  This is crucial as huge investments (4G, 5G, fibre, etc.) are required in the foreseeable future.  As the leader in scale, China Mobile is better positioned to invest and monetize its investment than China Unicom.

2. China Mobile is far more profitable than China Unicom

Economic profit is defined as EBITDA minus net capex.  By this measure, and because of its scale, China Mobile is consistently profitable in the last 7 years and Unicom is only profitable in 3 out of the last 7 years.

3. The return on invested capital track record between the two companies are very different despite both are operating in the same industry and are backed and regulated by the same central government.

Invested capital is defined as equity plus interest bearing debt minus cash and short term investment.  Op FCF is the numerator and is before tax.  ROIC declined significantly for both companies in recent years as both have to invest heavily in 4G LTE which debuted in 2014.  

The main point is China Mobile was able to absorb this capex and stay profitable whereas China Unicom was unprofitable in 3G (2010 – 13) and in hindsight was under-invested in 4G and now has to play catch-up in the crucial mobile segment.

4. The capex/investment burden will continue to heavily weigh on the telcos.  China Mobile has the balance sheet to fund investments.  China Unicom is less capitalized.

For competitive reason, telcos have to invest in their network because aside from price, consumers also value speed and reliability.  China Mobile has invested over 1 trillion RMB in capex while China Unicom invested around 555 billion RMB in the last 7 years.  The former has better coverage and speed and thus is able to charge more than the latter.

Going forward, both firms have to continue to invest in 4G and 5G is expected to rollout in 2019-20, which would spur another cycle of capex.

Additionally, in China SOE investment decisions are often driven by the central government, not rationality or market forces.  The most notorious example is the TD-SCDMA (3G) standard that is only usable in China.  The State Council issued a “Broadband China Strategy and Implementation Plan”.  Phase II of the plan was completed in 2015.  Phase III is scheduled to be completed in 2020.  One thing is certain, whether it makes economic sense or not, capex will be ramped up.

China Mobile has a pristine balance sheet with ¥452.6B of net cash.  Its EBITDA is enough to pay for capex.  In contrast, China Unicom net debt is ¥149B (net debt/EBITDA = 1.9x), but most importantly, its capex is consistently greater than EBITDA, which means it is bleeding cash flow.  The dollar-weighted net capex/EBITDA from 2010 – 16 is 60% for China Mobile and 103% for China Unicom.

Valuation

The stock price in HKD has been translated into RMB using an exchange rate of 1 HKD = 0.87 RMB.  If Unicom trades down to Mobile EV/EBITDA multiple, the pair trade would return 25%.  If Mobile trades up to Unicom multiple, total return would be 12.7%.  If the relationship mean-revert and Mobile trade at 0.5X EBITDA higher than Unicom, the pair trade could return 23 – 43%, depending on if Mobile’s multiple expand or Unicom’s multiple contract.

Catalyst

When investors realize that China Unicom is hardly breaking even after capex, which should be apparent as management telegraph its capex needs for LTE and 5G rollout