China Netcom: Low P/E, 3G Will Boost Revenue

Despite recent strength in China Netcom (CN) shares, we believe there is more upside remaining. The Ministry of Information Industry [MII] announced that TD-SCDMA has reached maturity and a large-scale testing is being implemented now.

We believe CN will be allocated the home-grown standard [TD-SCDMA] and that this will bring revenue to CN in 2H2007. MII released an anti-trust law on broadband, but we believe it will not impact CN, because broadband dominance is based on its monopoly of the fixed line network. Revenue remained stable in Q3, because the increase in broadband and value added services offset the decrease in voice businesses. We note that CN’s P/E and Price/Sales multiples are below half of industry averages. Furthermore, the first mover advantage that we expect for CN in 3G should be taken into account. With conservative variables, we calculate a target price of $48.78, 26.1% higher than the current price. BUY.

3G Network Will Generate Revenue
Recent progresses on 3G networks suggest that CN’s revenue in the future will be much more than just stable.

(1) 3G/TD-SCDMA Technology is mature. “3G in China” Global Summit 2006 was held on November 15 and 16. On the summit, Wen Ku, the chief of the Technology Department of the Ministry of Information Industry [MII] and the most important government official on 3G, announced “TD-SCDMA becomes a mature technology” and “TD-SCDMA value chain has been formed”.

(2) Pilot-Scale Testing Begins. In March, CN joined a TD-SCDMA test in Qingdao, while China Mobile (CHL) and China Telecom (CHA) tested TD-SCDMA in other cities at the same time. News came from China Academy of Telecom Research of MII that 20 thousand 3G mobile phone numbers are distributed to “friendly users” in November and December, 5 thousand of which will be distributed in Qingdao, the city that CN tested TD-SCDMA.

Our assumption is that the TD-SCDMA operation will be commercially launched in 2007, and TD-SCDMA will bring revenue to CN in 2H2007. Because the 3G test since March looks smooth and China government planned to operate 3G during Beijing 2008 Olympics.

We emphasize that CN will benefit from 3G anyway, as long as the Company obtains a 3G operation license. Investment including CAPEX has already been input into 3G, whether the Company will get the license or not.

2G or 3G, that is not the question. CN will be a mobile phone operator and will enjoy revenue from the new business line. TD-SCDMA or WCDMA or CDMA2000, that is the question to equipment providers, but not to CN investors. We believe there are equipment providers and other interest groups behind most good and bad words toward TD-SCDMA. Investors should only care that there would be a new business line, new revenue source, and new growth momentum.

Broadband Anti-Trust Rule Will Not Impact
At the end of October, MII announced Interconnection Fee Rules for Internet Switch Centers, which was named an anti-trust law for broadband. But we believe the rule will not impact CN much.

(1) Interconnection fee accounts less than 10% of CN’s total revenue.

(2) According to Xi Guohua, the vice minister of MII, MII actually just want fixed-line operators discounts 15% from interconnection fees.

(3) It is the fixed-line duopoly situation, which leads to the broadband duopoly. Users almost have got no choice when they want to access Internet. But MII does not intend to restructure the fixed-line duopoly.

(4) Fixed-line operators, CN and China Telecom , occupy 90% of the Internet access market. Other operators have few opportunities to challenge the market structure in the near future.

Total Revenue Stable, Non-Voice Business Upward in Q3
It was the first time that CN released quarterly revenue. Further financial transparency suggests management’s confidence. In the Q3 release, we note that that previous trend continued — revenue was stable, while non-voice businesses accounted for more proportion.

(1) Revenue in 1-3Q2006 was $65 billion. It suggests Q3 revenue increased 0.9% over half of 1H2006 revenue.

(2) Broadband subscribers at the end of Q3 increased to 14.3 mn by 24.5% over the end of 2005 and increased by 5.8% over the end of 1H2006. We believe strong growth will retain in 4Q2006 and 2007, because there is a large residential fixed-line customer base of 70.8 mn.

(3) Local voice usage (excluding Internet dial-up usage) in Q3 was close to half of that in 1H2006. Usage maintenance owed to the promotion of PHS1 value added services [VAS] and the promotion of “same number” service, which converges fixed line number and PHS number.

We believe that revenue the increase in broadband and PHS VAS will be sufficient to offset the revenue decrease in voice businesses in 4Q2006 and 2007. Furthermore, with 3G business, CN revenue will be much more than just stable.

Valuation and Recommendation
CN’s price multiples are significantly lower than its peers. P/E is 10.2x and Price/Sales is 1.1x. Both lower than half of industry averages. Price/Free cash flow is 3.0x, lower than 10% of the industry averages. [Ibid.] We believe CN is significantly undervalued and would be buyers of the shares up through the $40’s.

CN 1-yr chart: