The Smart Dividend Growth Idea (Part I): China Telecoms

Includes: CHA, CHL, CHU, TEF
by: Ramon Vredeling

We all know the phrase “better to be lucky than good” and that may be true on occasion, but if you want to have a long and profitable journey through the world of finance, you sure as hell better know what you’re doing. It wasn’t until I became a licensed stock broker a few years back that I really started to understand the multitude of possibilities that investors have when it comes to formulating the best investment strategy suited to their risk profile and investment goals.

I had a nice reminder of that during the last few weeks when I was studying up for my certified financial planner (CFB) exam, which I’m happy to say I passed. I again found myself up to my eyeballs in effective rates, yield curve, balance sheets, quick ratio’s, technical analysis, strategic asset allocation (SAA), CAPM, Delta, MiFID, Sharpe, standard deviation, MWR, Beta, margin, TARGET2-Securities (T2S)... you get the picture. The bottom line however remains unchanged, asset allocation determines total return.

There are numerous Tactical Asset Allocation (TAA) strategies proposed and debated here on SA. What normally happens with TAA strategies is that a portfolio is initially set up and diversified with long term goals in mind (SAA) and subsequently continuously readjusted with different asset classes. If equities are predicted to perform well in the near future, more capital is allocated. If bonds are predicted to perform well, then more investments in bonds (and so on).

There has been a heated debate recently between Dividend Growth (DG-) equity investors and Fixed Income pundits on the (dis)advantages of investing in the respective asset classes, but the simple fact is that the vast majority of investors will always have a diversified portfolio allocation of approximately 75%-35% equities and 20%-50% bonds under all circumstances.

In order to have success with TAA you need the proper skills to interpret and predict trends. Investors look at things like P/B, FCF, earnings and growth, technical indicators, and global economic conditions and predictions in order to make decisions on tactical allocation. In periods of volatility and economic uncertainty investors tend to change the allocation of their equity holdings to lower beta stocks, which are usually established large caps with historically stable dividend payments, providing preferably growing direct and indirect returns over time.

The first investment I ever made was in a Robeco Emerging Markets ETF, as at that time it was impossible to directly invest in developing markets like Latin America, Eastern Europe or Southeast Asia. Many investors were fortunate enough to enjoy outstanding returns on these ETF’s through the years during the 90’s and first part of this century. In the last few years however many US and EU investors got severely burned on direct investments in small- and midcap Chinese companies, (dual/multi-) listed on Western exchanges, due to bad accounting standards and controls, poor management, insufficient regulation and sometimes even plain fraud.

But of course there’s always another side to the coin, with potentially attractive propositions for Western investors still willing to invest outside of their ‘comfort zone’. As we are all made aware on almost a daily basis, China's economic rise has become one of the biggest stories of this generation. China has slowly but steadily become the world's top exporting country and is now the second-largest economy behind the US, surpassing Japan largely due to the sheer speed of China's manufacturing growth. Current predictions indicated that China will overtake the US as the world's largest economy in less than 20 years.

One reason China's economy is so big is simply that it has 1.35 billion people and growing. However, China's per capita GDP is still only 1/7th of that in the US and each year an average Chinese household only consumes 1/14th the value of goods and services purchased by an average US household, providing plenty of possibilities for growth for those companies with proper access and producing the right goods and services.

As stated on previous occasions I’ve been a big fan of Telco’s as of late, especially since the advent of the smartphone. Given present attractive market valuations, relative stability and predictability in earnings (growth), and a generally generous dividend policy in the sector, the telecoms have provided stability and increasing returns, without greatly increasing overall portfolio risk.

It has proved extremely difficult for Western telecoms like AT&T (NYSE:T), Vodafone/Verizon (VOD, VZ), France Telecom (FTE), Deutsche Telekom (OTCQX:DTEGY) or Telefonica (NYSE:TEF) to gain any meaningful traction in China’s telecom market, outside of a few minority stakes and strategic partnership agreements. Your best bet to profit long-term from China’s booming telecom market is still through a direct investment in one or several of the three major players, namely China Mobile (NYSE:CHL), China Telecom (NYSE:CHA) and China Unicom (NYSE:CHU).

China Mobile (CHL) provides wireless voice and value-added services through GSM networks covering mainland China and a substantial part of Hong Kong. In January 2009, it also started offering 3G services based on the TD-SCDMA standard. CHL ranks as the world’s largest mobile carrier and is still the dominant Chinese player by far with 617 million subscribers, of which 35 million are 3G users. H1 2011 net income climbed another 6.3% YoY to $ 9.59 billion (61.28 billion RMB), boosted by growth in its wireless data business and beating analysts' expectations.

CHL has a market cap of USD $ 195.7 billion and is currently sitting on an ever growing cash hoard of $ 51.1 billion. China Mobile has yet to make an overseas acquisition and its last major purchase was buying 20% of Shanghai Pudong Development Bank in 2010. CHL has a Beta of 0.58, an FP/E of 9.9, a P/B of 2.0, a P/CF of 5.5 and currently yields 3.7%.

China Telecom (CHA) is an integrated telecom service provider offering fixed-line, broadband access, and mobile services. It operates the largest wireline network in China, serving 172.2 million fixed-line subscribers (down 1.6% YoY), or over 64% of the total market. CHA also serves 70.1 million broadband access subscribers (up 10.4%), as well as 108 million CDMA mobile users (up 19.7%) of which 21.54 million are 3G users. H1 2011 net profit grew 10.2% YoY to $ 1.53 billion (9.81 billion RMB).

CEO Wang Xiaochu stated recently that CHA would “seize the strategic opportunity of migration of 2G towards 3G and the fiber rollout, optimized resources, allocation and leveraged proactiveness and creativity of our staff to achieve rapid scale development in mobile and broadband services.” The company currently has a market cap $ 51 billion, a Beta of 1.05, an FP/E of 15.7, a P/B of 1.4, a P/CF of 4.2 and dividend yield of 1.6%.

Last but not least, China Unicom (CHU). China Unicom is the second-largest fixed-line and mobile carrier in China after the 2008 restructuring. What differentiates China Unicom from the previous two carriers is their license, awarded in January 2009, to provide next-generation 3G wireless services using the W-CDMA technology, which it has since rolled out nationwide. CHU is currently the only carrier offering iPhone subscription plans, but competition may be intensified after China Telecom introduces CDMA iPhone in China. China Mobile still hasn’t given any time frame for an iPhone compatible with its TD-SCDMA network, which Apple (NASDAQ:AAPL) doesn’t support.

CHU posted a 9% YoY fall in H1 profit, as it continued to focus on attracting an ever larger user base through heavy subsidies. Even though this came at the expense of profitability, it still easily beat analyst expectations. The strategy seemed to pay off as CHU fared better in attracting high end users, compared to China Mobile and China Telecom. Net profit came in at $ 414.3 million (2.65 billion RMB) and was more than double the consensus of 1.28 billion RMB.

China Unicom added 9.9 million 3G users in H1 2011 to 25.8 million and currently has 184 million mobile subscribers total. After previously signing a mobile search deal with Baidu (NASDAQ:BIDU), CHU is also planning to release smart phones using its Linux-based WoPhone platform, beside their current Android and iPhone line-up, in line with plans by Alibaba (OTC:ALBCF) and Baidu to develop their own mobile platforms. CHU currently has a market cap $ 47 billion, a Beta of 0.85, an FP/E of 24.3, a P/B of 1.4, a P/CF of 5.6 and dividend yield of 0.6%. Spanish carrier Telefonica owns 9.7% of CHU, while China Unicom holds 1.4% of TEF.

The current expectation is that the number of mobile connections worldwide will rise to 7.4 billion in 2015 from 5 billion last year, with mobile data revenue rising 115% along the way. Mobile data has been and will continue to drive revenue growth for all Telco’s, but perhaps the largest beneficiaries will be carriers with exposure to the major emerging/developing markets. China will reach 1 billion wireless subscribers by the middle of next year, with a quarter using 3G phones. Still, China's wireless penetration rate will only be 74% by then, leaving enough room for CHL, CHA and CHU especially lure more high-end users to boost their ARPU (average rate per user).

I find it difficult to make a clear-cut choice between these three major Chinese carriers. China Unicom (CHU) has an important advantage in the 3G arena due to its W-CDMA technology and its future will depend on whether CHU can successfully execute its strategy and expand its subscriber base to gain better scale efficiency. The same applies to China Telecom (CHA) to some extent, with one clear distinction. China Telecom’s virtual monopoly in broadband access in southern China means the company is in a good position to provide integrated telecom services, allowing it to continue to profit from the boom in the broadband segment. This perhaps negates the competitive disadvantage in 3G compared to CHU to some extent. China Mobile (CHL) may we’ll be handicapped by its TD-SCDMA standard in the 3G arena, and an increasingly saturated urban market may force CHL to turn to lower-income rural areas for subscription growth. Nonetheless, CHL still enjoys unrivaled scale efficiency, superior network coverage, and a well-known brand and can leverage its competitive position and huge cash hoard to deliver solid growth in profits and FCF in the coming years.

Disclosure: I am long CHL, CHU, VOD, TEF.