Analyst Sees Upside to China Netcom on New Business Growth (CN)

David Riedel of Riedel Research Group recently published a positive note on fixed-line operator China Netcom (ticker: CN). Excerpts:

China Netcom’s net profit in 2005 was four times greater than the restated net profit in 2004. Excluding fixed assets revaluation in 2004 and upfront connection fees, revenue in 2005 increased by 5.9% yoy, net profit increased 76.6% yoy, and free cash flow increased 11.1%. Revenue increases came from high growth businesses including broadband, personalized ring, SMS, and Caller ID, while traditional business grew at a stable rate of 1.4% due to the rise of PHS subscribers. Total liabilities decreased by 7.9% to RMB139.8 bn and more significantly long-term liabilities were down 9.5% to RMB41.4 bn. The company joined the government supported TD-SCDMA massive test, which suggests the company may be a TD-SCDMA license candidate. In addition, the company is actively preparing for IPTV in an uncertain market.

Since the acquisitions in four north subsidiaries of parent company occurred near the end of 2005, only a small part of the high growth rates are due to the acquisitions. When the company consolidates the four subsidiaries for the full year 2006, the four subsidiaries should help growth in revenue and EPS to a greater degree.

Net profit margin went up from 7.5% in 2004 to 12.5% in 2005, while EBITDA margin was up from 48.5% in 2004 to 50.3% in 2005. These margin improvements give us confidence in China Netcom’s financial status in 2006.

Revenue came from high growth businesses

High growth businesses contributed 80.9% to total revenue increase in 2005. The company presented 4 high growth businesses including broadband, personalized ring, short message service, SMS, and Caller ID.

We believe broadband and personalized ring business will support revenue increases in 2006. Besides 35.13% subscriber growth and 50.2% revenue increase, ARPU of broadband in 2005 came in at RMB65.2 thousand, higher than RMB63.8 thousand in 2004. Personalized ring is a potential business attractive to and popular to the younger generation. But short message service and Caller ID will be mature soon in market because they should be basic functions of mobile phone and the improvement just supplied a gap to competing with other mobile operators.

Traditional businesses stable

China Netcom increased 1.4% in traditional businesses driven by 23.6% growth rate of Personal Handyphone System PHS subscribers and the perfect monopoly of fixed-line in north provinces.

Actually the north monopolist is still under threat. The company’s local fixed-line competes with mobile phone including its own PHS, therefore its local ARPU (both fixed-line and PHS) decreased from RMB36.6 in 2004 to RMB33.0 in 2005. While the company’s long-distance business, DLD, in the north market is open to other operators including underground operators, so the DLD revenue dropped RMB1bn yoy.

Liabilities improved

We view the liabilities improvements as significant since Netcom’s high debt ratio has been a key investor concern for some time. In 2005 total liabilities decreased by 7.9% to RMB139.8 bn, with long-term liabilities down 9.5% to RMB41.4 bn, current liabilities also dropped by 7.3% to RMB98.3 bn. Evidence of the debt improvement effort is RMB-14.7 bn net cash flow from financing activities.

Join 3G massive test, be a TD-SCDMA license candidate

At the beginning of March China Netcom joined the first massive test of TD-SCDMA in Qingdao with China Telecom in Baoding and China Mobile in Xiamen and test results will be announced at International TD-SCDMA Summit in June. It may suggest that China Netcom will be one of the three TD-SCDMA license candidates.

Based on government’s strong position on TD-SCDMA we believe a TD-SCDMA license will be good for Netcom.

Active in IPTV, uncertain future

China Netcom is going on with its IPTV plan. On March 24 both ZTE and Shanghai BellAlcatel won the bid to provide 50 thousands Beijing users with IPTV equipments. But we are not optimistic to IPTV. Customers have little reason to pay more for IPTV if there is no program difference from cable TV, which is already available to almost every family in China cities. The failure of charge channel projects on China’s cable TV may be a negative case for Netcom’s reference. It may take China Netcom a long time to educate the market.

Recommendation - Buy

China Netcom got a rapid expansion in add-on and new businesses and sustained a stable growth rate in traditional businesses. We continue to see growth in free cash flow enabling the company to pay down debt. We calculate a target price of $39.03, assuming value-added services and broadband businesses will grow at 10% in 1H2006, slowing thereafter, while fixedline businesses will keep a zero growth rate. Furthermore, our estimated 2006 P/E of 6.4x is lower than the company’s 2004 level and significantly lower than that of China Telecom.