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David Riedel of Riedel Research Group recently published a note on telecom operator China Telecom (CHA). Excerpts:

CHA’s total revenue in 2005 amounted to RMB169.3 bn -- it rose by 3.8%, which is lower than 6.4% in 2004 and 7.6% in 2003. Net profit in 2005 was RMB27.9bn, decreased by 4‰, but grew by 8% excluding connection fees. Traditional voice businesses became stagnant, while revenues of Internet and value added services increased quickly. But we do not believe Internet and value added businesses can drive total revenue to rapid growth with the heavy burdens of voice businesses. The Company issued RMB20 bn to lower financing cost and will start TD-SCDMA massive test in May. We calculated a target price of $35.91, which is lower than, but close to the current market price. Hold.

Details:

CHA’s total revenue in 2005 amounted to RMB169.3 bn, an increase of 3.8%, which is lower than the 6.4% increase in 2004, and 7.6% in 2003. Net profit in 2005 was RMB27.9 bn, a decrease of 4‰. CHA argued that excluding connection fees net profit in 2005 grew by 8.0%, but we believe that the decrease fairly reflects Company’s situation - Traditional businesses face intense competition, while new businesses, though growing fast, can merely supply the gap in traditional businesses. Fortunately, profit margin in 2005 maintained 2004 levels, which suggests that revenue and profit will be stable in 2006, or at least will not drop much.

Stagnant Voice Businesses

Top three revenue sources are all from voice businesses, but they are not fast growing.

Local usage fees revenue decreased by 0.05% due to competition from mobile phone operators. Growth rate of the local voice usage dropped in 2005, while voice ARPU kept its decreasing rate of more than 10%, therefore revenue of local usage fees dropped inevitably.

Voice businesses include: Monthly fees, Local usage fees, DLD/ILD, Interconnections.

Domestic long distance - DLD - business decreased by 0.91% because CHA continues to lose market share in the competitive market of long distance IP cards. CHA’s market share of DLD shrunk from 49.4% in 2003 to 45.8% in 2004, and to 43.7% in 2005.

There is a 1.8% increase in monthly fees because the charge is fixed for almost every user. There will be a monthly fee increase as long as there are new subscribers. We note that PAS (Personal Access System) is the mainstay of the traditional voice business. In other words, without the ‘semi-mobile’ business, fixed-line businesses will look much worse. We believe PAS will support traditional voice business further in 2006 for three reasons. First, PAS subscribers rose by 35.3%. Second, value added services like short message service - SMS - and color ring have been provided to PAS users. Third, handset subsidy reduced by 21.7%.

Internet and VAS Growing Fast

CHA highlighted two fast growing businesses, Internet and VAS, and we believe both will continue their upward trend in 2006.

Internet

Number of broadband subscribers increased by 51.9% in 2005, which could sufficiently offset the ARPU decrease. Operation data implies that there is competition in the Internet market, but the market is far from saturation. Therefore we believe the Internet revenue will maintain growth in 2006.

Value Added Services - VAS -

Most of VASs are new services for PAS, including Short Message Service (SMS), Color Ring Tone, and Caller ID. Color Ring is a new business for all mobile operators and attracts more and more young people, so we believe it will grow quickly in the future. SMS and Caller ID should be basic functions in mobile services and CHA merely supplied the gaps in the market, but based on a 35.3% growth rate of PAS subscribers we believe these businesses will expand rapidly in 2006.

Although Internet and VAS are growing fast, with the heavy burden of traditional voice business these services are hard-pressed to raise total revenue.

Issued RMB 20 bn Commercial Paper

CHA issued RMB20 bn one-year commercial paper in the PRC inter-bank debenture market on 10 April 2006. Annual interest rate is 3.05%, much lower than one-year bank loan interest rates.

CHA short-term debt is RMB 76 bn, 48.4% of its current liabilities, and 32.5% of its total liabilities, turning to commercial paper can help lower financing cost further. The Company issued RMB10 bn commercial paper last October and finance costs dropped 8.3% in 2005.

3G Testing

CHA planned to start the TD-SCDMA massive test in Baoding in May, and China Mobile and China Netcom also joined the test in other cities, which suggests these companies are TDSCDMA license candidates. We believe some TD-SCDMA licenses will be granted in 2H2006 after testing results are announced.

We believe any 3G license grant might not be good news to telecom operators. 2G is enough for most mobile users. The main question is how much potential users would be likely to pay for value added services specific to 3G. If operators launched a high-price strategy for 3G, users may be very limited, as may revenue. If operators set low prices for 3G, our question is how long will revenue cover the large cost investing in 3G and whether CHA can survive the promotion period.

Valuation and Recommendation

Based on our confidence in VAS, we assume VAS will increase by 20%hoh. Interconnection will grow at 10%hoh in 2006, similar to those in 2005. We found that most of CHA’s business lines grew fast in 1H and slowly in 2H, (Exhibit 6) therefore we assume other growth rates in 1H2006 will be similar to 1H2005 but not 2H2005. Internet will rise by 20% in 1H2006, but by 10% in 2H2006, while other business lines will keep the growth rates almost the same as 2005.

Generally, we believe the growth rate of total revenue in 1H2006 will be at 6.8%, 0.4 percentage points higher than 1H2005. Assuming that cash flow will drop in 2007, but grow at 3.5% in 2008 and thereafter, we calculate a target price of $35.91, lower than, but close to the current market price. Since the share price is fairly impacted, we recommend a HOLD.

Source: Analyst Says "Hold" China Telecom (CHA)