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Morningstar | China Unicom Loses Its Narrow Moat; Fair Value Estimate Reduced to HKD 11.20

We have moved China Unicom to no-moat and stable trend ratings from narrow moat and negative trend ratings previously. The main reason for the move to no-moat is persistent returns below its cost of capital. The negative trend was previously based on the loss of a technology advantage as the industry moved from 3G to 4G technology. This has now largely played out as most traffic is now on the 4G network, so we move to stable trend. The change in moat rating and slight decrease in the value of the CNY has reduced our fair value estimate for China Unicom to HKD 11.20 per share and USD 14.30 per ADR from HKD 11.40 and USD 14.50. At these price levels the company remains undervalued, but we would prefer narrow-moat rated China Mobile in this market.

We believe that China Unicom does not have an economic moat given it has earned returns below its cost of capital over the past 10 years and we expect the same over the next 10 years. If it was able to generate higher returns we could see qualitative arguments for a moat given the favorable market structure. China has three operators serving a huge market, and we believe that it is unlikely that the Chinese government will issue any new licenses for telecommunications network operators and is unlikely to allow foreign firms to enter what is considered a strategically important sector such as telecommunications. Indeed, there has been consistent market speculation that the government could merge the smallest two firms, China Telecom and China Unicom, in order to reduce the entire industry spend on 5G network rollout. Given both firms are currently earning below WACC returns and now share various infrastructure assets, we see this as a potentially sensible move.

However, it is the majority government ownership of all three telecom companies and apparent lack of concern about generating acceptable returns that leads us to assign no moat to China Unicom. Despite both China Unicom and China Telecom earning below WACC returns the government has taken an active role in setting industry wide prices and price reduction targets that have slowed revenue and profit growth making it more difficult for the smaller operators to lift their returns toward WACC. The delay in issuing 3G licenses, meaning a concentrated investment period in 3G then 4G and soon 5G mobile networks, in a shorter period of time than other markets has also not helped returns. The industry is also unbalanced. While we estimate that the industry as a whole is earning above WACC returns, China Mobile, with a mobile business nearly three times the size of the other operators, is earning outsized returns while the smaller operators earn below WACC. Other Chinese state-controlled industries that are currently tolerating below WACC returns from their key operators include railways, particularly as it relates to passenger railway operators, coal power producers, whose returns are capped by electricity prices set by the government, and various tollway owners. With government influencing bank lending and even private investment in the telecom operators when required, as we saw in 2017 with the recapitalizing of China Unicom, the below WACC returns do not inhibit the telecom operators from funding their businesses. They should therefore be able to continue to fund important network rollouts for China’s high-tech future even if they don’t earn economic profits.