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Morningstar | China Telecom Completes Solid 1H Reporting Season for the Chinese Telecom Companies. See Updated Analyst Note from 20 Aug 2018

China Telecom's first-half 2018 result was solid with services revenue up 7.0% and EBITDA up 6.5% and net profit up 8.1%. This completes a strong first-half reporting season for the big three Chinese telecom companies with industry services revenue growth of around 5% to 6% (using estimated numbers due to adjustments for accounting standard changes) and EBITDA growth of 3%, following from 6.4% services revenue growth and 5.9% EBITDA growth in 2017. China Telecom also had its highest subscriber growth over the past three years, adding 32 million mobile customers and 7 million fixed broadband customers over the past six months.

We increase our fair value estimate for China Telecom to HKD 4.40 per share (USD 57 per ADR) from HKD 4.10 (USD 52 per ADR) with increased long-term forecasts and value for China Tower partially offset by a weakening renminbi. This represents only 16.3 times 2018 forecast earnings per share and is still comfortably above the stock price so we believe the stock represents solid value at these levels. We make no changes to China Telecom's narrow economic moat which stems from cost advantages and brand strength. While the mobile business has fewer moat characteristics given its 16% share of the market, we continue to believe that it is highly unlikely the government will allocate more mobile network licenses in the market, which should allow each of the mobile operators to earn returns above their cost of capital in the long run.

With high growth in mobile data usage, we see solid demand for the China telecom companies' products. Industry mobile handset data usage grew 40% sequentially in the second quarter after growing 33% sequentially from fourth-quarter 2017 to first-quarter 2018. Year-on-year mobile data usage growth rates have been over 200% for the past three quarters.

As Chinese consumers conduct more of their daily life on their smartphones, the role of the telecom companies becomes crucial for a competitive economy. The government wants the telecom companies to continue to invest and to provide faster services at lower prices so we would not expect the government to force unduly harsh price cuts so it can encourage sufficient investment. Indeed, while the price cuts announced over the past few years sound tough, these have been more than offset by volume growth from the operators' perspective, as shown by their strong revenue growth. In China Telecom's case, mobile and wireline voice revenue declined by RMB 5.2 billion this half but this was more than offset by mobile handset Internet access revenue up RMB 11.4 billion. China Telecom continued to focus on bundling with 58% of its mobile customers also taking fixed-line products which has helped lower churn across both businesses.

Given telecom companies normally have high operating leverage, EBITDA growth across each of the three telecom companies has been below expectations given their high services revenue growth. We see a number of factors driving this including wage inflation. China Unicom's employee expenses were up 21% driven by the more flexible approach to employee pay afforded with the Mixed Ownership reform. This appears to have had an impact on wages in the other telecom companies with China Telecom's employee expenses also up 6%. Network operations and support expenses at China Telecom were also up 11.8% as the company increased spending to support traffic and market share growth.

China Telecom continued to take revenue share in mobile growing mobile revenue at 10.3%. With nationwide mobile data tariffs introduced from July 1, 2018, this growth rate could slow over the next 12 months. However, this development also represents an opportunity to further reduce complexity and costs in marketing and customer service in the medium term. Although a full cash flow statement was not provided, we can deduce that cash flow was strong given we are told that free cash flow was up 154% to RMB 18.4 billion, which implies operating cash flow was up 6.1% to RMB 51.3 billion.