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Morningstar | China Telecom Loses its Moat due to Continued Sub-WACC Returns, FVE Reduced to HKD 4.30

We downgrade China Telecom to a no-moat rating from a narrow moat rating 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. The company also reported its summarized third-quarter results and like its peers, it was negatively impacted by the removal of mobile data roaming from July 1. China Telecom reported service revenue growth of 4.1%, EBITDA decline of 5.6%, and NPAT decline of 8.5% after reporting 7%, 6.5%, and 8% growth, respectively, in the first half.

We revise down our fair value to HKD 4.30 (USD 56 per ADR) from HKD 4.40 (USD 57 per ADR) mainly from the removal of the moat rating. At the current price level, the stock looks mildly undervalued.

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 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 Telecom. 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 which have slowed revenue and profit growth making it more difficult for the smaller operators to lift their returns towards 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 outsize 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.

China Telecom is the incumbent fixed-line telecom operator in 21 provinces in southern China. It has just over twice as many fixed-line customers than China Unicom, with most also subscribing to its broadband business. Customers with multiple services tend to be stickier and more valuable. Thus, while China Telecom continues to lose fixed-line telephone subscribers because of mobile substitution, the growth in its broadband base limits those declines. The broadband business has 140 million customers and despite continuing to grow at around 10 million customers per year, has seen market share declines over the past three years as China Mobile has aggressively entered this space with pricing well below China Telecom. The strong cash flow from the firm's fixed-line business, with its largely sunk network costs, drive a narrow moat in many telecom markets but China Telecom’s low consolidated returns preclude this.