Asia Tour - Japanese Telcos and China Front of Mind
The Asian tour in December each year is a great way to get to the bottom of the developing trends and embed our thinking as we head into the New Year. This year was no different as we met with the Japanese, Taiwanese, Chinese and Malaysian telecom operators. In Japan, we were pleasantly surprised by the confidence the operators had to lower costs to defend against any risk around tariff headwinds and we remain sanguine around the prospects of Rakuten’s launch. With returns and shareholder returns unlikely to be impacted in 2019, we came away reassured that our preferred play (NTT) is likely to lead the market in return improvements. On our return, we upgraded China Tower to a Buy given the stock’s lacklustre performance, but most importantly the ability to access 10mn ‘social resources’ assured us that future growth was unlikely to be as capital intensive as initially feared.
Our confidence, however, on the Chinese telcos waned as the week progressed (LINK). The industry was at pains to allay our fears around 5G capex surprise – a repeat of their historic comments. Their claims were predicated around the lack of a business case for 5G which is fundamentally different to 4G when there was a clear consumer business case and China Mobile needed 4G to resolve its 3G debacle. However, the political developments over the week does show us that 5G strategy is not theirs to dictate. We think continued pressure on the equipment vendors could trigger several strategic shifts for the telco industry. First, the industry could be ‘coerced’ to invest more aggressively into 5G to sustain demand for the vendors. Secondly, it could accelerate the need to merge Unicom/Telecom (or at least see a joint network roll) to ensure the financing of a more extreme 5G rollout (it was interesting to see 5G spectrum issued at the end of the week after months of delays). Finally, it could suggest China Mobile’s international M&A ambitions are prioritised as a way to influence/fund emerging market equipment demand. However, there is also a possibility that 5G rollout is halted/slowed if Huawei can’t get access to US supplies given the China/USA sensitivities. Clearly, there are a number of very different outcomes which all raises the risk profile for the Chinese telcos as we head into 2019.
However, this changing view is positive for China Tower where our meeting convinced us to complete our 180° turn from Reduce to Buy (see HERE). We have been bearish initially on the basis that the MSA with the Telcos doesn’t allow China Tower to generate a reasonable return on capital. However, it appears that the company has found a way to grow outside of the MSA through partnerships with other government agencies such as the Electricity Grid, to co-locate equipment on their real estate. Since this is outside the MSA contracts are struck on a commercial basis, and there is no need for China Tower to build towers to fulfil co-location demand enabling the company to grow in a much less capital intensive way. Since the meeting we have cut 2018 and 2019 capex expectations by almost 50%. With growth likely to accelerate next year driven by 5G, and as a potential beneficiary of further trade tension between the USA and China, we think China Tower is in a sweet spot, and we upgraded to Buy with a HK$ 1.60 price target.
By contrast to the Chinese telcos, we were also confirmed in our generally bullish view of the Japanese telcos during our trip (see HERE). The market thinks earnings expectations will be falling in coming quarters due to DOCOMO price cuts and the launch of Rakuten. However, as we wrote HERE declining demand for the iPhone is likely a bigger positive effect, with DOCOMO confirming they will not be cutting price across the board, but rather introducing new separated plans which do not attract a handset subsidy; the real loser in what is happening is Apple. Our meeting with Rakuten also confirmed that in our mind there is no “magic sauce” but rather that they are not spending enough to introduce enough capacity to the market to be materially disruptive. Substantial cost cutting at the incumbents is likely to offset the revenue impact. Despite the fact that SB KK is about to IPO with a premium multiple largely the result of its 85% payout ratio, we did not come away expecting substantial near term increases in payout from the other players; rather they are likely to gradually rise from low levels over time. We think KDDI is the most likely to surprise on the upside in this regard, and the stock remains our top pick among the MNOs.
But what is certain is that Taiwan and Malaysia remain challenging markets. Despite the cancellation of the NT$499 plans in Taiwan (LINK), the operators continue to market the product ‘below the table’ suggesting that a turnaround to the dire trends is unlikely in the near future. In Malaysia, Telekom Malaysia remains in deep trouble from government mandated broadband price cuts and low cost wholesale. Maxis was first to take advantage of this and is bundling mobile with fixed and looking at content as well from a sister company (Astro). They are also pushing into Enterprise services, something we also heard from DIGI. Both DIGI and Maxis are focused on moving pre-paid subscribers over to post-paid and gradually pushing up ARPUs with additional services.
Therefore, as we head into 2019 we would focus investors’ attention on NTT & KDDI (Japan) and China Tower (China) on the BUY side, and for those looking for shorts, Chunghwa Telecom (Taiwan) remains expensive with difficult trends likely to remain.
Why would a Unicom/Telecom joint rollout of 5G be acceptable?
Our conversations with China Unicom indicated a key focus on lobbying for contiguous spectrum at 3.5Ghz with China Telecom. The company saw this as a more sensible approach to allow for bigger synergies assuming there was a merger/network sharing arrangement in the future. We are more sceptical about the relative synergies, but following the announcement on our return the conclusion was that the lobbying has worked and suggests a collaboration of some sort is still on the agenda. We see a few reasons why this could be accepted by the powers that be in China:
- Bigger 5G rollout possible: A combination of some sort between Unicom and Telecom would result in clear synergies allowing a more aggressive 5G rollout than previously possible given the returns of each operator;
- Competition to China Mobile: These additional synergies, and a network to compete with China Mobile will mean the combined entity will be able to compete more effectively with China Mobile;
- Better industry returns: A separate 5G rollout would mean substantially lower returns for CT and CU. This will contradict the policy for SOE reforms and is unlikely to be supported by SASAC. Although some of the improved returns will be re-invested into the network/consumers, we expect a better return profile than the alternative;
Competition not compromised: In most markets globally, the industry dictate competition and pricing. In China, whilst the industry does this to a certain extent, it is essentially the MIIT who dictates the level of competition and ensures consumers benefit. As a result, a ‘2 to 3’ merger does not necessarily mean lower competition as the MIIT will ensure prices continue to fall.
For the full weekly review and updated comp sheets, see HERE.
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