The Chinese Telecom Growth Story: Part 1
Few investment themes are as obvious today as the long-term secular growth story of China. The gap between standards of living in China versus the rest of the world, combined with the hard work of the Chinese people and growth-oriented government policies of the government, mean that the next century is almost certain to belong to China.
Unfortunately, the Chinese growth story isn’t necessarily conducive to successful investing. Competition is cutthroat in China, and chronic overcapacity has fueled low returns on capital and low margins for many companies. An inability for Chinese residents to invest outside of China has led to perpetually overvalued Chinese stock markets. For companies that list on non-Chinese exchanges, promising stocks like EDU already have excessive optimism priced into their valuation multiples. Some of the others have been exposed as frauds, as has been common practice on Seeking Alpha.
Nevertheless, there are still effective ways to play the China growth story. One of them is by investing in Chinese telecoms. Three companies dominate China’s telecommunications industry, and all have ADRs available for US investors: China Mobile (CHL), China Unicom (CHU) and China Telecom (CHA).
Chinese telecoms benefit from rapidly increasing wireless and broadband usage within China, and the nature of the telecommunications sector protects the incumbent operators from cutthroat competition. As well, the telecoms are available at reasonable valuations, allowing patient, long-term investors to potentially benefit from the long-term rise in telecom usage in China.
A variety of macro trends makes the Chinese telecom story an attractive one.
First, the percentage of Chinese residents who own cell phones remains low in China relative to developed countries. Mobile “penetration” stood at about 56% at the end of 2009, compared to nearly 100% in the United States and 120% in European countries like Germany and the UK (in countries that feature a high proportion of prepaid plans, as opposed to the United States’ general preference for postpaid plans, we often see penetration rates higher than 100% because some users own two or more SIM cards). China also lags behind numerous developing countries, such as Russia (penetration rate above 120%) or Mexico (penetration rate above 75%). While subscriber growth will certainly slow down in the coming years, saturation within the Chinese wireless market is at least several years away, which offers the three Chinese telecoms an ever-increasing pie to share amongst themselves.
Second, the Chinese market does not suffer from an excessive number of operators undercutting one another in order to steal market share. Different countries can have dramatically different competitive landscapes, depending on the number of mobile operators. In some countries like Pakistan or India, there are 5-7 different wireless providers all vying for consumers’ attention. Invariably, excessive competition prevents the operators from enjoying attractive margins and returns on capital, as each operator undercuts its competitors in order to maintain market share. In other countries, such as Tunisia or Colombia, a smaller set of 2-3 operators dominate the wireless market, and are able to grow subscribers while still maintaining pricing power and high profit margins.
As well, because wireless operators must spend large capital expenditures in initial years to build out their networks, it can be relatively tough for a new operator to break into a maturing mobile sector. Despite the high returns on capital that Tunisian and Colombian operators may enjoy, it would be relatively risky for a new operator to enter that market, given the high up-front capex investments that would be necessary.
In China, it’s unlikely that a new competitor tries to break into the telecom sector currently controlled by China Mobile (CHL), China Unicom (CHU) and China Telecom (CHA). First, the industry is mature enough such that a new entrant would find it risky to begin building out a wireless network from scratch. Second, the Chinese government is highly interested in keeping the Chinese telecommunications sector out of foreign hands. CHL, CHU and CHA are all majority owned by the Chinese government. China’s desire to control the media and limit political freedom necessitates that the country control the major providers of broadband and wireless communications in the country.
It’s also instructive to examine the telecommunications restructuring that the Chinese government undertook in 2008. The goal of the industry restructuring was to create a reasonably competitive telecom sector. When China was accepted to the World Trade Organization in 2001, the WTO stipulated that the country open up its telecom sector to foreign entrants after a “transitional” period. Yet China has no desire to see foreigners get a foothold in its telecom sector, and a key solution is to make its telecoms sufficiently competitive as to ward away potential entrants.
The 2008 restructuring attempted to do just that. Specifically, it tried to create a telecom industry comprised of three dominant, efficiently run telecom giants. The government pushed the two telecoms China Unicom and China Netcom to merge, resulting in a company that had both wireless and fixed wireline businesses. It also pushed China Unicom to sell one of its wireless platforms to China Telecom, allowing China Telecom, which was the country’s strongest wireline provider at the time, to become both a wireless and wireline provider. Finally, the government pushed China Mobile to purchase a small fixed wireline operator, and also enacted certain policies to help China Unicom and China Telecom to better compete with China Mobile. For instance, China Unicom was granted more advanced 3G wireless technology with which to build out its newest network. Prior to the restructuring, China Mobile was the clear dominant player in the wireless market, with more than 80% of mobile market share. Analysts predict that China Mobile will steadily lose market share to China Unicom and China Telecom as a result of the government policies, as well as the small base from which CHU and CHA are building their wireless operations.
For our purposes, the key takeaway is that we now have three major players in the Chinese telecom sector which are all state-owned and have been carefully positioned by the government to become the dominant players within Chinese telecom. We can rest assured that the Chinese market will not result in overcompetition. Certainly, we should expect China Mobile’s margins to decline as it loses some of its previously monopolistic pricing power. But from a long-term perspective, the telecom providers should be able to co-exist reasonably well, and be able to mutually share the benefits of rapidly increasing wireless and broadband usage in China.
In the next article, I’ll take a deeper dive into each of the three companies, with more in-depth discussions on valuations, technologies, and growth profiles of CHL, CHU and CHA.