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China Mobile Limited (0941.HK) Despite risk, undervalued strong player in telecom market

Friday, September 26, 2008

5501

China Mobile Limited(941)

Recommendation on 26 September 2008
Recommendation	Buy
Price on Recommendation Date	$80.350
Target Price	$101.600

Weekly Special - 000157.SZ Zoomlion

Highlight

We rate China Mobile Limited (0941.HK; CM) as Buy with HK$101.6 target price, since it will be able to maintain its dominant position in 2G market in the coming quarters. Its market share was enlarging in the last quarters and the company also accounted for a significant proportion (over 80%) for the total net adds of subscribers in the mobile market in recent months, due to its successful operation strategy: expansion in the rural market.

Despite its good earning fundamental, the stock price of CM in past few months was under a lot of pressure, because of the proposed asymmetrical regulation imposed on CM by the regulators to stop letting it maintain its dominance in the market. Also, the burden of operating TD-SCDMA for 3G business in the future of the company brings more worries to the investors.

Nevertheless, we think CM is now very attractive with its strong earning fundamental, dominance in the market, but a low valuation especially for a telecom company with obvious growth, and additionally relatively high dividend yield, particularly attractive in volatile market.

Our target price is based on our discount cash flow (DCF) model, where we made a 10% discount to the fair value of our DCF model in order to reflect its political risk for being imposed of asymmetric regulation, which is equivalent to a 2008E P/E at 14.7x, and 2009E P/E at 12.4x, suggests potential 26.4% upside. Recommend Buy.

Result of CM in 1H08

The result of CM in 1H08 showed its dominance in the market, outperforming its peers to a significant extent, and also CM showed its superior profitability too. The revenue of CM rose 17.9% from 166.58 billion (RMB, same in the date below unless otherwise stated) in 1H07 to 196.46 billion in 1H08. However, its net profit attributable to equity holder, surprisingly, rose 44.7% from 37.91 billion in 1H07 to 54.85 billion in 1H08. Its net profit in 1H08 is more than double of the sum of its peers total net profit in the same period.

What may surprise investors most from the result would probably the sharp raise of the net profit margin from 22.8% to 27.9%, a 5.1% increment.

Nevertheless, we would like to pinpoint that, the increase of net profit margin, to some extents, contributed by firstly the reduction of corporate tax rate this year, and secondly a one-off loss of depreciation expenses in 1H07 due to change of accounting estimates (change of useful lives of switching center equipment from seven years to five years).

If we excluded the tax saving factor because of lower tax rate this year, as well as the one-off expenses factor last year due to change of accounting estimates, approximately, the net profit of CM in 1H08 rose 20% and the net profit margin rose slightly.

Alert on fundamental change

On the contrast, despite showing a strong growth in net profit in the interim result, there are worries that the fundamental of CM may go worse, due to the low end user lowering the average revenue per user (APUR) of CM.

Indeed the ARPU of CM was under downward pressure in the past years. So it is reasonable to have such worries particular when the company penetrates significantly into rural market this year.

Nevertheless, we are still optimistic on CM, since firstly it was already able to sustain a higher ARPU, which declined at a much slower rate than its peers in the past. The high average minute of usage (MOU), notably outperforming its peers, of CM helped CM to maintain a higher ARPU in the past. Although it now expanded into rural market to absorb more low end users, we believe CM will be able to enhance the ARPU from users in rural market in coming years from boosting the MOU from such group of users when they become richer in coming years. Also, the trend to use Value-added service (VAS), including SMS, MMS, color ring and etc, helped the ARPU of CM too. The contribution to revenue from VAS businesses rose to 27% in 1H08 from 25.2% in 1H07.

Moreover, since it is expected the mobile market is going to be more competitive as the numbers of operators will increase, we think it is essential and necessary for CM to obtain the market in the rural market, and increase its market share as much as it is able before the new play entering the market. Therefore, sacrificing its profitability to enlarge its market share is indeed essential. Otherwise, its profitability will still be damaged by competition in the future too.

Although the faster than expect slide of ARPU in 1H08, we suggest to be alert on its change of fundamental, but we are still positive to the company, since it is most profitability among the telecom operators in the market. Also, as CM has a very strong financial position and they had nearly 180 billion cash on hand, it provides the company with more chances to invest further, or to have some expansion in oversea market thought merger and acquisition (M&A) to boost its growth in the future.

3G business – TD-SCDMA may be a burden

It is expected by the market that CM will be granted with the 3G license of TD-SCDMA (TD) in the coming quarter. Since the technology of TD is not as mature as the others (WCDMA of GSM and CDMA2000 of CDMA), the cost of using this technology will certainly higher. Also, the connectivity and the stability is also concerned. The feedback from the trial customers is not good. Therefore, CM is now expected to gain a very limited market share in the 3G market when 3G service will be provided by the operators.

From our point of view, as the PRC strongly supports the TD technology, we expect asymmetric regulations may be launched by the regulators to help CM in the 3G market, though they have their dominance in 2G market. We think it is reasonable because that the aim for restructuring of the telecom sector is to help small players in the market and to lower the dominance of large player in the market, in order to benefit the customer ultimately. As we are expected to see TD to gain less supported by the customers, we think asymmetric regulation may be help in such cases, so as to help promoting such technology.

Also, for the tariff plans that recently announced by CM for TD, we believe that ‘low tariff’ will be the strategy for CM to promote TD. Since the cost of TD will relatively affordable as they lease the network from parentco and the leasing fee depends on the usage of TD, but not a fixed rate of the revenue contributed by TD, therefore, it benefits CM more. Thus, referring to the case of PHS, we think TD will at least be attractive to some groups of users who want to use 3G service but have relatively low purchasing power. For long run, it depends how the operators further operate their 3G businesses.

Statement of risk

We believe the major risks of CM are as follows: (i) more severe asymmetric regulations imposed then expected; (ii) further fast decline of ARPU due to high proportion of low end users; (iii) worse than expect feedback of 3G business and (iv) stronger than expected competition in the market after restructuring.

Valuation

Our DCF-based target price is HK$101.6, where we made a 10% to the fair value of our DCF model in order to reflect its political risk for being imposed of asymmetric regulation. Our WACC for CM is 10.06%, which is based on the assumptions for (i) a 4.4 % risk free rate, (ii) a 7.0% market risk premium, (iii) a 1.24x beta, (iv) a 4.0% cost of debt, (v) a 25% corporate tax rate as well as (iv) a 30% target debt-to-capital ratio. A 1% terminal growth rate is also assumed, which is lowered for a more conservative assumption due to a more competitive market. At our DCF-based target price, which suggests a potential 23.8% upside, CM would trade at a 2008E P/E of 14.7x and 2009E P/E of 12.4x, which is already lower than the reasonable valuation range of global telecom operators. We believe it is conservative enough for a telecom stock with obvious growth to trade at such valuation, despite its risks.

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