The price is right China Telecoms...

See important disclosures, including any required research certifications, beginning on page 105

■ Investment case The China Telecoms Sector has been sold off (share prices have fallen by 16-21% over the past 2 years) in anticipation of negative outcomes from the planned replacement of the current business tax with a value-added tax (VAT) (see Appendix 2 on page 32), and the launch of 4G services. Although valuations are very depressed at present, we believe that earnings in the sector will be resilient compared with those of most other China sectors over the next few years. We therefore initiate coverage of the China Telecoms Sector with a Positive rating, and a Buy (1) rating for China Mobile and Outperform (2) ratings for China Telecom and China Unicom. China Mobile is our top pick in the sector as: 1) its earnings are the least exposed to the risks from VAT reform, and 2) we expect the company to be the key beneficiary of the move to 4G services, as this is likely to stem the erosion in its

revenue market share. Meanwhile, we prefer China Telecom to China Unicom, due to its superior balance sheet and as it should be better positioned to navigate the VAT-reform challenges. In the context of Daiwa’s view that China’s economy will deteriorate over the coming few years and the Renminbi will depreciate against the US Dollar as a consequence, we expect the China Telecoms Sector to be a defensive choice for investors, given that the telecoms companies’ balance sheets remain strong with little exposure to foreign debt. ■ Catalysts We believe the announcement of details on the VAT-reform programme relating to the telecoms sector, which are likely to emerge this year, will be the trigger for a sector-wide rerating. This is because our scenario analysis suggests that the stocks are trading at 19-24% below their past-10-year average EV/EBITDA multiples after factoring in the likely impact of the VAT reform. In addition, we believe an improvement in the average revenue per user (ARPU) trends across the sector from 2015 will be another catalyst as this should increase investor optimism over the monetisation of 4G investments. ■ Valuation Given the lingering uncertainties relating to VAT reform, we do not factor this into our earnings

forecasts. However, as we believe it is easier to assess the reform effects on valuations, we determine a DCF-based fair value for the stocks, then apply a reduction to arrive at our 6-month target prices for the 3 telcos. We have target prices of HKD86.6 for China Mobile (factoring in a HKD4.7 reduction to fair value), HKD11.60 for China Unicom (HKD1.6 reduction), and HKD4.00 for China Telecom (HKD0.5 reduction). ■ Risks Our Positive sector rating would be undermined by the following developments: 1) worse-than-expected VAT-reform measures, and 2) any inability to monetise data services effectively, due to competition or for substitution reasons.

4 April 2014

The price is right

• Depressed valuations and defensive earnings should drive a sector-wide rerating over the coming months

• VAT risks appear to be priced in; 4G is likely to accelerate industry revenue from 2015

• China Mobile is our top pick, followed by China Telecom

China Telecoms Sector

Key stock calls

Source: Daiwa forecasts.

Telecommunication Services / China

Positive (initiation)

Neutral

Negative

Ramakrishna Maruvada(65) 6499 6543

[email protected]

Jame Osman(65) 6321 [email protected]

New Prev.China Mobile (941 HK)Rating BuyTarget 86.60Upside 21.4%

China Unicom (762 HK)Rating OutperformTarget 11.60Upside 14.2%

China Telecom (728 HK)Rating OutperformTarget 4.00Upside 14.3%

How do we justify our view?How do we justify our view?

China Telecoms Sector 4 April 2014

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How do we justify our view?

Growth outlook

Valuation

Earnings revisions

Growth outlook China Telecoms Sector: industry service revenue growth forecasts (%)

We forecast a moderate industry-service revenue CAGR of 7.6% over 2013-16, driven by a 9.0% CAGR increase in mobile-service revenue, driven by an improvement in the ARPU trend across the sector. We expect the contribution of mobile-service revenue to overall industry-service revenue to rise from 77% to 80% over the period.

Source: Company, Daiwa forecasts

Valuation China Telecoms Sector: 2015E valuations

The telecoms stocks are trading at discounts of 31-34% to their past-10-year average EV/EBITDA multiples based on our forecasts and the current exchange rates. After accounting for the effects of VAT-reform measures and forward currency forecasts (USD1:CNY6.5), the discount range narrows to 19-24%. Similarly, on a PBR basis, the discounts are 24-49% based on our forecasts; this narrows to 18-45% after accounting for VAT-reform measures. The stocks, however, are trading at slight premiums to their past-10-year average PERs, after taking into account the likely impact of the VAT-reform measures.

EV/EBITDA PER P/BVCurent China Mobile 3.2 11.0 1.28China Unicom 2.9 12.8 0.84China Telecom 2.7 10.7 0.74Post-VAT reform China Mobile 3.8 12.6 1.37China Unicom 3.3 20.8 0.90China Telecom 3.1 15.6 0.79Past 10-year average China Mobile 4.7 12.1 2.5China Unicom 4.2 24.2 1.1China Telecom 4.1 12.3 1.2


Earnings revisions China Telecoms Sector: consensus earnings-forecast revisions

Over the past 6 months, the 2014-15 Bloomberg-consensus EPS forecasts have been cut for China Mobile and China Telecom, while those for China Unicom have seen relatively small revisions. We expect the consensus earnings forecasts for all 3 stocks to be cut further in the coming months. We believe the market may not have factored in the full extent of the impact arising from the network expansion and handset-subsidy strategies of these operators.

2014E 2015E

6M 6M

EPS EBITDA EPS EBITDAChina Mobile (9.5) (7.1) (12.3) (5.9)China Unicom (1.7) 0.0 (4.8) (1.4)China Telecom (4.9) (1.4) (9.6) (2.4)

Source: Bloomberg

Positive (initiation)

Neutral

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Mobile Fix ed-line Mobile as % service revenue (RHS)


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Executive summary

The price is right

We expect share prices to outperform from here on, as the VAT risks appear to be overly discounted and the transition to 4G should drive industry ARPU

Investment thesis Our positive investment thesis is premised on our belief that: 1) the VAT-reform risks have been overly discounted by the market, 2) the transition to 4G services will drive ARPU (we forecast a 2013-16 CAGR of 0.3-1%) and consequently industry revenue growth from 2015, and 3) the sector holds defensive appeal, especially as our economics team expects the macroeconomic data in China to deteriorate over the coming 2 years. We expect sector-wide outperformance against the MSCI China Index once the details of the VAT programme become available in the coming months. This is because we calculate that the stocks are trading at discounts of 19-24% to their past-10-year average EV/EBITDA multiples after factoring in our base-case VAT assumptions. We believe the transition to 4G will herald the biggest change in fortunes for China Mobile, by stemming the erosion in its revenue market share. Further, the company also scores better than its peers on 2 other investment yardsticks, namely its ability to withstand a weak macroeconomic environment and the impact of VAT reform, making it ourtop sector pick. Between China Telecom and China Unicom, we believe the risk-reward profile favours the former, due to the larger scale of its current business and good management execution capability. Valuation Our DCF-based 6-month target prices translate into the following EV/EBITDA valuation multiples, based on our 2015 forecasts: 4.3x for China Mobile (5.0x after accounting for the VAT-impact and an exchange rate of USD1:CNY6.5), 3.2x for China Unicom (3.6x), and 3.0x for China Telecom (3.4x). These multiples are near or below their respective past-10-year averages of 4.7x, 4.2x, and 4.1x. Profit outlook We expect the earnings outlook for the sector to be weak due to 4G-network investment and handset subsidies. For 2013-16, we forecast: a compound annual decline of 1.4% (base-case post-VAT: decline of 5.6%) for China Mobile, a CAGR of 18.4% (increase of 1.4%) for China Unicom, and a CAGR of 7.8% (decline of 5.2%) for China Telecom.

Defensive appeal and 4G monetisation prospects should be the key share-price drivers VAT risks appear to be priced in 4G should allow China Mobile to stem erosion in revenue market share

Sector stocks: key indicators

Share

Company Name Stock code Price New Prev. New Prev. % chg New Prev. % chg New Prev. % chg

China Mobile 941 HK 71.35 Buy 86.60 5.086 5.146

China Telecom 728 HK 3.50 Outperform 4.00 0.245 0.259

China Unicom 762 HK 10.16 Outperform 11.60 0.469 0.628

Rating Target price (local curr.) FY1

EPS (local curr.)

FY2


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Valuation and stock selection ....................................................................................................... 5

VAT reform ................................................................................................................................. 10

4G transition ............................................................................................................................... 12

Virtual operators and number portability ................................................................................ 20

Industry dynamics ..................................................................................................................... 22

Appendix 1: share-price performance review ........................................................................... 29

Appendix 2: VAT scenarios ....................................................................................................... 32

Appendix 3: telcos’ resilience – lessons from crises past .......................................................... 35

Appendix 5: regional valuations ................................................................................................ 42 Company Section

China Mobile .......................................................................................................................... 43

China Telecom ........................................................................................................................ 64

China Unicom ........................................................................................................................ 83

Contents


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Valuation and stock selection

China Mobile is our top pick, followed by China Telecom

Investment framework

The uncertainties relating to the VAT-reform measures for the telecoms sector and the issuance of licences for 4G services have been clouding the sector’s outlook for a while now. The market already appears to be discounting a certain level of impact from VAT reform, even though many aspects of the programme are not available. For example, the share prices of China telecom stocks have fallen by 16-27% over the past 2 years, underperforming the MSCI China Index by 19-24pp. To better assess the extent to which VAT risks are discounted into the share prices, we adopt the following investment framework.

• Our earnings forecasts reflect current industry conditions (and Daiwa’s exchange-rate outlook) without taking into account VAT-related effects. We think this approach is appropriate as the implementation timelines are uncertain, and also because we feel it is easier to assess the effects on valuations, rather than earnings, with higher accuracy.

• We construct a range of scenarios on how the VAT-reform programme could affect our (baseline) company forecasts and examine the potential effects on our valuations.

• Our base-case VAT scenario (which factors in, among other inputs, output VAT rates of 6-11% and a pass-through rate of 15%) assumes revenue and costs fall respectively by 5% and 4% compared with our forecasts for the companies from 2H14-2016. This would translate into a 7% reduction to our 2015 industry EBITDA forecasts.

• In setting our target prices we reflect the valuation impact of our base-case VAT scenario. For example, we arrive at a DCF-based fair value for China Mobile of HKD95.8/share based on our forecasts and at prevailing exchange rates. However, our 6-month

target price is HKD86.6, as we ascribe a HKD4.7/share reduction due to the VAT reforms and another HKD4.5/share reduction due to exchange-rate effects.

How we arrive at our target prices

HKD/share DCF-fair value on

our forecastsVAT-reform

impact Exchange-rate

effects6M target

priceChina Mobile 95.8 -4.7 -4.5 86.6China Unicom 13.8 -1.6 -0.7 11.6China Telecom 4.7 -0.5 -0.2 4.0

Source: Daiwa estimates

Valuation

Stocks are trading at discounts to historical averages on our base-case VAT scenarios Based on our scenario analysis, we believe the risks from VAT reform have been more than adequately discounted by the market. For example, we calculate that all the stocks are trading at about 19-24% below their past-10-year average EV/EBITDA multiples (7-30% below their past-5-year averages), after factoring in our base-case assumptions for the applicable VAT rates and a 2014 year-end exchange rate of USD1:CNY6.5 (2nd April: USD1:CNY6.20). China Telecom Sectors: EV/EBITDA valuations post base-case reform scenario (x) 2013 2014E 2015E 2016ECurrent (spot currency) China Mobile 3.1 3.4 3.2 2.8China Unicom 3.8 3.3 2.9 2.6China Telecom 3.3 2.9 2.7 2.5 Post-reform (target exchange rate) China Mobile 3.1 3.9 3.8 3.3China Unicom 3.8 3.6 3.3 3.0China Telecom 3.3 3.2 3.1 2.9Source: Daiwa forecasts

Further, the stocks offer 5-year average free cash flow of the firm to enterprise value yields of 4.9-6.6%, based on our 2014-18 forecasts, which we regard as appealing. China Telecoms Sector: free cash flow to enterprise value ratios (%)

2013 2014E 2015E 2016E 2013-16 annual

average2013-18 annual

averageCurrent (spot currency) China Mobile 5.4 -0.8 4.8 8.8 4.3 8.8China Unicom 3.3 5.9 5.8 5.9 5.8 6.9China Telecom 4.3 6.9 3.8 4.4 5.0 7.4 Post-reform (target exchange rate) China Mobile 5.4 -1.5 2.8 6.4 2.6 6.6China Unicom 3.3 4.9 3.9 3.7 4.2 4.9China Telecom 4.3 5.7 1.7 2.1 3.2 5.2Source: Daiwa forecasts


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What are the risks from here? Our worst-case VAT scenario would see our revenue and cost forecasts respectively fall by 8% and 3% each over the 2H14-2016 period. This does not take into account the likely responses from the companies – an overhaul of price packages to alter revenue structure and changes in capex plans – that could mitigate the impact. Valuations under our worst-case VAT outcomes

HKD/Share Fair value on our forecasts

Worst-case VAT-reform impact

Exchange-rate effects

Worst-case fair value

China Mobile 95.8 -12.2 -4.5 79.1China Unicom 13.8 -4.3 -0.7 8.9China Telecom 4.7 -1.3 -0.2 3.2


We see the risk-reward outcomes as being favourable for China Mobile, as we estimate there would be 11% upside potential for the share price even under our worst-case VAT scenario for the company. Meanwhile, we estimate the downsides of 12% and 10% to the share prices of China Unicom and China Telecom, respectively, under our worst-case scenario. Potential risk-reward matrix from VAT reform


Stock selection

Our order of preference in the sector is China Mobile, China Telecom, and China Unicom. This is after juxtaposing the effects of VAT reform, which are governed by the scale of operations and management execution capability, with variations in the operators’ 4G strategies.

China Telecoms Sector: key stock-selection criteria China Mobile

China Telecom

China Unicom

Macro factors Currency depreciation risk Low Low Moderate Asset-writedown risk Low Low Low Industry factors VAT-reform risk Low Low Moderate Scale of operations Large Large Medium Execution capability Good Very good Fair 4G transition risks Operational risk from delay in FD-LTE Low High Moderate Commercialisation risk of technology platform High Moderate Low

Source: Daiwa

China Mobile is our top pick, because we believe it is well-positioned to take advantage of the 4G opportunity and is also the least exposed among the 3 telecoms companies to VAT-reform risks.

• First, in our base-case VAT-reform scenario, we estimate there could be up to a 12% reduction to our 2015 earnings forecasts for China Mobile, compared with reductions of 38% for China Unicom and 31% for China Telecom.

• Second, we expect the company to gain market-share in the 3G/4G segments (mobile broadband) in the short-term. For example, we are forecasting its mobile broadband market share to rise by 8.2pp over 2013-16. Consequently, we believe the transition to 4G will likely herald the biggest change in its fortunes – we are forecasting it to stem the erosion in its revenue share over 2014-16 (stable revenue share at around 51-52% compared with a 4.3pp decline over 2010-14E).

• Third, it has the strongest balance sheet among the companies in the sector and has little exposure to foreign debt (2013: net-cash balance-sheet position).

• Fourth, after taking into account the likely impact of VAT reform, we estimate that the stock offers higher free cash flow of the firm to enterprise value yields (6.6%) than its rivals.

Between China Telecom and China Unicom, we have a preference for the former, as its earnings are relatively less exposed in terms of VAT-reform risks, because of the larger scale of its business. Other factors behind our relative preference for China Telecom are: 1) the company’s earnings are more immune to Renminbi depreciation risks than those of China Unicom, 2) it has a slightly better balance sheet (2013: net debt/EBITDA ratio of 1.0x versus 1.3x for China Unicom), and 3) it offers slightly better free cash flow to enterprise value yields on our forecasts (2014-18E average annual yield of 5.2% versus 4.9% for China Unicom).

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China Mobile China Unicom China Telecom


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Defensiveness relative to home market

Economic fundamentals set to worsen Our regional economist, Kevin Lai, citing deteriorating credit conditions and Renminbi-depreciation risks, recently (see The end of free lunch) cut Daiwa’s China GDP-growth forecast to 7.1% YoY (from 7.5% YoY) and expects the exchange rate to fall to USD1:CNY6.50 by the end of 2014, from USD1:CNY6.16. CNY-USD exchange rate movements

Source: Bloomberg, Daiwa

Kevin’s views on the economy appear to resonate in the market; the Renminbi has continued to depreciate against the US Dollar over the recent weeks, while news of corporate credit defaults is gaining momentum. China: recent debt defaults

Date Name of issuer Remarks Nature of business Source

07-Mar-14 Shanghai Chaori Solar Energy

Failed to pay CNY89.8m in interest on CNY1,000m bond

Solar Technology

Financial Times

18-Mar-14 Zhejiang Xingrun Real Estate

Owes CNY3,500m to creditors (banks)

Real-estate Bloomberg

20-Mar-14 Highsee Group Debt of CNY3,000m Resources (Steel)

The Standard

21-Mar-14 Haixin Iron and Steel Group

Failed to pay loans from Minsheng Bank (reportedly up to CNY20bn)

Resources (Steel)

Caixin

Source: Compiled from various sources

A key implication of this economic outlook, in our opinion, is that investor concerns about asset writedowns and currency-depreciation risks could overshadow earnings growth as the key driver of share prices in coming months. We believe the telecoms sector is well-positioned to withstand asset-writedown and currency-depreciation risks relative to other sectors.

Low earnings impact from currency depreciation concerns Both China Mobile and China Telecom have low levels of foreign currency-denominated assets and liabilities relative to their respective asset sizes. China Unicom’s earnings, on the other hand, are more exposed, because of its low pre-tax margin (2013: 4.6%) and moderate exposure to foreign currency denominated debt (2013: 32% of total debt, on our estimates). We estimate that for every 10% depreciation in the Renminbi against the US Dollar (beyond what is already reflected in our forecasts), our 2015 earnings forecast would be affected by 3%. China Telecoms Sector: impact of currency forecasts on our 2014 earnings forecasts Company What we factor in for 2014 Reason China Mobile 0 0.9% of total cash is denominated in foreign

currency China Unicom CNY2.5bn forex loss We estimate 32% of 2013 debt was

denominated in HKD/USD China Telecom 0 Less than 1-3% of cash and debt is

denominated in foreign currency

Source: Companies, Daiwa forecasts

While we expect the earnings impact from Renminbi depreciation to be modest, we see some implications for share-price performance, as the trading currency of the stock is the Hong Kong Dollar. In particular, the depreciation of the Renminbi has a negative impact on our target prices denominated in the Hong Kong Dollar – which is pegged to the US Dollar – as the functional currencies of the operators is Renminbi. We reflect Daiwa’s US Dollar-Renminbi exchange-rate forecast of USD1:CNY6.5 at the end of 2014 (currently: USD1:CNY6.16) in setting our target prices. It is interesting to note that while the share prices of all the 3 companies appear to be positively correlated with the Renminbi appreciation trend over the period from 2005 to now (a correlation coefficient in the range of 0.4-0.5x), the correlation trends (China Mobile: +0.4, China Unicom: -0.5, and China Telecom: -0.6) have been mixed in recent years, especially from the beginning of the Federal Reserve Board’s second round of Quantitative Easing (QE2). This may have been because industry factors have been a bigger factor in influencing the sector’s share prices in the past few years.

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http://asiaresearch.daiwacm.com/eg/cgi-bin/files/China_Economy-_140313.pdf#page=1


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China Telecoms Sector: share-price performance vs. Renminbi movement

Source: Bloomberg

Low asset-writedown risks By virtue of the nature of the business, the telecoms sector faces low asset-writedown risk. While a slowdown in economic growth could increase bad-debt provisions slightly – particularly in the enterprise customer segment – we think the overall effect on earnings or book values of the stocks we cover is likely be to be very small. Earnings resilience: many factors to consider The macroeconomic environment in general has implications for telecoms operators’ ability to access capital markets, stimulate customer demand, and optimise vendor relationships; with the length and depth of a slowdown determining the earnings resilience. In a credit-induced slowdown, access to capital markets could become restricted for many firms. We see little risk of this happening to the telecoms companies – China Mobile is in a net-cash position and China Telecom’s and China Unicom’s net debt/EBITDA ratios are below 1x. The trends in Bloomberg-consensus earnings revisions over the 2008-09 global financial crisis, while possibly an extreme case, illustrate that earnings risks are far higher than for other sectors. For example, the earnings revisions index for the Asia-Pacific ex-Japan market fell at a faster pace than its constituent telecoms sector as the global economic crisis intensified in late 2008.

Earnings revision index: MSCI AP Ex-Japan and MSCI AP ex-Japan Telecom Sectors

Source: Thomson Reuters

While the potential for a reduction in subscription volume or the usage of telecommunications services exists, even in markets which have gone through severe economic crises in the recent past, such as the US and Greece, demand for wireless and broadband subscriptions from retail consumers continued to be strong over 2008-13. Some operators saw weakness in some areas such as roaming revenues (Singapore), international call revenue (Singapore, Thailand), wire-line retail subscriptions (the US/Singapore), and enterprise customer demand (Australia, the US). In China, roaming and IDD revenues are not significant contributors to revenue in the sector; we expect demand to be inelastic, barring a major deterioration in economic fundamentals. However, operators’ ability to meet end consumer demand could be hampered by supply-chain (network and handset suppliers; open-channel distributors) disruptions – the most direct fallout we expect from a slowing economy. Meanwhile, one of the consistent themes from around the world, especially during periods of sharp downturns, is that telecoms operators’ have the flexibility to exercise cost discipline – by curtailing capex and handset subsidies – to protect their profits from reductions in customer demand. The China operators also have such flexibility in theory – subsidies and marketing expenses account for 21-25% of 2014E service revenue; while their 2014E capex to service revenue ratios range from 26-37%. However, we are unsure about whether or not they would act to protect profit-margins if the economic outlook deteriorated.

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Overall, we believe China Mobile has the most flexibility to protect its profit margin in a downturn, due to the strength of its balance sheet and minimal exposure to the enterprise wire-line segment. We expect share prices to be resilient compared to MSCI China Relative to the broader market (MSCI Index), the 12-month-forward valuation multiples of the telecoms sector (MSCI China Telecom Services Index) are trading at a 4% discount on a PBR basis but at a 20% premium on a PER basis. MSCI China Telecom Sector: 12-month forward PER valuation premium to MSCI China

Source: Thomson Reuters, Daiwa estimates

In comparison, the past-10-year average PBR and PER multiples traded at premiums of 10%. The past-5-year averages, which give more weight to industry evolution in recent years, were premiums of 0% for PBR and 5% on a PER basis. MSCI China Telecom Sector: 12-month forward PBV valuation premium to MSCI China


However, we think the PBR discount may have been understated, and believe the sector’s premium valuation to the market on a PER basis would stay or expand. This is because, compared with the broader market, the telecoms sector faces low writedown risks,

as earnings are relatively immune from Renminbi depreciation risks, in our view. China Telecoms Sector: summary of growth and margin forecasts

2013 2014E 2015E 2016E 2013-16E

change/CAGR2013-18E

change/CAGRMobile as a % of service revenue China Mobile 100 100 100 100 0 pp 0 ppChina Unicom 63 66 69 71 7.3 pp 10.2 ppChina Telecom 40 43 45 48 8.1 pp 13.1 pp Growth (% YoY) Service revenue China Mobile 5.4 4.2 8.4 7.4 6.6 6.3China Unicom 13.5 10.9 9.6 8.5 9.6 8.2China Telecom 10.1 7.3 7.1 8.5 7.6 7.3 EBITDA China Mobile -5.2 -5.8 5.6 11.6 3.5 4.4China Unicom 15.6 12.0 9.5 8.0 9.8 8.1China Telecom 36.3 8.9 7.2 8.3 8.1 7.8 Net profit China Mobile -5.9 -15.0 1.2 11.5 -1.4 0.6China Unicom 46.7 11.2 33.7 11.5 18.4 12.8China Telecom 17.6 12.8 5.8 5.1 7.8 9.3 Margin (% YoY) Service EBITDA (%) China Mobile 40.7 36.8 35.8 37.2 -3.4 pp -3.5ppChina Unicom 35.2 35.6 35.5 35.4 0.2 pp -0.2ppChina Telecom 34.0 34.5 34.5 34.4 0.5 pp 0.8ppSource: Companies, Daiwa forecasts

China Telecoms Sector: summary of growth and margin forecasts under our base-case VAT outcomes

2013 2014E 2015E 2016E 2013-16E change /CAGRGrowth (% YoY) Service revenue China Mobile 5.4 1.6 5.6 7.4 4.8China Unicom 13.5 8.1 6.8 8.5 7.8China Telecom 10.1 4.6 4.3 8.5 5.8 EBITDA China Mobile -5.2 -9.1 1.7 11.7 1.1China Unicom 15.6 7.8 5.3 8.0 7.0China Telecom 36.3 4.9 3.1 8.3 5.4 Net profit China Mobile -5.9 -20.0 -5.9 11.8 -5.6China Unicom 46.7 -14.9 7.8 13.8 1.4China Telecom 17.6 -4.4 -13.9 3.6 -5.2 Margin (% YoY) Service EBITDA (%) China Mobile 40.7 36.4 35.1 36.5 -4.2ppChina Unicom 35.2 35.1 34.6 34.5 -0.7ppChina Telecom 34.0 34.1 33.7 33.6 -0.4pp


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VAT reform

Earnings impact

We evaluate a few scenarios to better understand the impact of the VAT-reform process on the operators’ financials. Some of the details governing applicable tax rates and pass-through assumptions are covered in Appendix 2 (page 32), while our investment framework is covered on page 5. VAT-reform scenarios: impact to our 2015 forecasts

Scenario 1 Base case

Scenario 2 Worst case

Scenario 3Best case

Revenue impact -5% -8% -3%Opex impact -4% -3% -6%


Scenario analysis: impact of VAT reform on 2015 forecasts

China Mobile China Unicom China TelecomBase case scenario EBITDA -7% -7% -7%Net profit -12% -38% -31%Worst case scenario EBITDA -18% -20% -19%Net profit -32% -104% -83%Best case scenario EBITDA 3% 4% 4%Net profit 6% 22% 17%

Source: Daiwa forecasts

Scenario analysis: per-share (CNY) impact of VAT reform on our 2015 forecasts

China Mobile China Unicom China TelecomBase case EBITDA -0.83 -0.31 -0.10Book value -0.64 -0.24 -0.08Worst case EBITDA -2.15 -0.85 -0.27Book value -1.66 -0.65 -0.21Best case EBITDA 0.38 0.18 0.05Book value 0.29 0.14 0.04


Base case: earnings impact Our base case scenario involves an effective 5% reduction to our 2015 revenue forecasts and a 4% reduction in operational expenses for all the companies in the sector. It can be seen that under our base case, the 2015 earnings of China Mobile, China Unicom, and China Telecom would be affected by 12%, 38%, and 31%,

respectively, compared with our forecasts (see the industry dynamics section for details). China Telecoms Sector: industry forecasts under our base-case VAT implementation CNYbn 2012 2013 2014E 2015E 2016E 2013-16E CAGRIndustry outlook Service revenue 1,029 1,114 1,155 1,219 1,316 5.7%EBITDA 397 421 410 422 464 3.3%Net profit 151 150 123 116 128 -5.0%China Mobile Service revenue 560 591 600 634 681EBITDA 254 240 219 222 248Net profit 129 122 97 92 102 -5.6%China Unicom Service revenue 210 239 258 275 299EBITDA 73 84 91 95 103Net profit 7 10 9 10 11 1.4%China Telecom Service revenue 258 284 297 310 337EBITDA 71 97 101 104 113Net profit 15 18 17 14 15 -5.2%Source: Companies, Daiwa forecasts

Worst case: earnings impact Our worst case scenario assumes an 8% reduction to our revenues forecasts and a corresponding 3% reduction to operational costs, both compared to our current forecasts. As this could potentially imply very low level of profits for China Telecom and an operating loss situation for China Unicom, we believe the companies would almost certainly alter their business strategies and capital expenditure plans to mitigate the earnings impact. For example, companies can overhaul their price packages to alter revenue structure in order to take advantage of differences in applicable output VAT rates for voice and data services. We have not taken such responses into account because of their complexity. China Telecoms Sector: Industry forecasts under worst case VAT implementation CNYbn 2012 2013 2014E 2015E 2016E 2013-16E CAGRIndustry outlook Service revenue 1,029 1,114 1,138 1,181 1,275 4.6%EBITDA 397 421 386 368 406 -1.2%Net profit 151 150 104 74 83 -17.7%China Mobile Service revenue 560 591 591 614 659EBITDA 254 240 206 195 219Net profit 129 122 88 71 80 -13.0%China Unicom Service revenue 210 239 254 267 289EBITDA 73 84 84 82 89Net profit 7 10 4 -1 0 nmChina Telecom Service revenue 258 284 293 300 326EBITDA 71 97 95 91 98Net profit 15 18 12 4 3 -43.6%Source: Companies, Daiwa forecasts


- 11 -

Quantifying the valuation impact

As can be seen from above, the short-term effects of the VAT-reform initiative are negative, cushioned only by any transitional reliefs that would be provided to the sector. The bigger question, and one that is critical to assessing sector valuation risks, is how the medium-term cost structures evolve. In particular, it is important to ascertain whether suppliers will pass on savings in their input costs over time once VAT-reform policy is extended to cover a wider range of industries. We believe this is likely to be the case as thrust of the VAT reform policy is to encourage innovation and to reduce the overall tax burden in the economy. Under this scenario, we think a price-to-book approach may be a good tool to assess the valuation impact. Valuation impact of VAT reform using book value approach (in HKD/sh) China Mobile China Unicom China TelecomBase case -1.9 -0.32 -0.12Worst case -5.0 -0.86 -0.31Best case 0.9 0.19 0.06Assumptions Historical PBR trading multiples (x) 2.5 1.1 1.2Source: Daiwa estimates

Note: we used 10-year trading average to estimate impact as it provides a more conservative estimate for China Mobile, which is our top pick

An alternative method, which relies on an EV/EBITDA multiple approach, is a useful way to assess valuation risks, especially if the change in cost structure is likely to persist into the medium term. This is slightly unrealistic, in our view, as telecom operators enjoy good bargaining power given the size of their business (working capital payable days is one of the highest in the region, reflecting long-duration credit terms). Nevertheless, while setting our target prices for the China Telecom stocks, we have estimated VAT-reform impacts using the EV/EBITDA method as it is a more conservative approach. Valuation impact of VAT reform using EV/EBITDA multiple approach (in HKD/sh) China Mobile China Unicom China TelecomBase case -4.7 -1.6 -0.5Worst case -12.2 -4.3 -1.3Best case 2.1 0.9 0.3Assumptions Historical trading multiples: EV/EBITDA (x) 4.7 4.2 4.1CNY-HKD Exchange Rate 1.20 1.20 1.20Source: Daiwa estimates

Note: we used 10-year trading average to estimate impact as it provides a more conservative estimate for China Mobile, which is our top pick

Are VAT-reform risks priced in?

We believe the market has already discounted to a large degree the risks arising from VAT reform. We arrive at this conclusion based on the following observations. 1) Year-to-date, the share prices of the telecoms stocks have fallen in tandem, and by a larger percentage than the overall Hang Seng Index (HSI). China Telecoms Sector: share-price performances Share price change (HKD/share) China Mobile China Unicom China Telecom HSI Year-to-date -9.1 -1.4 -0.4From End June 2013 -9.7 -0.1 -0.2From peak since June 2013 -17.0 -3.1 -0.7From trough since June 2013 6.8 1.0 0.4 % change Year-to-date -11.3% -12.4% -10.7% -3.4%From End June 2013 -11.9% -1.4% -5.4% 8.3%From peak since June 2013 -19.2% -23.4% -17.1% -6.3%From trough since June 2013 10.6% 10.8% 11.1% 11.8%

Source: Bloomberg

2) The lack-of dispersion in returns in the sector over the past year is especially surprising given: 1) there are significant differences in the companies’ operational strategies, and 2) price-returns for the telecoms operators in many other Asia markets have diverged on account of their operational performances. This suggests to us that the market may have been concerned mainly about industry-wide issues, such as the VAT reform, rather than company-specific factors. One-year share-price performances in selected countries Country Best performer Worst performer Difference (pp) China China Unicom China Mobile

-0.4 -13.8 13.4pp Korea SK Telecom KT

12.8 -17.7 30.5pp Indonesia PT Telkom Indosat

3.2 -38.7 41.9pp Philippines Globe PLDT

37.5 -4.7 42.2pp India Reliance Communications Bharti Airtel

105.6 11.7 93.9pp

Source: Bloomberg

3) The magnitude of the corrections in the share prices this year exceeds our estimates in nearly all but the worst-case outcome scenario based on an EV/EBITDA valuation method. This suggests to us that the market appears to be pricing in expectations that changes in industry cost structures arising from VAT reform are permanent which, as explained above, is unrealistic in our view, as we expect the operators to be able to pass on the tax burden down the supply chain over the medium term.


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4G transition

4G likely to lead to increase in ARPU

Background

The 4G-network infrastructure strategies of the China operators are distinctly different, shaped by a unique set of circumstances. First, the starting points for the upgrade path to 4G is different for each operator, as their 2G and 3G networks were built on a heterogeneous set of standards. China Mobile’s 3G network is built on the home-grown TD-SCDMA standard; China Unicom’s is based on the well-established 3G HSDPA standard; and China Telecom runs a CDMA 2000 network. Second, the operators have shown a preference for different flavours of 4G standards. China Mobile has thrown its weight behind the TD-LTE standard, while China Unicom and China Telecom have a preference for the FDD-LTE technology variant. Third, the government has thrown its weight behind the TD-LTE standard, for which licenses were issued in December 2013. The market expects FDD-LTE licences to be issued by the end of 2014, although we think it may be contingent on the TD-LTE standard gaining market acceptance in the interim period. Technology-transition issues in general are important, as they can drive long-term competitive differentiation among operators. This happens often, mainly because the long-run incremental costs of production of networks and devices can be lower when a particular technology transition scheme gains critical mass. For example, during the 1G to 2G transition, many 2G CDMA operators in Asia refined their strategies to embrace alternative 2G GSM technology. M1 (M1 SP, SGD3.43, Hold [3]) in Singapore abandoned CDMA technology during the early 2000s in favour of GSM; Reliance Communications (RCOM) (RCOM IN, INR130.5, Sell [5]) in India decided to embrace GSM technology in addition to its CDMA, thus taking on the added costs of running 2 separate 2G networks.

More recently, during the 2G to 3G transition, China Unicom (2G: GSM; 3G: WCDMA) leapfrogged the competition and gained market share over 2009-13 from rival China Mobile (2G: GSM; 3G: TD-SCDMA). China Telecoms Sector: technology standards and spectrum bandwidth allocation

China Mobile

China Unicom

China Telecom Remarks

2G CDMA 800 (2x MHz) 10 GSM 900 (2x MHz) 40 6 Additional 2x5Mhz in some cities GSM 1800 (2x MHz) 40 20 3G TD-SCDMA 35 Additional 50MHz for indoors WCDMA 2100 (2x MHz) 15 CDMA 2000 (2 x MHz) 15 4G TD-LTE 1900MHz 202300MHz 50 20 20 2600MHz 60 20 20 FD-LTE Trials (paired spectrum) China Unicom

(1800MHz/2100Mhz); China Telecom: 1800MHz

Source: MIIT, Companies, GSM Association

4G strategies of operators

For the 3G to 4G transition, there are 2 key questions that arise. 1) Is the path that China Mobile is pursuing sustainable over the long term? While the answer depends on the degree to which the standard gains acceptance worldwide in the coming years, we think early indications are encouraging. Softbank in Japan and Sprint in the US already support the TD-LTE standard for 4G; also the handset ecosystem appears to be more mature than in the past, with CNY1,000 devices likely to become a reality in 2H14. Further, some technology experts are making a case for the adoption of hybrid network configurations that combine the relative advantages of the TD-LTE and FD-LTE standards.


- 13 -

China Mobile: Yulong Coolpad 8720L 4G phone retail prices

Source: China Mobile website

2) Will China Unicom and China Telecom leapfrog China Mobile with FDD-LTE? As the bulk of the transition across the world is likely to centre on the WCDMA to FDD-LTE standard, network vendors and chipset makers would dedicate a large amount of R&D resources to facilitate this transition. Meanwhile, we also expect good industry support behind the CDMA to FDD-LTE transition path as it is already deployed by Verizon in the US and KDDI in Japan. However, the ability of the China Unicom and China Telecom operators to leverage on the FDD-LTE standard would depend greatly on when the FDD-LTE licenses will be awarded and the relative maturity of the TD-LTE platform by that point in time. The market is expecting FDD-LTE licenses to be awarded by late 2014, though we think it could be delayed into 1H15 if TD-LTE adoption rates don’t match up to the regulator’s expectations. In the interim period, we think China Unicom will likely focus on attracting customers to its 3G HSDPA platform, which we regard as a relatively competitive offering with network access speeds of up to 42Mbps (China Mobile: TD-LTE ; TD-SCDMA: 2.8Mbps). Meanwhile, China Telecom appears to be facing a slightly more difficult challenge as its current CDMA EVDO network can provide access speeds of up to only 3.1Mbps. However, China Telecom is also backed by a better-quality management team, in our opinion, and appears to striking a balance between subsidies and market share in the interim period, while being relatively more aggressive than Unicom in investing in TD-LTE and FD-LTE hybrid networks.

Given the above, we are expecting TD-LTE technology to be moderately successful, even though the FDD-LTE route is likely to remain the mainstream choice.

4G adoption rates

In many regions of the world, the customers appear to be moving to 4G networks at a more rapid pace than during the 2G-3G transition, facilitated by relatively more mature network and handset ecosystems. For example, in Singapore, the proportion of 4G customers rose to 24% of the mobile subscriber base as of 2013, i.e., within less than a year of launch of 4G services. In contrast, adoption of 3G services was more measured, rising only by 4 percentage points within a year of the launch of services. In Korea, about 52% of mobile subscribers migrated to LTE within three years of the launch of services. LTE penetration rates across key markets on re-based timescales


Note: For China Mobile starting point is end 2014; while for the rest of the operators time scale starts from end 2011

In the case of China, however, we expect 4G migration rates to pick up significantly from 2016, post the issuance of FDD-LTE licenses by end 2014. In the interim period, China Mobile efforts are likely to be the key to determining the overall adoption rates. Given that given that China Mobile appears well prepared for the 3G-4G transition compared to the 2G-3G era, we expect overall industry take-up rates to be faster than before. We are expecting 4G customers as a proportion of the subscriber base to reach 24% by 2016. In contrast, 3G subscriber penetration levels reached 13% within the first three years of their launch. Overall, we expect the total proportion of 3G and 4G customers to increase from 34% for 2013 to 70% for 2016.

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Penetration of 3G/4G subscribers as proportion of total mobile subscribers

Source: MIIT, Companies, Daiwa forecasts

Shifts in consumer preferences

Across the globe, consumers are relying less on traditional methods of communications, such as making voice calls or sending SMS text messages, and instead showing an increasing preference for data services and other alternative forms of communication. For example, over-the-top (OTT) applications such as WeChat and Whatsapp have become effective substitutes for SMS messages in many places. Interestingly, this trend is observed equally in places where SMS usage levels are high (Singapore) or low (Hong Kong). SMS usage volume per subscriber per month: comparison

Source: OFCA HongKong, IDA Singapore, Companies

In the case of voice services as well, usage levels (per SIM card sold) have been falling across many countries over the past 3 years. However, some operators have adapted to the situation by offering unlimited voice-calls or other promotions to stimulate voice usage levels, sometimes successfully (eg, Axiata in Malaysia).

Voice average monthly minutes of use: comparison


Why did voice-usage levels decline across many countries in Asia? We think the proliferation of multiple SIM cards and data-only SIMs, which tend to overstate the subscriber numbers, could have been a key contributing factor. Interestingly, in China, the WeChat application’s ‘push-to-talk’ and ‘walkie-talkie’ services, which are gaining in popularity, have become partial substitutes for voice calls, thus affecting voice-usage levels, especially for China Mobile in the recent quarters. We expect the move to 4G networks to solidify this trend of falling voice usage levels. Smartphone penetration rates across subscribers (2013)

Source: Companies, Daiwa estimates

Meanwhile, data-usage levels are increasing steadfastly across the world, driven by the proliferation of smartphones and availability of higher speed 3G and 4G networks. China is no exception here.

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China Telecoms Sector: data usage per subscriber


OTT application threats

What are the revenue implications for operators when its customers use OTT applications, instead of legacy methods, for making voice calls and sending messages, especially in a 4G environment? The answer depends on how the operators package their products and also on the data tariffs relative to the current pricing environment. In the SMS segment, the pricing disparity between sending a text message on a legacy platform compared with through a chat application is likely to be significant. For example, China Mobile generated revenue of CNY0.055/SMS message in 2013. In contrast, a similar message sent via an OTT platform would generate only a fraction of this revenue (CNY0.02) based on China Mobile’s prevailing data prices. This is too large a price gap to bridge, in our view, though it could be mitigated partly by bundling services, similar to the strategy pursued by many of the operators in ASEAN (StarHub and Digi). The threat to the overall voice-revenue segment remains a more important risk factor to consider for incumbent operators as they constitute a large proportion of operators’ existing mobile-service revenue (2013: 61% for China Mobile, 53% for China Telecom, and 55% for China Unicom). The key issue to consider is how the ‘price-gap’ between calls made on conventional networks and via-OTT applications will evolve. Among other factors, this requires an understanding of how much data volume in Megabytes is consumed when a user makes a 1-minute voice call.

WeChat: data consumption for 10 ‘push to talk’ voice messages (normal bitrate)

Source: Daiwa

OTT applications: data consumption volume for sending a 1-minute push-to-talk voice message


We have tested WeChat and other OTT applications in Singapore in order to understand the typical megabyte (MB) ranges involved for various modes of communication. We noticed the following: 1) a 1-minute “push-to-talk” voice message consumes 50-250KB for each connected party 2) a 1-minute voice call consumes 250-500KB of data for each connected party 3) a 1-minute video call consumes 2MB of data for each connected party The variations here are partly due to different voice “codec” used by these services, which can have an impact on the quality of the call.

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- 16 -

WeChat: data consumption for a 2-minute two-way voice call (normal bitrate)

Source: Daiwa

Average data consumption per connected party for a 1-minute voice call currently


Based on the above, and assuming a voice-call using a data network equates to roughly 0.5MB (including both the sender and receiver), we conclude that, based on prevailing 4G tariffs, the price gap is not that significant if the voice call then migrates to an OTT-application. This is based on the following:

• Current data revenue per MB, at CNY0.20 as of 2013, is more than twice that of the average revenue per minute earned by market leader China Mobile.

• The marginal tariffs for data services on China Mobile’s data networks (CNY0.29/MB) is more than twice the average revenue per minute metric for the company.

The average tariff for a typical data-only 4G package on China Mobile’s network (costing CNY70 per month) is at par (CNY0.07 per MB) with the average voice revenue per customer. This implies that the revenue impact from customers shunning their existing voice-bundle packages all together for “data-only” products would be negative, but we think the proportion of customers who do this is very small.

Revenue earned for a 1-minute call on OTT platforms and legacy networks (CNY)


Note: assumes marginal pricing of data at CNY0.29/MB

It remains possible that push-to-talk messaging and “walkie-talkie” services could impact revenue generation initially (marginal tariffs for data services should be around 5 times higher than voice tariffs in order to have a zero revenue impact), but we are unsure whether this mode of communication can replace traditional two-way voice calls. In our opinion, “push-to-talk” services could also serve as a substitute for traditional SMS, and such a migration process could be revenue-accretive.

Could 4G drive an increase in industry ARPU?

As the mobile penetration level in China is already high, we think the China telecoms operators will increasingly rely on enhancing the revenue earned from their existing customer base as the means to drive revenue growth in the next few years. The migration of customers to the 4G platform is likely to facilitate this process as it should allow operators to: 1) up-sell higher tariff plans to its customers, 2) promote the use of bundled packages, and 3) stimulate consumption of volume data services. Many of the regional operators that offer 4G LTE services have already been successful in their efforts to stimulate ARPU. For example, Korea’s SK Telecom’s December 2013 quarter’s ARPU (billing) was 9.5% higher than the December 2011 quarter. US-based Verizon saw its ARPU rise by 4.7% over the same period.

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- 17 -

ARPU trends for some regional 4G operators

Source: Companies

On the other hand, while Japan’s NTT Docomo’s (9437 JP, JPY1,594, Hold [3]) December 2013 ARPU was 12.5% below its December 2011 level, this was mainly because of the effects of “monthly discounts” that the company offers to its customers for the purchase of a handset. In other words, the fall in ARPU is partly because of the accounting treatment involved – Optus in Australia uses a similar approach called “device credits” – to recognise handset subsides. The company’s ARPU, after excluding the impact of “monthly discounts” has been on a modest uptrend (+0.8% higher over the past 2 years). NTT Docomo: ARPU

Source: Companies

The ARPU development in all of the above mentioned places was a consequence of the companies’ efforts to drive smartphone penetration among their user bases, which stimulated data usage volume, and reliance on marketing strategies that lured customers to increase their monthly commitments. We expect the China operators to adhere to a similar script, and early signs look encouraging.

China Unicom: entry level packages before and after the launch of 4G services

Source: Company

For example, China Mobile’s 4G bundled plans start from CNY88/month (for now), which is 32% higher than its 2013 blended ARPU. On the other hand, China Unicom, as part of its 4G services launch, unveiled new packages that require higher (additional CNY10) monthly commitments from its customers than before. Further, our confidence in this regard partly emanates from the fact that we have some evidence of ARPU improvement happening during the 2G-3G transition phase, albeit primarily for China Unicom and China Telecom. China Telecoms Sector: 3G ARPU relative to blended ARPU

Source: Companies

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- 18 -

China Unicom: monthly mobile data usage volumes for 2G and 3G customers

Source: Companies

Overall, we forecast a 0.3-1% ARPU CAGR over 2013-16. Consequently, we expect the industry’s mobile-service revenue growth to rise from 7.6% YoY in 2014, to 10.0% YoY in 2015.

Competition

We think outright cuts in tariff plans are unlikely over 2014, as operators should be able to differentiate their products in terms of their network technology and handset offerings. To some extent, this is also evident in the way China Telecom has priced its services – at par with those of rival China Mobile. China Telecoms Sector: 4G data-only price plans China Mobile (CNY) China TelecomMonthly fee Data allowance Tariff/MB Monthly fee Data allowance Tariff/MB40 400 MB 0.100 0.10050 600 MB 0.083 0.08370 1GB 0.068 70 1GB 0.068100 2GB 0.049 100 2GB 0.049130 3GB 0.042 130 3GB 0.042180 5GB 0.035

200 6GB 0.033230 10GB 0.022 280 10GB 0.022Excess usage rate 0.290 Excess usage rate 0.307

Source: Companies

Note: China Mobile is offering a 1GB bonus data allowance that lowers the effective tariff to CNY 0.028/MB for CNY40 a month; China Telecom offers 6-month plan for CNY300

Further, while it is still early days, the 4G package offers do not appear to be significantly different from standard 3G plans (China Mobile appears to be focusing more on giving bonus data allowances than lowering monthly fees).

China Telecoms Sector: comparison of 4G plans vs. 3G plans CNY/month Data quota Voice quota (domestic) (mins) SMS quota BonusChina Mobile (4G LTE) 88 400MB 200 Separate package 200MB138 600MB 500 1GB238 1GB 1000 1GBChina Unicom (3G) 66 220MB 160 5096 340MB 240 80126 450MB 320 120China Telecom (3G) 49 200MB 100 3069 300MB 150 3089 400MB 240 30129 600MB 330 60

Source: Companies

Meanwhile, the standard 3G tariff plans also reveal only minor differences between the operators in terms of data allowances and voice minutes bundled into various packages. China Telecoms Sector: comparison of 3G price plans CNY/month Data quota Voice quota (domestic) (mins) SMS quotaChina Unicom (3G) 66 220MB 160 5096 340MB 240 80126 450MB 320 120156 570MB 420 150186 720MB 510 180China Telecom (3G) 49 200MB 100 3069 300MB 150 3089 400MB 240 30129 600MB 330 60159 750MB 450 60189 1GB 600 60

Source: Companies

As such, we think subsidy-based competition could be a bigger risk for the sector in the future, as attractive subsidies can hasten customer acquisitions. However, the behaviour of these companies over the past few years suggests the companies have improved the efficiencies of their subsidy programmes. For example, China Telecom’s handset subsidies as a proportion of total mobile service revenue has remained at the 23-25% level for the past 3 years, while for China Unicom, this ratio has fallen steadily from 7.8% in 2011 to 5.5% in 2013. Subsidy analysis for the iPhone with China Telecom leads us to the same conclusion. Finally, given the variations in the strengths of their individual balance sheets, we would not expect the small operators such as China Unicom and China Telecom to engage China Mobile in any prolonged subsidy war.

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How are the operators positioned?

Mobile market-share trends By virtue of China Mobile’s high absolute level of market share, we expect it to lose subscriber market share over 2013-18 to both its rivals. We expect China Telecom to take more share than rival China Unicom over this period, because it is starting from a lower market share base in 2013. That said, we forecast China Mobile to strengthen its market position significantly in the 3G/4G sub-segments over this period. China Telecoms Sector: subscriber market shares % 2010 2011 2012 2013 2014E 2015E 2016E 2017E 2018E

China Mobile 68.0 65.9 63.9 62.4 61.2 59.8 58.2 57.0 56.1China Unicom 19.5 20.2 21.5 22.9 23.8 24.4 24.8 25.2 25.4China Telecom 10.5 12.8 14.4 15.1 15.4 16.1 17.3 18.1 18.7Source: Companies, Daiwa forecasts

China Telecoms Sector: changes in subscriber market shares (pp YoY)


China Mobile likely to strengthen its position in the 3G/4G segments By 2018, we forecast China Mobile’s market share to rise by 5.6pp compared with 2013. In contrast, we expect China Unicom’s and China Telecom’s shares to fall by 3.3pp and 2.3pp respectively. This is because we think China Mobile’s recent (2013 onwards) focus on promoting handset-subsidies will allow it to gain incrementally greater customer share (in 3G and 4G segments) over 2013-18 than in the prior 3-year period.

China Telecoms Sector: 3G and 4G cumulative market shares


However, we see a few distinctive phases shaping this longer-term trend, depending on when the FDD-LTE licences are issued. Over the 2014-15 period, we forecast China Mobile to gain 9.1pp in subscriber market share. We expect China Telecom to concede more market share than China Unicom over the period (China Telecom: down 5.4pp; China Unicom: down 3.7pp), as we believe China Unicom’s product offering (3G-HSDPA) is relatively more competitive in terms of network speeds and handset ecosystem yardsticks. In 2016, a year after the rollout of the FDD-LTE networks, we expect China Mobile to concede market share slightly (0.9 pp YoY in 3G/4G segments). We expect China Telecom to be the main beneficiary of the rollout, as we think it has a better management execution track record and also as it is embracing 4G technology more aggressively than China Unicom.

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Virtual operators and number portability

Mobile virtual network operators

The impact of the emergence of mobile virtual network operators (MVNO) (businesses that resell telecommunications products and services without owning the underlying infrastructure), likely from 2H14, on the industry’s operating outlook remains uncertain, although we believe it is likely to be marginal over our forecast period. This assessment is based on our belief that the MVNOs that have been granted a licence to resell operators’ service offerings are likely to focus on providing differentiated products and services to niche segments of the market, rather than resorting to price competition. This is because we think there may not be a sufficient gap between wholesale and retail prices, as the MVNO scheme is still in its pilot stage, based on our discussions with industry players. Further, we think that a lack of a nationwide mobile number portability (MNP) regime could also be an obstacle to their success. This is because China’s mobile market penetration level is already high (2013: 93%), as are the barriers to switching operators among users. Consequently, we think the MVNOs may find it difficult to gain sufficient scale any time soon. List of MVNO licensees Company Nature of business Telephone World Retail chains Funtalk Digitone Telling JD.com Online mall SoShare OSS/BSS provider HiChina Alibaba’s domain registrar and web-hosting firm Huaxiang Telecom Owned by Tsinghua University Bewinner Mobile VAS and platforms firm Lianlian Online mobile recharge service provider Busap Provides TV services to trains and buses

Source: Eletricspeech.com

Among the 3 players, China Telecom and China Unicom have been more aggressive in partnering with MVNOs. We also think that the presence of MVNOs

could provide marginally more positive benefits to these companies than to China Mobile, given their smaller scale of operations. In December 2013, the Ministry of Industry and Information Technology (MIIT) granted licences to 11 companies to operate as MVNOs on China Telecom and China Unicom’s networks. More recently, in March 2014, news reports (eg, on Sina.com) said that China Mobile has selected 17 MVNO partners and is currently in the process of getting regulatory approval for these partnerships. Case studies: limited impact on many Asian markets MVNOs have had a limited impact in terms of taking market share in several countries in Asia up until 2013, due to several factors, including a lack of differentiated service offerings and lax regulatory environments. Regional markets: MVNO market shares

Source: OFCA Hong Kong, MCMC Malaysia, KCC Korea

In Hong Kong, the MVNOs had a combined market share of 7.9% as of 2013. In Korea, the MVNOs garnered a 4.5% market share at the end of 2013 after regulations paved the way for their entry in 2011. Hong Kong: MVNO market shares

Source: OFCA Hong Kong

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Within ASEAN, Malaysia has been one of the more successful markets in terms of having a relatively successful MVNO framework. However, the MVNOs had a cumulative market share of only about 2% after having a presence of more than 2 years in the market as at the end of 2013. Malaysia market: MVNOs Name Host network Remarks Tune Talk Celcom Low calling rates to under-served parts of market Baraka Telecom Digi Changed business to Mobile Virtual Network Enabler

in 2012 XOX.com Celcom Targets the Chinese community in Malaysia Talk Focus Digi Youth market Samata Communications

Digi

Ceres Telecom Celcom End-to-end solutions Virgin Mobile Umobile Launched in 2013

Source: MCMC Malaysia

Mobile number portability

We expect the MNP regime to have little impact on our 2014-16 earnings forecasts, because of its limited geographical scope. The government has most recently extended its pilot number portability (MNP) trials from one to four provinces beginning April 2014. MNP regimes have had limited success worldwide, expect in markets such as Hong Kong, where the presence of a large number of operators and the abolition of contract periods raised industry churn levels substantially (30% of subscribers switched operators within the first 9 months of the introduction of MNP). As an MNP regime itself merely reduces barriers to switching, other factors, such as technology and market-structure changes and penetration levels, all play an important role in determining its success. For example, in the past 2 years in India, Idea Cellular took advantage of the implementation of an MNP regime to boost revenue share partly at the expense of dual GSM/CDMA operator Reliance Communications. In China, we feel that a nationwide MNP regime could have more pronounced impact than in other countries in Asia, as the heterogeneous network rollout strategies could result in different service quality across platforms, which the operators and MVNOs could leverage upon in the future.


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Industry dynamics

Stable competition and muted earnings growth The industry outlook over the next 3 years (2014-16), given the current operating conditions (ie, not including the impact of the VAT), is likely to be characterised by moderate service-revenue growth, driven by the prospect of monetising data services and falling operating margins on the back of strategies to expand networks. Consequently, we forecast the net profit for the China Telecoms Sector to increase marginally at a 1.4% CAGR over 2013-16, compared with a 2.4% CAGR over 2010-13. We expect the competitive environment to be stable and believe the presence of MVNOs will have a marginal impact on the bottom lines of the stocks we cover. We expect the regulatory agenda for 2014-15 to be dominated mainly by the FDD-LTE licence issue and believe the likelihood of the interconnection rates being reviewed before 2015 is low. The pressure on sector net profit could be greater or smaller depending on the details and implementation timeline of the VAT. Sector net profit could decline by a 5.6% CAGR under our base-case VAT assumption (which factors in, among other inputs, an output VAT rate of 6-11% and a pass-through rate of 15%), up to a 17.7% CAGR decline under our bear-case scenario, and rise by a 4.2% CAGR under our best-case scenario (see the VAT-reform section of this report).

Customer growth outlook

Industry is at the mature stage With China’s mobile-penetration level at around 93% by the end of 2013, the China telecoms industry is clearly well past its growth phase. As such, we forecast the mobile subscriber growth rate for China to slow from a 12.7% CAGR over 2010-13 to an 8.3% CAGR over 2013-16. We expect the mobile penetration rate to reach 113% by 2016.

China Telecoms Sector: industry mobile subscriber growth and penetration rate


Despite potentially slow overall customer growth over 2014-16E, we expect to see significant increases in the 3G (2013-16E: 20% CAGR) and 4G (2016E: 27% of total subscriber base) customer segments, driven mainly by internal migration from 2G. China Telecoms Sector: industry mobile subscriber composition


We expect China Mobile to lead this shift in the migration of customers from the 2G to 3G/4G segments over our forecast period (we forecast the proportion of 2G customers to fall from 75% in 2013 to 32% by 2016, while the proportion of 3G/4G customers rises from 25% to 68% over the same period).

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China Telecoms Sector: mobile additions market share (%) 2010 2011 2012 2013 2014E 2015E 2016EMobile net adds share China Mobile 55.2 51.6 48.2 48.7 47.7 42.6 37.7China Unicom 17.7 25.3 31.5 35.6 34.1 32.2 30.1China Telecom 30.8 28.3 27.1 21.3 18.2 25.3 32.3Others -3.7 -5.1 -6.8 -5.6 0.0 0.0 0.03G/4G net adds share China Mobile 47.0 37.9 34.7 56.4 66.9 59.3 50.9China Unicom 30.7 32.3 34.4 25.1 21.6 23.2 23.7China Telecom 22.3 29.8 30.9 18.5 11.5 17.6 25.44G net adds share China Mobile 86.4 79.3 58.5China Unicom 8.8 9.0 20.0China Telecom 4.7 11.8 21.5


Meanwhile, we expect subscriber attritions in the fixed-line market, driven by the global trend of fixed-to-mobile migration, to continue well into the next few years. We forecast the number of fixed-line customers to decline at a 3.9% CAGR over the 2013-16 period, faster than the 3.2% rate seen over 2010-13. China Telecoms Sector: industry fixed-line subscriber growth and penetration rate


However, we still expect to see a strong increase in the number of fixed-broadband customer subscriptions, driven by an industry-wide focus on upgrading infrastructure (FTTH/B in key cities) to facilitate faster network access speeds. We forecast broadband customer growth at a 7.8% CAGR over 2013-16 and expect broadband penetration as a proportion of total fixed lines to reach 96% by 2016 (2013: 68%).

China Telecoms Sector: industry broadband subscriber growth and penetration rate


In terms of market share, we forecast the smaller players, such as new entrant China Mobile and others, to only slightly gain fixed-broadband market share over the 2013-16 period. This is because we expect their competitive activities to intensify only for certain segments of the market, such as the enterprise market, which accounted for roughly 22% of broadband customers in 2012. China Telecoms Sector: fixed-line and broadband market shares (%) 2010 2011 2012 2013 2014E 2015E 2016EFixed-line share China Unicom 32.8 32.6 33.1 32.8 33.0 32.8 33.0China Telecom 59.5 59.5 58.6 58.4 58.0 57.8 57.3Others 7.7 7.9 8.3 8.6 9.0 9.4 9.7Fixed-broadband share China Unicom 37.4 37.1 36.5 34.2 34.1 33.9 33.6China Telecom 50.3 51.2 51.4 53.0 53.1 53.0 52.9Others 12.3 11.7 12.1 12.8 12.8 13.1 13.5Source: Companies, Daiwa forecasts

Revenue outlook

We forecast a moderate industry revenue CAGR of 8.1% over 2013-16, driven by a 7.5% CAGR in service revenue and a rise in the proportion of non-service revenue for the sector from 10.6% to 12.0% over this period. We expect non-service revenue to account for more of total revenue increase over our forecast period as all operators are increasingly relying on handset sales to drive customer migration to 3G/4G platforms.

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China Telecoms Sector: industry operating-revenue growth


We expect the sector’s growth in service revenue to be led by the mobile segment, and forecast the contribution of mobile segment to total service revenue to rise from 77% in 2013 to 80% by 2016. China Telecoms Sector: service-revenue growth drivers


Revenue market shares While we expect the revenue composition of all 3 operators to shift to the mobile segment, we believe the revenue trends in the fixed-line segment are also important, especially for China Telecom, as we forecast the company to derive a major proportion of its revenue from fixed-line services (2016E: 51.9%) over our forecast period. China Telecoms Sector: service revenue composition (%) 2010 2011 2012 2013 2014E 2015E 2016EMobile as a % of service revenue China Mobile 100.0 100.0 100.0 100.0 100.0 100.0 100.0China Unicom 50.2 55.6 60.0 63.4 66.5 68.7 70.6China Telecom 22.3 29.6 36.0 40.0 42.6 45.1 48.1Fixed lines as a % service revenue China Mobile 0.0 0.0 0.0 0.0 0.0 0.0 0.0China Unicom 48.7 43.9 39.6 36.3 33.5 31.3 29.4China Telecom 77.7 70.4 64.0 60.0 57.4 54.9 51.9


Given the differential growth rates we expect for the mobile and fixed-line segments, we forecast China Mobile’s service-revenue market share to stabilise at around 52% over 2014-16. China Telecoms Sector: service-revenue market share (%) 2010 2011 2012 2013 2014E 2015E 2016EService revenue share China Mobile 56.2 55.9 54.5 53.1 51.9 52.0 51.7China Unicom 19.0 19.7 20.4 21.4 22.3 22.6 22.7China Telecom 24.8 24.4 25.1 25.5 25.7 25.4 25.6Mobile-service revenue share China Mobile 78.9 75.5 71.9 69.0 66.8 65.8 64.6China Unicom 13.4 14.8 16.2 17.7 19.1 19.7 20.0China Telecom 7.8 9.8 11.9 13.3 14.1 14.5 15.4Fixed-line service revenue share China Unicom 32.5 33.5 33.5 33.7 33.6 33.6 33.4China Telecom 67.5 66.5 66.5 66.3 66.4 66.4 66.6


Operating-margin trends

We forecast the operating margin for China Mobile to fall by 5.3pp over 2013-16 because of cost pressures (see below). On the other hand, while we see a marginal improvement for China Telecom and a flat operating margin for China Unicom, we expect these companies’ absolute operating margins to remain in the low range over our forecast period. China Telecoms Sector: operating margin


This is because escalating costs remain a major issue for all the China telecoms operators, due to their network-expansion plans and their increasing reliance on handset subsidies.

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China Telecoms Sector: EBITDA margin

(%) 2010 2011 2012 2013 2014E 2015E 2016E

2010-13 Change

(pp)

2013-16E Change

(pp)Service EBITDA margin China Mobile 49.3 47.5 45.3 40.7 36.8 35.8 37.2 -8.6 -3.4China Unicom 36.3 34.1 34.6 35.2 35.6 35.5 35.4 -1.1 0.2China Telecom 35.5 32.7 27.5 34.0 34.5 34.5 34.4 -1.5 0.5EBITDA margin China Mobile 49.3 47.5 45.3 38.2 33.8 32.6 33.8 -11.2 -4.3China Unicom 34.8 30.3 29.2 28.5 28.8 29.0 29.0 -6.3 0.6China Telecom 34.5 30.8 25.0 30.0 30.4 30.3 30.2 -4.5 0.2


In particular, we expect China Mobile’s service EBITDA margin for 2014-15 to come under greater pressure than those of its rivals due to the implementation of the China’s new asymmetric interconnection regime from January 2014, and also because we expect the company to increase its reliance on handset subsidies to drive customer migration to its 4G networks. In contrast, we expect the service EBITDA margins for China Unicom and China Telecom to be positively impacted by the new interconnect policy in 2014. The outlook for handset subsidies is likely to remain a key focus point for investors given its dual role of influencing near-term costs and driving medium-term revenue. China Telecoms Sector: handset subsidies as a proportion of mobile-service revenue


While we expect handset subsidies as a proportion of mobile-revenue services to rise for China Mobile (2016E: 5.6%; 2013: 4.5%), we expect this ratio to fall for both China Unicom (2016E: 5.0%; 2013: 5.2%) and China Telecom (2016E: 16.1%; 2013: 20.0%) – the divergence is partly because China Mobile started to put more emphasis on its handset-subsidy programme only recently in 2013, while China Unicom and China Telecom have been doing it for a while. The significant variation between China Telecom and China Unicom is partly due to different accounting treatments applied by these companies – China

Telecom’s treatment is more conservative (ie, the company recognises monthly commitment fees as service revenue over the life of the contract. Thus, it fully expenses subsidies upfront, while China Unicom treats a portion of monthly commitment fees as handset sales and, thus, recognises a lower level of subsidies upfront than China Telecom)– and also because of differences in technology platform strategies (China Telecom uses CDMA)) and business scale. Further, given the increasing reliance of the operators on third-party distributors, subsidy costs could also masquerade as sales commissions. Given this, we think the expenses incurred for both marketing and subsidy costs, when taken together, could form a more reliable indicator of customer acquisition costs. We expect sales, marketing and subsidy costs as a proportion of revenue to remain at an elevated level for all the 3 operators over our forecast period (2013-16E: 20-21% for China Mobile; 21-22% for China Unicom; 24-25% for China Telecom). China Telecoms Sector: marketing and subsidy costs as a proportion of service revenue


Meanwhile, we also expect to see variations in network-operating expense trends among the companies over our forecast period because of timing differences associated with their respective capex cycles. China Telecoms Sector: capex as a proportion of service revenue


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Profit outlook

We forecast an industry net profit CAGR of 1.4% over 2013-16, compared with a 2.4% CAGR over 2010-13 because we expect the operating margin to be weak over our forecast period. For China Mobile, we forecast earnings to decline at a 1.4% CAGR rate. China Telecoms Sector: net-profit CAGR 2013-16 forecasts, impact on the net-profit CAGR under our base-case and worse-case VAT-reform scenarios


We expect China Mobile to still account for the lion’s share of the industry profit (see sections marked in blue in the following table) over our forecast period because of its superior business scale. We forecast its share of industry EBITDA and net profit to remain stable, at around 53% and 74-75% respectively, over 2015-16E. China Telecoms Sector: EBITDA and net profit market shares (%) 2010 2011 2012 2013 2014E 2015E 2016EEBITDA market share China Mobile 63.9 64.4 63.9 57.1 53.2 52.6 53.4China Unicom 15.9 16.3 18.3 19.9 22.1 22.6 22.2China Telecom 20.2 19.3 17.8 22.9 24.7 24.8 24.4Operating profit share China Mobile 84.0 83.9 82.3 75.8 68.3 67.0 68.2China Unicom 2.8 2.9 6.3 8.8 12.6 13.7 13.6China Telecom 13.2 13.2 11.4 15.4 19.0 19.3 18.2Net profit share China Mobile 85.9 85.9 85.4 81.3 76.7 74.2 74.8China Unicom 2.8 2.9 4.7 7.0 8.6 11.0 11.1China Telecom 11.3 11.3 9.9 11.7 14.7 14.8 14.1


Balance sheets and cash flows

The wide disparity in the relative balance-sheet strengths within the sector is likely to persist over 2013-16E, our forecast period. In particular, China Mobile is likely to remain highly under-geared over 2013-16E as we do not expect the company to undertake any capital management initiatives, while we

expect China Unicom and China Telecom to marginally improve their net debt-to-EBITDA ratios over this period because of their surplus cash flows. China Telecoms Sector: key balance-sheet metrics

2010 2011 2012 2013 2014E 2015E 2016ENet debt/EBITDA (x) China Mobile -1.1 -1.2 -1.5 -1.7 -1.6 -1.6 -1.5China Unicom 1.2 1.4 1.7 1.4 1.2 1.0 0.8China Telecom 0.6 0.3 0.9 1.0 0.8 0.7 0.7Payable days (in sales) China Mobile 147 144 147 172 176 174 170China Unicom 222 180 170 138 136 135 134China Telecom 153 153 223 169 163 158 152Source: Companies, Daiwa forecasts

Meanwhile, we forecast the FCF-generation for equity shareholders to slow for China Mobile over 2014-16 (annual average of CNY 1.55/share versus 4.1 over 2010-13) because of its aggressive capex cycle. On the other hand, we expect China Unicom, whose FCF remained negative over 2009-12, to generate positive cash flows over 2014-16, as we think its capex cycle relative to its sales has peaked. China Telecoms Sector: Daiwa’s forecasts for FCF to equity shareholders (in HKD/sh) 2010 2011 2012 2013 2014E 2015E 2016EFree cash flow to equity per shareChina Mobile 5.8 5.1 5.3 2.0 -0.3 1.7 3.2China Unicom -0.3 -0.4 -0.5 0.4 0.8 0.8 0.8China Telecom 0.5 0.3 0.3 0.2 0.3 0.2 0.2Yield China Mobile 8.4% 7.3% 7.6% 2.8% -0.4% 2.5% 4.6%China Unicom -3.4% -3.8% -5.3% 4.7% 8.3% 8.2% 8.3%China Telecom 14.5% 10.5% 8.6% 5.2% 8.4% 4.7% 5.4%


Earnings versus those of the Bloomberg consensus

Our forecasts are below consensus Our 2014-15E EPS forecasts are lower than those of the Bloomberg consensus for all the 3 companies that we cover, probably because we are more conservative than the market on the EBITDA-margin development trend for these companies. China Telecoms Sector: Daiwa’s EPS forecasts versus those of the Bloomberg consensus (%)

2014E 2015E 2016EChina Mobile (9) (5) 6China Unicom (25) (19) (22)China Telecom (3) (8) (12)Source: Bloomberg, Daiwa forecasts

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As we expect the consensus to cut its 2014 earnings forecasts further for the industry, an important question to consider is whether such a scenario could put pressure on share prices. There are two issues to consider: 1) how accurate has the consensus been in the past with its earnings projections, and 2) what is the correlation between the consensus revisions and share-price performance. How accurate have the consensus forecasts been in the past? For earnings projections that were made a year ahead of the results, the consensus was reasonably accurate on China Mobile. But it has underestimated China Unicom and China Telecom consistently in the past. The 2-year forward earnings projections showed far more deviation than the actual results, especially for China Telecom and China Unicom. This situation could be because the net-profit margin for both China Telecom and China Unicom is rather low currently, making their earnings highly vulnerable to small shifts in their operating outlook. In the case of China Mobile, while the consensus has been accurate in the past, we think the market may not have factored in the effects of the shift in its business model to a subsidy-driven acquisition strategy – as the company started to focus on this only recently (2013). China Telecoms Sector: variance in actual EPS over one/two-year forward consensus forecasts

2006 2007 2008 2009 2010 2011 2012 20131-year forward EPS China Mobile 9% 10% -2% -2% 2% 3% 1% 0%China Unicom -32% 2% -2% -27% -48% -34% -9% -4%China Telecom 16% -3% -13% -13% -3% -12% -10% -3%2-year forward EPS China Mobile 38% 19% -15% -3% 4% 3% -5%China Unicom 9% 2% -47% -70% -53% -36% -20%China Telecom -2% -20% -41% -19% -16% -33% -14%

Source: Bloomberg, Daiwa

Do consensus revisions influence share-price performance? The correlation between earnings revisions and share-price performance was strong during the 2006-07 period, especially for China Mobile and China Telecom. This was probably because this period coincided with the period when China Mobile’s ARPU decline rate slowed considerably, compared with earlier years, thus surprising the market. China Unicom was also rerated during this period as it exhibited similar ARPU trends to those of China Mobile, even though its earnings fell short of market expectations.

In the past 5 years (2009-13), however, we believe the correlations between earnings revisions and price performances have not been that strong. This is because the market rerated both China Unicom and China Telecom initially (2009-10) on their perceived status as beneficiaries of 3G restructuring, especially following their respective announcements of handset partnerships with Apple, but subsequently derated them because of a mismatch in expectations. On the other hand, China Mobile’s share price fell over the past 2 years (2012-13), even though the consensus revisions were largely flat for this period. Overall, we feel that apart from VAT-reform developments, which do not appear to have been factored into consensus forecasts, market share and revenue-share trends over the next few months would be the share-price key drivers because of prevailing uncertainty over the timing of the issuance of FDD-LTE licences. China Mobile: annual consensus EPS revisions versus share-price performances

Source: Bloomberg

China Unicom: annual consensus EPS forecast revisions versus share-price performance

Source: Bloomberg

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China Telecom: annual consensus EPS forecast revisions versus share-price performance

Source: Bloomberg

Investment risks

We present below the main risks we see to our positive call on the sector. Some of the company-specific risks are detailed in the relevant company portion of the report. 1) A worsening of competitive pressure could impact our earnings forecasts negatively for all stocks under our coverage. 2) Worse-than-expected VAT-reform measures could impact our sector earnings forecasts and consequently our target prices. 3) Any inability to monetise data services effectively, due to competition or for substitution reasons, could undermine our operating margin forecasts for industry. 4) Timing of the issuance of FDD-LTE licences could impact our views on individual stocks in the sector. In particular, significant delays would pose risks to our positive calls on China Unicom and China Telecom, while the issuance of licences before TD-LTE standard attains maturity could jeopardise our positive call on China Mobile.

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Appendix 1: share-price performance review

Macro-, industry- and company-specific factors have dampened price performance

Background

By virtue of its significant weighting in many regional benchmark indices, the China Telecom Sector’s outlook remains important for investors of both country and sector-specific funds. In this section, we examine the reasons behind the China Telecom Sector’s underperformance compared to the MSCI AP ex-Japan Telecom Index over the past 3 years.

Reasons the sector has underperformed

The China telecoms stocks that we cover have underperformed the MSCI AP ex-Japan Telecom Index from beginning of 2011 to March 2014 by 17-29pp. A closer inspection of the share-price performances of the major constituents of the MSCI AP ex-Japan Telecom Index over this period reveals some of the underlying reasons behind this underperformance. Broadly, share-price returns measured in US Dollars terms can be attributed to market-related factors, industry or stock-specific issues, or other macro (currency) factors. This attribution becomes clearer when one examines the performances of Telekomunikasi Indonesia (PT Telkom) and Philippine Long Distance Telephone (PLDT) (TEL PM, PHP2,704, Buy [1]). While both these stocks underperformed the MSCI AP-ex-Japan Telecom Index over the 2011-March 2014 period, the reasons are very different. PT Telkom’s good share-price performance compared with the domestic index was negated largely by currency (Rupiah) weakness. On the other hand, PLDT’s poor relative performance was masked by a broader uplift in the Philippines market due to improvements in the

nation’s economic fundamentals (eg, Fitch upgraded the country’s credit rating in 2013). In the case of the China stocks, however, the underperformance appears to be due to both a weak domestic market as well as the sector’s relative underperformance. We think poor industry earnings growth over 2011-13 and minority investors’ dissatisfaction with the companies’ dividend policies (especially China Mobile) appear to be the primary reasons for the sector’s relative underperformance, in our view. This is evident when one contrasts the evolution of the telecoms industry earnings trajectory for China with that of Thailand. The industry earnings in Thailand for 2013 were 64% higher than those for 2007 (112% higher if we exclude the loss-making No.3 player in Thailand True Corp). In contrast, in China, the total industry net profit was only 11% higher than it was for 2007 (ie, the year before the industry restructuring). Industry net-profit growth: Thailand and China


While some of the stocks have been rerated because of strong earnings growth, others saw their share prices appreciate, mainly due to proactive dividend policies, amid falls in the 10-year yields in their respective domestic bond markets. The Malaysian companies (Maxis, Axiata, Digi.com) and the Singapore companies such as Singapore Telecom (SingTel) fall into this category.

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Dividend policies of the key companies in ASEAN Div. yield 2010 2011 2012 2013 Remarks SingTel 4.6 8.5 5.1 5.1 Payout raised to 55-75% in 2013 Axiata 3.3 4.0 6.8 3.3 Maxis 7.4 7.5 7.3 6.0 Payout in excess of 100% Digi 7.4 7.1 6.8 4.0 China Mobile 4.1 4.3 4.5 3.4 Payout ratio of 43% Gross DPS SingTel 0.14 0.26 0.16 0.17 Special dividend in 2011 Axiata 0.10 0.19 0.35 0.22 Special dividend in 2012 Maxis 0.40 0.40 0.40 0.40 Digi 0.16 0.18 0.26 0.21 China Mobile 2.98 3.29 3.41 3.08

Source: Companies, compiled by Daiwa

SingTel and Axiata raised their dividend policies over 2011-13 (SingTel raised its dividend payout ratio from 50-70% to 55-75%, while Axiata and Digi.com declared special dividends). Maxis, on the other hand, kept its dividend commitments (MYR0.40/ share) constant. Remarkably, Maxis consistently missed the Bloomberg-consensus earnings forecasts every year over the 2009-13 period (China Mobile in contrast largely met the consensus earnings expectations over this period) but the market appeared to take comfort in the company’s aggressive dividend policy (DPS over the 2009-13 period was in excess of the company’s EPS and annual FCF, as noted in above table). 10-year bond yield trends

Source: Bloomberg

In contrast, despite China Mobile’s strong net cash balance sheet over 2011-13, it stuck to its 43% payout ratio over this period. And the market appears to have responded by preferring ASEAN companies’ with more proactive dividend policies than the China telcos. In essence, we think the underperformance of the China Telcos over 2011-13 can be explained by: 1) weak industry earnings development, and 2) a lack of a proactive dividend policy, and 3) a fall in country risk premiums (10-year bond yields) in several ASEAN markets, which made the telecoms stocks in those countries relatively more attractive.

The road ahead: depressed valuations likely share-price driver

Undoubtedly, as the 4G investment cycle has just started, we expect the earnings-growth outlook for the China Telecoms Sector to be weak over 2013-16 (1.4% CAGR on our current forecasts; the net-profit could decline by up to a 5.6% CAGR in our base-case VAT-reform scenario). Also, we do not expect a major shift in these companies’ lacklustre dividend policies over our forecast period. However, what’s different now compared with the 2011-13 period is: 1) the global economic backdrop is one where 10-year bond yields in many Asian markets (ASEAN in particular) are rising steadily, thus reducing dividend-yield spreads over domestic risk-free rates in many of the countries (Singapore: average industry dividend yield spreads fell from 4.4% in 2012 to 2.2% in March 2014, as the 10-year bond yield rose from 1.6% to 2.5% over this period). In addition, valuations for the China Telecoms Sector appear attractive relative to the broader Asian telecoms markets. For example, the 12-month forward PER for the MSCI China Telecommunications Services Index is trading at a 25% discount to that of the MSCI AP ex-Japan Telecom Index – in contrast, the past-10-year average PER for the China telecoms sector traded at about a 1% premium to the Asia telecoms sector. Consequently, we believe the current depressed valuations of the sector, in addition to 4G monetisation prospects over time, should drive the performance of the China Telecoms Sector relative to the broader MSCI AP ex-Japan Index over the next 3-5 years. 12-month forward PER premium: MSCI China Telecom Services Indices compared with the MSCI AP ex-Japan Telecom Index


0

1

2

3

4

5

Singapore Malaysia China

Dec-09 Dec-10 Dec-11 Dec-12 Dec-13

(% )

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

Jan-

03

Jan-

04

Jan-

05

Jan-

06

Jan-

07

Jan-

08

Jan-

09

Jan-

10

Jan-

11

Jan-

12

Jan-

13

Jan-

14

Premium Mean +1STD

+2STD -1STD -2STD


- 31 -

Asia-Pacific telecoms companies: share-price returns over the period from January 2011 to March 2014 (%)

Source: Bloomberg

Asia-Pacific telecoms: breakdown of price returns over the period from January 2011 to March 2014 (%)

Source: Bloomberg, compiled by Daiwa

(100% )

(50% )

0%

50%

100%

150%

200%

DTAC

AIS

Globe

Digi

TCNZ

Telstra

LG Uplus

StarHub

TM M1

Idea Cellular

True Corp

Far EasTone

SK Telecom

Axiata

Maxis

PCCW

SingTel

SmarTone

PT Telkom

Taiwan M

obile

MXAPJTC Index

Hutch Tel

PLDT

Chunghwa

China Mobile

SK Broadband

China Unicom

China Telecom

KT Corp

XL Axiata

Bharti Airtel

RCOM

Indosat

(100% )

(50% )

0%

50%

100%

150%

AIS Digi TCNZ Telstra Far EasTone

Ax iata Max is SingTel PT Telkom Taiwan Mobile

MXAPJTC Index

PLDT Chunghwa China Mobile

China Unicom

China Telecom

Bharti Airtel

Return USD Ex cess return Market Return (LCY) Currency Impact


- 32 -

Appendix 2: VAT scenarios

Background

The PRC Government has been overhauling its taxation policy since 2009. One of the key reform measures that is being undertaken currently by the government is to replace the current business tax (BT) regime with a VAT. A pilot VAT programme was launched in Shanghai in 2011, covering R&D, logistics, transport and other sectors, and this was later expanded to include other cities in 2012. The pilot VAT programme was expanded to include the railway transportation industry and postal services industry from 1 January 2014. The VAT reform is likely to be expanded to cover all other sectors currently still subject to the BT by the end of 2015. It was widely expected in the market that the telecommunications sector would be covered under the VAT programme from the beginning of 2014. However, this was not the case. As regulations surrounding VAT-reform are influenced by several parties including the State Administration of Taxation (SAT), Ministry of Finance (MOF), and provincial and local-level tax bureaus, significant uncertainty exists over the timing and implementation details for the telecoms sector. That said, we still expect the telecommunications sector to be brought under the VAT programme sometime in 2014.

Effects of transition

China’s telecommunications industry currently pays about 3% of cumulative revenue in business tax and the market is currently concerned about the impact on the industry from the transition to a VAT regime. In theory, as VAT is a pass-through tax mainly affecting balance sheets, it should cause only a minor increase in China telecoms industry’s tax burden. However, in practise, the situation could turn out to be quite different, as the operators may end up having to absorb additional liabilities, especially in the short term.

In our opinion, the impact on the operators’ balance sheets and cash flows will depend on the following:

• Applicable input and output VAT rates for various types of revenue and expenditure,

• Ability to claim input VAT credits for various expenditure items, as some of suppliers may still be under the BT regime,

• Timing issues, such as a lag between recognition of output and input VAT credits, which could have an impact on cash flows, and

• Transition and relief policies, for example, relating to fixed-assets.

Applicable output and input VAT rates

It is widely expected in the market that the output VAT rate for telecommunications services will be pegged at 11%. Some of the industry players have told us that the government might help to cushion the impact on the industry with transitional policies, for example, by subjecting certain categories of revenue, such as voice or value-added services, to a lower VAT rate of 6%. China Telecoms Sector: revenue composition (2013)


On the other hand, based on the regulations governing the transportation sector, we think the input VAT rates could range from 6-17%, depending on the nature of expenses (6% rate for consulting fees, advertising and IT services; 17% input VAT for utility fees). A few issues and exceptions It is worth noting that input credits are generally not available to offset personnel expenses incurred by companies. And we do not believe the application of these general principles of VAT will be any different for the telecoms industry. Further, we also think the operators could face practical constraints in securing VAT credits for certain types of expenditure in the short term, as certain industries (eg, real estate) currently fall under the BT regime and may not transition to the VAT regime at the same time as the

33% 39%56%

67% 61%44%

0%

20%

40%

60%

80%

100%


Data services Voice, others


- 33 -

telecoms sector (ie, the operators may not be able to get VAT credit from certain suppliers if those suppliers have not yet transferred to the VAT system). China Telecoms Sector: composition of operating expenses (2013)


Meanwhile, the industry players we spoke to also felt that while input VAT credits for capital expenditure incurred by the operators are likely to be made available by the government, such a relief may not be possible for fixed assets held on the operators’ balance sheets prior to the transition date to the implementation of the VAT. If the government were to grant relief (for assets held prior to the change to VAT), we think it could cushion the impact on industry profit significantly. Revenue and cost impact As revenue and expenses on the income statements are reported net of VAT liabilities, we think the impact on the telcos’ income statement depends on the following factors:

• Ability of the operators to pass-through output VAT liability to customers, which will directly affect revenue generation, and

• The bargaining power of the operators with their suppliers, which will impact the overall expenditure recognised on the income statement.

The experience of the regional operators’ ability to pass on the VAT liability to their customers has been mixed. For example the Singapore operators have done this successfully over the past decade, while the Philippine operators have absorbed additional liabilities since February 2006.

The China experience, based on our discussions with the industry players, could mirror that of the Philippines, especially in the case of retail customers. However, the situation could be different for business customers, especially those who could benefit from input VAT credits.

How large is the corporate segment in China? While the exact numbers are not available, China Telecom said it derives around 45% of its revenue from corporate customers (and it is easier to pass on VAT to corporate customers).

Overall, on our estimates, the transition to a VAT regime could impact the 2015 industry revenue negatively by 3-8%, based on our scenario analysis. Scenario analysis: impact of the VAT reform on the 2015 revenue of the operators


Scenario 2Worst case

Scenario 3Best case

Applicable output VAT rate Data 6% 11% 6%Voice services 11% 11% 11%VAT – pass-through proportion 15% 0% 30%Revenue impact China Mobile -5.1% -8.2% -3.7%China Unicom -4.8% -8.2% -3.4%China Telecom -4.1% -8.2% -2.8%


On the expenses side of the income statement, however, the situation is less clear. The operators that we spoke to are hopeful of forcing their suppliers to share part of the additional tax burden. This could be achieved, for instance, if suppliers were to maintain their overall billings (including the VAT component) at the same level as the pre-VAT phase.

Overall on our estimates, our 2015 cash-expense forecasts for the operators could be 2-6% lower after the VAT is implemented under our scenario analysis. Scenario analysis: impact of the VAT reform on the operators 2015 expenses

Proportion of VAT-ready suppliers Applicable VAT ratesScenario 1 Base case


Scenario 3 Best case

Nature of expenses Personnel nm nm nm 0%Selling expenses 30% 10% 50% 6%Interconnection 100% 100% 100% 11%Network operations and support 30% 10% 50% 11%Cost of products sold 75% 50% 100% 11%Cash opex impact China Mobile -3.7% -2.2% -5.3% China Unicom -4.7% -3.1% -6.3% China Telecom -4.1% -2.6% -5.6%


The VAT reform process, in our opinion, is also likely to have a bearing on the operators’ tax management, and their procurement and sale of bundled product offers, and would probably require an upgrade in their IT and billings systems, based on our market research. For example, in theory, the operators can change their price packages and improve their revenue structures when their customers move from voice to data services, which will allow them to take advantage of a likely lower output VAT rate for data services (6% in our base-case scenario compared with 11% for voice).

15% 15% 21%

24% 20%21%

7% 10%7%

39%25% 25%

16%30% 26%

0%

20%

40%

60%

80%

100%


Personnel Selling ex pensesInterconnection Network operations and supportCost of products sold


- 34 -

Consequently, we think the quality of the management team and the lead time before the VAT-reform process kicks in are 2 attributes that could cushion the negative impact of the VAT.

As can be seen from the scenario-analysis table below, the revenue and cost impact for each operator can vary depending on a host of factors – the composition of revenue and costs when the policy kicks in, the pass-through rates, and the applicable tax rates and relief measures (about which we do not have much clarity currently). But as our primary objective is to get a first-order impact on valuations, we have dwindled down the above analysis into a few VAT-cases.

• Scenario 1 (base case): revenue impact of 5% across all operators and cost impact of 4% for all operators (base case) in tables above).

• Scenario 2 (worst case): assumes revenue impact of 8% and cost impact of 3%.

• Scenario 3 (best case): assumes revenue and cost impact of 3% and 6%, respectively, for all operators.

VAT reform: possible outcomes



Scenario 3Best case

Revenue impact -5% -8% -3%Opex impact -4% -3% -6%


Case studies

Singapore: little impact on the operators; managed to pass through the increases Singapore offers a good case study in that the operators have been broadly successful in passing through the Goods and Services Taxes (GST) to its customers. The GST regime was introduced in 1994 at an initial rate of 3% and subsequently raised to 4% in January 2004, and to 5% in January 2005, and finally 7% in July 2007. The Philippines: industry revenue modestly impacted as operators absorbed VAT increase in 2006 In February 2006, the VAT rate in the Philippines was increased from 10% to 12%. A change in the VAT system meant a change in the billing systems for Globe Telecom, which had to reconfigure its billing systems to reflect the 12% output VAT (from 10%).

In theory, VAT is a passed-on consumption tax, and hence, the ultimate end-user or consumer should have borne the tax burden. But in the case of Globe, the tax burden (arising from the increase in VAT) was absorbed by Globe. Globe Telecom: impact of a VAT increase in 2006 on its pay-as-you-go SMS tariffs and revenue recognition

Source: Company

For example, the PHP1/message (pay-as-you-go) rate charged to its subscribers did not change even after the VAT rate increased by 2pp. While Globe’s revenue was impacted negatively, it saw little impact on its subscription volumes, as the tariff rates were retained despite the increased VAT rate. Globe Telecom: impact of VAT increase in 2006 on its revenue and EBITDA margin

Source: Company

1.00 1.00

0.900.88

0.80

0.85

0.90

0.95

1.00

Pre VAT increase (Jan 2006) Post VAT increase (Feb 2006)

Retail Tariff Revenue recognized per message

(PHP/message)

50%

55%

60%

65%

70%

12.0

12.5

13.0

13.5

14.0

14.5

15.0

15.5

16.0

1Q05 2Q05 3Q05 4Q05 1Q06 2Q06 3Q06 4Q06 1Q07 2Q07 3Q07 4Q07

Revenue (LHS) EBITDA margin (RHS)

(PHPbn)


- 35 -

Appendix 3: telcos’ resilience – lessons from crises past

Operators responded to poor economic conditions by controlling costs and capex

Background

The telecoms sector is perceived by several investors as being a ‘defensive’ sector, as communication services are largely considered basic necessities by many people across the globe. But do telecoms stocks globally outperform other sectors during periods of economic slowdown? And to what degree are their revenue and earnings resilient in the face of an economic slowdown? Our regional economist Kevin Lai (please see The end of free lunch) feels that averting a financial crises in China would require delicate policy moves as the central bank’s ammunition is running low. Given this, and because it is difficult to segregate the relative roles of industry factors (regulations and competition), and the impact of macro conditions on share-price performances, we looked at a few examples from the recent past, when economic conditions were especially severe: the global financial crisis in 2008-09, the Greece and Spain debt crisis in 2010-12, the Argentina currency crisis in 2001-03 and the Asian financial crisis in 1997-98. We conclude that while the China telcos are not totally immune, they are likely to be more resilient than other sectors amid a deteriorating economy.

Global financial crisis (2007-09)

Telecoms as a an asset class outperformed in every region in the world From September 2007 to February 2009, which marked the most intense phase of the global financial crisis, telecoms stocks as an asset class outperformed the relevant benchmarks across the world. In Asia, barring PT Telkom, which was impacted by severe price competition, most of the incumbents outperformed their respective domestic indices. MSCI AP Ex-Japan and MSCI AP ex-Japan Telecom Sectors: performances over Sept 2007- Feb 2009

Source: Bloomberg, Daiwa estimates

Telecoms stocks’ share-price performances relative to domestic indices between September 2007 and February 2009

Source: Bloomberg, Daiwa estimates

The period of the global financial crisis also coincided with the global launch of the iPhone – the device’s universal appeal, along with Apple’s launch strategy (building exclusive operator relationships), had a pronounced impact on several operators’ financials and competitiveness.

-52%

-54%

-55%

-50%

-41%

-45%

-38%

-45%

(60% ) (50% ) (40% ) (30% ) (20% ) (10% ) 0%

MSCI World

MSCI EM

MSCI APEJ

MSCI US

Telecom Index Market

(10)

0

10

20

30

40

50

60

Chun

ghw

a

SK T

elec

om Digi

AIS

Tels

tra

PLDT

PCCW

Sing

Tel

Chin

a M

obile

Bhar

ti Ai

rtel

PT T

elko

m

(pp)

http://asiaresearch.daiwacm.com/eg/cgi-bin/files/China_Economy-_140313.pdf#page=1


- 36 -

US – smartphone sales remained strong during the crisis In the US, the epicentre of the financial crisis, AT&T (not rated) gained market share in the wireless segment because of its exclusive deal to market the iPhone from 3Q07. Its post-paid churn levels have also improved in the subsequent quarters, according to the company’s reports. AT&T: key segment financials (2007-10)

2007 2008 2009 2010 Remarks Wireless Revenue growth 13% 16% 9% 9% EBITDA margin 33.1% 34.3% 37.1% 37.2%

Customer additions (m) 9.1 7.0 8.1 3.9 Gained market share on back of demand for iPhone

ARPU growth (%) 2.2% 1.0% 0.0% -1.8% Wire-line Revenue growth 21% -3% -6% -3% EBITDA margin 36.5% 36.1% 33.3% 33.0%

Access lines net adds (m) -4.9 -6.0 -6.2 -5.8 Line losses accelerated during the financial crisis

Broadband net adds (m) 2.6 1.5 -0.5 0.5

Source: Company

On the other hand, both AT&T (not rated)and Verizon reported that several of their customers had cut back on their wire-line subscriptions as many faced difficulties in maintaining both wire-line and wireless connections due to the weak economy. Hong Kong: cyclical roaming revenue fell In Hong Kong, SmarTone’s (not rated) financial performance was severely impacted during the global financial crisis. Its net profit in FY09 (year end was June 2009) fell by 85% YoY on the back of a 5% YoY corresponding decrease in service revenue. Apart from a reduction in local tariffs, the company also suffered from a fall in roaming revenue. As a result, its ARPU fell by 7% YoY in FY09. Despite the sharp drop in its ARPU, the uptake of data services remained strong, with its contribution to service revenue rising by 5pp YoY. The company’s operating performance rebounded sharply in FY10 due to its focus on cost controls, a resurgence in roaming activities among customers, and a rise in demand for data services.

SmarTone: key financials % FY08 FY09 FY10 FY11 Remarks Service revenue growth 9% -5% 6% 33% Roaming revenue fell in 2009

Net profit growth 75% -85% 600% 156% Drop in revenue and increase in handset subsidies

EBITDA margin 26.7% 24.1% 29.9% 32.1% Customer adds ('000) 41 46 154 223

ARPU change (%) 5% -7% -5% 15%

FY09 ARPU driver: reduction in local tariffs and drop in roaming revenue

Source: Company

Singapore: fixed-line subscriptions were weak In Singapore, Singapore Telecom (SP ST, SGD3.64, Hold [3]) said that its fixed-line subscriptions came under pressure in 2009 due to the weak economy. In Australia, Optus indicated that enterprise-customer activity had slowed over the same period.

Europe debt crisis (2010-13)

The study of the debt crisis in Europe is interesting as it provides glimpses of how operators can potentially adapt their businesses to mitigate severe economic conditions. Greece: cost cuts to cushion profit margins Hellenic Telecommunications Organisation SA (OTE) (not rated) is the leading fixed-line and wireless services provider in Greece. In 2013, Greece accounted for 65% of the company’s overall revenue. OTE’s fixed-line and mobile revenue from Greece fell by 10% and 9.7% CAGRs, respectively, over 2009-13. Apart from the severe economic conditions that prevailed in Greece during this period, competitive and regulatory (a sharp reduction in mobile-termination rates over 2009-13) factors also played a role in revenue development. In particular, OTE reported during this period that its customers cut connections as a result of shrinking incomes (fixed-line disconnection rates rose from 45,000 in 2010 to 167,000 in 2012). However, the company adapted to these conditions mainly by aggressive cost-control measures – it reduced its headcount by 41% over 2009-13. As a result, its EBITDA margin remained stable, at around 29-30% over 2009-12, rising to 36% in 2013.


- 37 -

OTE: key financials 2010 2011 2012 2013 Remarks

Macro Real GDP growth -4.9% -7.1% -6.4% -3.7% Unemployment rate 12.6% 17.7% 24.3% 27.3% Fixed-line (%) Revenue growth 9% -27% -11% -9% Pro-forma EBITDA margin 30.5% 29.3% 29.0% 36.5%

Aggressive control of personnel costs

Fixed-line net adds ('000) -45 -130 -167 -110 Broadband net adds ('000) 345 196 209 222

Broadband demand remained healthy

Mobile (%) Revenue growth -9.7% -9.1% -7.5% -12.3% Pro-forma EBITDA margin 36.8% 38.1% 40.2% 37.4%

Net additions ('000) -1200 -115 -188 -220 Mandatory registration of prepaid subs in 2010

Source: Company

Spain: market leader stopped offering handset subsidies

Over 2010-13, the revenue of the leading operators in Spain, Vodafone (not rated) and Telefonica (not rated), were impacted by a triple whammy: 1) a rise in regulatory pressure (cuts in mobile termination rates), 2) an increase in competition (rise in the number of MVNOs), and 3) a weakening of the economy. Telefonica changed its business model in 2012 by stopping handset subsidies, and it started to promote the use of bundled (mobile, fixed-line and TV) products. Its key rival Vodafone followed suit initially but later reverted to using subsidies. Telefonica and Vodafone: key financials % YoY (Euro) 2011 2012 2013 Remarks Telefonica Revenue growth -8% -13% -14% Wireless revenue growth -9% -17% -21% Adjusted OBIDA margin (%) 44% 45% 49% Handset subsidies stopped from 2012 Vodafone Spain Service revenue growth -8% -17% -9% In pounds Organic service revenue growth -9% -12% -13% In local currency EBITDA margin 25% 24% 23% Vodafone did not follow Telefonica's lead

Source: Companies

Note: Vodafone: 2013: results for 1H FY14 ending September 2013; Full year ending March 2013 shown as 2012, etc; Telefonica: 2011 OBIDA adjusted to exclude restructuring charges

Latin America currency crisis (2001-03)

Over 2001-03, Argentina’s economy went through a tumultuous period, marked by currency devaluation and poor economic growth. Telefonica responded to this by implementing severe cost-cutting measures, with particular attention paid to controlling delinquent payments (bad-debt-to-sales fell from 3.3% in 2001 to 2.3% in 2002) and reigning in capex in 2002 (-68% YoY).

Asian financial crisis (1997-98)

During the Asian financial crisis in 1997, the currencies in many ASEAN countries, notably in Thailand, Indonesia, the Philippines and Malaysia, depreciated against the US dollar. Some of the fixed-line operators in these countries went into bankruptcy (eg, Bayantel [not listed] in the Philippines) due to high debt loads. However, many of the region’s wireless telecommunications stocks outperformed their respective domestic benchmark indices, with some of the stocks generating positive share-price returns in local currency terms. Currency movements relative to US dollar (June 1997 to July 1998)

Source: Bloomberg

It is to be noted, however, that the period of the Asian financial crisis coincided at a time when the cellular telecommunications industry across Asia was in its growth phase, as penetration levels were very low. This is quite different from today’s situation, where many markets are already fully penetrated.

(90% )

(80% )

(70% )

(60% )

(50% )

(40% )

(30% )

(20% )

(10% )

0%

10%

IDR MYR THB PHP KRW TWD SGD INR HKD CNY


- 38 -

Telecoms share-price performances relative to domestic indices (June 1997 to July 1998)

Source: Bloomberg

Note: China Mobile data is for Oct 1997-July 1998; domestic indices used are the MSCI China for China Mobile and the MSCI Singapore for SingTel

Implications for the China telcos

The experiences of the telecoms operators across the globe hold some lessons for how the China Telecoms Sector could evolve if the economic outlook worsens over the next few years. First, we expect subscription demand for smartphones and broadband connections in China to remain largely inelastic to economic conditions.

Second, many operators globally have faced pressure in terms of wire-line and roaming revenue during times of economic weakness, which is understandable as the level of corporate and traveller activity is closely linked to the business cycle. In the case of China, roaming revenue does not contribute significantly to overall revenue. Of the 3 operators, China Mobile has no exposure to the fixed-line market, while China Telecom (2013: fixed-line revenue accounted for 60% of total service revenue) is most exposed. Finally, globally the telecoms operators have adapted to prolonged and severe economic conditions by cutting costs and capex. In theory, the China telcos could adhere to a similar script – curtailing capex plans is probably more likely than cost cutting. Overall, we believe the China telcos have good flexibility to protect their profit margins amid weak economic conditions, suggesting they are likely to be more resilient than other sectors in a deteriorating economy.

(80% )

(60% )

(40% )

(20% )

0%

20%

40%

60%

TM

Chin

a M

obile

Sing

Tel

PT T

elko

m

PLDT AI

S

SK T

elec

om

Smar

Tone

Market return LCY Return LCY


- 39 -

Appendix 4: service coverage areas

Wire-line service coverage

China Telecom offers fixed-line services in mostly in the Southern parts of China. On the other hand, while China Unicom has a presence all over China, it is the leading operator in northern China, by virtue of its merger with China Netcom in 2008. The following charts show how the listed-companies’ service-coverage areas have evolved over time. For China Unicom, the charts depict areas where China Netcom was present before the merger. China Telecom: wire-line service-area coverage

Source: Company, Compiled by Daiwa

China Unicom: China Netcom’s wire-line service area coverage


Hong Kong

Guangdong

Hainan

Hubei

Hunan Jiangxi Fujian

Heilongjiang

Inner Mongolia

Hebei

Henan Jiangsu

Shandong

Anhui

Guangxi

Guizhou

Beijing

Tianjin

Jilin

Gansu

Shaanxi

Qinghai

Xinjiang

Tibet

Ningxia

Zhejiang

Yunnan

Liaoning

Shanxi

Sichuan Chongqing

Shanghai

Macau

Taiwan2002 Asset Injection

2003 First Acquisition

2004 Second Acquisition

2008 Fourth Acquisition

Hong Kong

Guangdong

Hainan

Hubei


Heilongjiang

Inner Mongolia

Hebei

Henan Jiangsu

Shandong

Anhui

Guangxi

Guizhou

Beijing

Tianjin

Jilin

Gansu

Shaanxi

Qinghai

Xinjiang

Tibet

Ningxia

Zhejiang

Yunnan

Liaoning

Shanxi

Sichuan Chongqing

Shanghai

Macau

Taiwan2004 Asset Injection

2005 Acquisition

2004 Acquisition 2007 Disposal


- 40 -

Wireless service coverage

China Mobile, China Unicom and China Telecom have a nationwide footprint in China. The following charts depict how the service-coverage areas of these companies expanded over time via acquisitions, principally from their parent companies. China Mobile: history of its wireless-service coverage area


China Unicom: history of its wireless-service coverage area


Hong Kong

Guangdong

Hainan

Hubei


Heilongjiang

Inner Mongolia

Hebei

Henan Jiangsu

Shandong

Anhui

Guangxi

Guizhou

Beijing

Tianjin

Jilin

Gansu

Shaanxi

Qinghai

Xinjiang

Tibet

Ningxia

Zhejiang

Yunnan

Liaoning

Shanxi

Sichuan Chongqing

Shanghai

Taiwan

Macau

2000 Acquisitions

2004 Acquisitions

1998 Acquisitions

2002 Acquisitions

1997 Asset Injection

1999 Acquisitions

2006 M&A

Hong Kong

Guangdong

Hainan

Hubei


Heilongjiang

Inner Mongolia

Hebei

Henan Jiangsu

Shandong

Anhui

Guangxi

Guizhou

Beijing

Tianjin

Jilin

Gansu

Shaanxi

Qinghai

Xinjiang

Tibet

Ningxia

Zhejiang

Yunnan

Liaoning

Shanxi

Sichuan Chongqing

Shanghai

Taiwan

Macau

2000 Asset Injection

2002 Acquisitions

2003 Acquisitions

2007 Acquisitions


- 41 -

China Telecom: history of its wireless-service coverage area


Hong Kong

Guangdong

Hainan

Hubei


Heilongjiang

Inner Mongolia

Hebei

Henan Jiangsu

Shandong

Anhui

Guangxi

Guizhou

Beijing

Tianjin

Jilin

Gansu

Shaanxi

Qinghai

Xinjiang

Tibet

Ningxia

Zhejiang

Yunnan

Liaoning

Shanxi

Sichuan Chongqing

Shanghai

Macau

Taiwan2008 CDMA business acquisition2008 CDMA network acquisition

2008 CDMA business acquisition2012 CDMA network acquisition

2008 CDMA business acquisition


- 42 -

Appendix 5: regional valuations

Peer comparison

Regional valuation comparison Company name Bloomberg Share price Market cap Rating PER (x) EV/EBITDA (x) Gross dividend yield (%) code 2-Apr-14 (USD) 2014E 2015E 2014E 2015E 2014E 2015EChina China Mobile 941 HK 71.35 185,499 Buy 11.2 11.1 3.4 3.2 3.9 4.0China Unicom 762 HK 10.16 31,155 Outperform 17.3 13.0 3.2 2.8 2.2 2.9China Telecom 728 HK 3.50 36,520 Outperform 11.4 10.8 2.9 2.7 3.0 3.2Korea KT Corp 030200 KS 29,100 7,180 Hold 8.7 7.3 3.4 3.0 6.2 6.9SK Telecom 017670 KS 207,000 15,794 Outperform 8.0 7.4 2.6 2.0 4.5 4.5LG Uplus 032640 KS 9,960 4,109 Outperform 8.8 7.3 3.8 3.2 3.0 4.0SK Broadband 033630 KS 4,210 1,177 Hold 17.7 9.6 3.7 3.3 n.a. n.a.Singapore SingTel*** ST SP 3.64 45,971 Hold 14.8 13.6 13.2 13.0 5.1 5.5StarHub STH SP 4.16 5,672 Underperform 18.4 17.3 9.9 9.4 5.0 5.0M1 M1 SP 3.43 2,518 Hold 17.0 16.5 9.8 9.4 5.0 5.1Philippines PLDT TEL PM 2,750 13,217 Buy 14.8 13.9 7.6 7.0 6.8 7.2Globe GLO PM 1,678 4,953 Buy 16.5 13.0 6.9 6.0 4.5 5.5Indonesia PT Telkom TLKM IJ 2,250 20,083 Not rated 14.5 13.4 5.4 5.1 4.7 5.1PT Indosat ISAT IJ 3,985 1,917 Not rated 35.9 21.3 3.7 3.5 1.7 2.2PT XL Axiata EXCL IJ 4,400 3,325 Not rated 45.3 24.8 6.2 5.4 1.2 1.8Thailand AIS* ADVANC TB 229.0 20,986 Buy 17.1 15.0 10.0 8.8 5.8 6.6DTAC* DTAC TB 119.5 8,722 Buy 17.7 13.1 7.9 6.5 5.7 7.6Malaysia Telekom Malaysia T MK 5.86 6,392 Not rated 22.8 21.2 6.7 6.4 4.1 4.4Maxis MAXIS MK 6.93 15,857 Not rated 24.7 23.3 13.0 12.5 5.8 5.7Axiata AXIATA MK 6.73 17,539 Not rated 20.5 18.6 8.6 8.0 3.7 4.2Digi DIGI MK 5.35 12,683 Not rated 22.5 20.9 13.1 12.4 4.4 4.7India Bharti** BHARTI IN 325.85 21,765 Hold 18.8 15.2 5.7 4.8 0.4 n.a.Reliance** RCOM IN 130.45 4,499 Sell 24.4 19.2 7.1 6.3 0.4 0.4Idea** IDEA IN 143.25 7,946 Sell 18.0 15.0 5.7 4.8 0.6 0.7Average of total * 18.6 15.1 6.8 6.2 3.8 4.4

Source: Bloomberg, Daiwa forecasts Note: Bloomberg Consensus multiple are used for Indonesia and Malaysia companies, *covered by Thanachart Securities, ** Year ended 31 March 2015 shown under 2014E


■ Investment case Following the correction in China Mobile’s share price (down 16% over the past two years) and with its 2013 BVPS of HKD49, we believe the risk-reward equation is in the stock’s favour. We therefore initiate coverage with a Buy (1) rating. First, we believe the transition to 4G services will help the company regain its lost competitiveness. We forecast its mobile broadband (3G/4G) market share and average revenue per user metric to rise by 8.2pp and 0.3% CAGR, respectively, over 2013-16. Consequently, we expect it to maintain a service revenue market share of around 51-52% over 2014-16, which would be a turnaround from the past (2010-14E: -4.3pp) and thus signal a recovery in its fortunes in the medium term.

Second, we think China Mobile is less exposed than its peers to VAT-reform risks by virtue of its larger scale of operations. Third, in the context of Daiwa’s view that China’s economy will worsen over the next few years and the CNY will depreciate against the USD as a consequence, we think China Mobile will be a defensive choice for investors, given its strong balance sheet (2013: net cash) with nil exposure to foreign debt. ■ Catalysts We expect to see more instances of increasing support for the 4G TD-LTE ecosystem in 2014 (eg, handsets with CNY1,000 price points), which we would see as a share-price catalyst. ■ Valuation Given the lingering uncertainties relating to VAT reform, we do not factor it into our earnings forecasts. However, as we believe it is easier to assess the reform effects on valuations, we determine a DCF-based fair value for the stock, then apply a reduction of HKD4.7/share to arrive at our 6-month target price of HKD86.6. ■ Risks Our call would be at risk if: 1) the company fails to monetise data

services, or 2) FD-LTE licences are issued before the TD-LTE ecosystem matures.

Telecommunication Services / Hong Kong941 HK

4 April 2014

China Mobile

Initiation: the one to back

• Transition to 4G should help regain its lost competitiveness • Company least exposed to VAT-reform risks among peers • Initiating coverage with a Buy (1) rating; our top sector pick

Source: FactSet, Daiwa forecasts

Telecommunication Services / Hong Kong

China Mobile941 HK

Target (HKD): 86.60Upside: 21.4%2 Apr price (HKD): 71.35

Buy (initiation)

OutperformHoldUnderperformSell

1

2

3

4

5

80

88

95

103

110

60

68

75

83

90

Apr-13 Jul-13 Oct-13 Jan-14 Apr-14

Share price performance

China Mobi (LHS) Relative to HSI (RHS)

(HKD) (%)

12-month range 64.50-88.30Market cap (USDbn) 184.893m avg daily turnover (USDm) 169.87Shares outstanding (m) 20,101Major shareholder ile Communication Corporation (74.1%)

Financial summary (CNY)Year to 31 Dec 14E 15E 16ERevenue (m) 670,578 733,264 789,347Operating profit (m) 113,575 114,722 129,003Net profit (m) 103,474 104,688 116,753Core EPS (fully-diluted) 5.086 5.146 5.739EPS change (%) (15.0) 1.2 11.5Daiwa vs Cons. EPS (%) (9.2) (5.4) 6.5PER (x) 11.2 11.1 9.9Dividend yield (%) 3.9 4.0 4.4DPS 2.229 2.255 2.515PBR (x) 1.4 1.3 1.2EV/EBITDA (x) 3.4 3.2 2.8ROE (%) 12.7 12.0 12.5


[email protected]




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Growth outlook China Mobile: service revenue growth forecasts

We forecast 2014 service revenue growth of 4.2% YoY, a sharp slowdown from the 6.8% CAGR seen over the 2010-13 period, due partly to the negative effects of the revised interconnection rates in force from January. However, we forecast revenue growth to accelerate to a 7.9% CAGR over the next 2-year period, 2014-16E, supported by a rise in wireless data and applications revenue.


Valuation China Mobile: 2015E valuations

The stock is trading at a 31% discount to its past-10-year average EV/EBITDA multiple of 4.7x. After accounting for the impact of VAT-reform measures, the discount narrows to 19% (7% discount to the past-5-year average of 4.1x). On a PBR basis, the discount is even steeper at 45-49% (a 28-33% discount to past-5-year PBR average of 1.9x). China Mobile is, however, trading at a slight premium to its average PER valuations, after taking into account the impact of VAT-reform measures.

EV/EBITDA PER PBRCurrent 3.2 11.0 1.28Post-VAT reform 3.8 12.6 1.37Past 10-year average 4.7 12.1 2.5Premium/discount to average Current (31) (9) (49)Post-VAT reform (19) 4 (45)

Source: Daiwa forecasts, Bloomberg

Earnings revisions China Mobile: Bloomberg-consensus EPS revisions

The 2014-15 Bloomberg-consensus earnings forecasts have been revised down steadily for China Mobile over the course of the past 2 years due to cost issues. We see further downside risk to the consensus earnings forecasts because we think the market may not have factored in the full extent of the near-term impact arising from the company’s network expansion and handset-subsidy strategies.

Source: Bloomberg


Growth outlook

Valuation

Earnings revisions

10.8%

6.8%

4.2%

7.9%

5.3%

0%

2%

4%

6%

8%

10%

12%

2007-10 2010-13 2014E 2014-16E 2016-19E

Service revenue

5.5

6.5

7.5

8.5

Oct

-11

Dec-

11

Feb-

12

A pr-1

2

Jun-

12

Aug-

12

Oct

-12

Dec-

12

Feb-

13

Apr-1

3

Jun-

13

Aug-

13

Oct

-13

Dec-

13

Feb-

14

Consensus 2014E EPS Consensus 2015E EPS

(CNY)

Buy (initiation)

OutperformHoldUnderperformSell

1

2

3

4

5


- 45 -

Key assumptions

Profit and loss (CNYm)

Cash flow (CNYm)


Year to 31 Dec 2009 2010 2011 2012 2013 2014E 2015E 2016ESubscribers 'million 522.3 584.0 649.6 710.3 767.2 819.6 866.7 909.12G Subscribers 518.9 563.3 598.4 622.4 575.6 470.9 376.6 291.83G Subscribers 3.4 20.7 51.2 87.9 191.6 312.0 359.2 338.0

Blended Average revenue per user per month (CNY)

76.9 73.1 71.3 68.7 66.6 64.6 65.9 67.3

Year to 31 Dec 2009 2010 2011 2012 2013 2014E 2015E 2016EMobile Service 452,103 485,231 527,999 560,413 590,811 615,466 667,129 716,599Mobile non service 0 0 0 0 39,366 55,112 66,135 72,748Other Revenue 0 0 0 0 0 0 0 0Total Revenue 452,103 485,231 527,999 560,413 630,177 670,578 733,264 789,347Other income 0 0 0 0 0 0 0 0COGS 0 0 0 0 0 0 0 0SG&A (224,916) (248,247) (279,587) (309,043) (389,829) (444,095) (494,110) (522,433)Other op.expenses (78,343) (83,832) (94,500) (98,572) (104,621) (112,908) (124,431) (137,911)Operating profit 148,844 153,152 153,912 152,798 135,727 113,575 114,722 129,003Net-interest inc./(exp.) 4,697 4,756 7,848 12,271 14,958 14,692 13,952 14,660Assoc/forex/extraord./others 351 1,225 4,876 6,299 7,972 8,932 10,132 11,124Pre-tax profit 153,892 159,133 166,636 171,368 158,657 137,199 138,806 154,787Tax (38,413) (39,047) (40,603) (41,919) (36,776) (33,614) (34,008) (37,923)Min. int./pref. div./others (257) (384) (109) (107) (111) (111) (111) (111)Net profit (reported) 115,222 119,702 125,924 129,342 121,770 103,474 104,688 116,753Net profit (adjusted) 115,222 119,702 125,924 129,342 121,770 103,474 104,688 116,753EPS (reported)(CNY) 5.745 5.966 6.275 6.438 6.058 5.148 5.208 5.808EPS (adjusted)(CNY) 5.745 5.966 6.275 6.438 6.058 5.148 5.208 5.808EPS (adjusted fully-diluted)(CNY) 5.672 5.890 6.198 6.359 5.986 5.086 5.146 5.739DPS (CNY) 2.471 2.595 2.730 2.773 2.621 2.229 2.255 2.515EBIT 148,844 153,152 153,912 152,798 135,727 113,575 114,722 129,003EBITDA 229,023 239,382 251,025 253,646 240,426 226,483 239,154 266,914

Year to 31 Dec 2009 2010 2011 2012 2013 2014E 2015E 2016EProfit before tax 153,892 159,133 166,636 171,368 158,657 137,199 138,806 154,787Depreciation and amortisation 80,179 86,230 97,113 100,848 104,699 112,908 124,431 137,911Tax paid (42,939) (38,868) (40,078) (44,583) (36,776) (33,614) (34,008) (37,923)Change in working capital 11,433 23,056 5,426 13,077 64,288 26,538 23,845 15,334Other operational CF items 4,558 1,828 (2,341) (10,001) (65,883) (23,624) (24,084) (25,784)Cash flow from operations 207,123 231,379 226,756 230,709 224,985 219,407 228,991 244,325Capex (115,798) (113,365) (123,416) (123,406) (184,900) (225,200) (193,467) (179,150)Net (acquisitions)/disposals 6 (39,637) 123 6 0 0 0 0Other investing CF items (56,123) (23,158) (53,656) (77,235) (43,000) 0 0 0Cash flow from investing (171,915) (176,160) (176,949) (200,635) (227,900) (225,200) (193,467) (179,150)Change in debt 0 0 (5,330) 0 (23,630) 0 0 0Net share issues/(repurchases) 132 93 136 531 0 0 0 0Dividends paid (48,614) (50,201) (52,575) (55,425) (56,010) (52,675) (45,337) (45,869)Other financing CF items 4,696 3,645 6,942 9,456 14,958 14,692 13,952 14,660Cash flow from financing (43,786) (46,463) (50,827) (45,438) (64,682) (37,983) (31,385) (31,209)Forex effect/others 54,826 19,083 41,652 85,289 84,602 0 0 0Change in cash 46,248 27,839 40,632 69,925 17,005 (43,776) 4,138 33,966Free cash flow 91,325 118,014 103,340 107,303 40,085 (5,793) 35,523 65,176

Financial summary


- 46 -

Balance sheet (CNYm)

Key ratios (%)


Company profile

China Mobile is a leading mobile services provider with operations in Mainland China and Hong Kong. In China, it provides cellular services based on the 2G GSM, 3G TD-SCDMA and 4G TD-LTE technology platforms, and the company has the distinction of possessing the world’s largest customer base. At the end of 2013, it had 767m customers. The stock was listed on the New York Stock Exchange and The Stock Exchange of Hong Kong on 22 October 1997 and 23 October 1997, respectively.

As at 31 Dec 2009 2010 2011 2012 2013 2014E 2015E 2016ECash & short-term investment 264,507 292,346 332,978 402,903 419,908 376,132 380,271 414,237Inventory 3,847 4,249 7,944 7,195 9,152 9,739 10,649 11,464Accounts receivable 9,920 15,001 28,818 20,429 25,650 26,542 27,925 29,163Other current assets 9,081 10,286 12,945 16,066 12,479 14,341 15,140 15,939Total current assets 287,355 321,882 382,685 446,593 467,189 426,753 433,985 470,802Fixed assets 406,169 440,164 464,400 486,016 564,227 676,519 745,555 786,793Goodwill & intangibles 37,621 37,707 37,712 37,818 37,957 36,894 36,894 36,894Other non-current assets 20,223 62,182 67,761 81,682 98,019 106,041 115,263 125,477Total assets 751,368 861,935 952,558 1,052,109 1,167,392 1,246,207 1,331,697 1,419,966Short-term debt 68 5,049 68 68 68 68 68 68Accounts payable 166,085 197,914 210,562 228,884 300,350 328,366 354,505 371,891Other current liabilities 43,652 52,667 62,614 68,844 70,495 70,427 70,427 70,427Total current liabilities 209,805 255,630 273,244 297,796 370,913 398,861 425,000 442,386Long-term debt 33,551 28,615 28,617 28,619 4,989 4,989 4,989 4,989Other non-current liabilities 378 287 278 385 766 766 766 766Total liabilities 243,734 284,532 302,139 326,800 376,668 404,616 430,755 448,141Share capital 2,139 2,139 2,140 2,142 2,142 2,142 2,142 2,142Reserves/R.E./others 504,609 574,018 646,924 721,305 786,631 837,430 896,781 967,665Shareholders' equity 506,748 576,157 649,064 723,447 788,773 839,572 898,923 969,807Minority interests 886 1,246 1,355 1,862 1,951 1,951 1,951 1,951Total equity & liabilities 751,368 861,935 952,558 1,052,109 1,167,392 1,246,139 1,331,629 1,419,898EV 917,382 889,948 844,446 775,030 734,484 778,260 774,121 740,155Net debt/(cash) (230,888) (258,682) (304,293) (374,216) (414,851) (371,075) (375,214) (409,180)BVPS (CNY) 25.260 28.714 32.337 35.992 39.240 41.767 44.720 48.246

Year to 31 Dec 2009 2010 2011 2012 2013 2014E 2015E 2016ESales (YoY) 9.6 7.3 8.8 6.1 12.4 6.4 9.3 7.6EBITDA (YoY) 5.8 4.5 4.9 1.0 (5.2) (5.8) 5.6 11.6Operating profit (YoY) 2.7 2.9 0.5 (0.7) (11.2) (16.3) 1.0 12.4Net profit (YoY) 2.0 3.9 5.2 2.7 (5.9) (15.0) 1.2 11.5Core EPS (fully-diluted) (YoY) 2.2 3.8 5.2 2.6 (5.9) (15.0) 1.2 11.5Gross-profit margin 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0EBITDA margin 50.7 49.3 47.5 45.3 38.2 33.8 32.6 33.8Operating-profit margin 32.9 31.6 29.2 27.3 21.5 16.9 15.6 16.3Net profit margin 25.5 24.7 23.8 23.1 19.3 15.4 14.3 14.8ROAE 24.3 22.1 20.6 18.8 16.1 12.7 12.0 12.5ROAA 16.4 14.8 13.9 12.9 11.0 8.6 8.1 8.5ROCE 29.2 26.6 23.9 21.3 17.5 13.8 13.1 13.7ROIC 41.8 38.8 35.0 33.1 28.7 20.3 17.4 17.9Net debt to equity net cash net cash net cash net cash net cash net cash net cash net cashEffective tax rate 25.0 24.5 24.4 24.5 23.2 24.5 24.5 24.5Accounts receivable (days) 8.3 9.4 15.1 16.0 13.3 14.2 13.6 13.2Current ratio (x) 1.4 1.3 1.4 1.5 1.3 1.1 1.0 1.1Net interest cover (x) n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a.Net dividend payout 43.0 43.5 43.5 43.1 43.3 43.3 43.3 43.3Free cash flow yield 8.0 10.3 9.0 9.4 3.5 n.a. 3.1 5.7

Financial summary continued …


- 47 -

The one to back

Investment thesis

We initiate coverage of China Mobile with a Buy (1) rating and 6-month target price of HKD86.6. Our positive investment thesis is premised on our beliefs that: 1) the risks from the likely implementation of a value-added-tax (VAT) for the telecoms sector, as part of the overall reform of China’s tax system under way currently, are largely discounted, and 2) the adoption of TD-LTE technology will help the company regain its lost competitiveness and slow the rate of erosion in its revenue market share. We believe 2014 will be a transition year for China Mobile in many ways. The shift in its business model, with an emphasis on handset subsidy-driven subscriber acquisitions and 4G network expansion, in combination with the new interconnection regime (under which the rules governing voice and SMS interconnection charges changed from January 2014 as the regulator embraced asymmetric policies that favour rivals at the expense of China Mobile) would likely weigh on its earnings. One area of disappointment for some investors in recent weeks was the company’s decision to maintain a 43% dividend payout ratio for 2013, despite the fall in profits compared to 2012. Certainly this signals to us that dividends would rise only when profit growth resumes, which appears likely only from 2015 based on our forecasts. Notwithstanding some investors’ concerns about the company’s inefficient capital structure, we think the market may instead focus on the likely improvement in China Mobile’s competitive position as the key catalyst, especially as we think current valuations are very appealing.

TD-LTE offers potential for the company to change course

China Mobile lost market share in 2010-13 Over 2010-13, China Mobile’s mobile service revenue and industry service revenue market shares fell by 9.9pp and 3.1pp, respectively, as it lost competitiveness in the 3G services arena to rivals China Unicom and China Telecom. This development was a consequence of China Mobile’s approach to 3G, whereby the company promoted services on its home-grown TD-SCDMA standard, while rivals China Unicom and China Telecom leveraged on relatively more globally established WCDMA and CDMA 2000 technology platforms, and pulled ahead. China Mobile: industry service revenue and mobile service revenue market-share trends

Source: Company, Daiwa estimates

The 3G race was lost right at the start China Mobile’s 3G commercialisation efforts were off to a slow start due to a myriad of problems. There were network quality issues (call connection rates and handover issues) due to the relative immaturity of the TD-SCDMA technology standard, a dearth of compelling applications, and handset range and price points being uncompetitive as the supply chain was not fully developed. Further, the company was also relatively unsuccessful in its attempts to internationalise the technology standard. Current status – 3G hiccups addressed, battle lines drawn for 4G China Mobile finally began to increase the pace of 3G subscriptions from 2012 by: 1) positioning its product for mid-to-low end users, 2) addressing the handset supply chain bottle necks (eg, mainstream chipset makers started supporting the technology in their baseband solutions), and 3) embarking on a subsidy-driven subscriber acquisition process from 2013.

56%

53%

52%

60%

65%

70%

75%

80%

85%

50%

51%

52%

53%

54%

55%

56%

57%

2009 2010 2011 2012 2013 2014E

Industry service revenue (LHS) Mobile service revenue (RHS)


- 48 -

China Mobile: key milestones in TD-SCDMA evolution 2009 2010 2011 2012 2013

Base stations ('000) 80 135 220 280 446Network utilization %) 13% 24% 27%Subscribers m 3.4 20.7 51.2 87.9 191.6Handset sales volume (m) 50 150Coverage 238 cities 656 cities County-level Contiguous ContiguousAvailability of CNY 1000 handsets Yes Yes Yes

Source: Company

In particular, the availability of handsets priced below CNY1,000 (from 2011) was perhaps the catalyst behind the surge in subscriber migration rates to its 3G platform, in our view. Meanwhile, the company has disclosed its future network technology roadmap. Its strategy relies on coordinating operations among 4 different technology standards: 1) GSM to support legacy voice services, 2) WLAN for data access from laptops, 3) 3G TD-SCDMA for data access from handsets, and 4) 4G TD-LTE for delivery of mobile broadband services. Crucially, China Mobile has thrown its weight behind the TD-LTE technology standard for 4G services – TD-LTE provides a better upgrade path to the 3G TD-SCDMA platform than the more mainstream FD-LTE technology variant. With the award of 4G licences for the TD-LTE standard in December 2013, there are questions as to whether this development could tilt the competitive balance in the industry once again. This is especially so as rivals China Unicom and China Telecom are trialling, and appear to be keen on embracing, the FD-LTE technology platform. Will the 4G battle outcome be any different than during 3G? In our opinion, the outcome of the 4G battle would depend on the timing of the award of FD-LTE licences and the relative maturity of the TD-LTE ecosystem at that point in time. The market currently expects issuance of 4G FD-LTE licences sometime towards the end of 2014, though past experience (for award of 3G and 4G TD-LTE licenses) suggests delays are more the norm than the rule. In our view, China Mobile has a ‘window of opportunity’ in 2014 to take the lead in driving 4G subscriber adoption. Further, we believe the company is better positioned to capitalise on this opportunity than during the early days of 3G for the following reasons.

First, the handset supply chain is much more mature than before. For example, chipset makers like Qualcomm, which supplies solutions for many Tier-1 handset vendors, is already supporting the TD-LTE standard in some of its baseband solutions. Further, mass market TD-LTE handsets with price points of around CNY1,000 are already nearing a reality, driven by China Mobile’s strategy of promoting 3-mode, in addition to 5-mode, handsets. We note that Coolpad’s (2369 HK, Not rated) 4G TD-LTE compatible device already retails at CNY1,300, and at its latest analyst briefing, the company said it intends to lower the TD-LTE device price point to CNY700 by 2H14. China Mobile: 4G handsets range Brand Model Retail price Mode Coolpad 8720L 1099 3-mode (TD-LTE/TD-SCDMA/GSM) Lenovo A788T 999 3-mode (TD-LTE/TD-SCDMA/GSM) Huawei G716 2888 TDSCDMA/GSM/LTE HTC 8088 5288 TD-LTE/FD-LTE/TD-SCDMA/GSM Apple iPhone 5S 5288 4GLTE/TD-SCDMA/WCDMA/GSM Samsung Note 3 5299 GSM,TD-LTE Upcoming Coolpad 8705 799 3-mode (TD-LTE/TD-SCDMA/GSM)

Source: Company website

Note: For Coolpad’s device roadmap, please refer to our memo “2013 analyst meeting takeaways, aggressive on LTE smartphone” by Eric Chen on 21 March 2014

Second, the technology standard appears to be gaining acceptance among global players. Softbank (9984 JP, JPY8,066, Hold [3]) in Japan and Sprint (S US, not rated) in the US are already exponents of TD-LTE technology, and hybrid TD-LTE and FD-LTE network configurations appear to be gaining popularity. The global acceptance of a technology standard is important mainly because it has implications for handset and network deployment costs in the long run. While a global user base would certainly improve economies of scale, we expect TD-LTE to be a moderately successful technology platform that will coexist with the FDD-LTE standard. Third, China Mobile’s recent shift in business model in favour of the handset subsidy-driven acquisition process will also likely incentivise customers to migrate to its 4G networks.


- 49 -

China Mobile: key parts of its 4G strategy Category Remarks Network strategy 3G TDSCDMA 25MHz in 2000MHz bands (10MHz in 1900 band)

4G TD-LTE 130MHz bandwidth spread in 1900MHz (for smaller cities), 2300MHz and 2600MHz (for larger cities) bands

Handset

Mode To promote 5-mode (TD-LTE/FDD-LTE/TD-SCDMA/WCDMA/GSM) and 3-mode (TD-LTE/TD-SCDMA/GSM) handsets

Target volumes 3G: targeting 200m in 2014 (2013: 150m; 2012: 50m) 4G: targeting 100m TD-terminals in 2014;

Variety 4G: 32 handset models currently available Tariffs Promoting CNY88/month package TD-LTE coverage plans

Coverage TD-LTE: 16 cities covered as of Feb 2014; targeting 75% population coverage by end 2014

Capex 2014: 74.9bn (2013: 31bn); total capex of CNY 225


Can 4G lead to an ARPU uplift? We think the company’s average revenue per user (ARPU) metric will rise from 2015, driven by its handset-subsidy strategy to promote its 4G offerings. This belief is based on an assessment of the company’s business model and prevailing 4G tariffs, along with our expectation for a stable competitive landscape. China Mobile is shifting its business model to a handset-subsidy-driven acquisition process. As it is in the early stages of implementing this strategy, we think it will likely result in initial adopters upgrading their tariff plans, to avail themselves of attractive discounts on handsets. We have seen a similar phenomenon play out not only in developed economies like Japan and the US, where operators pursued an LTE strategy aggressively, but also in emerging markets like the Philippines where operators used subsidy-driven models to improve stickiness among their customers. For example, Globe Telecom (Globe PM, PHP1,678, Buy [1]), which focused mainly on the prepaid market until 2009, started focusing on handset subsidies as a tool to migrate customers to its higher tariff post-paid plans. As a result, the company’s service revenue, which had been stagnant over the 3-year period from 2008-10, accelerated to an annual rate of 8-10% over the subsequent 3-year period spanning 2011-13. There were also other factors at play in the case of Globe Telecom. The improvement in its revenue performance was a result of its market-share gains, and its reported ARPU did not actually increase – the positive uplift from a customer migrating from a pre-paid to a post-paid plan was diluted by incremental low spend customers – though the pace of decline slowed.

Nevertheless, overall we think this example clearly suggests revenue growth generation should improve as a result of China Mobile’s shift to a subsidy model. Globe Telecom: net service revenue growth and subsidy expense trends


We also think the prevailing data tariffs of China Mobile will be accretive to its revenue performance. For example, in Beijing, the lowest tariff package starts at CNY88 per month, higher than its current average ARPU. While it is still early days, the company at its 4Q13 results briefing indicated that 4G ARPU and monthly data consumption levels were CNY180 and 700MB during the first month of the service launch. Data pricing appears right to cushion OTT impact to voice services In 4Q13, however, China Mobile indicated that its voice revenue was under threat from over-the-top (OTT) applications; at the moment, we think this may be due to substitution effects from push-to-talk (P2T) voice messages. While the popularity of P2T messages is certainly on the rise, the broader question for investors is whether the situation would cascade down the line with customers using OTT applications for traditional 2-way voice communications. One way of assessing the long-term revenue impact arising from a shift in the carriage of 2-way voice calls from legacy to 4G packet networks is to compare current pricing for voice services (on a per-minute basis) vis-à-vis the equivalent cost for carrying them on packet networks (on a per MB basis). A rule of thumb is 1 minute of voice call consumes around 0.25-1MB of data. The marginal pricing of 4G data services, at CNY0.29/MB, is higher than the marginal price for voice services (CNY0.19/minute for voice calls that exceed package allowances). This would imply that for customers who exceed their monthly usage allowances, making voice calls using OTT applications does not

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

16.0%

(2% )

0%

2%

4%

6%

8%

10%

12%

14%

2006 2007 2008 2009 2010 2011 2012 2013

Net service revenue growth (LHS)

Marketing and subsidy as % revenue (RHS)

2010: Globe shifted to a subsidy-driven acquisition process


- 50 -

result in huge savings compared with higher quality calls on legacy networks. Given this, we think the transition from voice to data services is likely to be an orderly one. We expect the pace of revenue share erosion to slow We forecast China Mobile to maintain its share of industry service revenue at 51.8% per year over the 2014-16 period, and its mobile service revenue market share losses to narrow to 1-1.2pp annually from 2015. China Mobile: industry service revenue and mobile service revenue market-share forecasts


Costs of transformation unlikely to weigh on share-price outlook

The subsidy-driven business model and network expansion costs will undoubtedly weigh on China Mobile’s near-term profit outlook (2014-15). As such, we forecast a fall in operating margins and ROEs over our forecast period. Given our outlook, one of the key questions that arise is whether the share price can rally under such circumstances. We think so as: 1) valuations appear attractive, and 2) the market will likely focus more on revenue growth momentum and the company’s improving competitive position as rerating drivers. Globe Telecom went through a similar experience over 2010-13. Its adjusted operating margins (operating margin over net service revenue) fell by 13.6pp over the 2010-13 period due to its subsidy and network expansion strategies. However, the share price doubled over this period – partly as the market took comfort in its improving revenue profile. While there are some notable differences – Globe benefited from a fall in country risk premium and also adjusted its policy to minimise the impact on its dividends – we think this is

a clear illustration of the market rewarding a company for regaining its competitive position. Above all, we think China Mobile’s valuations are very attractive. The shares are trading at a discount to their long-term averages on various measures, partly reflecting the company’s loss of its competitive position over the years, which we believe will change somewhat over the course of the next 2 years. Globe Telecom: operating margin and share-price performance trends

Source: Company, Bloomberg

Note: share price return compared to end-2009 price level

What could go wrong?

Our positive call could go wrong in the event of any worse-than-anticipated impact from VAT-reform measures or if the TD-LTE technology does not achieve critical industry support. Apart from these 2 risks, China Mobile’s ability to monetise its investments while mitigating pressures in legacy voice and SMS businesses remains a key area of concern. Monetisation of data services … will the experience be closer to that of Indonesia? As China Mobile is investing heavily in its networks, the company will have to successfully monetise these investments. We believe it will be successful with such monetisation looking at the prevailing 4G data tariffs and based on our expectation of a stable competitive landscape. Indonesia’s XL Axiata’s (EXCL IJ, Not rated) experience, however, is a reminder of how things can go wrong while executing such a strategy.

53%

52%52%

51%

60%

62%

64%

66%

68%

70%

50%

51%

52%

53%

54%

55%

2013 2014E 2015E 2016E 2017E 2018E

Industry service revenue (LHS) Mobile service revenue (RHS)

0%

20%

40%

60%

80%

100%

120%

140%

0%

5%

10%

15%

20%

25%

30%

35%

40%

2009 2010 2011 2012 2013

Return compared to 2009 share price (RHS) Service Operating margin (LHS)

2009-13: Operating margin down 19 ppShare price up 116%


- 51 -

XL Axiata: adjusted revenue growth and network opex trends

Source: Company

XL Axiata, which successfully gained market share over 2006-09 by focusing on the voice segment, started expanding its 3G network ahead of demand from 2011. Its efforts to monetise its network investments were relatively successful over 2011-12, and revenue growth picked up in tandem with its moves to gradually raise effective tariffs over this period. However, price competition in the data segment from new player PT Hutchison 3 Indonesia in 4Q12 forced it to cut its prices in 2013 and revenue generation was impacted. Given the significant network expansion costs the company had incurred over 2010-13, its operating margins fell by 16pp over this period, and the share price declined by 29% from October 2012 to the end of 2013. How do we monitor progress? The global acceptance of the TD-LTE technology can be gauged by following news flow in the handset supply chain (the availability of a variety of TD-LTE-capable smart phones below CNY1,000 is key) and from the development plans of Softbank and Sprint, who are key proponents of the standard. We also believe monthly subscriber data, apart from quarterly revenue trends, will also assume importance within the context of tracking the company’s network monetisation efforts.

Other issues

Risks of asset injections China Mobile currently leases certain TD-SCDMA network infrastructure (mainly base station sites) from its unlisted parent company. Further, it is working in cooperation with a subsidiary of its parent company called China Tietong for the rollout of fixed-line broadband services. According to China Mobile, there is no agreement that requires it to purchase the TD-SCDMA assets from the parent. However, as this technology platform is now integral to China Mobile’s future network strategy which calls for coordination among 4 different technology standards (GSM, WLAN, TD-SCDMA and TD-LTE), we believe there is high likelihood of the company acquiring these assets. The listed Chinese telecom operators have a long history of acquiring assets from their parent companies. Deals completed recently have been valued near their book value, and such transactions have been justified to the market on the basis that the acquirers were better off purchasing the assets than to continue leasing them. Assuming this rationale would apply in the case of China Mobile and based on our forecasts for lease payments (2013: CNY3.84bn; 2016E: CNY10.0bn) and likely deal size (CNY125-250bn assuming capex per 3G base station in the range of USD50,000-100,000), we think the asset injection risk would materialise only from 2016. Meanwhile, China Mobile received permission from the regulator in December 2013 to offer fixed-line services independently. This raises the question of whether it makes sense for the company to acquire fixed-line assets from its parent. The financial and operational details of China Tietong are not available; assuming its asset base is around one-tenth that of China Telecom’s (the broadband market share of China Tietong and other smaller players was 9% in 2013), we think the investment size could be CNY40-50bn. Regulatory interference on interconnection rates While another round of asymmetric interconnection policy adjustments that essentially equate to the re-distribution of profits from China Mobile to its rivals cannot be ruled out, we think such a risk is low in 2014-15.

4%

9%

14%

19%

24%

29%

34%

39%

(5%)

0%

5%

10%

15%

20%

25%

30%

35%

2009 2010 2011 2012 2013

Adjusted revenue growth (LHS) Network costs as % revenue (RHS)

2010-13: XL expanded its 3G network agressivelybut tariff competition picked up in 4Q12


- 52 -

This is because the most recent revision to the rates was announced in December 2013 and according to China Mobile, the regulator would review these rates once every 2 years. Impact of mobile virtual number operator policy and shifts in MNP regime We see progress on these 2 issues as slightly negative developments for China Mobile, though we believe the risks to our forecasts, especially for 2014-15, is low. The Mobile Virtual Number Operator (MVNO) framework is currently operating on a pilot basis, and the government has most recently extended its pilot number portability (MNP) trials from 1 to 4 provinces from April.

Investment risks

Some of the key risks to our positive call arise from the following sources: 1) A worsening of competitive pressure could impact our earnings forecasts negatively. 2) An earlier-than-expected issuance of FDD-LTE licences or unforeseen commercialisation risks for the TD-LTE platform could have negative repercussions for our market-share forecasts. 3) China Mobile has evinced an interest in expanding its footprint globally over the years, which raises the prospects of irrational M&A activity. 4) Asset injection risks, especially for the TD-SCDMA network, could impact our outlook negatively depending on the terms.


- 53 -

Key trends and financials

Operational trends

Customer shift towards 3G/4G networks to continue China Mobile made a slow start, compared to its competitors, in driving 3G subscriptions among its customers. The proportion of 3G customers among the company’s mobile subscriber base rose from less than 1% in 2009 to just 25% in 2013 (2013: China Telecom: 56%; China Unicom: 44%) As the 3G network and handset supply chains are now more mature, we think customer acquisitions should gather pace this year; we forecast the 3G penetration rate among its subscribers to rise to 38% by the end of 2014. We believe the 4G migration rate for the company could be faster than during the 3G phase, especially as CNY1,000 handsets are likely to become a reality by 2H14. We forecast China Mobile’s 4G customer base to rise from 3% in 2014 to 52% by 2018. This assumes that the TD-LTE standard continues to gain global acceptance as a complementary platform to operators’ 4G FD-LTE deployments. China Mobile: mobile subscriber additions and 3G/4G penetration forecasts


ARPU likely to bottom in 2014 China Mobile saw its blended ARPU fall at a 3% CAGR over 2010-13. This was driven by 2 factors: 1) a loss in

the competitiveness of its products and service offerings on the 3G platform (eg, the iPhone was not available from China Mobile until 2014) which may have impacted the customer mix, and 2) changes in customer behaviour, with voice and SMS usage levels having been on a downtrend over the period. Given the rising popularity of over-the-top operators (WeChat in China), and the already high level of SMS usage, SMS usage levels look likely to go down over the next 3 years. Voice usage levels are also likely to decline over our forecast period, mainly because we expect incremental customer usage levels to be low. China Mobile: voice minutes of usage per month forecasts


China Mobile: SMS usage volume trends

Source: Company

For 2014, we forecast China Mobile’s ARPU to fall by 3% YoY as the twin issues of declining voice and SMS usage, as well as the negative impact of the new interconnection policy, are likely to take their toll. However, we expect the ARPU to resume its upward march from 2015, driven by rising data usage, and also because we believe the company’s drive to expand handset subsidies in 2014 will encourage customers to sign up for higher tariff plans. Signing up for higher tariff plans would be especially so as China Mobile’s shift to a subsidy-driven business model is in its early stages (started in 2013).

0%

20%

40%

60%

80%

100%

0

10

20

30

40

50

60

70

2009 2010 2011 2012 2013 2014E 2015E 2016E 2017E 2018E

Net additions (LHS) 3G/4G penetration (RHS) 4G penetration (RHS)

(million)

300

350

400

450

500

550

2009 2010 2011 2012 2013 2014E 2015E 2016E 2017E 2018E

Voice MOU

0

20

40

60

80

100

120

140

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013


- 54 -

We forecast its ARPU to rise at a 2% CAGR over the 2-year period from 2015-16E. China Mobile: mobile average revenue per subscriber forecasts


Wire-line segment: broadband likely a niche focus In December 2013, China Mobile was granted permission by the regulator to enter the fixed-line services market. Prior to this, the company had been working in cooperation with China Tietong, a fixed-line operator owned by its parent company, in rolling out broadband services, since 2011. While China Mobile now has the leeway to develop its wire line business with fewer restrictions, we continue to believe the company’s focus will be targeted primarily at corporate clients and high-end retail customers. As such, we do not think the broadband market will contribute significantly to its customer numbers or revenue over our forecast period. China Mobile: fixed-broadband data points Criteria Remarks Customers Corporate leased line (IP-VPN) customers of 0.781m at end 2012; 1m as of 1H13Partnerships Tietong has fixed-broadband market share of less than 13% as of 2013

Source: Company

Financials

Revenue mix to shift towards non-voice services We forecast 2014 service revenue growth of 4.2% YoY, a sharp slowdown from the 6.8% CAGR seen over 2010-13 due to the negative effects of the revised interconnection rates in force from January 2014, and as we forecast the revenue decline for SMS (2014: -6.2% YoY; 2013: 4.9%) to accelerate amid a fall in volumes.

It is important to note that the lowering of the interconnection rates is a key factor behind our expectation for a contraction in voice segment revenue for 2014 (2014E -6.3% YoY). While alternative forms of communications such as the ‘push-to-talk’ functionality provided by the WeChat application will divert some demand for voice services, we do not think they will be effective substitutes for voice calls, as the technology for carrying continuous voice calls over the OTT platform still suffers from quality issues. China Mobile: service revenue growth forecasts


However, we expect revenue growth to accelerate to a 7.9% CAGR over the next 2-year period from 2015-16, supported by a rise in wireless data and applications revenue. Overall, we expect mobile non-voice services (mobile data and application) to be the key driver of revenue growth and expect its contribution to overall service revenue to rise from 35.0% to 49.8% over 2013-16. We expect the contribution of voice and SMS services to fall to 45.2% and 3.8%, respectively, over this period. China Mobile: revenue composition forecasts


50

55

60

65

70

75

80

2009 2010 2011 2012 2013 2014E 2015E 2016E 2017E 2018E

Blended ARPU

(CNY)

10.8%

6.8%

4.2%

7.9%

5.3%

0%

2%

4%

6%

8%

10%

12%

2007-10 2010-13 2014E 2014-16E 2016-19E

Service revenue

60.2%

45.2%35.0%

49.8%

0%

10%

20%

30%

40%

50%

60%

70%

80%

2010 2011 2012 2013 2014E 2015E 2016E

Mobile-voice Mobile non-voice


- 55 -

China Mobile: non-voice sub-segment forecasts


Cost escalation likely to remain an issue We forecast the company’s operating margin to decline by 5.3pp over 2013-16, driven by our expectation of a 4.3pp fall in the service EBITDA margin and a sharp rise in depreciation expenses, both over this period. China Mobile: key margin forecasts


We expect the service EBITDA margin to be under pressure during our forecast period because of the following factors. China Mobile: 2013 operating expenses composition

Source: Company

First, the company is in the early stages of implementing its subsidy-driven handset acquisition programme, which would dilute its EBITDA margin. We forecast handset subsidies to rise from 4.5% of service revenue in 2013 to 5.6% by 2016, and to stabilise thereafter. China Mobile: handset subsidy and marketing costs trends


Second, its LTE network expansion strategy means network and support expenses would increase before the company is in a position to monetise its investments. Also, the significant increase in 3G subscribers in 2013 would imply that the company’s lease costs – China Mobile rents its 3G network capacity from its parent company – will likely rise. We forecast leased costs and other expenses (which include network maintenance costs etc) to rise by 2.5pp relative to service revenue over 2013-15. China Mobile: personnel cost drivers

2010 2011 2012 2013 Remarks Total staff ('000) 477 499 517 535 Permanent workers 164 175 182 194

% change 7% 4% 7% Headcount continues to increase

Average annual wage (CNY '000) 22.2 24.9 27.2 28.6 Including third party labour costs

% change 12% 9% 5% Average wage per permanent employee (CNY '000) 39.5 42.2 43.7 45.6

Excluding third party labour costs

7% 3%


Third, we do not expect company to be able to keep its personnel costs in check, partly given wage inflation and as it is unlikely to rationalise its workforce. We note that while China Mobile’s employee benefit expenses (2013: 6% of service revenue) appear low relative to its competitors, this is partly because the company relies on third party labour, the costs of which are classified under ‘other expenses’. Adjusted for this aspect, personnel costs accounted for 10% of service revenue in 2013 (China Unicom: 13.3%; China Telecom: 16%).

7.0% 3.8%

28.0%

46.0%

0%

10%

20%

30%

40%

50%

2010 2011 2012 2013 2014E 2015E 2016E

SMS Non-voice (ex-SMS)

40.7%

37.2%38.2%

33.8%

21.5% 16.3%

0%

10%

20%

30%

40%

50%

60%

2010 2011 2012 2013 2014E 2015E 2016E

Service EBITDA margin EBITDA margin Operating margin

Depreciation21.2%

Leased lines3.8%

Employee expenses

12.2%

Interconnection5.3%Sales and

marketing18.6%

Others (maintenance

etc)26.6%

Cost of goods sold

12.4%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

15%

17%

19%

21%

23%

25%

2010 2011 2012 2013 2014E 2015E 2016E

Subsidy and sales and marketing as % service revenue (LHS)

Subsidy as % mobile service revenue (RHS)


- 56 -

China Mobile: key expenses forecasts 2010 2011 2012 2013 2014E 2015E 2016E

Service revenue growth 7.3% 8.8% 6.1% 5.4% 4.2% 8.4% 7.4%Operating revenue growth 7.3% 8.8% 6.1% 12.4% 6.4% 9.3% 7.6%Adjusted Cash opex growth 10.4% 12.6% 10.5% 13.4% 11.0% 10.0% 5.1%Total Opex growth 9.6% 12.6% 8.8% 20.6% 12.6% 11.0% 6.8%Key components Depreciation 7.5% 12.6% 3.8% 3.8% 7.8% 10.2% 10.8%Leased lines 29.6% 33.1% 91.0% 89.0% 31.5% 21.9% 7.4%Employee expenses 14.6% 21.2% 13.4% 9.0% 7.0% 7.0% 7.0%Interconnection 0.2% 7.5% 6.8% 3.4% 1.8% 8.4% 7.4%Sales and marketing 13.2% 6.9% 8.3% -12.5% 3.9% 8.4% 7.4%Others (maintenance etc) 7.9% 14.9% 8.1% 15.7% 12.2% 8.7% 3.0%Subsidy 11% 30% 18% 0%Sale of telecom products 40% 20% 10%Cost of telecom products 39% 20% 6%


Earnings mix and growth China Mobile’s earnings mix is slightly unusual when compared with its regional peers because of its vast cash reserves. The interest income on its net cash balance together with the earnings contribution from its investment in Shanghai Pudong Bank accounted for 12% of its pre-tax earnings in 2013. We expect this ratio to rise to 19% by 2016E. Adjusting for tax effects, this implies the interest income and associates’ contribution to its profits would increase from 13.7% to 18.5% from 2013 to 2016E. China Mobile: contribution of net interest income and associates’ profits to pre-tax forecasts


Overall, we forecast a 2013-16 EPS CAGR of -2% (2010-13 CAGR was +1%) and the net margin to fall by 4.5pp over this period.

China Mobile: earnings growth and net margin forecasts


Capex likely on an uptrend and to peak in 2015 China Mobile increased its capital expenditure YoY in 2013, and we expect this trend to continue in 2014 given its aggressive TD-LTE expansion plans. From 2015, we look for capex to start tapering off (see chart below). China Mobile: mobile base stations forecasts


China Mobile said it spent CNY31bn in 2013 on constructing its TD-LTE network. Given its ambitious expansion targets (eg, a target of 500,000 base stations by 2014), we forecast its LTE-related capex levels to continue to be elevated at CNY75m a year over 2014-15. We forecast the company’s total capex to be in the region of CNY200-225bn a year for 2014-15 (30-37% of service revenue) and to fall to CNY179.1m, or 25% of service revenue, for 2016.

0%

2%

4%

6%

8%

10%

12%

2010 2011 2012 2013 2014E 2015E 2016E

Net interest income Associates income

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

(20%)

(15%)

(10%)

(5%)

0%

5%

10%

15%

2010 2011 2012 2013 2014E 2015E 2016E

Net profit growth (LHS) Net margin (RHS)

0%

20%

40%

60%

0

500

1,000

1,500

2,000

2,500

3,000

2007 2008 2009 2010 2011 2012 2013 2014E 2015E 2016E

Base station (LHS) 3G base station proportion

4G base station proportion


- 57 -

China Mobile: capex forecasts


China Mobile has, in the past, underestimated its capex outlays ahead of time, especially when guiding 2 years ahead. However, the company has been able to meet the guidance it issues at the beginning of any given financial year over the past 5 years. Given this, there is broader uncertainty as to whether China Mobile’s plans to move towards voice-over-LTE (VoLTE) and LTE-advanced technologies in time would keep its capex at elevated levels from 2015. While possible, we expect capex levels to fall gradually starting from 2015 and expect its capex-to-sales ratio to stabilise at about the 18% level. Our 2017 capex forecast is still 24% above the 2012 level, the year prior to the LTE-network build expansion phase. China Mobile: capex guidance history

Capex (CNYbn) Deviation from guidance (%)

Year Guidance two

years ago Guidance

one-year ago Actual Two years ago One-year ago 2007 78 100 105 35% 5%2008 98 127 136 39% 7%2009 119 134 129 9% -3%2010 131 123 124 -5% 1%2011 98 132 129 31% -3%2012 130 132 127 -2% -3%2013 126 185 47%

Source: Company

Free cash flow generation to slow over 2014-16E We believe China Mobile’s free cash flow generation over 2014-16 will be low, as we expect high levels of capex over this period. We forecast the company to generate cumulative free cash flow after interest expenses (FCFE) of CNY138bn over 2014-16E (2011-13: CNY251bn) which equates to an average of CNY1.6/share each year. We expect FCFE generation to pick up once the LTE-investment cycle is complete, likely from 2017.

China Mobile: free cash flow and operating cash flow forecasts


Balance sheet: working capital management remains a key issue China Mobile’s balance sheet is likely to remain highly under-geared over our forecast period. We believe the absence of a pro-active approach to managing its capital structure has been a source of frustration for many minority shareholders over the years. Despite this, we see no catalyst in sight that suggests an imminent turnaround. China Mobile: net debt/EBITDA ratio forecasts


There are 2 aspects to China Mobile’s balance sheet that we find interesting, apart from the obvious under-leverage issue. One relates to the payable days, which appear high in absolute terms (around 4-5 months of sales) but are still below peers. However, this appears to be due to the favourable credit terms afforded to the company given its scale of operations, and as such we think is unlikely to reverse anytime soon. The other area relates to the build-up of deferred revenue liabilities on its balance sheet over 2010-13. We believe this was likely a consequence of the handset buying process in China.

0%

5%

10%

15%

20%

25%

30%

35%

40%

0

50

100

150

200

250

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

E

2015

E

2016

E

Cash Capex (LHS) Capex/service revenue (RHS)

(CNYbn)

(50)

0

50

100

150

200

250

300

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

E

2015

E

2016

E

Free cash flow to equity Operating cash flow

(CNYbn)

(2.0)

(1.8)

(1.6)

(1.4)

(1.2)

(1.0)

(0.8)

(0.6)

(0.4)

(0.2)

0.0

2010 2011 2012 2013 2014E 2015E 2016E


- 58 -

Our reading of the accounting treatment involved is as followings: 1) the customer pays full price for the device upfront and gets a tariff rebate on a monthly basis, and 2) the company expenses the subsidy involved upfront on the income statement and books the portion of cash received upfront, which is then used to offset tariff rebates in future months as deferred revenue. This would suggest that the company’s working capital cash inflow should increase during years when it increases the size of its handset subsidy programme. In our opinion, this is positive, though only marginally, as the company’s balance sheet position is already very strong. China Mobile: balance sheet analysis

2010 2011 2012 2013 2014E 2015E 2016ENon-current assets (CNYbn) 540 570 606 700 819 898 949Net cash 259 304 374 415 371 375 409Financed by (%) Net working capital 28% 26% 26% 29% 29% 29% 28%Equity 72% 74% 74% 71% 71% 71% 72%Payables (days of sales) 147 144 147 172 176 174 170Deferred revenue as % cash 17% 17% 15% 15%


Dividend policy China Mobile’s dividend payout ratio rose steadily over 2002-05 from 20% to 39%, was further increased to 47-48% over 2006-07, but has remained at around the 43% level since 2008. The company’s approach to dividend declarations is not very clear-cut, as it has not disclosed a formal minimum dividend commitment for future years. We assume its dividend payout ratio remains constant at 43% over our forecast period, suggesting a fall in DPS levels compared to 2013. While the company could pay more, based on the strength of its balance sheet, we are not confident that it would given its track record.

China Mobile: dividend and payout ratio forecasts


Asset returns – key issues In our view, China Mobile has a superior asset return profile compared with its peers in China. Most of its key metrics of interest, such as ROA, ROE and ROIC,

are still in a healthy range albeit that they have been steadily declining over the past 5 years. In particular, its ROE and ROA have been depressed by the build-up of cash on its balance sheet. Looking ahead however, we expect a further deterioration in these key metrics, due partly to our outlook for muted net-profit growth amid an expansion of its fixed asset base. A Dupont analysis of our forecasts suggests the trend of the weakening ROE profile is mainly a consequence of a fall in operating margins over our forecast period. Could a deteriorating asset return profile weigh on the share-price outlook? While possible, we expect the market to look toward an upturn in the asset turnover ratio as a sign that China Mobile’s 4G data monetisation efforts are paying off. China Mobile: key return ratios


China Mobile: 5-factor Dupont return on equity breakdown

2010 2011 2012 2013 2014E 2015E 2016EAdjusted EBIT margin 31.8% 30.1% 28.4% 22.8% 18.3% 17.0% 17.8%Asset Turnover 60% 58% 56% 57% 56% 57% 57%Interest burden 103% 105% 108% 110% 112% 111% 110%Tax efficiency 75% 76% 76% 77% 76% 76% 76%Leverage ratio 149% 148% 146% 147% 148% 148% 147%Return on average equity (%) 22.1% 20.5% 18.8% 16.1% 12.7% 12.0% 12.5%


Forecasts versus consensus

Our 2014-15 EPS forecasts are 5-9% below those of the Bloomberg consensus, due partly to our expectation of a weak EBITDA profile over the period (we forecast the service EBITDA margin to range from 32.6-33.8% over 2014-15 compared with 38.2% for 2013). We think the market may not have factored in the full extent to which the company’s cost structures could be adversely affected as it implements its handset subsidy-driven acquisition model in pursuit of its leadership ambitions in China’s 4G services market.

25.0%

30.0%

35.0%

40.0%

45.0%

50.0%

0.04

0.54

1.04

1.54

2.04

2.54

3.04

2010 2011 2012 2013 2014E 2015E 2016E

DPS (LHS) Payout ratio (RHS)

(CNY)

0%

10%

20%

30%

40%

50%

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

E

2015

E

2016

E

ROA ROE ROIC Op cash flow ROCE


- 59 -

Further, while our 2014-15 revenue forecasts are not significantly higher than those of the consensus, we are unsure from the details available to us (consensus service and product revenue breakdown is not available to us), whether the consensus has fully factored in the regulatory impact of lower interconnect rates in 2014. China Mobile: Daiwa forecasts vs. consensus (%)

2014E 2015E 2016ESales 1 4 4 EBITDA (6) (5) 2 Adjusted net profit (7) (4) 10 Adjusted EPS (9) (5) 6 DPS (6) (13) 8

Source: Bloomberg, Daiwa forecasts

Earnings-forecast revision trends The Bloomberg consensus has cut its 2014-15 earnings and EBITDA forecasts steadily by 18-26% and 12-14%, respectively, for China Mobile over the past 2 years. This was likely due to the market factoring in the impacts of company’s 4G network expansion plans and changes by the regulator (new interconnection rulings issued in 2013). China Mobile: Bloomberg-consensus EPS-forecast revisions

Source: Bloomberg

China Mobile: Bloomberg-consensus EBITDA-forecast revisions

Source: Bloomberg

Do the consensus revisions matter to the share price? Given the recent trend of downward consensus revisions, and because our forecasts suggest further continuation of this risk trend, we think a key question that needs be addressed is to what extent consensus revisions drive the stock. Over the past 6 years, the consensus had a pretty good track record of forecasting the company’s earnings and EBITDA one year in advance. However, despite slightly positive revisions, China Mobile’s share price was relatively immune to these developments for many of these years. This suggests to us that the market’s share-price reaction was in response to perceived changes in the company’s long-term competitive positioning rather than its near-term earnings. Further, while we expect the consensus to continue cutting its forecasts, this is partly due to changes in the company’s business model. As such, we think that in the coming months, the market may once again focus its attention more on the likely improvement in the company’s competitive position (as determined by revenue market share) than on possible downward earnings revisions by the consensus, especially as valuations are low compared with its past-10-year trading history. China Mobile: consensus EPS-forecast revisions

2006 2007 2008 2009 2010 2011 2012 20131-year forward EPS 9% 10% -2% -2% 2% 3% 1% 0%2-year forward EPS 38% 19% -15% -3% 4% 3% -5%

Source: Bloomberg

China Mobile: consensus EBITDA-forecast revisions

2006 2007 2008 2009 2010 2011 2012 20131-year forward EBITDA 8% 14% -3% 1% 2% 4% -2% -1%2-year forward EBITDA 21% 8% -11% 1% 6% 0% -6%

Source: Bloomberg

China Mobile: consensus’s revisions to earnings and share-price performance

Source: Bloomberg

5.5

6.5

7.5

8.5

Oct

-11

Dec-

11

Feb-

12

A pr-1

2

Jun-

12

Aug-

12

Oct

-12

Dec-

12

Feb-

13

A pr-1

3

Jun-

13

Aug-

13

Oct

-13

Dec-

13

Feb-

14


(CNY)

240,000

250,000

260,000

270,000

280,000

290,000

300,000

310,000

Oct

-11

Dec-

11

Feb-

12

Apr-1

2

Jun-

12

Aug-

12

Oct

-12

Dec-

12

Feb-

13

A pr-1

3

Jun-

13

Aug-

13

Oct

-13

Dec-

13

Feb-

14

Consensus 2014 EBITDA Consensus 2015 EBITDA

(CNY)

(15%)

(10%)

(5%)

0%

5%

10%

15%

20%

25%

2009 2010 2011 2012 2013



- 60 -

Valuation Methodology We value China Mobile using a 10-year DCF model with the following inputs: a weighted average cost of capital of 10.5%, comprising a 6% equity-risk premium and 0% long-term debt-to-capital ratio, and a terminal FCF growth rate of 2.0%. In addition, we value the company’s investment in Shanghai Pudong Bank (600000 CH, Not rated) at 20% below its current market value, because it holds only a minority equity stake, and factor in a HKD4.7/share reduction to accommodate the impact that we expect from the VAT-reform process. Key value drivers Our 10-year DCF-model assumes a FCF margin on service revenue will rise from 2.5% in 2014, to 12.1% by 2023. This is driven by our expectation that the company’s capex will decline starting from 2015, to reach a steady state rate of 19% of service revenue from 2017. China Mobile: Daiwa’s free cash flow to firm margin forecasts Margin on service revenues 2014E 2015E 2016E 2017E 2018E Terminal (2023)

EBITDA 36.8% 35.8% 37.2% 37.3% 37.2% 36.9%Capex -36.6% -29.0% -25.0% -20.0% -18.0% -18.0%Change in net working capital 4.3% 3.6% 2.1% 1.9% 1.3% 1.1%Taxes Paid -5.5% -5.1% -5.3% -5.3% -5.1% -6.1%Free cash flow to the firm (margin) -1.5% 4.8% 8.6% 13.4% 14.8% 13.1%


In our model, we factor in CNY7.5/share (10% of the fair value) contribution from efficient working-capital management and a minus CNY30.1/share contribution (-40% of fair value) due to tax effects.

China Mobile: key components of Daiwa’s valuation (excluding VAT-reform and the stake in Pudong Bank)


China Mobile: impact of the VAT reform, currency movements and the Pudong-bank stake


Note: Investment value is from Pudong Bank stake

Sensitivity analysis on long-term margins Embedded in our valuation framework is an expectation that the FCF margin will rise over the long term. We estimate that a 1PP decrease in the terminal FCF margin would impact our valuation by HKD2.5/share (3% of our target price). Implied multiples’ historical bands Our target price translates into 2015E PER, EV/EBITDA, and PBR multiples of 13.4x, 4.3x and 1.56x, respectively. The past-10-year average trading multiples for the stock are: PER of 12.1x, EV/EBITDA of 4.7x and PBR of 2.5x. The past-5-year average trading multiples for the stock are: PER of 11.0x, EV/EBITDA of 4.1x and PBR of 1.9x.

76.8 74.6

7.5

30.120.4

0

10

20

30

40

50

60

70

80

90

Simple free cash flow

Working capital management

Tax effects Net cash Fair value for core

(CNY/share)

94.0

86.6

1.74.7

4.5

82

84

86

88

90

92

94

96

98

Fair value at spot price

Investments VAT-reform Currency movements

Target price

(HKD/share)


- 61 -

China Mobile: 10-year forward EV/EBITDA bands

Source: Company, Daiwa forecasts, Bloomberg

China Mobile: 10-year forward PER bands


China Mobile: 10-year forward adjusted EV/EBITDA bands


China Mobile: 10-year forward PBR bands


China Mobile: 10-year forward dividend yield bands


China Mobile: 10-year forward EV/EBIT bands


2

4

6

8

10

12

14

Jan-

03

Jan-

04

Jan-

05

Jan-

06

Jan-

07

Jan-

08

Jan-

09

Jan-

10

Jan-

11

Jan-

12

Jan-

13

Jan-

14

+1 stdevMean

12M forward EV/EBITDA (x)

-1 stdev

+2 stdev

8

13

18

23

28

Jan-

03

Jan-

04

Jan-

05

Jan-

06

Jan-

07

Jan-

08

Jan-

09

Jan-

10

Jan-

11

Jan-

12

Jan-

13

Jan-

14

+1 stdevMean

12M forward PER (x)

-1 stdev

+2 stdev

2

4

6

8

10

12

14

Jan-

03

Jan-

04

Jan-

05

Jan-

06

Jan-

07

Jan-

08

Jan-

09

Jan-

10

Jan-

11

Jan-

12

Jan-

13

Jan-

14

+1 stdevMean

12M forward Adjusted EV/EBITDA pre-lease

-1 stdev

+2 stdev

1

2

3

4

5

6

7

Jan-

03

Jan-

04

Jan-

05

Jan-

06

Jan-

07

Jan-

08

Jan-

09

Jan-

10

Jan-

11

Jan-

12

Jan-

13

Jan-

14

+1 stdevMean

12M forward PBR (x)

-1 stdev

+2 stdev

2%

3%

4%

5%

Jan-

03

Jan-

04

Jan-

05

Jan-

06

Jan-

07

Jan-

08

Jan-

09

Jan-

10

Jan-

11

Jan-

12

Jan-

13

Jan-

14

+1 stdev

Mean

12M forward Dividend Yield (%)

-1 stdev

+2 stdev

-2 stdev

4

6

8

10

12

14

16

18

20

Jan-

03

Jan-

04

Jan-

05

Jan-

06

Jan-

07

Jan-

08

Jan-

09

Jan-

10

Jan-

11

Jan-

12

Jan-

13

Jan-

14

+1 stdevMean

12M forward EV/EBIT (x)

-1 stdev

+2 stdev


- 62 -

Impact of VAT-reform on our implied multiples

The following tables show the P&L profile and implied valuation multiples under a few different scenarios for the VAT reform. Base-case scenario (minus HKD4.7/share impact on our valuation) This scenario assumes: 1) applicable VAT input tax rates of 11% for voice and 6% for value-added services, and a VAT price pass-through proportion ratio of 15%, and 2) cost reductions that equate to roughly 4% savings compared with our current forecasts over 2H14-2016 period. Under this scenario, China Mobile would trade at 2015 PER, EV/EBITDA and PBR ratios of 13.2x, 3.8x, and 1.37x, respectively. China Mobile: base-case scenario for VAT reform impact (CNYbn)

2012 2013 2014E 2015E 2016EService revenue 560 591 600 634 681Revenue 560 630 654 697 750Cash expenses 309 390 435 474 502EBITDA 254 240 219 222 248Pre-tax profit 171 159 129 122 136Net profit 129 122 97 92 102EBITDA margin 45.3% 38.2% 33.4% 31.9% 33.1%Service EBITDA margin 45.3% 40.7% 36.4% 35.1% 36.5%Book value 723 789 834 886 956Net debt -374 -415 -365 -362 -395Valuations (x) PBR 1.46 1.45 1.37 1.27EV/EBITDA 3.1 3.9 3.8 3.3PER 9.5 12.4 13.2 11.8


Worst-case scenario (minus HKD12.2/ share impact on our valuation) This scenario assumes: 1) applicable VAT input tax rates of 11% for both voice and value-added services, and a VAT price pass-through proportion ratio of 0%, and 2) cost reductions that equate to roughly 3% savings compared with our current forecasts over the 2H14-16 period. Under this scenario, China Mobile would trade at 2015 PER, EV/EBITDA and PBR ratios of 17.0x, 4.4x, and 1.40x, respectively.

China Mobile: worst-case VAT-reform scenario (CNYbn) 2012 2013 2014E 2015E 2016E

Service revenue 560 591 591 614 659Revenue 560 630 644 675 726Cash expenses 309 390 437 479 507EBITDA 254 240 206 195 219Pre-tax profit 171 159 117 94 106Net profit 129 122 88 71 80EBITDA margin 45.3% 38.2% 32.0% 29.0% 30.2%Service EBITDA margin 45.3% 40.7% 34.9% 31.8% 33.3%Book value 723 789 824 865 933Net debt -374 -415 -355 -341 -372Valuations (x) PBR 1.46 1.47 1.40 1.30EV/EBITDA 3.1 4.1 4.4 3.8PER 9.5 13.7 17.0 15.1Source: Company, Daiwa forecasts

Best-case scenario (plus HKD2.1/share impact on our valuation) This scenario assumes: 1) applicable VAT input tax rates of 11% for voice and 6% for value-added services, and a VAT price pass-through proportion ratio of 30%, and 2) cost reductions that equate to about 6% savings compared with our current forecasts over the 2H14-16 period. Under this scenario, China Mobile would trade at 2015 PER, EV/EBITDA, and PBR ratios of 10.9x, 3.4x, and 1.34x, respectively. China Mobile: best-case scenario for VAT reform impact (CNYbn) 2012 2013 2014E 2015E 2016EService revenue 560 591 606 647 695Revenue 560 630 661 711 766Cash Expenses 309 390 431 464 491EBITDA 254 240 230 247 275Pre-tax profit 171 159 141 147 163Net profit 129 122 106 111 123 EBITDA margin 45.3% 38.2% 34.8% 34.7% 35.9%Service EBITDA margin 45.3% 40.7% 37.9% 38.1% 39.5%Book value 723 789 842 905 976Net debt -374 -415 -374 -381 -415 Valuation P/Book 1.46 1.44 1.34 1.24EV/EBITDA 3.1 3.6 3.4 2.9PER 9.5 11.4 10.9 9.9FCFF/EV 5.7% -0.4% 5.5% 9.4%



- 63 -

Appendix

Company background

China Mobile was incorporated under Hong Kong law in September 1997, with the mobile-telecommunications assets of two provinces injected initially by the former Ministry of Posts and Telecommunications. The company then undertook a series of acquisitions involving its parent China Mobile Communications Corporation (CMCC) over 1997-2004 that expanded the company’s geographical coverage to all 31 provinces and autonomous regions in Mainland China. In 2006, China Mobile expanded into Hong Kong via the acquisition of China Resources People’s Telephone Company. Later, the company acquired a 20% stake in Shanghai Pudong Bank in 2010.

Following the industry-wide restructuring in 2008, China Mobile entered into an agreement with CMCC, which is valid to date, to lease TD-SCDMA network capacity. As of the end of December 2013, the company had a nationwide footprint in China and Hong Kong for its cellular communications services. It also obtained permission from the China regulator in December 2013 to launch fixed-line services. For 2013, China Mobile had the distinction of being the largest wireless operator in China and the world with 767m subscribers.

Shareholding structure

China Mobile’s ordinary shares are listed on the Hong Kong Stock Exchange, and its American Depositary Shares (ADS), each currently representing the right to receive 5 ordinary shares, are listed on the New York Stock Exchange. The parent China Mobile Communications Corporation effectively owns a 74.1% equity stake in the company. The company’s free float is about 25.9%.

China Mobile: summary of key corporate developments Date Target/Related entity Seller/Buyer Remarks Key acquisitions Sep-97 Asset injection (2 provinces) Ministry of Posts Guangdong and Zhejiang Mobile assets

1998-2004 Series of acquisitions

China Mobile Communications Corporation (CMCC)

Jun-98 Acquisition (1 provinces) CMCC Jiangsu (consideration HKD22.5bn or USD2.9bn)

Nov-99 Acquisition (3 provinces) CMCC Fujian, Henan, Hainan (consideration HKD49.7bn - USD6.9bn - comprising cash of HKD19.0bn and 1,273m new shares)

Nov-00 Acquisition (7 provinces) CMCC Beijing, Shanghai, Tianjin, Hebei, Liaoning, Shandong, Guangxi (Consideration HKD256bn - USD32.8bn - comprising cash of USD74.6bn and 3,779m new shares)

Jul-02 Acquisition (8 provinces) CMCC Anhui, Jiangxi, Chongqing, Sichuan, Hubei, Hunan, Shaanxi, Shanxi (consideration USD8.573bn comprising initial payment of USD5.773bn and a deferred consideration of USD2.880bn) Initial payment of USD5.773bn comprising cash of USD3.150bn + new stock issued to Vodafone

Jul-04 Acquisition (10 provinces+ 2 companies) CMCC

Neimenggu, Jilin, Heilongjiang, Guizhou, Yunnan, Xizang, Gansu, Qinghai, Ningxia, Xinjiang (consideration USD3.650bn comprising initial payment of USD2bn and deferred consideration of USD1.65bn)

Mar-06 People's Telephone Company Mobile operator based in Hong Kong ((Consideration of HKD3.384bn or USD436m) Mar-11 China Topssion CMCC Engaged in the sale of handsets and devices (Consideration CNY237m) Key investments Oct-10 20% equity in Shanghai Pudong Bank Consideration of CNY39.5bn (USD6.0bn) Aug-12 15% equity in Anhui USTC Consideration of CNY1.36bn (USD218m) Key agreements

Dec-08 to date TD-SCDMA network capacity lease China Mobile leases TD-SCDMA network capacity from its parent CMCC (annual fees based on capacity used; 2013: CNY3.9bn)

Key acquisitions of parent CMCC May-08 China Tietong Provider of fixed-line services acquired as part of industry restructuring

Source: Company


■ Investment case We initiate coverage of China Telecom, the largest fixed-line services operator and the third-largest wireless operator in China, with an Outperform (2) rating, as we see the current valuations of the stock as very low. For 2013-18, we forecast an EBITDA CAGR of 7.8%, driven by a 3.5pp gain in mobile-service revenue market share over the period. (Based on our base-case scenario for the introduction of value-added-tax [VAT], which factors in output VAT rates of 6-11% among others, we estimate the EBITDA CAGR would be 5.2%.) Consequently, we forecast an annual average free cash flow yield over 2014-18 of 7.4% (we estimate it would be 5.2% after factoring in the

VAT-reform impact), which we regard as appealing. Within the sector, China Telecom is our second preferred stock. We prefer it to China Unicom (762 HK, HKD10.16) even though we have Outperform (2) ratings for both, because it is less exposed to Renminbi-depreciation risks and it should be better-positioned to navigate the VAT-reform challenges. On the other hand, as the company faces slightly elevated technology-evolution risks than its peers, we prefer China Mobile (941 HK, HKD71.35, Buy [1]) to China Telecom over the short term. ■ Catalysts The issuance of FDD-LTE licences in 2014 would be a key share-price catalyst, in our view, as it would allow the company to transition its services to 4G. ■ Valuation Given the lingering uncertainties about the VAT reform, we do not factor it into our earnings forecasts. However, as we believe it is easier to assess the reform effects on valuations, we determine a DCF-based fair value for the stock, then apply a reduction of HKD0.5/share to get our 6-month target price of HKD4.00.

■ Risks The key risk to our call would be any significant delay in the issuance of an FD-LTE licence.


4 April 2014

China Telecom

Initiation: attractive valuation, good long-term prospects

• Valuations are compelling, while stock offers growth prospects over the long term

• Company better positioned than China Unicom with respect to Renminbi-depreciation risks

• Initiating coverage with an Outperform (2) rating



China Telecom728 HK


BuyOutperform (initiation)

HoldUnderperformSell

1

2

3

4

5

80

88

95

103

110

3.0

3.3

3.6

3.9

4.3



China Tele (LHS) Relative to HSI (RHS)

(HKD) (%)

12-month range 3.15-4.22Market cap (USDbn) 36.523m avg daily turnover (USDm) 23.70Shares outstanding (m) 80,932Major shareholder China Telecom Group (70.9%)

Financial summary (CNY)Year to 31 Dec 14E 15E 16ERevenue (m) 346,138 371,790 404,149Operating profit (m) 31,586 33,026 34,435Net profit (m) 19,795 20,936 22,007Core EPS (fully-diluted) 0.245 0.259 0.272EPS change (%) 12.8 5.8 5.1Daiwa vs Cons. EPS (%) (2.9) (8.3) (11.7)PER (x) 11.4 10.8 10.3Dividend yield (%) 3.0 3.2 3.4DPS 0.085 0.090 0.095PBR (x) 0.8 0.7 0.7EV/EBITDA (x) 2.9 2.7 2.5ROE (%) 7.0 7.0 7.0


[email protected]




- 65 -

Growth outlook China Telecom: service-revenue growth forecasts

We forecast a service-revenue CAGR of 7.6% over 2013-16, representing a slowdown compared with the 10.0% CAGR over the 2010-13 period. We expect this to be driven by the mobile-services division (2013-16E: 14.4% revenue CAGR), while we expect relatively modest revenue growth in the fixed-line division (2013-16E: 2.6% CAGR).


Valuation China Telecom: 2015E valuations

The stock is trading currently at a 34% discount to its past-10-year average EV/EBITDA multiple. After accounting for the likely impact of the VAT-reform measures the discount narrows to 24%. On a PBR basis, the discount is steeper, at 39% currently and 34% after the VAT-reform measures. However, China Telecom trades at a premium to its average PER valuation over the past 10 years, after taking into account the likely impact of VAT-reform measures.

EV/EBITDA PER PBRCurrent 2.7 10.8 0.74Post-VAT reform 3.1 15.6 0.79Past 10-year average 4.1 12.3 1.2Premium/discount to average Current (34) (13) (39)Post-VAT reform (24) 27 (34)


Earnings revisions China Telecom: consensus EPS-forecast revisions

The 2014-15 Bloomberg-consensus earnings forecasts have been cut steadily for China Telecom over the past 2 years. We see further downside risks to the 2015 consensus earnings forecasts. This is because we believe the market may not have factored in the full extent of the impact arising from the company’s network-expansion strategy.

Source: Bloomberg


Growth outlook

Valuation

Earnings revisions

6.1%10.0%

7.6% 6.4%

33.6%

14.4%11.1%

-2.4%

0.9% 2.6% 1.6%

(5%)

0%

5%

10%

15%

20%

25%

30%

35%

40%

2007-10 2010-13 2013-16E 2016-19E

Service revenue Mobile service Fixed-line

0.25

0.30

0.35

0.40

Oct

-11

Dec-

11

Feb-

12

Apr-1

2

Jun-

12

Aug-

12

Oct

-12

Dec-

12

Feb-

13

Apr-1

3

Jun-

13

Aug-

13

Oct

-13

Dec-

13

Feb-

14

Consensus 2014 EPS Consensus 2015 EPS

(CNY)



1

2

3

4

5


- 66 -

Key assumptions


Cash flow (CNYm)


Year to 31 Dec 2009 2010 2011 2012 2013 2014E 2015E 2016ESubscribers (m) 56.1 90.5 126.5 160.6 185.6 205.5 233.5 269.82G Subscribers 52.0 78.2 90.2 91.6 82.5 75.5 61.5 34.23G Subscribers 4.1 12.3 36.3 69.1 103.1 128.1 156.0 165.1


59.5 54.3 52.4 53.9 54.8 55.3 55.9 56.4

Access lines (m) 188.6 175.1 169.6 163.0 155.8 147.8 141.8 135.8Wireline Broadband Subscribers (m) 53.5 63.5 76.8 90.1 100.1 110.1 118.1 126.1Access line ARPU (CNY) 32.9 28.6 24.1 21.7 20.2 19.2 18.6 18.1

Year to 31 Dec 2009 2010 2011 2012 2013 2014E 2015E 2016EMobile 35,620 53,953 82,701 117,826 151,186 170,977 192,455 220,223Fixed Line 173,750 165,911 162,340 165,247 170,398 175,161 179,335 183,926Other Revenue 0 0 0 0 0 0 0 0Total Revenue 209,370 219,864 245,041 283,073 321,584 346,138 371,790 404,149Other income 0 0 0 0 0 0 0 0COGS 0 0 0 0 0 0 0 0SG&A (133,716) (144,053) (169,688) (212,232) (225,033) (241,033) (259,118) (282,127)Other op.expenses (52,243) (51,656) (51,224) (49,655) (69,083) (73,519) (79,646) (87,587)Operating profit 23,411 24,155 24,129 21,186 27,468 31,586 33,026 34,435Net-interest inc./(exp.) (4,375) (3,600) (2,254) (1,564) (5,153) (5,411) (5,339) (5,329)Assoc/forex/extraord./others 892 492 139 171 773 203 203 203Pre-tax profit 19,928 21,047 22,014 19,793 23,088 26,378 27,890 29,309Tax (4,549) (5,031) (5,416) (4,753) (5,422) (6,463) (6,833) (7,181)Min. int./pref. div./others (204) (118) (96) (115) (121) (121) (121) (121)Net profit (reported) 15,175 15,898 16,502 14,925 17,545 19,795 20,936 22,007Net profit (adjusted) 15,175 15,898 16,502 14,925 17,545 19,795 20,936 22,007EPS (reported)(CNY) 0.188 0.196 0.204 0.184 0.217 0.245 0.259 0.272EPS (adjusted)(CNY) 0.188 0.196 0.204 0.184 0.217 0.245 0.259 0.272EPS (adjusted fully-diluted)(CNY) 0.188 0.196 0.204 0.184 0.217 0.245 0.259 0.272DPS (CNY) 0.075 0.071 0.070 0.068 0.075 0.085 0.090 0.095EBIT 23,411 24,155 24,129 21,186 27,468 31,586 33,026 34,435EBITDA 75,654 75,811 75,353 70,841 96,551 105,105 112,672 122,022

Year to 31 Dec 2009 2010 2011 2012 2013 2014E 2015E 2016EProfit before tax 19,928 21,047 22,014 19,793 23,088 26,378 27,890 29,309Depreciation and amortisation 52,243 51,656 51,224 49,655 69,083 73,519 79,646 87,587Tax paid (4,625) (3,448) (4,064) (4,011) (5,422) (6,463) (6,833) (7,181)Change in working capital 5,432 5,485 5,336 6,009 13,984 3,376 4,296 5,419Other operational CF items 6,792 4,363 1,184 834 (7,232) 5,208 5,136 5,126Cash flow from operations 79,770 79,103 75,694 72,280 93,501 102,018 110,134 120,260Capex (40,311) (41,597) (48,495) (50,028) (79,992) (80,300) (97,948) (106,297)Net (acquisitions)/disposals (23) (41) (6) 0 0 0 0 0Other investing CF items (2,921) (4,096) 4,864 1,776 (27,956) 0 0 0Cash flow from investing (43,255) (45,734) (43,637) (48,252) (107,948) (80,300) (97,948) (106,297)Change in debt (2,220) (32,483) (21,453) (14,431) 10,571 0 0 0Net share issues/(repurchases) 0 0 0 0 0 0 0 0Dividends paid (6,493) (5,608) (6,174) (5,625) (5,522) (6,098) (6,880) (7,276)Other financing CF items (20,862) (4,212) (2,781) (1,359) (4,562) (5,411) (5,339) (5,329)Cash flow from financing (29,575) (42,303) (30,408) (21,415) 487 (11,509) (12,219) (12,606)Forex effect/others 43 1,480 (265) 923 (395) 0 0 0Change in cash 6,983 (7,454) 1,384 3,536 (14,355) 10,209 (33) 1,357Free cash flow 39,459 37,506 27,199 22,252 13,509 21,718 12,186 13,963

Financial summary


- 67 -


Key ratios (%)


Company profile

China Telecom is an integrated information-services operator. The company provides cellular services, based on a CDMA technology platform, in addition to fixed-line and broadband services in China. As at the end of 2013, it had 156 wire-line subscribers and mobile subscribers of about 186m. China Telecom’s H shares and American Depositary Shares are listed on Hong Kong stock exchange and the New York Stock Exchange, respectively.

As at 31 Dec 2009 2010 2011 2012 2013 2014E 2015E 2016ECash & short-term investment 35,246 27,792 29,176 32,712 18,357 28,566 28,533 29,890Inventory 2,628 3,170 4,840 5,928 6,523 7,021 7,541 8,198Accounts receivable 17,438 17,328 18,471 18,768 20,022 21,551 23,148 25,163Other current assets 5,624 6,955 7,089 7,802 7,881 7,962 8,044 8,126Total current assets 60,936 55,245 59,576 65,210 52,783 65,100 67,266 71,376Fixed assets 297,895 289,693 287,325 406,227 418,498 433,324 451,627 470,337Goodwill & intangibles 42,233 39,888 37,633 39,132 37,962 29,917 29,917 29,917Other non-current assets 25,456 22,529 34,581 34,503 33,996 33,996 33,996 33,996Total assets 426,520 407,355 419,115 545,072 543,239 562,337 582,806 605,626Short-term debt 53,155 31,027 20,953 16,735 47,760 47,759 47,759 47,759Accounts payable 86,909 93,251 104,212 175,072 151,136 156,538 162,951 171,041Other current liabilities 3,417 2,645 2,093 1,654 1,202 1,202 1,202 1,202Total current liabilities 143,481 126,923 127,258 193,461 200,098 205,499 211,912 220,002Long-term debt 52,768 42,549 31,150 83,073 62,617 62,617 62,617 62,617Other non-current liabilities 7,658 5,919 3,829 2,508 1,860 1,860 1,860 1,860Total liabilities 203,907 175,391 162,237 279,042 264,575 269,976 276,389 284,479Share capital 80,932 80,932 80,932 80,932 80,932 80,932 80,932 80,932Reserves/R.E./others 140,800 150,536 175,158 184,137 196,809 210,506 224,561 239,292Shareholders' equity 221,732 231,468 256,090 265,069 277,741 291,438 305,493 320,224Minority interests 881 496 788 961 923 923 923 923Total equity & liabilities 426,520 407,355 419,115 545,072 543,239 562,337 582,806 605,626EV 298,169 272,891 250,326 294,668 319,554 309,344 309,377 308,020Net debt/(cash) 70,677 45,784 22,927 67,096 92,020 81,810 81,843 80,486BVPS (CNY) 2.740 2.860 3.164 3.275 3.432 3.601 3.775 3.957

Year to 31 Dec 2009 2010 2011 2012 2013 2014E 2015E 2016ESales (YoY) 12.1 5.0 11.5 15.5 13.6 7.6 7.4 8.7EBITDA (YoY) (9.1) 0.2 (0.6) (6.0) 36.3 8.9 7.2 8.3Operating profit (YoY) (20.1) 3.2 (0.1) (12.2) 29.7 15.0 4.6 4.3Net profit (YoY) (39.4) 4.8 3.8 (9.6) 17.6 12.8 5.8 5.1Core EPS (fully-diluted) (YoY) (39.4) 4.8 3.8 (9.6) 17.6 12.8 5.8 5.1Gross-profit margin 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0EBITDA margin 36.1 34.5 30.8 25.0 30.0 30.4 30.3 30.2Operating-profit margin 11.2 11.0 9.8 7.5 8.5 9.1 8.9 8.5Net profit margin 7.2 7.2 6.7 5.3 5.5 5.7 5.6 5.4ROAE 7.0 7.0 6.8 5.7 6.5 7.0 7.0 7.0ROAA 3.5 3.8 4.0 3.1 3.2 3.6 3.7 3.7ROCE 7.0 7.6 7.9 6.3 7.3 8.0 8.1 8.1ROIC 6.0 6.4 6.5 5.3 6.0 6.4 6.5 6.6Net debt to equity 31.9 19.8 9.0 25.3 33.1 28.1 26.8 25.1Effective tax rate 22.8 23.9 24.6 24.0 23.5 24.5 24.5 24.5Accounts receivable (days) 30.3 28.9 26.7 24.0 22.0 21.9 21.9 21.8Current ratio (x) 0.4 0.4 0.5 0.3 0.3 0.3 0.3 0.3Net interest cover (x) 5.4 6.7 10.7 13.5 5.3 5.8 6.2 6.5Net dividend payout 39.7 36.2 34.1 37.0 34.8 34.8 34.8 34.8Free cash flow yield 17.4 16.6 12.0 9.8 6.0 9.6 5.4 6.2



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Attractive valuation, good long-term prospects

Investment thesis

We initiate coverage of China Telecom with an Outperform (2) rating and 6-month DCF-based target price of HKD4.00. Our positive investment thesis is premised on our belief that: 1) the risks from the implementation of the VAT-reform measures are largely discounted by the market, and 2) the company will be able to deliver moderate free-cash-flow and EBITDA growth over the medium term, as we expect FDD-LTE licences to be awarded by the end of 2014. However, the company faces slightly more of a risk with respect to technology obsolescence than its peers, in our opinion, as we believe the CDMA-handset supply chain will weaken in the years ahead, as some of the proponents of this technology (Verizon [not rated] and KDDI [9433 JP, JPY5,759, Outperform [2]) have migrated to 4G FD-LTE networks. As such, securing a 4G FD-LTE licence without significant delays would be crucial to ensuring the company’s long-term competitiveness in the mobile segment. Given the uncertainty surrounding the timeframe of FD-LTE licence issuance, we prefer China Mobile (941 HK, HKD71.35, [1] Buy) to China Telecom over the short term.

Business strategy

China Telecom’s strategy over the coming years is likely to centre on improving the scale of its mobile business by investing in 4G networks, and strengthening competitiveness in the wire-line business by upgrading its broadband-network infrastructure. At its 4Q13 results briefing on 19 March, the company disclosed its key strategic thrusts, highlighting the following initiatives.

1) A major phase of its fixed-broadband network upgrade project has been completed. In 2014, the company’s focus will be on the promotion of high-speed broadband products (100Mbps price plans) and value-added applications such as iTV and OTT-TV. 2) In the cellular segment, it intends to run integrated 3G/4G network operations. 3) In 2014, it plans to boost 3G customer subscriptions in rural areas by promoting “cheap” handsets (price points below CNY299), as its network utilisation rates are still low (35% for 2013). 4) For 4G services, it plans to rely on a hybrid platform that supports both the TD-LTE and FD-LTE technology standards, and intends to roll out the services progressively, starting from key hotspot areas (which can be found in shopping malls and densely populated areas) in key cities. 5) China Telecom launched TD-LTE commercial services in 100 cities in February this year (for data-card users) and is currently waiting to secure trial licences for FD-LTE technology. 6) The company said it could launch 4G services for smartphone users within a month of its obtaining FD-LTE licences. 7) Even after securing the relevant FD-LTE licences, the company intends to focus its investment in these 100 cities, as currently they collectively account for more than 70% of the mobile-data traffic generated on its networks. Overall, China Telecom’s 4G services (on TD-LTE) are currently marketed to data-card customers, and we believe the company will have to wait for FD-LTE licences before it can target the more lucrative smartphone-customer segment. China Telecom: key aspects of its 4G strategy Category Remarks Network strategy 3G CDMA 2000 2x10MHz in 800MHz band; 2x15MHz in 2100MHz band

4G TD-LTE To be used for hotspots; 40MHz bandwidth spread in 2300MHz and 2500MHz bands

4G FDD-LTE Conducting trials in 1800MHz band Handset Mode To promote 4-mode (FDD-LTE/CDMA2000/WCDMA/GSM) handsets Target volumes Targeting 36m 4G terminals in 2014 Price To sell 3G handsets below the CNY299 price point in rural areas Tariffs 4G data-card tariffs on a par with those of China Mobile TD-LTE coverage plans Coverage 100 cities covered by Feb 2014; Capex CNY42.3bn in mobile capex planned in 2014 (mainly for 4G)

Source: Company, Daiwa


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Implications

Fixed-division performance is important Unlike its rivals, China Telecom derives a major proportion of its revenue from the provision of fixed-line services (2013: 60% of service revenue). As such, trends in fixed-line services are equally as important for the company as those in the mobile division. The 4Q13 results, which saw a 3.1% YoY increase in fixed-line revenue, were encouraging, given the 2-5% YoY declines seen over 2009-11, and also because they defied the conventional thinking among investors that fixed-line operations were a structurally declining business across the world. In particular, we believe that China Telecom’s focus on value-added services and on enterprise segments appears to be paying off, and forecast fixed-line service revenue to rise at a 2.4% CAGR over 2013-16. Share of industry revenue pie likely to remain steady, but we see gains in mobile We forecast China Telecom to improve its revenue market share in the mobile segment by 2.7pp over the next five years (2014-18) to reach 16.8% by 2018. However, given the differential growth rates we expect between the fixed-line and mobile segments, we forecast China Telecom’s share of overall industry revenue to be stable at 25-26% over 2014-18. China Telecom: industry service and mobile-service revenue market-share forecasts


Prospects of moderate growth appears attractive We are forecasting a five-year EBITDA CAGR of 7.8% (5.2% after factoring in the VAT-reform impact) over 2013-18. On our forecasts the stock offers an average free cash flow to enterprise value yield over 2014-18 of 5.2%, which we see as attractive.

Relative preferences

We prefer China Telecom to China Unicom Given the short-term challenges ahead for the company (the lack of a FD-LTE licence is a key hurdle), we prefer China Mobile to China Telecom. However, we prefer China Telecom to China Unicom, because: 1) China Telecom has a superior balance sheet (2013: net debt/EBITDA of 1.0x compared with 1.4x for China Unicom), and 2) its earnings are less exposed to currency-depreciation risks.

What could go wrong?

The Korea experience, according to our analyst Thomas Kwon, highlights the difficulties that confront fixed-line operators that are also late adopters of the LTE technology. Over the past 3 years, KT Corp (030200 KS, KRW29,100, Hold [3]) has recorded weak revenue in the fixed-line market. Meanwhile, it has lost 1.5pp in subscriber market share in the LTE-mobile segment over this period, because it entered the market in 2012, a year behind its rivals. The share price of KT Corp is trading at 37% below its level at the end of 2010. By contrast, the share price of incumbent SK Telecom (017670 KS, KRW207,000, Outperform [2]) is 19% above its end-2010 level, while smaller rival LG Uplus (032640 KS, KRW9,960, Outperform [2]), which has been the most aggressive operator in LTE, saw its share price appreciate by 39% over the period.

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KT Corp: performance data 2010 2011 2012 2013 Remarks

Market share (%) Mobile 31.6% 31.5% 30.8% 30.1% KT lost 1.5pp in market share LTE segment 0.0% 24.7% 27.7% Fixed-line revenue growth (% YoY) 8.8 -5.9 -8.0 -6.7 Fixed-line performance was weak Annual share-price performance (%) KT Corp 18% -23% 0% -11% KT’s shares are 37% below end-

2010 level; SKT: +19%; LGU:+39%

SK Telecom 2% -18% 8% 51% LG Uplus -16% 3% 5% 38%

Source: Companies, Bloomberg, Daiwa estimates

For China Telecom, we expect a good fixed-line revenue performance over 2013-15 because of the company’s focus on value-added services and enterprise customers. Further, we expect its mobile broadband market share to recover from 2016.

Investment risks

Some of the key risks to our positive call arise from the following sources. 1) An increase in competitive pressure could affect our earnings forecasts negatively. 2) Significant delays in the issuance of FDD-LTE licences or changes to the company’s strategy (for example, adopting TD-LTE as its main 4G technology standard) could have negative repercussions on our market-share forecasts. 3) Any worse-than-anticipated revenue trend in the fixed-line division could also affect our target price negatively, as the company derives a major proportion of its revenue from this segment (for 2013, 60% of service revenue came from the fixed-line segment).


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Operational trends

Customer shift towards 3G and 4G networks to continue China Telecom has been the most successful company among its peers in driving 3G adoption among its customers. The proportion of 3G customers among the company’s mobile subscriber base rose from 7% at the end of 2009 to 56% at the end of 2013. This compares with 25% for China Mobile and 44% for China Unicom, at the end of 2013. Among other factors, we believe that strong management execution was critical in achieving this. In 4G, we expect the company to have a relatively slow start in terms of the number of mobile subscribers due to a reliance on the FD-LTE platform as its main 4G technology standard. We believe FD-LTE licences will be awarded by 1H15. However, we expect China Telecom’s 4G subscriber base to rise significantly from 2016, and account for 59% of the company’s mobile subscriber base by 2018. China Telecom: mobile subscriber additions and 3G and 4G mobile-subscriber mix and net-addition forecasts


ARPU likely to be on an upward trend We expect average voice-call usage levels to trend down over our forecast period. Despite this, we believe average revenue per user (ARPU) will be on an uptrend over 2013-16, supported by a rise in the popularity of bundled package offers and an increase in the consumption of data services. China Telecom: voice minutes of usage/month


The SMS usage level is low for China Telecom compared with its peers, and as such we believe cannibalisation risk from the rising popularity of over-the-top (OTT) applications, such as WeChat, is relatively small. China Telecom: SMS usage volume

Source: Company

China Telecom was able to raise its ARPU steadily from 2012 by promoting the iPhone on its network, following a deal with Apple. For 2014-16, we forecast blended ARPU to rise at 1.0% CAGR compared with a CAGR of 0.4% over 2010-13.

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China Telecom: mobile average revenue per subscriber


Wire-line segment: broadband remains the key We expect China Telecom’s customer growth in the broadband business to slow over 2014-16, because of the entry of China Mobile into the fixed-line business since late 2013. However, we forecast the broadband ARPU to be relatively firm over the period (2013-16E: a compound annual decline of 2.7% compared with a compound annual decline of -7.0% over 2009-13). China Telecom: fixed-broadband subscriber additions and ARPU


Meanwhile, we expect the traditional fixed-line access users and legacy voice ARPU to continue to trend down over 2014-16, albeit at a slower rate than at the 2010-13 period. We forecast a compound annual decline of 3.7% for voice ARPU over 2013-16 (2010-13: a compound annual decline of 11.0%).

China Telecom: wire-line access additions and ARPU


Our expectations for a decrease in the rate of slowdown in ARPU for broadband and fixed-line segments are based on the following: 1) China Telecom is promoting bundled offers to mitigate ARPU pressure on wire-line voice. 2) The company is pursuing a strategy of upgrading speed and technology for broadband access in order to facilitate the delivery of value-added services. For example, China Telecom has been steadily upgrading its broadband network access speed across its coverage footprint since 2011. In key southern cities, it has started providing fibre-to-the-home (FTTH) services to improve the customer experience. Also, it has launched new products, such as iTV, cloud-based services, online games and video applications, that leverage on the high bandwidth speeds made possible by its network upgrade strategy. China Telecom: key drivers of broadband business

2010 2011 2012 2013 1H13Broadband subs (m) 63 77 90 100FTTH/B subscribers 15 27 21FTTH subscribers as a % broadband subscribers 17% 27%Southern cities: 20Mbps access speed coverage ratio 58% 71% 82%Subscribers with speed greater than 4Mbps 27% 50% 73%Broadband capex (CNYbn ) 27.6 33.1 35.9 33.0

Source: Company

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Financials

Revenue mix to shift in favour of mobile services We forecast a service-revenue CAGR of 7.6% for 2013-16, slower than the 10% CAGR seen over 2010-13. We expect this to be driven by strong growth in the company’s mobile-services division (2013-16E: 14.4% revenue CAGR), combined with a relatively modest revenue-growth performance for the fixed-line division (2013-16E: 2.6% CAGR). China Telecom: revenue growth forecasts


We expect the company’s non-voice mobile services to be the key revenue-growth driver over 2013-16 and expect its contribution to overall service revenue to rise from 19.5% to 26.4% over this period. As, unlike its peers, China Telecom derives the bulk of its revenue from the provision of fixed-line services (2013: China Telecom: 60.0%, China Unicom: 36.3%, and China Mobile: 0%), we expect this division to account for a major proportion of service revenue over 2013-16 (2016E: China Telecom: 51.9%, China Unicom: 29.4%, and China Mobile: 0%), despite the shift in mix towards mobile services. In particular, we forecast the proportion of broadband services as a percentage of overall revenue to remain relatively high over 2013-16 (2016E: 40.9%).

China Telecom: revenue composition forecasts


Cost escalation likely to remain an issue We forecast the operating margin to be flat over 2013-16, as we expect network-support expenses to rise at a faster rate than sales. China Telecom: key margins


China Telecom’s service EBITDA margin (excluding lease payments, which ceased from 2013) fell by 7.7pp over the 2010-13 period, due to a sharp increase in its handset-subsidy costs brought about by the company’s entry in the mobile segment following the industry’s restructuring in 2009. China Telecom: 2013 operating expenses composition

Source: Company

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For 2014, we forecast the service EBITDA margin to rise by 0.5pp YoY to 34.5%, driven by our expectation of a fall in interconnection expenses following the change in related regulations in January 2014, and as we expect the company to rein in sales and marketing expenditure to mitigate a likely increase in network expenses that we see in 2014. However, we expect the trend that we have been seeing for service EBITDA margin expansion to halt in 2015-16, for the following reasons: First, the company’s handset-subsidy-driven customer-acquisition model, which has been in place since 2009, has reached a steady state level. Given this, and the company’s conservative accounting practises (i.e., its subsidies are fully booked upfront. This is different from China Unicom, which recognises lower subsidies upfront as it books a proportion of monthly commitment fees as handset sales), we forecast handset subsidies to fall from accounting for 20.0% of mobile-service revenue in 2013 to 18.4% in 2014E, and reach 16.1% by 2016E. China Telecom: handset subsidy and marketing costs trends


Second, we expect increases in marketing and network expenses to negate the positive effects of a maturing handset subsidy cycle over 2015-16. We believe sales and marketing activities are likely to intensify after the government awards the FD-LTE licences, which is likely to happen before 1H15. Furthermore, we think the growth in network expenses is likely to outpace service revenue growth over this period. China Telecom: personnel costs drivers

2010 2011 2012 2013 Remarks

Total permanent staff ('000) 312 310 306 309

Split between temporary/contract workers has not been disclosed

Average annual wage (CNY '000) 113.7 125.9 139.1 152.1 % change 11% 10% 9% Wage inflation

Source: Company

Meanwhile, given the rampant wage-price inflation in China (9-11% YoY over the past 3 years on our estimates), we see little scope for cost controls in the area of personnel expenses, another key contributor to the company’s operating expenses (2013: 15.9% of total opex). China Telecom: key expenses

2010 2011 2012 2013 2014E 2015E 2016EService revenue growth 4.8% 7.9% 11.9% 10.1% 7.3% 7.1% 8.5%Operating revenue growth 5.0% 11.5% 15.5% 13.6% 7.6% 7.4% 8.7%Adjusted cash opex growth 7.6% 12.6% 20.6% 0.2% 6.5% 7.0% 8.6%Total opex growth 4.9% 12.8% 18.5% 12.3% 6.9% 7.7% 9.1%Key components D&A -1.1% -0.8% -3.1% 39.1% 6.4% 8.3% 10.0%Network expenses -1.6% -0.2% 19.3% 31.3% 10.3% 11.5% 8.5%Employee expenses 8.1% 10.2% 9.3% 9.1% 8.0% 7.0% 7.0%Interconnection 15.5% 17.2% 8.1% 12.9% -8.7% 4.6% 13.4%Sales, marketing & others -0.7% 9.2% 23.3% 15.3% 7.1% 4.1% 8.5%Leases 58.9% 42.7% 34.4% -100.0% Subsidies 15% 30% 41% 4% 4% 4% 10%Sales of telecoms products 11% 132% 73% 50% 10% 10% 10%Costs of telecoms products 0% 159% 80% 53% 10% 10% 10%Source: Company, Daiwa forecasts

Earnings growth We forecast an EPS CAGR of 8% over 2013-16 (2010-13 CAGR was 3%) and for the net-profit margin to remain stable over this period at around 5-6%. Given the low absolute level that we see for the net margin over this period, we expect earnings volatility to be high. China Telecom: earnings growth and net-profit margin


Capex on an up-cycle We forecast China Telecom’s capex to remain elevated over the 2014-16 period, driven by its strategy to invest in building broadband and mobile infrastructure. Thus, we expect 2014-16E capex to range from CNY80bn to CNY106bn, which translates into a capex/sales ratio of 28-30% over this period.

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China Telecom: capex


We expect the company to earmark about 43% of its annual capex over our forecast period to roll out mobile networks and a further 37% to upgrade its broadband infrastructure. China Telecom: capex breakdown


While China Telecom increased its spending on broadband investments over 2009-13 (CNY153bn versus CNY83bn over 2004-08), we expect absolute spending to remain stable at about CNY36bn a year given the company’s ambitious plans to roll out high-speed broadband services across its coverage footprint. China Telecom: capex composition Criteria RemarksBroadband capex 2004-08: CNY82.9bn; 2009-13: CNY153bnTotal mobile capex (assets acquired from parent) 2009-13: CNY132.0bnMobile base station 2012: 0.27m (Unicom: 0.74m; Mobile: 1.1m)

Source: Company

When will the capex cycle peak? We forecast the capex/sales ratio to stabilise at around the 25% level from 2017. This steady state rate is higher than the 20% level incurred by the company over 2009-12, as it started investing directly in mobile business only from 2013, following the purchase of the assets from its parent.

FCF generation to slow over 2014-16E We expect China Telecom’s free cash flow generation to slow over 2014-16 as its capex is likely to increase. We forecast the company to generate a cumulative free cash flow after interest expenses (FCFE) of CNY31.8bn over 2014-16E (2011-13: CNY53.5bn), which equates to an average of CNY0.2/share each year. We expect the FCFE generation to pick up once the capex cycle normalises, likely from 2017. We note that the company’s FCF profile is not directly comparable to what we have seen in the past as the company was leasing its mobile network from its parent over 2009-12. China Telecom: FCF and operating cash flow


Balance sheet: working capital management remains a key issue Based on conventional debt ratio metrics, such as net debt/EBITDA, we think the balance sheet was fairly levered in 2013. China Telecom: net debt / EBITDA ratio (x)


The company’s funding structure (2013: 57% of non-current assets were financed by equity; 19% with debt) seems appropriate to us. One area of concern is the relatively high level of payables on its books (equivalent to 5-8 months of sales over the past four years) but this

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appears to be a reflection of good vendor credit terms enjoyed by all the telecoms operators in China. More importantly, we do not think this is going to reverse anytime soon. China Telecom: key balance-sheet metrics

2010 2011 2012 2013 2014E 2015E 2016ENon-current assets (CNYbn) 352 360 480 490 497 516 534Financed by (%) Net working capital 19% 21% 30% 24% 24% 24% 24%Net debt 13% 6% 14% 19% 16% 16% 15%Equity 66% 71% 55% 57% 59% 59% 60%Payables (days of sales) 153 153 223 169 163 158 152Source: Company, Daiwa forecasts

Dividend policy China Telecom maintained the absolute quantum of its dividend to shareholders, at HKD0.085 per share over the 2006-12 period. Excluding 2008, a year when profitability was very low due to asset-impairment charges taken by the company, the dividend-payout ratio ranged from 25% to 42% over this period. The company has not disclosed a formal minimum dividend commitment for future years. We are however assuming a payout ratio of 35% in our forecasts, given its track record. China Telecom: dividend and payout ratio


Asset returns: key issues China Telecom’s key asset return ratios (ROA, ROE and ROIC) were in a low range over 2004-13 due to a large asset base deployed for the provision of mature fixed-line services. Based on a Dupont analysis of our forecasts, we expect the return on equity to be relatively stable at around 7% as we expect an improvement in the asset-turnover ratio, driven by its expansion into the mobile segment, to be negated by a slight fall in the operating margin, due to its network expansion plans.

China Telecom: key return ratios


Note: 2008 data omitted because of distortion caused by industry restructure

China Telecom: 5-factor Dupont return on equity breakdown

2010 2011 2012 2013 2014E 2015E 2016EAdjusted EBIT margin 11.1% 9.9% 7.5% 8.8% 9.2% 8.9% 8.6%Asset turnover 53% 59% 59% 59% 63% 65% 68%Interest burden 85% 91% 93% 82% 83% 84% 85%Tax efficiency 76% 75% 76% 77% 76% 76% 76%Leverage ratio 184% 170% 185% 200% 194% 192% 190%Return on average equity (%) 7.0% 6.8% 5.7% 6.5% 7.0% 7.0% 7.0%Source: Company, Daiwa forecasts

Forecasts versus Bloomberg consensus

Our 2014-15 EPS forecasts are 2-13% below those of the Bloomberg consensus due partly to our expectation of an increase in depreciation expenses (2015: 8% YoY) over this period. China Telecom: Daiwa’s forecasts versus those of the Bloomberg consensus

2014 2015 2016Sales (2) (3) (1)EBITDA 1 (1) 7 Adjusted net profit (1) (11) 1 Adjusted EPS (2) (13) 7 DPS 4 (5) 12


Earnings revisions The 2014-15 Bloomberg-consensus earnings forecasts have been revised down steadily for China Telecom over the past 2 years by 23-25%.

25%

27%

29%

31%

33%

35%

37%

39%

0.04

0.05

0.06

0.07

0.08

0.09

0.10

2010 2011 2012 2013 2014E 2015E 2016E


(CNY)

(1%)

1%

3%

5%

7%

9%

11%

13%

15%

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

E

2015

E

2016

E



- 77 -

China Telecom: Bloomberg-consensus revisions to EPS forecasts

Source: Bloomberg

China Telecom: Bloomberg-consensus revisions to EBITDA forecasts

Source: Bloomberg

Do consensus revisions matter? As our forecasts imply a possible risk of the consensus cutting its 2015 EPS forecasts, a key question that we think needs be addressed is to what extent consensus revisions drive the share price. History suggests that the consensus has in general overestimated the company’s earnings every year since 2006; however, it does appear that the share price is correlated to consensus earnings revisions. China Telecom: consensus’ revisions to annual earnings

2006 2007 2008 2009 2010 2011 2012 20131-year forward EPS 16% -3% -13% -13% -3% -12% -10% -3%2-year forward EPS -2% -20% -41% -19% -16% -33% -14%

Source: Bloomberg

China Telecom: consensus’s revisions to annual EBITDA

2006 2007 2008 2009 2010 2011 2012 20131-year forward EBITDA 2% 0% -5% -6% -2% -6% -7% 1%2-year forward EBITDA -3% -9% -15% -8% -7% -17% 3%

Source: Bloomberg

China Telecom: Bloomberg consensus revisions to EPS and share-price performance

Source: Bloomberg

0.25

0.30

0.35

0.40

Oct

-11

Dec-

11

Feb-

12

Apr-1

2

Jun-

12

Aug-

12

Oct

-12

Dec-

12

Feb-

13

Apr-1

3

Jun-

13

Aug-

13

Oct

-13

Dec-

13

Feb-

14

Consensus 2014 EPS Consensus 2015 EPS

(CNY)

100,000

105,000

110,000

115,000

120,000

125,000

130,000

Oct

-11

Dec-

11

Feb-

12

A pr-1

2

Jun-

12

Aug-

12

Oct

-12

Dec-

12

Feb-

13

A pr-1

3

Jun-

13

Aug-

13

Oct

-13

Dec-

13

Feb-

14

Consensus 2014 EBITDA Consensus 2015 EBITDA

(CNY)

(20%)

(15%)

(10%)

(5%)

0%

5%

10%

15%

20%

25%

30%

2009 2010 2011 2012 2013



- 78 -

Valuation Methodology We value China Telecom using a 10-year DCF model with the following inputs: a weighted average cost of capital of 9.7%, comprising a 6% equity-risk premium, a 30% long-term debt-to-capital ratio, and a terminal free cash flow growth rate of 2.0%.

In addition, we factor in a HKD 0.5/share reduction to our fair value to accommodate the anticipated impact of the VAT-reform process.

Key value drivers Our 10-year DCF-model assumes the free cash flow margin on service revenue will decline from 7.6% in 2014 to 7.4% by 2023. This is driven by our expectation that the capex cycle will reach a steady state rate of 25% of service revenue from 2017. China Telecom: FCF to firm margin forecasts Margin on service revenue 2014 2015 2016 2017 2018 Terminal (2023)EBITDA 34.5% 34.5% 34.4% 35.0% 34.7% 34.2%Capex -26.3% -30.0% -30.0% -25.0% -25.0% -25.0%Change in net working capital 1.1% 1.3% 1.5% 1.3% 1.1% 0.8%Taxes paid -2.1% -2.1% -2.0% -2.2% -2.2% -2.8%Free cash flow to firm (margin) 7.6% 4.1% 4.3% 9.4% 8.9% 7.4%


Given the low FCF margin in 2015-16, China Telecom’s valuation is very sensitive to not only long-term EBITDA-margin and capex trends, but also to working-capital fluctuations and tax effects (especially arising from long-term trends in depreciation/capex). In our model, we factor in that CNY0.6/share (16% of fair value) will come from efficient working-capital management and that minus CNY1.6/share will come from (-43% of the fair value) tax effects. As such, any swings in working capital or tax savings, especially arising from changes in the company’s depreciation policies could significantly impact our valuation.

China Telecom: key components of the valuation of the core business (excluding VAT-reform impact)


China Telecom: impact of VAT reform and currency movements on Daiwa’s 6-month target price


Sensitivity analysis to long-term margins Embedded in our valuation framework is an expectation that the FCF margins will rise over the long term. A 1pp decrease in the terminal FCF margin, would impact our valuations by HKD0.4/share (10% of our target price). Implied multiples trading ranges Our 6-month target price translates into 2014E PER, EV/EBITDA and PBR multiples of 13.6x, 2.6x and 0.9x, respectively. The past-10-year average trading multiples for the stock are: PER of 12.3x, EV/EBITDA multiple of 4.1x and PBR of 1.2x. The past-5-year average trading multiples for the stock are: PER of 14.6x, EV/EBITDA multiple of 3.9x and PBR of 1.0x.

5.8

3.7

0.61.6

1.1

0

1

2

3

4

5

6

7




(CNY/share)

4.7

4.0

0.5

0.2

3.60

3.80

4.00

4.20

4.40

4.60

4.80


VAT-reform Currency movements Target price

(HKD/share)


- 79 -

China Telecom: 10-year forward EV/EBITDA bands


China Telecom: 10-year forward PER bands


China Telecom: 10-year forward adjusted EV/EBITDA bands


China Telecom: 10-year forward Price-to-book bands


China Telecom: 10-year forward dividend yields


China Telecom: 10-year forward EV/EBIT bands


2

3

4

5

6

7

8

Jan-

03

Jan-

04

Jan-

05

Jan-

06

Jan-

07

Jan-

08

Jan-

09

Jan-

10

Jan-

11

Jan-

12

Jan-

13

Jan-

14

+1 stdevMean


-1 stdev

+2 stdev

-2 stdev

2

7

12

17

22

Jan-

03

Jan-

04

Jan-

05

Jan-

06

Jan-

07

Jan-

08

Jan-

09

Jan-

10

Jan-

11

Jan-

12

Jan-

13

Jan-

14

+1 stdev

Mean

12M forward PER (x)

-1 stdev

+2 stdev

-2 stdev

3

4

5

6

7

8

Jan-

03

Jan-

04

Jan-

05

Jan-

06

Jan-

07

Jan-

08

Jan-

09

Jan-

10

Jan-

11

Jan-

12

Jan-

13

Jan-

14

+1 stdev

Mean


-1 stdev

+2 stdev

-2 stdev

0.5

1.0

1.5

2.0

2.5

Jan-

03

Jan-

04

Jan-

05

Jan-

06

Jan-

07

Jan-

08

Jan-

09

Jan-

10

Jan-

11

Jan-

12

Jan-

13

Jan-

14

+1 stdev

Mean

12M forward PBR (x)

-1 stdev

+2 stdev

-2 stdev

1%

2%

3%

4%

5%

Jan-

03

Jan-

04

Jan-

05

Jan-

06

Jan-

07

Jan-

08

Jan-

09

Jan-

10

Jan-

11

Jan-

12

Jan-

13

Jan-

14

+1 stdev

Mean


-1 stdev

+2 stdev

5

7

9

11

13

15

17

19

21

Jan-

03

Jan-

04

Jan-

05

Jan-

06

Jan-

07

Jan-

08

Jan-

09

Jan-

10

Jan-

11

Jan-

12

Jan-

13

Jan-

14+1 stdev

Mean


-1 stdev

+2 stdev


- 80 -

Impact of VAT reforms on our implied multiples

The following tables show the P&L profile and implied valuation multiples under a few different scenarios for the VAT reform. Base-case scenario (minus HKD0.5/share impact on our valuation) This scenario assumes: 1) applicable VAT input tax rates of 11% for voice and 6% for value-added services and a VAT price pass-through proportion ratio of 15%, and 2) cost reductions that equate to roughly 4% savings compared with our current forecasts over the 2H14-16 period. Under this outlook, China Telecom would trade at 2015 PER, EV/EBITDA and PBR ratios of 16.3x, 3.1x and 0.79x, respectively. China Telecom: base-case scenario on the impact of VAT reform CNYbn 2012 2013 2014 2015 2016Service revenue 258 284 297 310 337Revenue 283 322 337 353 384Cash expenses 212 225 236 249 271EBITDA 71 97 101 104 113Pre-tax profit 20 23 22 19 20Net profit 15 18 17 14 15EBITDA margin 25.0% 30.0% 30.0% 29.6% 29.5%Service EBITDA margin 27.5% 34.0% 34.1% 33.7% 33.6%Book value 265 278 288 299 313Net debt 67 92 85 89 88Valuation PBR 0.81 0.82 0.79 0.75EV/EBITDA 3.3 3.2 3.1 2.9PER 12.8 14.1 16.3 15.8


Worst-case scenario (minus HKD1.34/share impact on our valuation) This scenario assumes: 1) applicable VAT input tax rates of 11% for voice and value-added services, and a VAT price pass-through proportion ratio of 0%, and 2) cost reductions that equate to roughly 3% savings compared with our current forecasts over the 2H14-2016 period. Under this outlook, China Mobile would trade at 2015 PER, EV/EBITDA and PBR ratios of 65.8x, 3.7x and 0.82x, respectively.

China Telecom: bear-case scenario on the impact of VAT reform CNYbn 2012 2013 2014 2015 2016

Service revenue 258 284 293 300 326Revenue 283 322 332 342 372Cash expenses 212 225 237 251 274EBITDA 71 97 95 91 98Pre-tax profit 20 23 16 5 4Net profit 15 18 12 4 3EBITDA margin 25.0% 30.0% 28.6% 26.5% 26.4%Service EBITDA margin 27.5% 34.0% 32.4% 30.2% 30.1%Book value 265 278 283 288 301Net debt 67 92 90 100 101Valuation P/Book 0.81 0.83 0.82 0.78EV/EBITDA 3.3 3.4 3.7 3.4PER 12.8 20.1 65.8 74.9Source: Company, Daiwa forecasts

Best-case scenario (plus HKD0.27/share impact on our valuation) This scenario assumes: 1) applicable VAT input tax rates of 11% for voice and 6% for value-added services and a VAT price pass-through proportion ratio of 30%, and 2) cost reductions that equate to roughly 3% savings compared with our current forecasts over the 2H14-2016 period. Under this outlook, China Telecom would trade at 2015 PER, EV/EBITDA and PBR ratios of 9.7x, 2.7x and 0.76x, respectively. ■ China Telecom: best-case scenario on the impact of VAT-reform CNYbn 2012 2013 2014E 2015E 2016EService revenue 258 284 300 317 344Revenue 283 322 341 361 392Cash Expenses 212 225 234 244 265EBITDA 71 97 107 117 127Pre-tax profit 20 23 29 33 34Net profit 15 18 21 24 26EBITDA margin 25.0% 30.0% 31.4% 32.5% 32.4%Service EBITDA margin 27.5% 34.0% 35.7% 37.0% 36.9%Book value 265 278 293 309 324Net debt 67 92 80 78 76Valuation P/Book 0.81 0.81 0.76 0.73EV/EBITDA 3.3 3.0 2.7 2.5PER 12.8 11.0 9.7 9.1FCFF/EV 4.3% 7.1% 4.8% 5.4%



- 81 -

Appendix

Company background

China Telecom was incorporated in China in September 2002, with the assets of parent China Telecom Group located in 4 provinces and municipalities injected into the company. It then undertook a series of acquisitions involving its parent over 2002-08 that expanded the geographical coverage of its wire-line service offerings in Mainland China. China Telecom entered the cellular telecommunications business in 2008 following the purchase of the CDMA business (not the underlying assets) of China Unicom (part of the industry restructuring initiated by the government). The company leased CDMA network assets from its parent, China Telecom Group, from 2008-12, and acquired these assets (in 30 provinces) in December 2012. To-date, China Telecom Group continues to hold the relevant licences, while the listed company has exclusive right to operate the permitted businesses. As at 31 December 2013, the company had a nationwide foot print in China (and Macau) for its

cellular communications services. Its wire-line services, however, are offered mainly in the south China region, spanning 21 provinces (including municipalities and autonomous regions). As at the end of 2013, China Telecom was the third-largest wireless operator in China with 186m subscribers, and the largest fixed-line services operator with 156m subscribers.


China Telecom’s share capital comprises domestic shares, H-shares and American Depositary Shares (ADS). The domestic shares (82.5% of total share capital) are controlled by China Telecom Group and Guangdong Rising Assets Management. Its H-shares and ADS (17.1% of total share capital in aggregate) have been listed on the Stock Exchange of Hong Kong and the New York Stock Exchange, respectively, both since 2002. Parent China Telecom Group effectively owns 70.9% of the equity in the company, while Guangdong Rising Assets Management, an entity controlled by a state-owned enterprise owned and controlled by the provincial governments of Guangdong province, owns a 6.9% stake. The free-float of the company is about 17.1%.


- 82 -

China Telecom: summary of key corporate developments Date Target/related entity Seller/buyer Remarks Capital-raising activities Nov-02 IPO (issued 8.02bn H shares over Nov-Dec 2002 (offered at

HKD1.47/USD18.98 per share) May-04 Issued 5.3bn new H shares priced at HKD2.3/USD29.49 per share/ADS;

(raised CNY12.7bn in net proceeds) Key acquisitions Sep-02 Asset injection from parent (4

provinces) Parent China Telecom Group Shanghai, Guangdong, Jiangsu, Zhejiang (consideration CNY68.3bn ;

comprising of 68,317m domestic shares with CNY1 par value each) Dec-03 First Acquisition (6 provinces) Parent China Telecom Group Anhui, Fujian, Jiangxi, Guangxi, Chongqing, Sichuan (Consideration

CNY46bn ; CNY11bn upfront + CNY35bn long-term payable) Jun-04 Second Acquisition(10 provinces) Parent China Telecom Group Hubei, Hunan, Hainan, Guizhou, Yunnan, Shaanxi, Gansu, Qinghai,

Ningxia, Xinjiang (CNY27.8bn ; CNY8.34bn in cash and CNY19.46bn long-term)

Jun-07 Third Acquisition Parent China Telecom Group China Telecom System Integration Co; China Telecom Global Limited; China Telecom (Americas) Corporation (consideration CNY1.408bn )

Jun-08 Fourth Acquisition (1 province) Parent China Telecom Group Beijing (CNY5.557bn ) Jun-08 CDMA business China Unicom CNY43.8bn consideration (as part of industry restructuring) Aug-Dec 2011 Fifth Acquisition Parent China Telecom Group (Aug 2011) E-surfing Pay Co; (Dec 2011); E-surfing Media Co (total

consideration CNY61m) Apr-12 Sixth Acquisition Parent China Telecom Group Besttone Holding (consideration CNY48m); digital trunking business Dec-12 CDMA network Parent China Telecom Group CNY87.2bn consideration; CDMA fixed-assets in 30 provinces Key disposals Apr-11 100% equity in Besttone E-Commerce Besttone Holding Consideration payable in shares; 4.1% of Besttone Holdings enlarged

share capital Apr-13 80% equity in E-surfing Media co Parent China Telecom Group CNY1.248bn consideration Key business expansions, agreements and investments

Sept-2008 to Dec 2012 CDMA network lease China Telecom leased CDMA network infrastructure from its parent (annual fees: 28% of CDMA service revenue)

Aug-12 Parent China Telecom Group Lease of CDMA network facilities located in Xizang Autonomous Region Jun-13 iMUSIC Culture & Technology Co. Engaged in provision of music production and related information services Key acquisitions of parent China Telecom Group

Jul-08 CDMA network assets (acquisition) Parent Unicom Group CNY66.2bn consideration Jan-09 China Satellite (acquisition) State-Owned Assets Supervision and

Administration Commission of the State Council Zero consideration

Source: Company


■ Investment case China Unicom (China’s second-largest fixed-line and mobile operator by subscribers) outpaced its China competitors over 2010-13 with a total 3.5pp gain in revenue service market share, as it leveraged on the benefits conferred by its choice of 3G platform. We expect its pace of revenue market share gains to slow over 2014-16 as we believe rival China Mobile is likely to improve its competitiveness in the 4G era. Still, we believe China Unicom’s current efforts to up-sell its higher price plans to its customers should help it generate sound long-term earnings growth (2013-18E EBITDA CAGR of 8.1%, or 6.5% after the VAT-reform impact) – a prospect we find attractive, along with its appealing-looking valuations.

China Unicom possesses a slightly higher risk profile than its peers, in our view. Notably, we believe its earnings are more exposed than rivals to Renminbi depreciation risk and VAT-reform measures. As such, we think China Unicom is undervalued, but have a relative preference for its rivals China Mobile (941 HK, HKD71.35, Buy [1]) and China Telecom (728 HK, HKD3.50, Outperform [2]). We initiate coverage with an Outperform (2) rating. ■ Catalysts We believe details governing China’s VAT-reform programme, likely to emerge in 2014, could trigger a re-rating of the stock. We assume a negative HKD1.6/share impact in our valuation but believe this is priced in. The possible issuance of 4G FDD-LTE licences towards end-2014 is also a likely catalyst for the stock, as it should enable China Unicom to transition its services to 4G in a more straightforward manner. ■ Valuation Our DCF-based 6-month target price is HKD11.60. China Unicom trades at a 2015E EV/EBITDA of 2.8x (3.3x post the VAT-reform impact), which is well below its past-10-year average of 4.2x, and which we consider attractive.

■ Risks We see the key risks as any worsening of competitive pressures and delays in the issuance of FDD-LTE licences.


4 April 2014

China Unicom

Initiation: the one for risk takers

• Depressed valuations coupled with sound growth prospects • But risk profile is higher compared to its 2 China peers • Initiating with Outperform rating and DCF-based target price

of HKD11.60



China Unicom762 HK




1

2

3

4

5

90

100

110

120

130

9.0

10.1

11.3

12.4

13.5



China Unic (LHS) Relative to HSI (RHS)

(HKD) (%)

12-month range 9.17-13.26Market cap (USDbn) 31.153m avg daily turnover (USDm) 36.24Shares outstanding (m) 23,782Major shareholder China Unicom BVI Ltd (41.3%)

Financial summary (CNY)Year to 31 Dec 14E 15E 16ERevenue (m) 326,633 355,181 382,966Operating profit (m) 21,016 23,493 25,733Net profit (m) 11,569 15,473 17,259Core EPS (fully-diluted) 0.469 0.628 0.700EPS change (%) 11.2 33.7 11.5Daiwa vs Cons. EPS (%) (25.0) (18.6) (21.8)PER (x) 17.3 13.0 11.6Dividend yield (%) 2.2 2.9 3.3DPS 0.178 0.238 0.265PBR (x) 0.9 0.8 0.8EV/EBITDA (x) 3.2 2.8 2.6ROE (%) 5.2 6.7 7.1


[email protected]




- 84 -

Growth outlook China Unicom: service revenue CAGRs

We forecast a service revenue CAGR of 9.6% for China Unicom over 2013-16, representing a slowdown compared to the 13.3% CAGR over the 2010-13 period. We expect this to be driven by strong revenue growth from the company’s mobile services division (2013-16E: 13.7% CAGR), offset partially by a fairly modest revenue performance from its fixed-line division (2013-16E: 2.2% CAGR).


Valuation China Unicom: 2015E valuations

We focus our valuation multiples analysis for China Unicom on 2015E, as we believe that year enables us to capture the full-year impact of the upcoming VAT-reforms. Based on our 2015E numbers, the stock is trading at a 31% discount to its past-10-year average EV/EBITDA multiple. After accounting for the impact of VAT-reform measures, the discount narrows to 21%. On a PBR basis, the discounts are 24% and 18%, respectively. China Unicom is also trading at a discount to its average PERs, after taking into account the impact of VAT-reform measures. These depressed valuations underpin our Outperform (2) rating on the stock.

EV/EBITDA PER PBRCurrent (x) 2.9 12.8 0.84Current, post VAT reform (x) 3.3 20.8 0.90Past-10-year average (x) 4.2 24.2 1.1Premium/discount to average (%) Current (31) (47) (24)Current, post-VAT reform (21) (14) (18)


Note: current multiples are based on China Unicom’s share prices of 2 April 2014

Earnings revisions China Unicom: consensus 2014-15E EBITDA revisions

The 2014-15 Bloomberg consensus EBITDA forecasts for China Unicom were revised down steadily over the course of the past 2 years, due to an escalation in the company’s costs. Our 2014 and 2015 EBITDA forecasts are 2% and 3%, respectively, below the consensus ones, and we foresee further downside to the 2015 consensus earnings expectations. This is because we think the market may not have factored in the full extent of the impact likely arising from the company’s network expansion strategy.

Source: Bloomberg


Growth outlook

Valuation

Earnings revisions

20.1%

13.3%

9.6%

5.9%

9.5%

22.4%

13.7%

7.8%

2.7% 2.2%1.0%

0%

5%

10%

15%

20%

25%

2007-10 2010-13 2013-16E 2016-19E


90,000

95,000

100,000

105,000

110,000

115,000

120,000

125,000

Oct

-11

Dec-

11

Feb-

12

Apr-1

2

Jun-

12

Aug-

12

Oct

-12

Dec-

12

Feb-

13

Apr-1

3

Jun-

13

Aug-

13

Oct

-13

Dec-

13

Feb-

14

Consensus 2014E EBITDA Consensus 2015E EBITDA

(CNY)



1

2

3

4

5


- 85 -

Key assumptions


Cash flow (CNYm)


Year to 31 Dec 2009 2010 2011 2012 2013 2014E 2015E 2016ESubscribers 'million 147.6 167.4 199.7 239.3 281.0 318.5 354.1 388.02G Subscribers 144.9 153.4 159.6 162.9 158.4 145.3 125.7 100.33G Subscribers 2.7 14.1 40.0 76.5 122.6 169.5 214.0 222.5


41.5 43.6 46.9 47.9 48.4 48.9 49.4 49.9

Access lines (millions) 102.8 96.6 92.9 92.0 87.6 84.0 80.4 78.0

Wireline Broadband Subscribers (millions)

38.6 47.2 55.7 63.9 64.6 70.6 75.4 80.2

Access line ARPU 32.8 28.7 25.2 22.0 20.7 19.5 18.5 17.9

Year to 31 Dec 2009 2010 2011 2012 2013 2014E 2015E 2016EMobile 71,991 89,550 126,526 164,771 207,526 237,905 264,436 290,478Fixed Line 81,353 80,056 81,705 83,277 86,566 88,728 90,745 92,488Other Revenue 601 1,692 936 878 946 0 0 0Total Revenue 153,945 171,298 209,167 248,926 295,038 326,633 355,181 382,966Other income 0 0 0 0 0 0 0 0COGS 0 0 0 0 0 0 0 0SG&A (95,337) (111,706) (145,755) (176,267) (211,075) (232,574) (252,185) (271,760)Other op.expenses (47,587) (54,433) (58,021) (61,057) (68,196) (73,043) (79,503) (85,474)Operating profit 11,021 5,159 5,391 11,602 15,767 21,016 23,493 25,733Net-interest inc./(exp.) (945) (1,607) (1,244) (3,424) (2,940) (6,477) (3,749) (3,608)Assoc/forex/extraord./others 2,201 1,221 1,451 1,343 887 887 887 887Pre-tax profit 12,277 4,773 5,598 9,521 13,714 15,426 20,631 23,012Tax (2,721) (922) (1,371) (2,425) (3,306) (3,856) (5,158) (5,753)Min. int./pref. div./others 0 0 0 0 0 0 0 0Net profit (reported) 9,556 3,851 4,227 7,096 10,408 11,569 15,473 17,259Net profit (adjusted) 9,556 3,851 4,227 7,096 10,408 11,569 15,473 17,259EPS (reported)(CNY) 0.402 0.163 0.179 0.301 0.440 0.489 0.654 0.730EPS (adjusted)(CNY) 0.402 0.163 0.179 0.301 0.440 0.489 0.654 0.730EPS (adjusted fully-diluted)(CNY) 0.400 0.162 0.178 0.288 0.422 0.469 0.628 0.700DPS (CNY) 0.160 0.080 0.100 0.120 0.160 0.178 0.238 0.265EBIT 11,021 5,159 5,391 11,602 15,767 21,016 23,493 25,733EBITDA 58,608 59,592 63,412 72,659 83,963 94,059 102,995 111,207

Year to 31 Dec 2009 2010 2011 2012 2013 2014E 2015E 2016EProfit before tax 12,277 4,773 5,598 9,521 13,714 15,426 20,631 23,012Depreciation and amortisation 47,587 54,433 58,021 61,057 68,196 73,043 79,503 85,474Tax paid (4,669) (1,039) (896) (1,679) (3,219) (3,856) (5,158) (5,753)Change in working capital 6,268 6,327 4,341 633 (2,263) 7,890 7,842 7,632Other operational CF items (2,142) 3,727 2,402 5,218 6,963 5,590 2,862 2,721Cash flow from operations 59,321 68,221 69,466 74,750 83,391 98,093 105,680 113,086Capex (78,130) (75,555) (77,861) (86,783) (72,758) (79,356) (86,989) (94,347)Net (acquisitions)/disposals 611 375 (1,936) 1,086 1,544 0 0 0Other investing CF items (12,828) 3,687 (3,173) (13,783) (5,896) 0 0 0Cash flow from investing (90,347) (71,493) (82,970) (99,480) (77,110) (79,356) (86,989) (94,347)Change in debt 41,723 23,594 10,934 36,575 3,645 0 0 0Net share issues/(repurchases) (8,802) 0 35 1 1,102 0 0 0Dividends paid (4,572) (3,670) (2,070) (2,283) (2,686) (3,805) (4,385) (5,865)Other financing CF items 260 (1,977) (2,886) (6,419) (5,044) (3,903) (3,749) (3,608)Cash flow from financing 28,609 17,947 6,013 27,874 (2,983) (7,708) (8,134) (9,473)Forex effect/others 1,757 (723) 133 (272) (20) 0 0 0Change in cash (660) 13,952 (7,358) 2,872 3,278 11,029 10,556 9,266Free cash flow (18,809) (7,334) (8,395) (12,033) 10,633 18,737 18,690 18,739

Financial summary


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Key ratios (%)


Company profile

China Unicom is an integrated information services operator with operations in Mainland China. It provides cellular services, based on 2G GSM, 3G WCDMA technology platforms, in addition to fixed-line and broadband services. As at end 2013, the company had 88 million wire line subscribers and mobile subscribers of about 281 million. The company was listed on the New York Stock Exchange and the Stock Exchange of Hong Kong on 21st June 2000 and 22nd June 2000 respectively.

As at 31 Dec 2009 2010 2011 2012 2013 2014E 2015E 2016ECash & short-term investment 8,816 22,768 15,410 18,282 21,560 32,589 43,145 52,411Inventory 2,412 3,728 4,651 5,803 5,536 6,533 7,104 7,659Accounts receivable 15,133 10,597 12,615 14,509 15,450 17,039 18,476 19,873Other current assets 4,252 5,115 6,127 9,580 9,664 9,664 9,664 9,751Total current assets 30,613 42,208 38,803 48,174 52,210 65,825 78,388 89,695Fixed assets 351,157 366,060 381,859 430,997 431,625 437,938 445,424 454,298Goodwill & intangibles 2,771 2,771 2,771 2,771 2,771 2,771 2,771 2,771Other non-current assets 32,504 30,414 32,800 34,182 42,565 42,565 42,565 42,565Total assets 417,045 441,453 456,233 516,124 529,171 549,099 569,149 589,329Short-term debt 63,971 59,785 70,372 139,240 129,470 129,470 129,470 129,470Accounts payable 112,204 105,867 104,365 117,364 112,804 123,280 133,129 142,715Other current liabilities 23,650 32,585 39,190 45,716 52,965 54,652 53,765 52,965Total current liabilities 199,825 198,237 213,927 302,320 295,239 307,402 316,364 325,150Long-term debt 7,759 35,020 34,502 2,536 13,483 13,483 13,483 13,483Other non-current liabilities 2,994 2,355 1,906 1,763 1,550 1,550 1,550 1,550Total liabilities 210,578 235,612 250,335 306,619 310,272 322,435 331,397 340,183Share capital 2,310 2,310 2,311 2,311 2,328 2,328 2,328 2,328Reserves/R.E./others 204,155 203,531 203,587 207,194 216,571 224,335 235,423 246,817Shareholders' equity 206,465 205,841 205,898 209,505 218,899 226,663 237,751 249,145Minority interests 2 0 0 0 0 0 0 0Total equity & liabilities 417,045 441,453 456,233 516,124 529,171 549,099 569,149 589,329EV 256,217 265,338 282,765 316,795 314,694 303,665 293,109 283,843Net debt/(cash) 62,914 72,037 89,464 123,494 121,393 110,364 99,808 90,542BVPS (CNY) 8.763 8.736 8.737 8.891 9.204 9.531 9.997 10.476

Year to 31 Dec 2009 2010 2011 2012 2013 2014E 2015E 2016ESales (YoY) 3.4 11.3 22.1 19.0 18.5 10.7 8.7 7.8EBITDA (YoY) (13.6) 1.7 6.4 14.6 15.6 12.0 9.5 8.0Operating profit (YoY) (45.3) (53.2) 4.5 115.2 35.9 33.3 11.8 9.5Net profit (YoY) 50.7 (59.7) 9.8 67.9 46.7 11.2 33.7 11.5Core EPS (fully-diluted) (YoY) 51.0 (59.4) 9.4 61.9 46.7 11.2 33.7 11.5Gross-profit margin 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0EBITDA margin 38.1 34.8 30.3 29.2 28.5 28.8 29.0 29.0Operating-profit margin 7.2 3.0 2.6 4.7 5.3 6.4 6.6 6.7Net profit margin 6.2 2.2 2.0 2.9 3.5 3.5 4.4 4.5ROAE 4.6 1.9 2.1 3.4 4.9 5.2 6.7 7.1ROAA 2.5 0.9 0.9 1.5 2.0 2.1 2.8 3.0ROCE 4.3 1.8 1.8 3.5 4.4 5.7 6.3 6.7ROIC 3.5 1.5 1.4 2.8 3.6 4.7 5.2 5.7Net debt to equity 30.5 35.0 43.5 58.9 55.5 48.7 42.0 36.3Effective tax rate 22.2 19.3 24.5 25.5 24.1 25.0 25.0 25.0Accounts receivable (days) 45.3 27.4 20.3 19.9 18.5 18.2 18.2 18.3Current ratio (x) 0.2 0.2 0.2 0.2 0.2 0.2 0.2 0.3Net interest cover (x) 11.7 3.2 4.3 3.4 5.4 3.2 6.3 7.1Net dividend payout 39.8 48.9 55.7 39.9 36.4 36.4 36.4 36.4Free cash flow yield n.a. n.a. n.a. n.a. 5.5 9.7 9.7 9.7



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One for risk takers

Investment thesis

We initiate coverage of China Unicom with an Outperform (2) rating and a DCF-based 6-month target price of HKD11.60. Our investment thesis for China Unicom is premised upon the following developments taking hold: 1) we expect 4G FDD-LTE licences to be awarded to China Unicom by the end of 2014, and 2) we expect the 4G TD-LTE ecosystem to become mature by the end of this year. The PRC Government awarded TD-LTE licences in December 2013; this favours China Mobile at present. We expect China Unicom’s TD-LTE service to become moderately successful, ie, good enough to be a competitive offerings, but not to the extent that it dethrones the worldwide alternative FD-LTE.

Business strategy

China Unicom viewed the transition from 2G to 3G networks that has occurred so far since 2009 as a revolutionary one, as it presented the company with an opportunity to offer data services to its voice-centric business. In contrast, the company believes the 3G to 4G transition, that is scheduled to take place in China from the latter part of this year, is an evolutionary one that should result in better access speeds for the provision of mobile broadband services. As such, the company is focusing on developing an integrated 3G and 4G infrastructure. Towards this end, China Unicom has said it: 1) is upgrading its 3G network in several areas (with access speeds of up to 42Mbps), 2) plans to utilise its recently awarded 4G TD-LTE licence mainly to boost capacity for hotspots, 3) is building a trial network on 4G FDD-LTE (in both 1,800MHz and 2,100MHz bands) technology in preparation for its future launch of services, and

4) expects to have uniform tariffs for the provision of services on both 3G and 4G networks. In our view, this is a sensible strategy as several of China Unicom’s global peers are already adopting this as their preferred technology roadmap. This strategy also entails little risk relating to the development of a sound handset ecosystem – a factor that cannot be overlooked given the divergent technology approaches of the telecom operators in China. China Unicom: key aspects of its 4G strategy Category Remarks Network strategy 3G HSPA 2x15MHz in 2,100MHz band; trials in 21 provinces in U-900 band

4G TD-LTE To be used for hotspots; 40MHz bandwidth spread in 2,300MHz and 2,500MHz bands

4G FDD-LTE Conducting trials in 1,800MHz and 2100MHz bands Handsets Mode To promote 4-mode (TD-LTE/FDD-LTE/WCDMA/GSM) handsets Target volumes Targeting 160m terminals in 2014 (120m in 2013) with 30m on contract Tariffs No distinction likely between 3G and 4G services TD-LTE coverage plans Coverage 25 cities by March 2014; 60 cities by May 2014; 300 cities by end-2014 Capex Likely less than CNY10bn

Source: Company, Daiwa expectations

As such, we see a reasonably low-risk technology upgrade path in the future for China Unicom. However, the company’s medium-term strategy and earnings could be at risk depending on the timing of China’s award of 4G FDD-LTE licences and the relative success of TD-LTE technology during the interim period.

Implications

Pace of market-share gains likely to slow China Unicom outpaced its domestic competitors over 2010-13, when it gained a total 3.5pp in revenue service market share, as it leveraged on the benefits conferred by its choice of 3G platform.


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China Unicom: industry service revenue and mobile service revenue market shares


However we expect the pace of these revenue market share gains to slow over 2014-16, as we believe its rival China Mobile is likely to improve its competitiveness in the 4G era. Its 4G tariffs appear accretive As part of its 4G TD-LTE launch, in March this year China Unicom released new packages with monthly commitment fees that are CNY10 higher than before. For example, its entry-level 3G package was priced at CNY 66/month previously, whereas 4G packages start from CNY76/month. This development implies the company is positioning itself to up-sell packages with higher price points to its existing 3G customers, which we believe should continue to support the uptrend seen in its average revenue per user over the past few years. China Unicom: 4G entry-level packages

Monthly fee Voice

minutes Data volume

(MB) Remarks

4G 76 200 400 Entry-level package is 15% higher than during 3G 106 300 800 136 500 1,024

Prior to 4G launch 66 160 220 96 240 340 126 320 450

Source: Company

We see moderate long-term EBITDA growth However, the market-share gains we expect should be sufficient for the company to generate moderate EBITDA growth over the long term; we forecast a 2013-18 EBITDA CAGR of 8.1% (6.5% after the VAT-reform impact). We find this prospect attractive and as such believe the stock’s current trading valuations look appealing.

Where the stock stands in our sector universe

Higher risk profile vs. peers Daiwa’s regional economist, Kevin Lai, is forecasting the Renminbi to depreciate to 6.5 versus the US Dollar by end 2014, and 6.83 by the end of 2015 (from a level of around 6.205 currently). A weakening of the Renminbi is negative for China Unicom’s earnings development, as we estimate that around 30% or more of its net liabilities are denominated in US Dollars or Hong Kong Dollars. Consequently, we factor in a CNY2.5bn forex loss for China Unicom in 2014E. Given that the company’s convertible bond is due to mature in 2015, and as the company relies on short-term commercial papers as a source of funding, it is likely that forex losses could become realised cash losses if the currency depreciation trend takes hold. We prefer China Unicom’s peers on a relative basis While our forecasts show China Unicom offers better EBITDA and earnings growth prospects than its rivals over the medium-term, we have a preference for its bigger domestic rivals, China Mobile and China Telecom, for the following reasons: China Unicom’s balance sheet is slightly inferior to those of its rivals (2013 net debt/EBITDA ratio of 1.4x, versus 1.0x for China Telecom and -1.7x for China Mobile). China Unicom’s free cash flow to enterprise value yields for the 2014-18E period (4.9% on average based on our forecasts) are slightly inferior to China Telecom’s (5.2%), after taking into account the impact of China’s planned VAT reform measures. This situation arises mainly because China Telecom’s superior scale of business gives it additional headroom to fund its capex plans. On the other hand, China Mobile, which is our top sector pick, offers a 6.6% yield (post the VAT-reform impact) for the same period, based on our forecasts. Finally, China Unicom is more exposed to both of its domestic peers to potential Renminbi depreciation risks.

19.0%

21.4%22.3% 22.7% 22.7%

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22%

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25%

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E

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E

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E

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E

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E



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Investment risks

We present the main risks we see to our positive call on China Unicom below. The first of these is a sector-related risk, the second one is an industry-related risk, while the third one is specific to China Unicom. 1) A worsening of competitive pressures could impact our earnings forecasts negatively. 2) Significant delays in the issuance of FDD-LTE licences or a change in the company’s strategy (for example to adopt TD-LTE as main the 4G technology standard instead of FDD-LTE) could have negative repercussions for our market-share forecasts. 3) Larger-than-expected Renminbi depreciation could have a negative impact on our earnings forecasts for China Unicom.


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Operational trends

Customer shift towards 3G/4G networks looks set to continue The proportion of 3G customers among China Unicom’s mobile subscriber base increased from 2% in 2009 to 44% in 2013. We expect China Unicom’s 4G subscriber base to ramp up significantly only from 2016 and reach 42% of its total mobile subscriber base by 2018. This assumes 4G FD-LTE licences are awarded towards the end of 2014. China Unicom: mobile subscriber additions and 3G/4G penetration


ARPU likely to be on an uptrend Even though China Unicom has been operating in an industry environment characterised by falling ARPU amid declining usage of voice and SMS services during the past few years, the company achieved an improvement in its blended ARPU over the 2009-13 period, due to a favourable shift in its customer mix. In particular, China Unicom was able to capitalise on the global popularity of the iPhone with an exclusive sales arrangement with Apple in 2010.

China Unicom: voice minutes of usage per month


China Unicom: SMS usage volume trends

Source: Company

Looking ahead, we expect the company’s overall ARPU levels to continue to rise over the 2014-16 period, driven by an improving customer mix towards mobile broadband services. We forecast its blended ARPU to rise at a 1.0% CAGR for 2013-16, compared to the 3.6% CAGR recorded for 2010-13. China Unicom: mobile average revenue per subscriber


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Net additions (LHS) 3G/4G penetration (RHS) 4G penetration (RHS)

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Blended ARPU 3G/4G ARPU

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Fixed-line segment: broadband remains the key We think the entry of rival China Mobile into the fixed-line business since December 2013 (prior to end, 2013 China Mobile worked in cooperation with its parent’s subsidiary China Tietong) is likely to slow the rate of China Unicom’s customer growth in its fixed-line broadband business over 2014-16. However, we forecast a fairly stable ARPU trend for China Unicom’s fixed-line business of -0.7% over 2013-16 (versus a -1.7% CAGR for 2009-12; the CAGR over 2010-13 was a positive 2.4% as the company reclassified broadband ARPU in 2013). China Unicom: fixed-line broadband subscriber additions and ARPU


China Unicom’s expansion of its geographical footprint into southern China (since 2009, some assets were acquired in 2012), along with the company’s strategy to upgrade its access-line technology to fibre to the home or building (FTTH/B) should help support these forecasts, in our view. In particular, the upgrading of its access lines to FTTH/B would not only facilitate higher download speeds but also helps the company to offer cloud computing applications to its customers, thus supporting its overall ARPU trends. As of 2013, China Unicom derived 15% of its fixed-broadband ARPU from such value-added services, according to the company. China Unicom: key drivers of broadband business

2011 2012 2013Broadband access ports (m) 86 106 119Broadband subscribers (m) 56 64 65Broadband subs as % of access ports 65% 60% 54%FTTH/B-enabled access ports 45% 59% 71%Broadband capex (CNYbn) 25.7 25.5 17.5

Source: Company

We expect the company’s traditional fixed-line access users and legacy voice ARPU to continue on their downtrend. We forecast its voice ARPU to fall at a 3.4% CAGR over 2013-16 (after rising at a 10.8% CAGR over 2010-13).

China Unicom: fixed-line access user additions and ARPU


Financials

Revenue mix should shift in favour of mobile We forecast a 2013-16 service revenue CAGR of 9.6% for the company, representing a slowdown compared to the 13.3% CAGR seen over the 2010-13 period. We expect this to be driven by strong growth in its mobile services revenue (2013-16E: 13.7% CAGR), offset partially by a fairly modest revenue performance at its fixed-line division (2013-16E: 2.2% CAGR). China Unicom: service revenue CAGRs


Overall, we expect mobile non-voice services to be the key driver of the company’s revenue growth in the next few years and forecast their contribution to overall service revenue rise from 28.9% in 2013 to 38.8% in 2016.

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Net additions (LHS) Fix ed-voice ARPU (RHS)

(m) (CNY)

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13.3%

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China Unicom: revenue composition


Cost escalation likely to remain an issue We forecast the company’s operating-profit margin to rise by a modest 1.4pp over 2013-16, mainly due to our expectation for a fall in depreciation expenses relative to revenue over this period. China Unicom: trend in key margins


Our examination of the company’s cost structures suggests there is ample room for China Unicom to enhance its operating-profit margin by controlling its expenses. However, we believe this is unlikely to materialise over the next 3 years due to 4 reasons that we go on to discuss.

China Unicom: composition of operating expenses (2013)

Source: Company

First, to our surprise, there was little evidence of strong operational leverage in China Unicom’s business over 2010-13 (its operating-profit margin rose by 2.3pp in total from a very low base). While network support expenses and depreciation expenses fell as a proportion of revenue over 2010-13, poor control of personnel expenses, along with the company’s mobile strategy involving the promotion of subsidised handsets, weighed negatively on both its operating-profit and EBITDA margins over the period. Second, we expect sales and marketing costs as a proportion of service revenue to remain stable but at an elevated level over 2013-16. This is because China Unicom intends to invest in the development of its online distribution channels; also, further competitive pressures are likely to increase slightly given rival China Mobile’s launch of its 4G services early this year. China Unicom’s sales and marketing expenses rose from 14.5% of its service revenue in 2010 to 18.0% in 2013 due to expansion of its distribution channels since 2010 along with its increased reliance on social channels in 2013. We forecast these expenses relative to service revenue to remain at the 18% level over 2013-16. That said, we expect China Unicom’s 3G handset subsidies as a proportion of its mobile service revenue to trend down over the 2013-16 period given the company’s efforts to align subsidies closely with customers’ monthly commitments.

34.5%

31.8%

28.9%

38.8%

19.3% 17.9%

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Mobile-voice Mobile non-voiceFixed-broadband Adjusted fixed-line voice

35.2%35.4%

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Depreciation24.4%

Network expenses

12.1%

Employee expenses

11.4%Interconnection

7.2%

Sales and marketing

15.4%

G&A6.8%

Cost ofgoods sold

22.7%


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China Unicom: handset subsidy and marketing costs


Third, we think wage inflation pressures are unlikely to let up over 2013-16. Wage inflation, combined with the company’s moves to increase the proportion of permanent employees in its workforce appear to have been key factors behind the large increases in its personnel expenses seen over 2010-13. China Unicom: personnel cost drivers

2010 2011 2012 2013 Remarks

Total no. of staff ('000) 310 297 289 284 Decrease in temporary workersPermanent workers (%) 70% 73% 76% 78% Shift in mix Average annual wage (CNY '000) 18.5 21.9 24.5 27.8 % change YoY 19% 12% 13% Wage inflation

Source: Company

Fourth, we expect the company’s network expenses to remain elevated over 2014-16 due to the 4G investment cycle, negating cost savings from the change in China’s interconnection fee regime implemented at the start of 2014. China Unicom: key expenses

2010 2011 2012 2013 2014E 2015E 2016EService revenue growth 8.1% 13.3% 13.0% 13.5% 10.9% 9.6% 8.5%Operating revenue growth 11.3% 22.1% 19.0% 18.5% 10.7% 8.7% 7.8%Adjusted cash opex growth 12.1% 17.3% 12.2% 12.5% 10.3% 9.7% 8.7%Total opex growth 16.2% 22.7% 16.5% 17.7% 9.4% 8.5% 7.7%Key components Depreciation & amortisation 14.4% 6.6% 5.2% 11.7% 7.1% 8.8% 7.5%Network operations and support expenses 21.4% 11.6% 10.4% 3.7% 9.9% 9.6% 8.5%Employee benefit expenses 6.4% 14.0% 8.2% 10.4% 9.0% 9.0% 9.0%Interconnection 6.0% 19.3% 14.0% 8.2% 4.7% 9.6% 8.5%Sales and marketing 12.9% 21.1% 21.9% 22.7% 10.9% 9.6% 8.5%G&A 6.4% 7.1% 9.3% 17.0% 11.5% 9.6% 8.5%Net cost of goods sold 547% 89.9% -3.3% 11.3% 26.6% 13.3% 11.4%Sale of telecom products 237% 220% 66.6% 45.5% 10.0% 5.0% 5.0%Cost of telecom products 297% 178% 51.5% 40.8% 11.8% 6.0% 5.8%Source: Company, Daiwa forecasts

Earnings growth We forecast a 2013-16 EPS CAGR of 18% (which compares to a reported 2010-13 EPS CAGR of 37%) and the company’s net-profit margin to rise slightly by 1.0pp in total over the period. Given the low absolute

net-profit margin levels we expect over the period, we expect its earnings volatility to be high. China Unicom: handset subsidy and marketing costs trends


Capex likely to increase post issuance of FDD-LTE licences China Unicom’s capex levels have increased significantly post the 2009 industry restructuring, following its merger with fixed-line operator China Netcom and due to the company’s investments in 3G mobile networks. Roughly one-third of the company’s capex in each year over this period was spent on its mobile network, and China Unicom’s base station site count has more than doubled as a result. While capex efficiency has improved over the past 5 years, we estimate that China Unicom spent about CNY172bn on its mobile networks over 2009-13, which is 54% higher than its CNY111bn investment outlay (excluding capex of assets acquired) over 2001-08. China Unicom’s mobile base stations: net additions


Given this aggressive network footprint expansion and investments over the past 5 years, a key question remains whether and when the capex cycle would trend downwards. We forecast China Unicom’s capex/service revenue ratio to remain stable but at an elevated level

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2006

2007

2008

2009

2010

2011

2012

2013

2014

E

2015

E

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E

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E

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E

Base stations net addtion (thousands) (LHS)

3G base station net addtion proportion


- 94 -

of 30% over 2014-17, but expect this to fall to 25% from 2018 following completion of a significant portion of its investments in the 4G network. China Unicom: capex trend


Free cash flow should remain positive over 2014-16E China Unicom generated negative free cash flow after interest expenses (FCFE) for 2009-12, but this turned positive in 2013. We forecast the company to generate cumulative FCFE of CNY45bn over 2014-16, which equates to an average of CNY0.76/share each year. China Unicom: free cash flow and operating cash flow


Balance sheet: working capital management remains key issue Based on conventional debt ratio metrics, such as net debt/EBITDA, we think China Unicom’s balance sheet is fairly levered.

China Unicom: net debt/EBITDA ratio forecasts


A key issue that we see on the balance sheet, however, is in the area of working capital management, where the China telecoms companies appear to be quite different compared with their peers in ASEAN. For example, in 2013 around 28% of China Unicom’s non-current assets were financed by working capital (excluding cash and short-term debt), compared with 24% for Philippine Long Distance Telephone (PLDT) (TEL PM, PHP2,750, Buy [1]. We believe this reflects the extended credit terms made available to China operators – China Unicom’s payables days ranged from 4-7 months of revenue over 2009-13, and we believe this level is unlikely to reverse adversely anytime soon. China Unicom: key balance sheet metrics

2010 2011 2012 2013 2014E 2015E 2016ENon-current assets (CNYbn) 399 417 468 477 483 491 500Financed by (%) Net working capital 30% 29% 28% 28% 30% 31% 32%Net debt 18% 21% 26% 25% 23% 20% 18%Equity 52% 49% 45% 46% 47% 48% 50% Payables (days of sales) 222 180 170 138 136 135 134Source: Company, Daiwa forecasts

Dividend policy China Unicom does not have a stated policy for its dividend payout ratio or minimum dividend level. The company’s official policy is to achieve a “long-term, sustainable and steadily increasing dividend”. Over the 2010-13 period, China Unicom’s dividend payout ratios fluctuated in a range of 36-49% Given our moderate earnings growth forecasts over 2014-16, we assume its dividend payout ratio will remain stable at 36% (2013: 36%).

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0

20

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E

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(CNYbn)

(40)

(20)

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(CNYbn)

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(x )


- 95 -

China Unicom: dividend and payout ratio


Asset returns: key issues China Unicom has earned very poor returns on its assets in the past – ROA, ROE and ROIC were all at low levels over 2004-13. While we see an improvement in these metrics over 2014-16E, we expect the absolute levels to continue to remain low. A Dupont analysis suggests that low asset turnover and operating margins are primary drivers behind the low levels of ROE generated by the company. This situation is primarily a result of the aggressive capex spending programmes of the past, and could change provided: 1) the company exercises good cost discipline, which is unlikely over 2014-16E, or 2) the capex cycle peaks, which we expect could happen from 2017. China Unicom: key return ratios


Note: 2008 data omitted because of distortion caused by industry restructure

China Unicom: 5-factor Dupont return on equity breakdown

2010 2011 2012 2013 2014E 2015E 2016E

Adjusted EBIT margin 3.7% 3.3% 5.2% 5.6% 6.7% 6.9% 7.0%Asset turnover 40% 47% 51% 56% 61% 64% 66%Interest burden 75% 82% 74% 82% 70% 85% 86%Tax efficiency 81% 76% 75% 76% 75% 75% 75%Leverage ratio 208% 218% 234% 244% 242% 241% 238%Return on average equity (%) 1.9% 2.1% 3.4% 4.9% 5.2% 6.7% 7.1%Source: Company, Daiwa forecasts

Forecasts versus consensus

Our 2014-16 forecasts for China Unicom are below those of the Bloomberg consensus (as the next table shows), as we believe the market may not have factored in the full impact of the depreciation costs associated with the network expansion strategies. Also, the inclusion of forex losses into our forecasts may have contributed to the variance for 2014. China Unicom: Daiwa forecasts versus consensus (%) 2014E 2015E 2016ESales (1) (2) (3)EBITDA (2) (1) (1)Adjusted net profit (24) (16) (19)Adj. EPS (25) (19) (22)DPS (21) (10) (17)


Earnings revision trends The 2014-15 Bloomberg consensus EPS and EBITDA forecasts have been revised down steadily for China Unicom over the past 2 years. Over the past 6 months, however, consensus EPS and EBITDA revisions for 2014 have turned positive, perhaps helped by the PRC Government’s new policy for interconnection fees which came into force in January 2014. China Unicom: Bloomberg-consensus EPS revisions

Source: Bloomberg

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2010 2011 2012 2013 2014E 2015E 2016E


(CNY)

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E


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0.9

1.0

1.1

1.2

1.3

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2

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-12

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(CNY)


- 96 -

China Unicom: Bloomberg consensus EBITDA revisions

Source: Bloomberg

Do consensus revisions matter? As our forecasts imply a possible risk of downward revisions to the consensus 2015 EPS forecasts for China Unicom, a key question that needs addressing is to what extent consensus revisions drive the stock. A look at the past years’ trend suggests the consensus has in general over-estimated the earnings and EBITDA prospects for China Unicom every year since 2009, though the variance has fallen over the years – 2013 EBITDA and earnings turned out to be reasonably accurate. However, China Unicom’s share-price performance reveals a slightly different story. The stock appreciated in 2010 despite downward consensus EBITDA revisions, while in 2013 the opposite happened. In our belief, the market may have wrongly perceived the extent of benefits that could have accrued to the company from its deal with Apple in 2010. The 2006-07 period, however, appears to have been an exception; apart from positive industry sentiment, we think positive earnings surprises may have contributed to the share-price gains seen during that period. China Unicom: consensus annual EPS revisions

2006 2007 2008 2009 2010 2011 2012 20131-year forward EPS -32% 2% -2% -27% -48% -34% -9% -4%2-year forward EPS 9% 2% -47% -70% -53% -36% -20%

Source: Bloomberg

China Unicom: consensus annual EBITDA revisions

2006 2007 2008 2009 2010 2011 2012 2013

1-year forward EBITDA 5% 132% 97% -13% -5% -4% -1% 1%2-year forward EBITDA 136% 100% 57% -16% -8% -3% -3%

Source: Bloomberg

China Unicom: Bloomberg-consensus EPS revisions and share price performance

Source: Bloomberg

90,000

95,000

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125,000

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14Consensus 2014E EBITDA Consensus 2015E EBITDA

(CNY)

(60% )

(40% )

(20% )

0%

20%

40%

60%

2009 2010 2011 2012 2013



- 97 -

Valuation

Methodology

We value China Unicom on a 10-year discounted cash flow (DCF) model with the following inputs: a WACC of 9.7%, comprising a 6% equity risk premium and 30% long-term debt-to-capital ratio, and a terminal free cash flow growth rate of 2.0%.

Note that given the uncertainties related to the VAT reform, we do not factor this into our earnings forecasts for the company. However, as we believe it is easier to assess the reform effects on its valuations, we determine a fair value for the stock, then apply a reduction (HKD1.6/share) to derive our 6-month DCF-based target price of HKD11.60. We illustrate the VAT-reform impact on our valuation further on in this section. Key value drivers Our 10-year DCF-model for China Unicom assumes that the company’s free cash flow margin on its service revenue would rise from 7.7% in 2014E to 8.4% by 2023E. This outlook is driven by our forecast for the company’s capex cycle will trend down from 30% of service revenue in 2015 to 25% in 2018. China Unicom: forecasts for free cash flow to the firm Margin on service revenue 2014E 2015E 2016E 2017E 2018E Terminal (2023E)EBITDA 35.6% 35.5% 35.4% 35.2% 35.0% 34.8%Capex -30.0% -30.0% -30.0% -30.0% -25.0% -25.0%Change in net working capital 3.0% 2.7% 2.4% 2.0% 1.8% 1.4%Taxes Paid -1.5% -1.8% -1.8% -1.8% -1.8% -2.8%Free cash flow to firm (margin) 7.7% 6.8% 6.2% 5.7% 10.2% 8.4%


Given the low level of free cash flow margin we project for 2014, China Unicom’s valuation is very sensitive not only to long-term EBITDA-margin and capex trends, but also to working capital fluctuations and tax effects (especially arising from long-term trends in depreciation/capex).

China Unicom: key components of valuation of core business (excluding VAT-reform impact)


China Unicom: impact of VAT reform and currency movements on target price


In our model, we factor in a contribution of CNY3.3/share (30% of our fair value excluding the impact of VAT reform) from likely efficient working capital management and a negative contribution of CNY 4.3/share (-40% of our fair value excluding the impact of the VAT reform) due to tax effects. As such, any swings in the company’s working capital or tax savings, especially arising from changes to depreciation policies, could have a significant impact on our valuation. Our fair value for the stock works out at HKD13.8/share (CNY10.9/share) at prevailing exchange rates. However, after incorporating the impact of VAT reform (HKD1.6/share) and our forward currency forecast (USD:CNY 2014 year-end exchange rate of 6.5), we arrive at a 6-month target price of HKD11.60.

16.9

10.9

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25




(CNY/share)

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VAT-reform Currency movements Target price

(HKD/share)


- 98 -

Sensitivity analysis to long-term margins Embedded in our valuation framework is our expectation that the company’s free cash flow margins will rise over the long term. A 1.0pp decrease in the terminal free cash flow margin, which could arise from either higher-than-expected long-term capex/service revenue or lower-than-expected long-term EBITDA margin assumptions, could impact our valuation by a negative HKD1.1/share (9.8% of our target price). Multiples and historical bands Our target price of HKD11.60 for China Unicom implies 2015E PER, EV/EBITDA and PBR multiples of 14.7x, 3.2x and 0.95x, respectively. The stock’s past-10-year average trading multiples were as follows: a PER of 24.2x, an EV/EBITDA multiple of 4.2x and a PBR of 1.1x. For the past-5-year period, however, its average valuation multiples have expanded to: a PER of 36.2x, an EV/EBITDA multiple of 4.7x and a PBR of 1.9x). China Unicom: past-10-year forward EV/EBITDA bands


China Unicom: past-10-year forward PER bands

Source: Company, Daiwa forecasts,, Bloomberg

China Unicom: past-10-year forward PBR bands


China Unicom: past-10-year forward adjusted EV/EBITDA bands


China Unicom: past-10-year forward EV/EBIT bands


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- 99 -

China Unicom: past-10-year forward dividend yield bands


Impact of VAT reform on implied multiples

The following tables show the P&L profile and implied valuation multiples for China Unicom under a few different scenarios depending on the impact of VAT reform. Base-case scenario (minus HKD1.6/share impact on our valuation) This scenario assumes: 1) applicable VAT input tax rates of 11% for voice and 6% for value-added services and a VAT price pass-through proportion ratio of 15%, and 2) cost reductions that equate to about 4% of savings compared to our current forecasts for 2014-16. We assume the VAT reform is implemented from 2H14. Under this outlook, at its current share price China Unicom would be trading at 2015E PER, EV/EBITDA and PBR ratios of 21.9x, 3.3x and 0.90x, respectively. China Unicom: base-case scenario for VAT reform impact (CNYbn) 2012 2013 2014E 2015E 2016EService revenue 210 239 258 275 299Revenue 249 295 318 337 364Cash expenses 176 211 228 242 261EBITDA 73 84 91 95 103Pre-tax profit 10 14 12 13 14Net profit 7 10 9 10 11 EBITDA margin 29.2% 28.5% 28.4% 28.3% 28.3%Service EBITDA margin 34.6% 35.2% 35.1% 34.6% 34.5%Book value 210 219 224 232 243Net debt 123 121 113 106 97 Valuation (x)* PBR 0.91 0.93 0.90 0.86EV/EBITDA 3.8 3.6 3.3 3.0PER 19.1 23.6 21.9 19.2FCFF/EV 3.3% 4.9% 3.9% 3.7%


Note: * implied valuation multiples based on share price as of 2nd April 2014

Worst-case scenario (minus HKD4.3/share impact on our valuation) This scenario assumes: 1) applicable VAT input tax rates of 11% for voice and value-added services and a VAT price pass-through proportion ratio of 0%, and 2) cost reductions that equate to roughly 3% savings compared to our current forecasts over 2014-16. Under this outlook, we would expect China Unicom to generate losses in 2015-16. At its current share price, the stock would be trading at 2015E EV/EBITDA and PBR multiples of 4.0x and 0.94x, respectively. Our fair value for the shares would be HKD8.9/share, around 12% below its current share price. China Unicom: worst-case VAT-reform scenario (CNYbn) 2012 2013 2014E 2015E 2016EService revenue 210 239 254 267 289Revenue 249 295 314 327 352Cash expenses 176 211 229 245 264EBITDA 73 84 84 82 89Pre-tax profit 10 14 6 -1 0Net profit 7 10 4 -1 0 EBITDA margin 29.2% 28.5% 26.9% 25.1% 25.2%Service EBITDA margin 34.6% 35.2% 33.3% 30.8% 30.7%Book value 210 219 219 222 232Net debt 123 121 118 117 109 Valuation (x)* PBR 0.91 0.95 0.94 0.90EV/EBITDA 3.8 3.9 4.0 3.6PER 19.1 50.0 nm nmFCFF/EV 3.3% 3.4% 0.8% 0.4%



Best-case scenario (plus HKD0.91/share impact on our valuation) This scenario assumes: 1) applicable VAT input tax rates of 11% for voice and 6% for value-added services and a VAT price pass-through proportion ratio of 30%, and 2) cost reductions that equate to about 3% of savings compared to our current forecasts for 2014-16. We assume VAT-reform is implemented from 2H14. Under this outlook, at its current share price China Unicom would be trading at 2015E PER, EV/EBITDA and PBR BV ratios of 11.0x; 2.8x and 0.87x respectively.

0%

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- 100 -

China Unicom: best-case scenario for VAT reform impact (CNYbn) 2012 2013 2014E 2015E 2016EService revenue 210 239 261 281 305Revenue 249 295 322 345 371Cash expenses 176 211 226 237 255EBITDA 73 84 96 107 116Pre-tax profit 10 14 18 25 28Net profit 7 10 13 19 21EBITDA margin 29.2% 28.5% 29.9% 31.2% 31.2%Service EBITDA margin 34.6% 35.2% 36.9% 38.2% 38.0%Book value 210 219 228 241 253Net debt 123 121 109 96 87Valuation (x) PBR 0.91 0.91 0.87 0.83EV/EBITDA 3.8 3.3 2.8 2.5PER 19.1 15.8 11.0 10.0FCFF/EV 3.3% 6.2% 6.7% 6.8%




- 101 -

Appendix

Company background

China Unicom was incorporated in Hong Kong in 2000. The company initially provided cellular services using both GSM and CDMA technology platforms prior to the restructuring of the telecommunications industry in 2008. In October 2008, the company merged with China Netcom Group and also disposed of its CDMA mobile business to China Telecom. The merged entity changed its name to China Unicom (Hong Kong) and transformed itself to an integrated wireless and fixed-line services provider. China Unicom Group became a leading provider of fixed-line services in 10 provinces located in northern China, where the Netcom group was previously dominant.

The company also initially leased (2009-12) and later bought (in 2012) wire-line assets located in 21 southern provinces in China from its parent group. As a result, China Unicom group operates wireless and fixed-line business nationwide. As of end-2013, China Unicom Group was the second-largest operator in the mobile and fixed-line services market in China, with a subscriber base of about 281m mobile subscribers and 88m fixed-line subscribers.


China Unicom is listed on the Stock Exchange of Hong Kong and the New York Stock Exchange. China Unicom’s main shareholders are: 1) China United Network Communications Group Company Limited, which indirectly and beneficially owns a 75.6% stake in the company, and 2) Telefónica International, which owns 5%. The company’s free float is 19.4%.


- 102 -

China Unicom: summary of key acquisitions, investments, agreements and disposals Date Target/Related entity Seller/Buyer Remarks Key acquisitions 2000-07 Acquisition of mobile (GSM/CDMA) assets Apr-00 Asset injection (12 provinces) Various parties including

parent China Unicom Group

Mobile assets in Guangdong, Jiangsu, Zhejiang, Fujian, Liaoning, Shandong, Hebei, Hubei, Anhui, Beijing, Shanghai and Tianjin

Paging assets (Guoxin Paging); long distance telephony business Consideration paid in stock Dec-02 China Unicom New Century (9 provinces) Parent China Unicom

Group GSM and CDMA assets in Jilin, Heilongjiang, Jiangxi, Henan, Shaanxi, Sichuan, Guangxi, Xinjiang, Chongqing (consideration HKD4.523bn payable in cash)

Dec-03 China Unicom New World (9 provinces) Parent China Unicom Group

GSM and CDMA assets in Shanxi, Hunan, Hainan, Yunnan, Gansu, Qinghai, Inner Mongolia, Ningxia, Xizang (Consideration HKD3.015bn)

Sep-04 100% equity in China Unicom International Parent China Unicom Group

Hong Kong- based wholesale voice services (consideration HKD37.4m)

Dec-07 100% equity in Guizhou Province assets Parent China Unicom Group

Cellular coverage expanded to 31 provinces nationwide (consideration CNY880m)

Jan-09 Industry restructuring Consideration of CNY4.43bn payable in cash Fixed-line business in 21 provinces China Unicom Group and

Netcom Group Underlying assets were not acquired

Business and assets in Tianjin Municipality Parent China Unicom Group

Local access telephone business and assets

Backbone transmission assets in 10 provinces Netcom Group In northern China region Dec-11 100% equity in Broadband Online Parent China Unicom

Group CNY158m consideration

Dec-12 100% equity in China Unicom New Horizon Parent China Unicom Group

CNY12.2bn consideration; fixed line assets in 21 southern provinces

Key disposals Dec-02 Guoxin Paging Parent China Unicom

Group Consideration HKD2.591bn

Jun-08 CDMA business China Telecom CNY43.8bn consideration; China Unicom booked gain of CNY26.1bn net of cash Oct-08 China Unicom Macau China Telecom CDMA business sold as part of industry restructuring Oct-08 China Unicom Huasheng China Telecom CDMA handset business; sold as part of industry restructuring Key business expansions, agreements and investments Oct-04 China Unicom Macau Expansion of CDMA business in Macau Jul-05 China Unicom Huasheng Engaged in CDMA handset business Aug-08 China Unicom Huakai Engaged in sale of handsets and telecommunications equipment Dec-08 China Unicom New Horizon China Unicom leased fixed-line assets in 21 southern provinces Sep-09 Telefonica China Unicom entered into mutual investment agreement Key acquisitions of China Netcom Jun-04 Listing re-organization

(6 northern provinces; 2 southern provinces) Various parties Fixed-line assets in northern regions of Beijing, Tianjin, Hebei, Liaoning, Shandong, Henan;

Southern provinces of Shanghai, Guangdong Oct-05 Acquisition (4 provinces) Parent China Netcom

Holdings Fixed line services in Shanxi, Neimenggu, Jilin, Heilongjiang (consideration CNY12.8bn comprising upfront cash of CNY3.0bn cash and a deferred payment of CNY9.8bn)

Jan-07 Disposal ( 2 southern provinces) Parent China Netcom Holdings

Guangdong, Shanghai (consideration CNY3.5bn)

Source: Company


- 103 -

Daiwa’s Asia Pacific Research Directory

Daiwa’s Asia Pacific Research Directory

HONG KONG

Hiroaki KATO (852) 2532 4121 [email protected] Regional Research Head

John HETHERINGTON (852) 2773 8787 [email protected] Regional Deputy Head of Asia Pacific Research

Rohan DALZIELL (852) 2848 4938 [email protected] Regional Head of Product Management

Kevin LAI (852) 2848 4926 [email protected] Deputy Head of Regional Economics; Macro Economics (Regional)

Christie CHIEN (852) 2848 4482 [email protected] Macro Economics (Taiwan)

Jonas KAN (852) 2848 4439 [email protected] Head of Hong Kong Research; Head of Hong Kong and China Property

Grace WU (852) 2532 4383 [email protected] Head of Greater China FIG; Banking (Hong Kong, China)

Jerry YANG (852) 2773 8842 [email protected] Banking (Taiwan); Insurance (Taiwan and China)

Leon QI (852) 2532 4381 [email protected] Banking (Hong Kong, China); Broker (China)

Winston CAO (852) 2848 4469 [email protected] Capital Goods – Machinery (China)

Alison LAW (852) 2532 4308 [email protected] Head of Regional Consumer; Consumer (Hong Kong/China)

Jamie SOO (852) 2773 8529 [email protected]

Consumer (Hong Kong/China)

Anson CHAN (852) 2532 4350 [email protected]

Consumer (Hong Kong/China)

Eric CHEN (852) 2773 8702 [email protected] Pan-Asia/Regional Head of IT/Electronics; Semiconductor/IC Design (Regional)

Lynn CHENG (852) 2773 8822 [email protected]

IT/Electronics (Semiconductor)

Felix LAM (852) 2532 4341 [email protected] Head of Materials (Hong Kong, China); Cement and Building Materials (China, Taiwan); Property (China)

Dennis IP (852) 2848 4068 [email protected] Power; Utilities; Renewables and Environment (Hong Kong/China)

John CHOI (852) 2773 8730 [email protected] Regional Head of Small/Mid Cap; Small/Mid Cap (Regional); Internet (China)

Jackson YU (852) 2848 4976 [email protected]

Small/Mid Cap (Regional)

Joey CHEN (852) 2848 4483 [email protected] Steel (China)

Kelvin LAU (852) 2848 4467 [email protected] Head of Transportation (Hong Kong, China); Transportation (Regional)

Jibo MA (852) 2848 4489 [email protected] Head of Custom Products Group; Custom Products Group

Thomas HO (852) 2773 8716 [email protected] Custom Products Group

PHILIPPINES

Norman H PENA (63) 2 737 3021 [email protected] Banking/Property

Michael David MONTEMAYOR

(63) 2 737 3023 [email protected]

Consumer/Retail

Patricia PALANCA (63) 2 737 3024 [email protected] Utilities/Mining

SOUTH KOREA

Chang H LEE (82) 2 787 9177 [email protected] Head of Korea Research; Strategy; Banking

Sung Yop CHUNG (82) 2 787 9157 [email protected] Pan-Asia Co-head/Regional Head of Automobiles and Components; Automobiles; Shipbuilding; Steel

Jun Yong BANG (82) 2 787 9168 [email protected] Tyres; Chemicals

Mike OH (82) 2 787 9179 [email protected] Capital Goods (Construction and Machinery)

Sang Hee PARK (82) 2 787 9165 [email protected] Consumer/Retail

Jae H LEE (82) 2 787 9173 [email protected] IT/Electronics (Tech Hardware and Memory Chips)

Joshua OH (82) 2 787 9176 [email protected] IT/Electronics (Handset Components)

Thomas Y KWON (82) 2 787 9181 [email protected] Pan-Asia Head of Internet & Telecommunications; Software (Korea) – Internet/On-line Game

TAIWAN

Mark CHANG (886) 2 8758 6245 [email protected] Head of Taiwan Research

Steven TSENG (886) 2 8758 6252 [email protected]

IT/Technology Hardware (PC Hardware)

Christine WANG (886) 2 8758 6249 [email protected] IT/Technology Hardware (Automation); Cement; Consumer

Kylie HUANG (886) 2 8758 6248 [email protected] IT/Technology Hardware (Handsets and Components)

INDIA

Punit SRIVASTAVA (91) 22 6622 1013 [email protected] Head of India Research; Strategy; Banking/Finance

Saurabh MEHTA (91) 22 6622 1009 [email protected] Capital Goods; Utilities

SINGAPORE

Adrian LOH (65) 6499 6548 [email protected] Head of Singapore Research, Regional Head of Oil and Gas; Oil and Gas (ASEAN and China); Capital Goods (Singapore)

Angeline LOH (65) 6499 6570 [email protected] Banking/Finance, Consumer/Retail

David LUM (65) 6329 2102 [email protected] Property and REITs

Ramakrishna MARUVADA (65) 6499 6543 [email protected] Head of ASEAN & India Telecommunications; Telecommunications (ASEAN & India)


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Daiwa’s Offices

Office / Branch / Affiliate Address Tel Fax

DAIWA SECURITIES GROUP INC

HEAD OFFICE Gran Tokyo North Tower, 1-9-1, Marunouchi, Chiyoda-ku, Tokyo, 100-6753 (81) 3 5555 3111 (81) 3 5555 0661

Daiwa Securities Trust Company One Evertrust Plaza, Jersey City, NJ 07302, U.S.A. (1) 201 333 7300 (1) 201 333 7726

Daiwa Securities Trust and Banking (Europe) PLC (Head Office) 5 King William Street, London EC4N 7JB, United Kingdom (44) 207 320 8000 (44) 207 410 0129

Daiwa Europe Trustees (Ireland) Ltd Level 3, Block 5, Harcourt Centre, Harcourt Road, Dublin 2, Ireland (353) 1 603 9900 (353) 1 478 3469

Daiwa Capital Markets America Inc Financial Square, 32 Old Slip, New York, NY10005, U.S.A. (1) 212 612 7000 (1) 212 612 7100

Daiwa Capital Markets America Inc. San Francisco Branch 555 California Street, Suite 3360, San Francisco, CA 94104, U.S.A. (1) 415 955 8100 (1) 415 956 1935

Daiwa Capital Markets Europe Limited 5 King William Street, London EC4N 7AX, United Kingdom (44) 20 7597 8000 (44) 20 7597 8600

Daiwa Capital Markets Europe Limited, Frankfurt Branch Trianon Building, Mainzer Landstrasse 16, 60325 Frankfurt am Main, Federal Republic of Germany

(49) 69 717 080 (49) 69 723 340

Daiwa Capital Markets Europe Limited, Paris Representative Office 36, rue de Naples, 75008 Paris, France (33) 1 56 262 200 (33) 1 47 550 808

Daiwa Capital Markets Europe Limited, London, Geneva Branch 50 rue du Rhône, P.O.Box 3198, 1211 Geneva 3, Switzerland (41) 22 818 7400 (41) 22 818 7441

Daiwa Capital Markets Europe Limited, Moscow Representative Office

Midland Plaza 7th Floor, 10 Arbat Street, Moscow 119002, Russian Federation

(7) 495 641 3416 (7) 495 775 6238

Daiwa Capital Markets Europe Limited, Bahrain Branch 7th Floor, The Tower, Bahrain Commercial Complex, P.O. Box 30069, Manama, Bahrain

(973) 17 534 452 (973) 17 535 113

Daiwa Capital Markets Hong Kong Limited Level 28, One Pacific Place, 88 Queensway, Hong Kong (852) 2525 0121 (852) 2845 1621

Daiwa Capital Markets Singapore Limited 6 Shenton Way #26-08, DBS Building Tower Two, Singapore 068809, Republic of Singapore

(65) 6220 3666 (65) 6223 6198

Daiwa Capital Markets Australia Limited Level 34, Rialto North Tower, 525 Collins Street, Melbourne, Victoria 3000, Australia

(61) 3 9916 1300 (61) 3 9916 1330

DBP-Daiwa Capital Markets Philippines, Inc 18th Floor, Citibank Tower, 8741 Paseo de Roxas, Salcedo Village, Makati City, Republic of the Philippines

(632) 813 7344 (632) 848 0105

Daiwa-Cathay Capital Markets Co Ltd 14/F, 200, Keelung Road, Sec 1, Taipei, Taiwan, R.O.C. (886) 2 2723 9698 (886) 2 2345 3638

Daiwa Securities Capital Markets Korea Co., Ltd. One IFC, 10 Gukjegeumyung-Ro, Yeouido-dong, Yeongdeungpo-gu, Seoul, 150-876, Korea

(82) 2 787 9100 (82) 2 787 9191

Daiwa Securities Capital Markets Co Ltd, Beijing Representative Office

Room 301/302，Kerry Center， 1 Guanghua Road，Chaoyang District， Beijing 100020, People’s Republic of China

(86) 10 6500 6688 (86) 10 6500 3594

Daiwa SSC Securities Co Ltd 45/F, Hang Seng Tower, 1000 Lujiazui Ring Road, Pudong, Shanghai 200120, People’s Republic of China

(86) 21 3858 2000 (86) 21 3858 2111

Daiwa Securities Capital Markets Co. Ltd, Bangkok Representative Office

18th Floor, M Thai Tower, All Seasons Place, 87 Wireless Road, Lumpini, Pathumwan, Bangkok 10330, Thailand

(66) 2 252 5650 (66) 2 252 5665

Daiwa Capital Markets India Private Ltd 10th Floor, 3 North Avenue, Maker Maxity, Bandra Kurla Complex, Bandra East, Mumbai – 400051, India

(91) 22 6622 1000 (91) 22 6622 1019

Daiwa Securities Capital Markets Co. Ltd, Hanoi Representative Office

Suite 405, Pacific Palace Building, 83B, Ly Thuong Kiet Street, Hoan Kiem Dist. Hanoi, Vietnam

(84) 4 3946 0460 (84) 4 3946 0461

DAIWA INSTITUTE OF RESEARCH LTD

HEAD OFFICE 15-6, Fuyuki, Koto-ku, Tokyo, 135-8460, Japan (81) 3 5620 5100 (81) 3 5620 5603

MARUNOUCHI OFFICE Gran Tokyo North Tower, 1-9-1, Marunouchi, Chiyoda-ku, Tokyo, 100-6756 (81) 3 5555 7011 (81) 3 5202 2021

New York Research Center 11th Floor, Financial Square, 32 Old Slip, NY, NY 10005-3504, U.S.A. (1) 212 612 6100 (1) 212 612 8417

London Research Centre 3/F, 5 King William Street, London, EC4N 7AX, United Kingdom (44) 207 597 8000 (44) 207 597 8550


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Disclaimer

This publication is produced by Daiwa Securities Group Inc. and/or its non-U.S. affiliates, and distributed by Daiwa Securities Group Inc. and/or its non-U.S. affiliates, except to the extent expressly provided herein. This publication and the contents hereof are intended for information purposes only, and may be subject to change without further notice. Any use, disclosure, distribution, dissemination, copying, printing or reliance on this publication for any other purpose without our prior consent or approval is strictly prohibited. Neither Daiwa Securities Group Inc. nor any of its respective parent, holding, subsidiaries or affiliates, nor any of its respective directors, officers, servants and employees, represent nor warrant the accuracy or completeness of the information contained herein or as to the existence of other facts which might be significant, and will not accept any responsibility or liability whatsoever for any use of or reliance upon this publication or any of the contents hereof. Neither this publication, nor any content hereof, constitute, or are to be construed as, an offer or solicitation of an offer to buy or sell any of the securities or investments mentioned herein in any country or jurisdiction nor, unless expressly provided, any recommendation or investment opinion or advice. Any view, recommendation, opinion or advice expressed in this publication may not necessarily reflect those of Daiwa Securities Capital Markets Co. Ltd., and/or its affiliates nor any of its respective directors, officers, servants and employees except where the publication states otherwise. This research report is not to be relied upon by any person in making any investment decision or otherwise advising with respect to, or dealing in, the securities mentioned, as it does not take into account the specific investment objectives, financial situation and particular needs of any person. Daiwa Securities Group Inc., its subsidiaries or affiliates, or its or their respective directors, officers and employees from time to time have trades as principals, or have positions in, or have other interests in the securities of the company under research including derivatives in respect of such securities or may have also performed investment banking and other services for the issuer of such securities. The following are additional disclosures. Japan Daiwa Securities Co. Ltd. and Daiwa Securities Group Inc. Daiwa Securities Co. Ltd. is a subsidiary of Daiwa Securities Group Inc. Investment Banking Relationship

Within the preceding 12 months, The subsidiaries and/or affiliates of Daiwa Securities Group Inc. * has lead-managed public offerings and/or secondary offerings (excluding straight bonds) of the securities of the following companies: Blackgold International Holdings Ltd (BGG AU); Tosei Corporation (8923 JP); Modern Land (China) Co. Ltd (1107 HK); China Everbright Bank Company Limited (6818 HK); econtext Asia Ltd (1390 HK).

*Subsidiaries of Daiwa Securities Group Inc. for the purposes of this section shall mean any one or more of: Daiwa Capital Markets Hong Kong Limited (大和資本市場香港有限公司), Daiwa Capital Markets Singapore Limited, Daiwa Capital Markets Australia Limited, Daiwa Capital Markets India Private Limited, Daiwa-Cathay Capital Markets Co., Ltd., Daiwa Securities Capital Markets Korea Co., Ltd. Hong Kong This research is distributed in Hong Kong by Daiwa Capital Markets Hong Kong Limited (大和資本市場香港有限公司) (“DHK”) which is regulated by the Hong Kong Securities and Futures Commission. Recipients of this research in Hong Kong may contact DHK in respect of any matter arising from or in connection with this research. Ownership of Securities For “Ownership of Securities” information, please visit BlueMatrix disclosure Link at https://daiwa3.bluematrix.com/sellside/Disclosures.action. Investment Banking Relationship For “Investment Banking Relationship”, please visit BlueMatrix disclosure Link at https://daiwa3.bluematrix.com/sellside/Disclosures.action. Relevant Relationship (DHK) DHK may from time to time have an individual employed by or associated with it serves as an officer of any of the companies under its research coverage. DHK market making DHK may from time to time make a market in securities covered by this research.

Singapore This research is distributed in Singapore by Daiwa Capital Markets Singapore Limited and it may only be distributed in Singapore to accredited investors, expert investors and institutional investors as defined in the Financial Advisers Regulations and the Securities and Futures Act (Chapter 289), as amended from time to time. By virtue of distribution to these category of investors, Daiwa Capital Markets Singapore Limited and its representatives are not required to comply with Section 36 of the Financial Advisers Act (Chapter 110) (Section 36 relates to disclosure of Daiwa Capital Markets Singapore Limited’s interest and/or its representative’s interest in securities). Recipients of this research in Singapore may contact Daiwa Capital Markets Singapore Limited in respect of any matter arising from or in connection with the research. Australia This research is distributed in Australia by Daiwa Capital Markets Stockbroking Limited and it may only be distributed in Australia to wholesale investors within the meaning of the Corporations Act. Recipients of this research in Australia may contact Daiwa Capital Markets Stockbroking Limited in respect of any matter arising from or in connection with the research. Ownership of Securities For “Ownership of Securities” information, please visit BlueMatrix disclosure Link at https://daiwa3.bluematrix.com/sellside/Disclosures.action. India This research is distributed by Daiwa Capital Markets India Private Limited (DAIWA) which is an intermediary registered with Securities & Exchange Board of India. This report is not to be considered as an offer or solicitation for any dealings in securities. While the information in this report has been compiled by DAIWA in good faith from sources believed to be reliable, no representation or warranty, express of implied, is made or given as to its accuracy, completeness or correctness. DAIWA its officers, employees, representatives and agents accept no liability whatsoever for any loss or damage whether direct, indirect, consequential or otherwise howsoever arising (whether in negligence or otherwise) out of or in connection with or from any use of or reliance on the contents of and/or omissions from this document. Consequently DAIWA expressly disclaims any and all liability for, or based on or relating to any such information contained in or errors in or omissions in this report. Accordingly, you are recommended to seek your own legal, tax or other advice and should rely solely on your own judgment, review and analysis, in evaluating the information in this document. The data contained in this document is subject to change without any prior notice DAIWA reserves its right to modify this report as maybe required from time to time. DAIWA is committed to providing independent recommendations to its Clients and would be happy to provide any information in response to any query from its Clients. This report is strictly confidential and is being furnished to you solely for your information. The information contained in this document should not be reproduced (in whole or in part) or redistributed in any form to any other person. We and our group companies, affiliates, officers, directors and employees may from time to time, have long or short positions, in and buy sell the securities thereof, of company(ies) mentioned herein or be engaged in any other transactions involving such securities and earn brokerage or other compensation or act as advisor or have the potential conflict of interest with respect to any recommendation and related information or opinion. DAIWA prohibits its analyst and their family members from maintaining a financial interest in the securities or derivatives of any companies that the analyst cover. This report is not intended or directed for distribution to, or use by any person, citizen or entity which is resident or located in any state or country or jurisdiction where such publication, distribution or use would be contrary to any statutory legislation, or regulation which would require DAIWA and its affiliates/ group companies to any registration or licensing requirements. The views expressed in the report accurately reflect the analyst’s personal views about the securities and issuers that are subject of the Report, and that no part of the analyst’s compensation was, is or will be directly or indirectly, related to the recommendations or views expressed in the Report. This report does not recommend to US recipients the use of Daiwa Capital Markets India Private Limited or any of its non – US affiliates to effect trades in any securities and is not supplied with any understanding that US recipients will direct commission business to Daiwa Capital Markets India Private Limited. Taiwan This research is distributed in Taiwan by Daiwa-Cathay Capital Markets Co., Ltd and it may only be distributed in Taiwan to institutional investors or specific investors who have signed recommendation contracts with Daiwa-Cathay Capital Markets Co., Ltd in accordance with the Operational Regulations Governing Securities Firms Recommending Trades in Securities to Customers. Recipients of this research in Taiwan may contact Daiwa-Cathay Capital Markets Co., Ltd in respect of any matter arising from or in connection with the research. Philippines This research is distributed in the Philippines by DBP-Daiwa Capital Markets Philippines, Inc. which is regulated by the Philippines Securities and Exchange Commission and the Philippines Stock Exchange, Inc. Recipients of this research in the Philippines may contact DBP-Daiwa Capital Markets Philippines, Inc. in respect of any matter arising from or in connection with the research. DBP-Daiwa Capital Markets Philippines, Inc. recommends that investors independently assess, with a professional advisor, the specific financial risks as well as the legal, regulatory, tax, accounting, and other consequences of a proposed transaction. DBP-Daiwa Capital Markets Philippines, Inc. may have positions or may be materially interested in the securities in any of the markets mentioned in the publication or may have performed other services for the issuers of such securities. For relevant securities and trading rules please visit SEC and PSE Link at http://www.sec.gov.ph/irr/AmendedIRRfinalversion.pdf and http://www.pse.com.ph/ respectively. United Kingdom This research report is produced by Daiwa Capital Markets Europe Limited and/or its affiliates and is distributed in the European Union, Iceland, Liechtenstein, Norway and Switzerland. Daiwa Capital Markets Europe Limited is authorised and regulated by The Financial Conduct Authority (“FCA”) and is a member of the London Stock Exchange, Eurex and NYSE Liffe. Daiwa Capital Markets Europe Limited and/or its affiliates may, from time to time, to the extent permitted by law, participate or invest in other financing transactions with the issuers of the securities referred to herein (the “Securities”), perform services for or solicit business from such issuers, and/or have a position or effect transactions in the Securities or options thereof and/or may have acted as an underwriter during the past twelve months for the issuer of such securities. In addition, employees of Daiwa Capital Markets Europe Limited and/or its affiliates may have positions and effect transactions in such securities or options and may serve as Directors of such issuers. Daiwa Capital Markets Europe Limited may, to the extent permitted by applicable UK law and other applicable law or regulation, effect transactions in the Securities before this material is published to recipients.


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This publication is intended for investors who are not Retail Clients in the United Kingdom within the meaning of the Rules of the FCA and should not therefore be distributed to such Retail Clients in the United Kingdom. Should you enter into investment business with Daiwa Capital Markets Europe’s affiliates outside the United Kingdom, we are obliged to advise that the protection afforded by the United Kingdom regulatory system may not apply; in particular, the benefits of the Financial Services Compensation Scheme may not be available. Daiwa Capital Markets Europe Limited has in place organisational arrangements for the prevention and avoidance of conflicts of interest. Our conflict management policy is available at http://www.uk.daiwacm.com/about-us/corporate-governance-regulatory . Regulatory disclosures of investment banking relationships are available at https://daiwa3.bluematrix.com/sellside/Disclosures.action. Germany This document has been approved by Daiwa Capital Markets Europe Limited and is distributed in Germany by Daiwa Capital Markets Europe Limited, Niederlassung Frankfurt which is regulated by BaFin (Bundesanstalt fuer Finanzdienstleistungsaufsicht) for the conduct of business in Germany. Bahrain

This research material is issued/compiled by Daiwa Capital Markets Europe Limited, Bahrain Branch, regulated by The Central Bank of Bahrain and holds Investment Business Firm – Category 2 license and having its official place of business at the Bahrain World Trade Centre, South Tower, 7th floor, P.O. Box 30069, Manama, Kingdom of Bahrain. Tel No. +973 17534452 Fax No. +973 535113

This material is provided as a reference for making investment decisions and is not intended to be a solicitation for investment. Investment decisions should be made at your own discretion and risk. Accordingly, no representation or warranty, express or implied, is made as to and no reliance should be placed on the fairness, accuracy, completeness or correctness of the information and opinions contained in this document, Content herein is based on information available at the time the research material was prepared and may be amended or otherwise changed in the future without notice. All information is intended for the private use of the person to whom it is provided without any liability whatsoever on the part of Daiwa Capital Markets Europe Limited, Bahrain Branch, any associated company or the employees thereof. If you are in doubt about the suitability of the product or the research material itself, please consult your own financial adviser. Daiwa Capital Markets Europe Limited, Bahrain Branch retains all rights related to the content of this material, which may not be redistributed or otherwise transmitted without prior consent. United States This report is distributed in the U.S. by Daiwa Capital Markets America Inc. (DCMA). It may not be accurate or complete and should not be relied upon as such. It reflects the preparer’s views at the time of its preparation, but may not reflect events occurring after its preparation; nor does it reflect DCMA’s views at any time. Neither DCMA nor the preparer has any obligation to update this report or to continue to prepare research on this subject. This report is not an offer to sell or the solicitation of any offer to buy securities. Unless this report says otherwise, any recommendation it makes is risky and appropriate only for sophisticated speculative investors able to incur significant losses. Readers should consult their financial advisors to determine whether any such recommendation is consistent with their own investment objectives, financial situation and needs. This report does not recommend to U.S. recipients the use of any of DCMA’s non-U.S. affiliates to effect trades in any security and is not supplied with any understanding that U.S. recipients of this report will direct commission business to such non-U.S. entities. Unless applicable law permits otherwise, non-U.S. customers wishing to effect a transaction in any securities referenced in this material should contact a Daiwa entity in their local jurisdiction. Most countries throughout the world have their own laws regulating the types of securities and other investment products which may be offered to their residents, as well as a process for doing so. As a result, the securities discussed in this report may not be eligible for sales in some jurisdictions. Customers wishing to obtain further information about this report should contact DCMA: Daiwa Capital Markets America Inc., Financial Square, 32 Old Slip, New York, New York 10005 (telephone 212-612-7000). Ownership of Securities For “Ownership of Securities” information please visit BlueMatrix disclosure Link at https://daiwa3.bluematrix.com/sellside/Disclosures.action. Investment Banking Relationships For “Investment Banking Relationships” please visit BlueMatrix disclosure link at https://daiwa3.bluematrix.com/sellside/Disclosures.action. DCMA Market Making For “DCMA Market Making” please visit BlueMatrix disclosure link at https://daiwa3.bluematrix.com/sellside/Disclosures.action. Research Analyst Conflicts For updates on “Research Analyst Conflicts” please visit BlueMatrix disclosure link at https://daiwa3.bluematrix.com/sellside/Disclosures.action. The principal research analysts who prepared this report have no financial interest in securities of the issuers covered in the report, are not (nor are any members of their household) an officer, director or advisory board member of the issuer(s) covered in the report, and are not aware of any material relevant conflict of interest involving the analyst or DCMA, and did not receive any compensation from the issuer during the past 12 months except as noted: no exceptions. Research Analyst Certification For updates on “Research Analyst Certification” and “Rating System” please visit BlueMatrix disclosure link at https://daiwa3.bluematrix.com/sellside/Disclosures.action. The views about any and all of the subject securities and issuers expressed in this Research Report accurately reflect the personal views of the research analyst(s) primarily responsible for this report (or the views of the firm producing the report if no individual analysts[s] is named on the report); and no part of the compensation of such analyst(s) (or no part of the compensation of the firm if no individual analyst[s)] is named on the report) was, is, or will be directly or indirectly related to the specific recommendations or views contained in this Research Report. The following explains the rating system in the report as compared to relevant local indices, based on the beliefs of the author of the report. "1": the security could outperform the local index by more than 15% over the next six months. "2": the security is expected to outperform the local index by 5-15% over the next six months. "3": the security is expected to perform within 5% of the local index (better or worse) over the next six months. "4": the security is expected to underperform the local index by 5-15% over the next six months. "5": the security could underperform the local index by more than 15% over the next six months. Additional information may be available upon request. Japan - additional notification items pursuant to Article 37 of the Financial Instruments and Exchange Law (This Notification is only applicable where report is distributed by Daiwa Securities Co. Ltd.) If you decide to enter into a business arrangement with us based on the information described in materials presented along with this document, we ask you to pay close attention to the following items. • In addition to the purchase price of a financial instrument, we will collect a trading commission* for each transaction as agreed beforehand with you. Since commissions may be included in

the purchase price or may not be charged for certain transactions, we recommend that you confirm the commission for each transaction. • In some cases, we may also charge a maximum of ¥ 2 million (including tax) per year as a standing proxy fee for our deposit of your securities, if you are a non-resident of Japan. • For derivative and margin transactions etc., we may require collateral or margin requirements in accordance with an agreement made beforehand with you. Ordinarily in such cases, the

amount of the transaction will be in excess of the required collateral or margin requirements. • There is a risk that you will incur losses on your transactions due to changes in the market price of financial instruments based on fluctuations in interest rates, exchange rates, stock prices,

real estate prices, commodity prices, and others. In addition, depending on the content of the transaction, the loss could exceed the amount of the collateral or margin requirements. • There may be a difference between bid price etc. and ask price etc. of OTC derivatives handled by us. • Before engaging in any trading, please thoroughly confirm accounting and tax treatments regarding your trading in financial instruments with such experts as certified public accountants.

*The amount of the trading commission cannot be stated here in advance because it will be determined between our company and you based on current market conditions and the content of each transaction etc.

When making an actual transaction, please be sure to carefully read the materials presented to you prior to the execution of agreement, and to take responsibility for your own decisions regarding the signing of the agreement with us. Corporate Name: Daiwa Securities Co. Ltd. Financial instruments firm: chief of Kanto Local Finance Bureau (Kin-sho) No.108 Memberships: Japan Securities Dealers Association, Financial Futures Association of Japan Japan Securities Investment Advisers Association Type II Financial Instruments Firms Association

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