Telecom JV Makes China Mobile a Deep Value Buy

China Mobile's share price is set to get a 25% boost

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Dec 28, 2015
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The Chinese telecom sector is finding different ways to enhance efficiency and save costs. A state backed joint venture between the three telecom companies created China Tower, which will own and operate cell towers on behalf of China Mobile (CHL, Financial), China Unicom (CHU, Financial) and China Telecom (CHA, Financial). All the three companies are sharing a tower asset pool of around $16.3 billion.

The venture was created with a $1.6 billion share capital, with China Mobile’s share standing at 40%, and China Unicom and China Telecom's shares as the remaining stake of 60%. China Tower is also planning to raise $9.7 billion in a private placement from outside investors. This would have a dilutive effect on the JV ownership of telecom companies. The JV was first named China Communication Facilities Services Corporation, which was later changed to China Tower. The JV is expected to result in a $24 billion one-time gain for the Telcos involved. China Mobile’s share price will get a 25% boost, according to our calculations. Given that China Mobile is already trading low, it’s one of the best value ideas of 2016. The importance and cost implications of the JV are analyzed below.

Cost savings and other benefits

The China Tower venture will result in cost savings and new avenues of income for carries. Three types of benefits are expected:

  1. CAPEX savings
  2. OPEX savings
  3. Lease income.

Due to the elimination of overlap investment, carriers will save billions of dollars in CAPEX. Reduced individual spending will lead to lower CAPEX going forward. Three towers cost around $84,960, while sharing a single tower will bring that cost down to $45,440 for carriers.

China Tower is planning to add 1 million cell towers during the next two years. CAPEX savings on each tower amounts to around $39,520.

If China Tower successfully deploys one million cell towers, substantial cost savings are expected during the next two years

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KPMG thinks that a 16% to 20% decline in CAPEX should be expected amid tower sharing. Note that smaller players will enjoy larger percentage savings in CAPEX as compared to established players like China Mobile.Ă‚ China Mobile can save up to $15 billion in CAPEX once China Tower completes construction of 1 million cell sites.

However, it’s worth mentioning here that China Mobile’s network is not built for FDD-LTE. Therefore, smaller players will have to build some of their own. Nonetheless, inter-operability allows smaller players to enhance network quality.

Regarding OPEX, carriers will save operating expenses amid efficient use of assets. Sharing of rent and fuel expenses will reduce site operating expenses for carriers. A case study on Indian carriers revealed that cost per operator per tower site can decrease by 35.1% if tower sharing is allowed. Another research mentions that tower sharing can reduce the tower OPEX by 12% to 15% annually. As tower operating costs make up around 60% of the carriers total OPEX, a decrease of 12% to 15% can materially impact the operating expenses of operators.

Finally, tower sharing can result in annuity income for China Tower, which will be absorbed by carriers amid ownership of China Tower. But, this rental income will be offset by the lease costs incurred by the carriers to utilize the towers. The net effect of rental income would be almost zero for the carriers. However, China Mobile can benefit from rental income as it holds the majority of China Tower assets, yet it has enough of its own to minimize the lease it has to pay to China Tower.

To review, the JV will result in capital expenditure savings mostly for smaller players, operating expenditure savings equally for all players and annuity income favoring established player like China Mobile.

Qualitative implications of China Tower

The most direct implications of the creation of China Tower include reduction in overlapping investments and duplication of work related to building network infrastructure, improvement in resource utilization, reduction in carriers’ investment scale and utilization of existing assets efficiently. Further, sharing of tower assets will conserve resources, while playing an important role in environmental protection.

“Flexibility to use under-utilized towers allows carriers to cut overlapping investments alongside increasing resource utilization.”

As the JV encourages sharing of assets, a single tower would serve the needs of all the three carriers instead of each carrier deploying their own tower. This will result in quick and effective rollout of services like 4G, and reduce the time to market.

Quality of network and customer services will improve as carries shift their focus towards operations instead of assets.

Competition will get intense as the tower sharing venture moves forward. Sharing of assets, or renting of tower assets, lower the barriers to entry for new players. Smaller players can use the existing infrastructure to close their coverage and quality gap with the large players. For instance, China Unicom and China Telecom will easily utilize China Mobile’s network by renting the underutilized capacity to beef up their network. New players, including mobile virtual networks, can easily rent the networks to create more competition. Note that MNVOs don’t have their own networks; they provide mobile services by leasing network time from established players. The China Tower JV paves the way for MNVOs.

Competition will increase, and quality gap will close down leading to a tense pricing environment for carriers.

As far as scale of the players is concerned, there are two sides to the story. On one hand, sharing agreements like this expose established players to a market-share loss amid increasing competition and closing quality gap. Large players like China Mobile already have the network in place. It’s the smaller companies that utilize the network to enhance their quality and coverage. So, the sharing generally doesn’t really benefit the established companies. And, their market share is at risk. On the other hand, established players’ return per asset increases amid optimum utilization of towers and rent earned from the lessee carriers. Further, all the network is never in place. Currently, China Mobile is aggressively rolling out LTE. Joint venture allows the company to reduce CAPEX to a certain extent.

Overall, we favor KPMG’s view that inter-operator tower sharing benefits established players.

To review, the JV is quite significant as it results in efficient use of resources, encourages competition and enables faster time to market. As a result, subscribers will benefit amid quick access to new technology, consistent network quality across networks and favorable pricing. From a carrier’s point of view, it will benefit from reduced capital and operating expenditure. However, competition and pricing pressure will offset some of the cost benefit for the carriers. Established players like China Mobile are a safer bet as they can sustain increased competition amid their resource-rich position. They can even indulge in price wars to knock the competition out. Smaller players are at risk from adoption of MNVOs’ services. Overall, China Mobile is the safest bet to play the JV.

Quantifying the benefits

Let’s analyze the cost savings of China Mobile in the light of the JV. As mentioned above, building three towers can cost the three carries around $84,960. However, if the carriers share a single tower, the cost comes down to $45,440 per tower. This translates into a CAPEX savings of $39,520 per tower. Now, China Tower is building 1 million towers during the next two years. CAPEX savings of $39,520 per tower is incorporated in the model for the next two years. Beyond that, 15% of the carrier CAPEX is assumed to be the projected savings, in line with the KPMG’s estimate of 16% to 20% CAPEX savings for passive infrastructure savings.

OPEX saving of 12% p.a. is assumed in line with the industry’s expectations of 12% to 15% decline in tower OPEX through sharing, see Cost Savings and Other Benefits. Further, gain on asset transfer is not added in the calculation as it’s a non-cash gain.

CAPEX and OPEX savings are expected to continue in perpetuity because carriers will save these expenses each year, thanks to tower sharing. For that reason, a multiple is derived to use for CAPEX and OPEX savings. Capital Asset Pricing Model is used to calculate the discount rate, which is then used in the perpetuity formula to derive the multiple. Towards the end, investment costs are subtracted from cost benefits to arrive at the net benefit achieved from the JV. See the calculations below:

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The estimate sheet reveals that Tower Sharing can result in $61 billion of cost savings for China Mobile, which translates into a valuation upside of around 25%. Note that the cost benefit analysis didn’t account for the income that can be generated from the lease of the assets as the income will be offset by fees carriers have to pay in order to utilize the towers.