Who Are the Winners in China's Telecom Reshuffle?

In June,  China Telecom ,  China Unicom , and  China Netcom  announced detailed restructuring plans that will change the landscape of China's telecom industry. Fixed-line operator China Telecom will acquire China Unicom's CDMA business with cash. China Unicom's remaining GSM assets will merge with fixed-line operator China Netcom in a stock exchange to form the new China Unicom. For China's dominant mobile operator  China Mobile , there is little structural change other than its parent company's acquisition of China Railcom, a relatively small fixed-line operator.

Background on the Reorganization
Rumors of the industry reorganization have been around for several years, and if you are familiar with the Chinese telecom market, you will have no problem figuring out why the reorganization has to happen. Over the past five years, wireless services have grown to dominate the telecom market in China; in 2007 alone, the two wireless carriers China Mobile and China Unicom added about 86 million new users, in contrast to a decline of 2.3 million for fixed-line carriers China Telecom and China Netcom. This trend further accelerated in the first five months of 2008, as more than 5 million fixed-line users terminated services, while 47 million new mobile users were added, 38 million of which went to China Mobile.

The Chinese government, wary of China Mobile's growing dominance and concerned about the fixed-line operators' weakening business, finally decided to intervene with an industrywide restructuring to change the current market setup. The goal is to introduce more competition, increase mobile penetration, and reduce duplicate wireless infrastructure investment.

Effects on Market Structure
After the revamp, China Mobile will lead the mobile carriers with a 69% market share, while China Unicom and China Telecom take 23% and 8% of the market, respectively. In the fixed-line area, China Telecom remains number one with a 60% share and China Unicom ranks second with 30% of the market. The remaining 10% goes to other providers, such as China Railcom, a subsidiary of China Mobile's parent.

We don't expect competitive dynamics to change substantially in the short run, but business risks could increase. The reorganized China Unicom and China Telecom could potentially face lengthy and difficult integrations, which may take from several months to a year. In the meantime, we expect China Mobile to continue aggressively expanding its share in the lucrative wireless market and force its rivals to fight harder for customers. Some believe that China Unicom and China Telecom may have a competitive edge over China Mobile by offering bundled fixed-line and wireless services, but we think it is unclear if Chinese consumers would be particularly enthusiastic about such bundling services.

However, we do believe the Chinese government is trying to level the playing field by forcing China Mobile to adopt the home-grown, unproven TD-SCDMA technology for its 3G services. This should tilt the competition in favor of China Unicom and China Telecom, which can launch their 3G services in a more cost-effective way based on more mature WCDMA and CDMA2000 technologies. If these two carriers are indeed successful in their 3G business, we think they will likely narrow the gap with China Mobile and become meaningful competitors in the longer run.

Impact on Carriers
 China Telecom 
Moat Rating: Narrow | Fair Value Uncertainty Rating: High | Morningstar Rating: 3 Stars
After the reorganization, China Telecom will finally receive the wireless license it has coveted for many years. The leading fixed-line operator has agreed to pay $6.4 billion in cash for China Unicom's CDMA business, which delivered operating income of $175 million in 2007 but saw a 1.6% sales decline. This cash-based acquisition will change China Telecom's capital structure and pressure future investments in network expansion and upgrades. In the first few years after 3G services are launched, we expect mobile voice and associated value-added services such as messaging and music will remain the major revenue contributors, as no killer 3G applications are available yet. As a result, we think China Telecom will need to rely on aggressively cutting prices to sign up wireless users. That said, the long-term business expansion and scale benefits should be recognized when 3G killer applications are commercially launched, and when the firm could target business users with bundled fixed and mobile services.

 China Unicom 
Moat Rating: Narrow | Fair Value Uncertainty Rating: High | Morningstar Rating: 3 Stars
We think China Unicom will turn out to benefit the most from this reorganization. The merger with China Netcom and the divestment of its CDMA business will help boost China Unicom's margins substantially in the short term. The carrier will not only shed the lower-margin CDMA business for a significant amount of cash from China Telecom, but it will also acquire China Netcom's GSM assets, which deliver much higher margins than its own. Moreover, China Unicom will no longer be required to straddle both GSM and CDMA networks. Instead, it can narrow its focus on GSM or the future WCDMA 3G network to expand its competitive advantage. Further, China Unicom's original fixed-line business could share certain resources with China Netcom and deliver more scale advantages. However, we think the integration process could be arduous and risky, offsetting some merger synergies.

 China Netcom 
Moat Rating: Narrow | Fair Value Uncertainty Rating: High | Morningstar Rating: 3 Stars
China Netcom is the weakest of the original four publicly traded telecom operators and it lacks the experience and resources to operate a wireless network itself. As a result, we think that the merger with China Unicom should make China Netcom's shareholders better off. Old shares will be canceled on Oct. 31, 2008, if all conditions between the two parties are satisfied and the merger takes effect on schedule.

 China Mobile 
Moat Rating: Wide | Fair Value Uncertainty Rating: High | Morningstar Rating: 3 Stars
It has an obvious disadvantage of not providing bundled services, but we still believe that China Mobile is best positioned in China's wireless market, especially in the short run. On the negative side, telecom regulators may implement some measures--such as differentiated pricing policies and number portability--that strongly favor its competitors China Unicom and China Telecom, which may create uncertainties for China Mobile. On the positive side, China Mobile may be able to negotiate some preferential policies with the regulators, given the critical role the mobile carrier is expected to play in promoting TD-SCDMA standards.

Effects on Telecom Equipment Providers
According to industry estimates, China will spend more than CNY 400 billion ($58 billion) in 3G network construction and associated equipment after the telecom reshuffle, as it becomes clear that all three wireless operators will receive 3G licenses. Among the three 3G technologies, the transition to CDMA 2000 from the current CDMA network will require the least capital investment. As a result, the lion's share of spending on 3G will be tied to WCDMA and TD-SCDMA equipment. In the 3G area, carriers will strive to control costs, improve network utilization and efficiency, and utilize better customer and maintenance services. We think domestic equipment providers like Shenzhen-based Huawei Technologies and ZTE Corporation have better opportunities, given their advantages in local knowledge and competitive pricing. In addition, these Chinese firms have already built proven track records in the 3G equipment area globally, with expanding international market share. Further, although foreign competitors have entered into China's TD-SCDMA equipment market through joint ventures, they are uncertain about TD-SCDMA's future due to delays in China's 3G license issuance, which led to inadequate investment. For example, KaiMing, a local venture with investment from  Nokia (NOK),  Texas Instruments (TXN), and others, terminated its business this April. All in all, domestic players will benefit the most in China's new telecom era.