A reality check for the Xiaomi IPO
The most recent news on the upcoming Xiaomi IPO indicates that the 'Apple of China' may have more conservative expectations that was initially thought. In our view, realism has entered the IPO process.
China Tower, a Chinese state-owned wireless infrastructure operator, has filed for an initial public offering that will be the biggest globally this year and the largest IPO since Postal Savings Bank of China raised $7.6 billion in 2016. According to exchange filings, shares in China Tower were priced between HK$1.26 and HK$1.58 and will begin trading on August 8, 2018.
The timing of this IPO is weighing on risk appetite as the Hang Seng has slumped 15% from its January highs, the yuan has significantly depreciated against the USD since May, and Sino-US tensions are escalating with a trade deal seeming some ways off.
Given these circumstances, China Tower has encountered a lukewarm response to its IPO and priced itself at the low end of the marketed range (HK$1.26, raising $6.9bn in contrast to the desired $10bn).
In comparison to Ping An Good Doctor, which held its IPO in April and was 650 times oversubscribed, China Tower was only just oversubscribed, illustrating precisely how much investor enthusiasm has been dented by the geopolitical and economic events that have unfolded throughout 2018.
China Tower was formed in 2015 by combining the transmission facility assets of China Mobile, China Unicom, and China Telecom in a bid to reform the nation’s state-dominated wireless industry. The company is the world’s largest owner of telecom tower infrastructure, as per the prospectus.
State-backed China Mobile, the world’s largest wireless carrier, owns a 38% in China Tower, along with China Unicom and China Telecom, each with stakes of about 28%. China Reform Holdings, a state-owned investment fund, holds the remaining 6%. Other than being shareholders, the three carriers also pay leasing fees to use China Tower’s facilities.
China's tech sector, under the government initiatives of “Internet Plus”, “Made in China 2025”, and “Outline on the National Information Technology Development Strategy”, is emerging as an innovation and technology powerhouse. These blueprints set targets for a fourth industrial revolution in China driven by information technology, artificial intelligence, and robotics with the aim of being globally competitive and dominant in all these sectors.
China Tower will be integral to achieving the nation's dominance in many of these areas, which will rely on the high speed 5G wireless network rollout.
According to the prospectus, the company plans to use 60% of the IPO proceeds for capital expenditure plans primarily relating to China’s 5G rollout; this includes both upgrading old towers and building new towers.
Another 30% will go toward repaying bank loans, and the remaining 10% will be put aside for working capital and corporate purposes.
When you consider China Tower as a giant telecom stock with a monopoly position, the attraction is reasonably obvious. The firm has superior organic growth prospects in the world’s second-largest economy, whose middle class is expanding in both size and wealth. China has a similar proportion of city dwellers as the US did in 1940; moreover, between 2009 and 2030 the country will add 850 million people to its middle class.
This means the Chinese middle class will grow from 12% of the country's population in 2009 to 73% in 2030. Wage growth in China has risen for approximately two decades and as consumers become wealthier, the ability to afford wireless services increases.
Additionally, increasing demand for "internet of things" applications will increase mobile data traffic, providing a necessity for telecom operators to increase demand for mobile towers. This is reflected in China Tower’s profitability, which improved noticeably in 2017. The company made a profit of 1.9 billion yuan ($299 million) last year and posted an EBITDA margin of 59% (comparable to US peers), compared with 76 million yuan in 2016 and a loss of 3.6 billion yuan in 2015.
China’s online user base has increased to 771.98 million as at 31 December 2017, double the population of the US and still has room to grow (according to the China Internet Network Information Center). Additionally, only 54.6% of the population in China is online compared with 88.1% in the US.
We expect internet penetration and sector revenues to continue rising in the coming years, thus supporting growth for China Tower.
It is expected that Chinese telecom companies will be commercially launching 5G in 2020 and trials will commence in 2019. This means operators will need to strengthen their networks with further equipment, smaller cells, and distributed antennas. This should accelerate China Tower’s growth from these segments, which in 2017 only contributed around 2% to revenue.
China Tower already has more 12 times as many towers than its closest rivals, and this is only going to increase if China’s ambitious 5G plans are achieved, further adding to revenue growth prospects.
Looking at China Tower’s valuation on a relative basis, the stock may trade at a discount to US peers. If we compare the debt adjusted valuation metric EV/EBITDA, the valuation disparity to US peers is apparent. We have considered the company filing’s and our estimations suggest an EV/EBITDA of 7.30, accounting for pricing at the low end of the marketed range.
This seems cheap compared too median 19.2 EV/EBITDA of US telecom leaders. Compared to China’s telecom leaders, however, our estimation suggests a valuation premium.
In summary the stock looks cheap compared to US peers, and features accelerating profits with room for further expansion and growth prospects. The catch is that China Mobile is a state-owned enterprise. We could argue that this is a positive, in the sense that a state-sponsored wireless infrastructure operator should operate as an effective monopoly; being on the same side as the state could in this sense be reassuring.
The downside, however, is that state-owned enterprises are often used to advance government policy goals which may not necessarily align with the interests of shareholders (such as, for example, state pressure on the company to reduce data fees). China Tower’s largest shareholders; China Mobile Ltd., China Unicom Group Corp., and China Telecom Corp. also account for 99.4% of revenue. Given that lease agreements are negotiated at “arms length”, according to the prospectus, there is a conflict of interest in relation to pricing power which could limit profitability.
The three five-year lease agreements settled in 2016 by China Mobile, China Unicom, and China Telecom represented lease rates below that of global peers and generated significant savings for China Tower’s three biggest shareholders, illustrating the lack of pricing power China Tower may have and exactly how the conflicting loyalties will directly affect China Tower’s revenue growth.
There is a risk that prospective shareholders could lose out when it comes time to renegotiate these lease agreements in 2021 as China Tower has already set a precedent for feeble bargaining power with its three biggest customers. However, given that the three telcos are the entire market for mobiles and data in China, the fact that 99.4% of China Tower’s revenue is sourced from these three companies is not all bad.
Given the influence of the state and lack of pricing power, the concerns of private shareholders may not be a priority for the company. For that reason, income chasers who see telecom stocks as bond proxies may want to persist with the more established US and European names given China Tower’s dividend yield ratio is only around 1% (well below global peers).
For investors hunting value, however, the discount relative to China Tower's US counterparts could be attractive.
China Tower represents an opportunity to gain exposure to the state-backed initiative of IT innovation and 5G communications dominance, but whether this will work out as profitable for shareholders or the Chinese nation is debatable.