March 11, 2014 Hong Kong: Telecom Services Equity Research CSL acquisition FCF accretive: Prefer HKT among HK telcos HKT’s pending acquisition of CSL signals industry consolidation The HK mobile industry stands to benefit from HKT’s proposed US$2.4bn HONG KONG TELECOM VALUATION COMPS acquisition of CSL in the longer term, in our view, as it would reduce 12-Mo. Market Up/Down Total Name Ticker Rating Tgt Px Price Side Return competitive intensity in Asia’s highest penetrated mobile market. The deal PCCW 0008.HK Neutral 3.60 3.75 -4% 2% HKT Trust 6823.HK Neutral 8.90 8.25 8% 14% is pending regulatory approval after receiving PCCW and HKT HTHK 0215.HK Neutral 2.60 2.61 0% 4% SmarTone 0315.HK Neutral 10.00 9.20 9% 12% shareholders’ approval (99.98%) at the EGM on Feb 28. The acquisition P/E EV/EBITDA Div Yld could also potentially remove the overhang of the upcoming spectrum re- Name 2014E 2015E 2014E 2015E 2014E 2015E PCCW 13.0x 11.5x 5.6x 5.2x 6.0% 6.8% auction, which we would see as an industry-wide positive. HKT HKT Trust 22.7x 16.5x 8.9x 8.5x 5.9% 6.0% HTHK 15.6x 15.6x 6.4x 6.3x 4.8% 4.8% management estimates 10%-15% opex synergy on the combined mobile SmarTone 15.8x 16.3x 4.5x 4.5x 3.8% 3.7% business after full integration, or US$596mn-934mn in savings by our ROE ROIC CROCI Name 2014E 2015E 2014E 2015E 2014E 2015E estimate, which we believe is achievable for an in-market consolidation. PCCW 22.1% 23.4% 18.1% 19.9% 9.7% 9.8% This amount of savings would lower CSL’s implied EV/AFF to 18.2x-21.0x HKT Trust 7.7% 10.7% 39.3% 35.2% 7.4% 7.5% HTHK 7.2% 7.1% 14.6% 13.2% 7.7% 7.2% from 24.8x for 2015E (vs. 17.8x for HKT on the announcement date). SmarTone 19.6% 17.7% 68.8% 73.6% 13.2% 11.7% Prices in HK$, as of market close of March 7, 2014. HKT remains our preferred HK telco; raising TP to HK$8.90 Source: Bloomberg, Goldman Sachs Global Investment HKT is our preferred HK telco on its pricing power in FTTH and fixed-line Research. telephony. In 4Q13, HKT raised its fixed line telephony monthly rate by 64% to HK$180 for private residential units (c.46% of HK) when contracts KEY RISKS are renewed. We estimate HKT has a 70% share in the 1.1mn private residential segment; assuming 5% churn, this implies additional revenue of HKT: Upside: Higher-than-expected fiber and mobile growth; Downside: Merger doesn't receive regulatory HK$109mn/286mn in 2014E/15E as 24-month contracts roll over. Coupled approval, regulatory pressure on fixed-line, higher-than- expected fixed-line disconnection, high interest rate with stable 2H13 revenue on higher broadband prices and lower CAC, we environment. raise our 2014/15 AFF estimates by 8%/9%. Lastly, we roll forward our DCF PCCW: Upside: Stronger-than-expected IT solutions and pay and raise our 12-month target price by 27% to HK$8.90 (including HK$0.90 TV business; Downside: reinvestment risk. per share of synergy benefits). Our PCCW SOTP-based target price rises SmarTone: Upside: Continued market share gain; Downside: 13% to HK$3.60. Stay Neutral on both. Further roaming revenue decline, greater-than-expected handset subsidies. HTHK: Upside: stronger-than-expected growth in the Cut SmarTone and HTHK estimates; rolling forward valuations enterprise and carrier segment; Downside: price SmarTone: We cut FY14E-16E EPS by 30%-38% on continued service competition in mobiles as the industry slows. revenue decline and higher opex on expanded network capacity. We roll our DCF valuation forward and our 12-month target price declines 9% to HK$10.0. Maintain Neutral. HTHK: We cut 2014E/15E EPS by 37%/38% as we factor in worse-than-expected revenue pressure and higher taxes starting 2014 and introduce 2016E EPS of HK$0.17. We roll our DCF forward and our revised 12-month target price drops 10% to HK$2.60. Maintain Neutral. Piyush Mubayi +852-2978-1677 [email protected] Goldman Sachs (Asia) L.L.C. Goldman Sachs does and seeks to do business with Tina Hou companies covered in its research reports. As a result, +852-2978-0178 [email protected] Goldman Sachs (Asia) L.L.C. investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. For Reg AC certification and other important disclosures, see the Disclosure Appendix, or go to www.gs.com/research/hedge.html. Analysts employed by non- US affiliates are not registered/qualified as research analysts with FINRA in the U.S. The Goldman Sachs Group, Inc. Global Investment Research March 11, 2014 Hong Kong: Telecom Services HKT’s pending acquisition of CSL signals potential industry consolidation and improved market dynamics Regulatory approval last remaining obstacle for merger On Dec 20, 2013, HKT announced that it had entered an agreement with CSLNW (Telstra owns 76.4%, New World 23.6%) to acquire the entire share capital of CSLNW for US$2.425bn (HK$18.87bn). At its EGM on Feb 28, 2014, HKT received shareholders’ approval (99.98%) for the proposed acquisition. Completion of the acquisition remains conditional upon the approval of OFCA, Hong Kong’s telecommunications regulator. The sale agreement includes a non-competition clause that requires both Telstra and New World not to engage in any direct or indirect mobile wireless core operations (including WiFi) in Hong Kong for three years from the date of the deal completion. The acquisition will be initially funded by a US$2.5bn 18-month bridge loan from Standard Chartered Bank at an interest rate comparable to HKT’s current bank loan facilities, or just below 3%. Management indicated that it intends to refinance the bridge loan quickly after deal close with a combination of debt and equity. 24.8x EV/AFF for CSL drops to 18.2x-21.0x on synergy gains Management targets to reduce the operating expenses of the combined mobile businesses by 10% to 15% after full integration of the business. Synergies should come from: a) Removal of overlapping base stations. b) Replacement of backhaul transmission network lease with HKT’s own infrastructure. c) Network and spectrum sharing should generate economies of scale and lower both capex and maintenance spending. d) Retail/distribution channel optimization as the rental leases expire in up to 2-3 years and related cost savings from the streamlining process. PCCW/HKT has 48 retail outlets throughout Hong Kong. Adding the 32 One2free stores and nine 1O1O stores, the combined HKT/CSL entity will have a reach of 89 stores. In comparison, HTHK has 60, CMHK 45 and SmarTone 32. e) Improved bargaining power in equipment/content procurement and administrative cost savings. Other gains could potentially accrue on the revenue side from: a) CSL’s bundling of its services with those of the fixed-line carrier, a proven strategy to lower churn in other markets. b) We believe the benefits of CSL’s superior brand position and a robust network more than offset the risks from ‘bill shock’. Lastly, and rather unusually, since CSL used to be a part of HKT a decade ago, we believe the risks around execution are meaningfully lower than would be otherwise. Goldman Sachs Global Investment Research 2 March 11, 2014 Hong Kong: Telecom Services Exhibit 1: HKT/CSL combined entity would have 89 stores Hong Kong telcos retail outlets Hong Kong Kowloon New Territories Total PCCW/HKT9152448 One2free8111332 1O1O3339 HKT+CSL 20 29 40 89 HTHK 14 24 22 60 CMHK 8152245 SmarTone 10 10 12 32 Source: Company data. The deal translates to 9.2x CSL’s FY13 (June year-end) EBITDA. The multiple would drop to 5.7x if we were to use HKT’s handset amortization policy. In contrast, the multiple being paid for Hong Kong wireless companies (i.e. SmarTone – the only publicly listed pure wireless operator in HK) is 3.6x 2014E EV/EBITDA while the Asia Pacific telecom average multiple is 6.8x. A comparison with the five M&A transactions in Hong Kong since 2000 shows that the 9.2x EV/EBITDA multiple is below the 11.6x historical average. Recent acquisitions in the EU and the US imply a lower average multiple of 6.8x. As a result of the range in multiples, we estimate AFF based multiples are a better way to look at the transaction. Based on CSL’s FY13 (June YE) normalized adjusted funds flow (AFF) of HK$760mn, the proposed acquisition implies an EV/AFF of 24.8x compared to HKT’s 2013 EV/AFF of 17.8x (Dec 24, 2013). Further, including synergy benefits, multiples would improve to 18.2x-21.0x from 24.8x. We believe this should be factored into valuations in cases where in-market consolidation also involves the incumbent fixed-line telco. Factoring in synergy gains from this merger would lower the EBITDA multiple for CSL from 9.2x to 8.1x-8.6x, or from 9.2x to 5.7x on HKT’s handset accounting. Goldman Sachs Global Investment Research 3 March 11, 2014 Hong Kong: Telecom Services Exhibit 2: Historical transactions in Hong Kong and recent transactions globally 9.2x implied EV/EBITDA is lower than historical average of 11.6x in Hong Kong, but higher than recent global average of 6.8x Hong Kong Transactions EV/EBITDA Announcement Date Target Target Country Acquirer (Last FY) Mar 2006 New World PCS Hong Kong Telstra Corporation 7.3x Oct 2005 China Resources Peoples Hong Kong China Mobile Hong Kong Company Telephone Company 6.4x Jun 2005 Sunday Communications Hong Kong PCCW 19.0x Jun 2002 CSL (40%) Hong Kong Telstra Corporation 6.7x Feb 2001 CSL (60%) Hong Kong Telstra Corporation 18.5x Average 11.6x Other Recent Transactions EV/EBITDA Announcement Date Target Target Country Acquirer (Last FY) Asia Jan 2013 Companhia de Macau CITIC Telecom International Holdings 8.5x Telecomunicações de Macau Europe Jul 2013 E-Plus Gruppe Germany Telefónica Deutschland Holding 6.3x Jun 2013 Telefónica Ireland Ireland Hutchison 3G Ireland 6.0x Feb 2012 Orange Austria Telecommunication Austria Hutchison 3G Austria 6.9x Dec 2011 Orange Communications Switzerland Matterhorn Mobile Holdings 6.5x US Jul 2013 Leap Wireless International US AT&T 6.7x Jan 2013 Allied Wireless US AT&T 8.0x Communications Corporation Oct 2012 MetroPCS Communications US T-Mobile USA 5.5x Average 6.8x Source: Company data.