China Initiating Coverage

13 December 2016 Communications | Telecommunications Buy China Unicom Target Price: HKD12.65 Price: HKD9.33 Playing Catch Up Market Cap: USD28,794m Bloomberg Ticker: 762 HK

We initiate coverage on CU with a BUY and DCF-based TP of HKD12.65 Share Data (36% upside). We are positive on the stock due to the following: Avg Daily Turnover (HKD/USD) 495m/63.9m 1. We expect CU's 3-year recurring NP CAGR of 42.4% to be much faster 52-wk Price low/high (HKD) 7.77 - 10.2 than its peers on stronger 4G growth and higher operating leverage; 2. In the coming years, we expect steadily rising ARPU and FCF, driven Free Float (%) 26 by data usage growth and falling capex; Shares outstanding (m) 23,947 3. Trading at 3.4x FY17F EV/EBITDA, 0.5SD below its 3-year mean, Estimated Return 36% despite improving and strong growth momentum ahead. Shareholders (%) 4G penetration is catching up. While a laggard of the three telcos in 4G China Unicom Group 74.4 network rollout, China Unicom’s (CU) 3Q average 4G sub net adds have accelerated to 5.5m, from 2Q’s 4.4m. –This was mainly due to:

i. Improved 4G network quality;

ii. Benefits from network sharing with China Telecom (CT) in rural areas to Share Performance (%) speed up the rollout of 4G network in those areas. YTD 1m 3m 6m 12m We believe that CU’s 4G sub net adds would continue to ramp up and expect Absolute (1.3) 8.5 4.1 8.4 2.2 its 4G penetration to reach 41%, 61% and 80% by the end of FY16F-18F Relative (5.2) 7.5 6.4 0.2 (3.8) respectively. Source: Bloomberg Steadily rising ARPU and FCF. Given that 4G subs have a higher ARPU (76% higher than blended), we are of the view that increasing 4G penetration should China Unicom (762 HK) also lead to higher blended ARPU, which we expect to rise by ~5% pa during Price Close Relative to Hang Seng Index (RHS) 10.5 120 FY15-18F. 10.0 113 9.5 107 On the other hand, we are also of the view that CU’s 4G investment peak has 9.0 100 8.5 93 already passed. In the 139 focus cities (84% of CU’s data traffic), CU’s 4G 8.0 87 7.5 80 network has already reached full coverage. Network sharing with CT and 500 450 refarming of the 900MHz spectrum for the rollout of 4G service in rural areas 400 350 300 should further reduce its capex burden going forward. Given the falling capex, 250 200 FCF should stay on an uptrend. We expect FCF yield to rise to 8.8% in FY18F, 150 100

from -1.4% this year. 50

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Strong earnings growth ahead. CU’s recurring NPM is lowest in the sector -

Oct Apr

Jun

Feb

Dec Aug (FY16F ~1%). This makes its recurring NP growth the most sensitive to the acceleration of 4G adoption and retreat of marketing expenses once 4G Source: Bloomberg segment’s momentum is built up. We believe these two factors have been materialising from 2H16 onwards. Therefore, we expect its recurring NP growth Table Of Contents to also ramp up rapidly in tandem and grow at a CAGR of 42.4% in FY15-18F, the fastest in the sector. Initiate with a BUY and HKD12.65 TP. Our TP is derived from a DCF-based valuation. This also implies a 4x forward EV/EBITDA, 1SD above its 3-year mean. CU is currently trading at 3.4x FY17F EV/EBITDA, 0.5SD below its three-year mean. We consider this unjustified given that CU’s 4G service has started to catch up with peers and its forecast recurring NP CAGR in FY15-18 would be the fastest in the sector, given its largest operating leverage (42.4% vs peers’ average of 10.6%). Key risks include unfavourable changes to regulation/policy and stiffer-than- expected competition.

Forecasts and Valuations Dec-14 Dec-15 Dec-16F Dec-17F Dec-18F Total turnover (CNYm) 284,750 277,050 279,490 300,125 314,342 Reported net profit (CNYm) 12,124 13,372 2,231 7,375 12,206 Recurring net profit (CNYm) 12,124 3,799 2,231 7,375 12,206 Recurring net profit growth (%) 15.5 (68.7) (41.3) 230.6 65.5 Recurring EPS (CNY) 0.51 0.16 0.09 0.31 0.51 DPS (CNY) 0.20 0.17 0.03 0.09 0.25 Recurring P/E (x) 16.3 52.4 89.2 27.0 16.3 P/B (x) 0.88 0.86 0.84 0.84 0.83 P/CF (x) 2.03 1.60 2.76 2.44 2.40 Dividend Yield (%) 2.4 2.0 0.3 1.1 3.1 Analyst EV/EBITDA (x) 3.36 3.73 3.95 3.41 2.99 Ken Chui, CFA Return on average equity (%) 5.4 5.8 1.0 3.1 5.1 Net debt to equity (%) 50.3 55.3 55.2 51.6 46.0 +852 2103 9415 Our vs consensus EPS (adjusted) (%) (21.5) 9.4 14.7 [email protected]

Source: Company data, RHB

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China Unicom China Initiating Coverage

13 December 2016 Communications | Telecommunications

Financial Exhibits

Financial model updated on: 2016-11-28. Asia Financial summary Dec-14 Dec-15 Dec-16F Dec-17F Dec-18F China Recurring EPS (CNY) 0.51 0.16 0.09 0.31 0.51 Communications EPS (CNY) 0.51 0.56 0.09 0.31 0.51 China Unicom DPS (CNY) 0.20 0.17 0.03 0.09 0.25 Bloomberg 762 HK BVPS (CNY) 9.5 9.6 9.9 9.9 10.0 Buy Weighted avg adjusted shares (m) 23,865 23,947 23,947 23,947 23,947

Valuation basis Valuation metrics Dec-14 Dec-15 Dec-16F Dec-17F Dec-18F Recurring P/E (x) 16.3 52.4 89.2 27.0 16.3 DCF valuation: i. WACC-9.3%; P/E (x) 16.3 14.9 89.2 27.0 16.3 ii. Terminal growth rate-1%. P/B (x) 0.88 0.86 0.84 0.84 0.83 FY17F EV/EBITDA: 4.0x, 1SD above its 3-year FCF Yield (%) 6.4 (4.7) (1.4) 5.1 8.8 forward mean. Dividend Yield (%) 2.4 2.0 0.3 1.1 3.1

EV/EBITDA (x) 3.36 3.73 3.95 3.41 2.99 Key drivers EV/EBIT (x) 16.4 30.3 55.5 23.9 15.4 Strong mobile data usage growth due to rising 4G adoption. Income statement (CNYm) Dec-14 Dec-15 Dec-16F Dec-17F Dec-18F

Total turnover 284,750 277,050 279,490 300,125 314,342 Key risks Gross profit 188,903 177,603 176,242 192,393 205,517 i. Unfavourable changes to regulations/policies; EBITDA 92,840 87,503 83,216 94,218 103,384 ii. Stiffer-than-expected competition; iii. Faster-than-expected drop in voice and SMS Depreciation and amortisation (73,868) (76,738) (77,285) (80,748) (83,329) due to substitution impact from instant Operating profit 18,972 10,765 5,931 13,470 20,055 messaging apps, like Weixin. Net interest (4,334) (6,496) (4,165) (4,608) (4,827) Income from associates & JVs 0 (801) 181 88 101 Company Profile Exceptional income - net 0 12,059 0 0 0 China Unicom (CU) is the second largest mobile/ fixed Pre-tax profit 16,000 16,845 2,929 9,834 16,275 broadband (FBB) network operator in China, with 20%/ Taxation (3,876) (3,473) (698) (2,458) (4,069) 27% of market share in terms of total number of subscribers. Recurring net profit 12,124 3,799 2,231 7,375 12,206

CU’s 3-year forward EV/EBITDA band Cash flow (CNYm) Dec-14 Dec-15 Dec-16F Dec-17F Dec-18F Change in working capital 12,871 46,972 (6,209) (5,562) (11,596) Cash flow from operations 97,501 124,506 72,144 81,588 82,893 Capex (84,881) (133,900) (75,000) (71,512) (65,446) Cash flow from investing activities (83,544) (133,690) (70,443) (73,528) (75,738) Dividends paid (3,805) (4,789) (4,071) (679) (2,245) Cash flow from financing activities (10,153) 5,777 (4,073) (699) (2,258) Cash at beginning of period 21,560 25,364 21,957 19,584 26,945 Net change in cash 3,804 (3,407) (2,373) 7,361 4,897 Ending balance cash 25,364 21,957 19,584 26,945 31,843

Company data, RHB Balance sheet (CNYm) Dec-14 Dec-15 Dec-16F Dec-17F Dec-18F Total cash and equivalents 25,364 22,063 19,690 27,051 31,949 Tangible fixed assets 438,321 454,631 452,346 443,110 425,228 Intangible assets 2,771 2,771 2,771 2,771 2,771 Total investments 8,939 37,827 37,827 37,827 37,827 Total other assets 38,467 58,447 71,044 86,356 104,967 Total assets 545,072 610,346 618,706 634,197 640,790 Short-term debt 115,392 109,177 109,177 109,177 103,718 Total long-term debt 23,880 40,676 40,676 40,676 38,642 Other liabilities 1,714 2,362 2,362 2,362 2,362 Total liabilities 318,515 379,396 382,812 396,182 400,530 Shareholders' equity 226,557 230,950 235,894 238,015 240,260 Total equity 226,557 230,950 235,894 238,015 240,260 Net debt 113,908 127,790 130,163 122,802 110,412 Total liabilities & equity 545,072 610,346 618,706 634,197 640,790

Key metrics Dec-14 Dec-15 Dec-16F Dec-17F Dec-18F Revenue growth (%) (3.5) (2.7) 0.9 7.4 4.7 Recurrent EPS growth (%) 15.1 (68.8) (41.3) 230.6 65.5 Gross margin (%) 66.3 64.1 63.1 64.1 65.4 Operating EBITDA margin (%) 32.6 31.6 29.8 31.4 32.9 Net profit margin (%) 4.3 4.8 0.8 2.5 3.9 Dividend payout ratio (%) 39.5 30.4 30.4 30.4 50.0 Capex/sales (%) 29.8 48.3 26.8 23.8 20.8 Interest cover (x) 4.11 1.55 1.14 2.28 3.25

Source: Company data, RHB

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China Unicom China Initiating Coverage

13 December 2016 Communications | Telecommunications

Investment Thesis Laggard catching up

While a laggard of the three telcos in 4G network rollout, CU’s 3Q16 average 4G sub net  CU’s 3Q average 4G sub net adds adds have increased to 5.5m, from 2Q16’s average of 4.4m. 4G penetration also accelerated. increased to 34% in September, from 19% at the beginning of this year (23% and 28% by the end-1Q16/2Q16). This was mainly because of: i. The company’s strategy to focus on 139 cities, which contribute 84% of its data traffic, to roll out its 4G network and service. This enabled it to narrow the gap in 4G network quality with peers more quickly in those cities; ii. Network sharing with CT in rural areas also helps its 4G sub net add to pick up in those areas.

Figure 1: CU’s 4G subs net adds Figure 2: CU’s 4G penetration

7.0 40% 6.1 6.0 35% 5.4 5.4 34% 5.0 32% 30% 30% 5.0 4.5 4.4 4.5 28% 4.2 26% 25% 25% 4.0 23% 21% 20% 19% 3.0 15% 2.0 10%

1.0 5%

0.0 0% 2016/02 2016/03 2016/04 2016/05 2016/06 2016/07 2016/08 2016/09 2016/1 2016/2 2016/3 2016/4 2016/5 2016/6 2016/7 2016/8 2016/9

Source: Company data Source: Company data

We believe that CU’s 4G sub net adds would continue to ramp up in the coming months. As a result, we expect that the company’s 4G penetration to reach 42.5% by the end of this year and surge further to 61.7% and 80% by FY17 and FY18 respectively.

Figure 3: CU’s 4G penetration, FY14-18F

90.0%

80.0% 80.0% 70.0%

60.0% 61.0%

50.0%

40.0% 41.0%

30.0%

20.0% 15.4% 10.0%

0.0% 0.0% FY14 FY15 FY16F FY17F FY18F

4G penetration (%) Source: Company data, RHB

Rising ARPU Given: i. No nationwide unlimited data package;  There is no nationwide unlimited data package in China.

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China Unicom China Initiating Coverage

13 December 2016 Communications | Telecommunications

ii. Still low average mobile data usage (DOU) in China – ~525MB/ ~370MB for the sector and CU in 1H16 – when compared to other neighbouring regions (Taiwan/  DOU in China is still low. Korea/ Japan/ Singapore and HK: 1.4-6GB), which also have rolled out 4G service.

Figure 4: DOU of different regions  Therefore, rising 4G penetration should effectively drive data usage and data revenue growth.

Source: National Communications Commission (TW), Office Of The Communications Authority (HK), Infocomm Development Authority of (SG), Tefficient

We believe rising 4G penetration in China and rising demand for data heavy applications  CU’s ARPU should be up from (eg mobile games, videos) should effectively drive data usage and data revenue growth. CNY46.3 last year, to CNY47.9 this In fact, data usage and ARPU of 4G subs are indeed much higher (DOU: 2x more than year. that of blended average; ARPU: 69% higher than blended ARPU). As a result, we expect that CU’s data revenue to grow at a CAGR of 17.9% during FY15-18F. This should in turn drive ARPU up from CNY46.3 last year, to CNY47.9 this year and rise further to CNY53.5 in FY18F.

Figure 5: CU’s data revenue, FY13-18F Figure 6: CU’s ARPU, FY14-18F

CAGR of 17.7% 120,000 60.0 in FY15-18F 53.3 101,983 51.4 47.7 100,000 CAGR of 3.9% in 91,837 50.0 46.3 FY13-15 44.6 76,580 80,000 40.0 67,012 62,558 57,937 60,000 30.0

40,000 20.0

20,000 10.0

0 0.0 FY13 FY14 FY15 FY16F FY17F FY18F FY14 FY15 FY16F FY17F FY18F

Data revenue (CNY m) ARPU (CNY) Source: Company data, RHB Note: CU restated its total subs in FY14 and FY15 last year to exclude non-billing subs. ARPU in these two years were also restated Source: Company data, RHB

Selling & marketing (S&M) expenses to stay under control Given that:

i. Profitability is one of the major key performance index (KPI) applied by the State-  CU’s S&M expenses should stay owned Assets Supervision and Administration Commission of the State Council under control. (SASAC) on the three telcos. As such, we do not expect competition would heat up to a level that is likely to hurt their respective bottomlines; ii. CM has already guided that S&M expenses would be flat or up slightly YoY, implying that these expenses, as a percentage of sales, would continue declining this year. It also guided that this ratio would remain on a downtrend in the mid to long term. CU was more aggressive in allocating more resources to drive 4G adoption this year during 1H16. However, we believe that it is only a short-term strategy as it is not encouraged by SASAC (as mentioned above). Once the 4G momentum has built up, S&M expenses, as a percentage of sales, should start declining. In fact, based on our discussion with management, it too has expressed its reluctance to drive 4G adoption via S&M expenses. We also noticed that CU’s S&M expenses may have already declined QoQ in 3Q.

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China Unicom China Initiating Coverage

13 December 2016 Communications | Telecommunications

Therefore, we expect that CU’s S&M expenses to stay under control and as a percentage  We expect that CU’s S&M expenses of total revenue, would decrease to 11.2% this year, from 11.5% last year. It is likely to as a percentage of total revenue to retreat to 10.9% next year and lower to 10.8% in FY18F. decrease to 11.2% and 10.9% this and next year respectively.

Figure 7: CU’s S&M expenses to sales ratio, FY13-18F

16.00% 14.5% 14.1% 14.00% 11.5% 12.00% 11.2% 10.9% 10.8%

10.00%

8.00%

6.00%

4.00%

2.00%

0.00% FY13 FY14 FY15 FY16F FY17F FY18F

S&M expenses as a % of total revenue (%) Source: Company data, RHB

Falling capex; rising FCF Given that: i. In the 139 focus cities mentioned above, CU’s 4G network coverage has already reached full coverage;  We expect CU’s capex-to-sales ratio to decline to 26.8%, from 48.3% last ii. In addition, network sharing with CT in rural areas should further reduce CU’s 4G year capex burden going forward; iii. Moreover, given the much higher data traffic capacity of 4G network when compared to that of 3G network, strong data usage growth should not lead to corresponding significant increase in capex. Therefore, we believe that just like CM, CU’s 4G capex has also peaked and should keep on declining in the coming years. We expect its capex-to-sales ratio to decline to 26.8%  We expect that CU’s FCF yield to this year, from 48.3% last year. It is likely to decline further to 20.8% in FY18F. rebound to -1.4% this year, from - 4.7% last year. Given the backdrop of rising ARPU and falling capex, FCF should be on an uptrend going forward. We expect that FCF yield to rebound from -4.7% last year, to -1.4%, 5.1% and 8.8% for FY16F-18F.

Figure 8: CU’s capex to sales ratio, FY13-18F Figure 9: CU’s FCF yield, FY13-18F

60.0% 10.0% 8.8% 48.3% 8.0% 50.0% 6.0% 6.4% 40.0% 5.1% 4.0% 29.8% 30.0% 26.8% 24.9% 23.8% 2.0% 20.8% 20.0% 0.0% FY13 FY14 FY15 FY16F FY17F FY18F -1.4% 10.0% -2.0% -2.1% -4.0% 0.0% -4.7% FY13 FY14 FY15 FY16F FY17F FY18F -6.0%

Capex to sales ratio (%) FCF yield (%) Source: Company data, RHB Source: Company data, RHB

Strong earnings growth

CU’s recurring NPM is the lowest in the sector (FY16: ~1%). This makes its recurring NP  We expect CU’s recurring NP to grow growth the most sensitive to acceleration of 4G adoption and retreat of marketing at a CAGR of 42.4% in FY15-18F, expenses once 4G segment’s momentum has built up. We believe these two factors are being fastest in the sector. materialising from 2H16 onwards. Therefore, we expect its recurring NP growth to also ramp up rapidly in tandem and grow at a CAGR of 42.4% in FY15-18F, being fastest in the sector.

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China Unicom China Initiating Coverage

13 December 2016 Communications | Telecommunications

Valuation

Our TP is a DCF-derived valuation. We justify this valuation by saying that we believe once 4G adoption ramps up (reaching 41.0%/ 61.0% by the end of this and next year), CU would be able to start seeing relatively stable and predictable cash flows.

Figure 10: DCF valuation FY17F FY18F FY19F FY20F FY21F FY22F FY23F FY24F FY25F FY26F EBIT 13,470 20,055 26,246 33,046 45,819 56,323 65,187 72,083 76,742 78,713 EBIT x (1-tax) 10,102 15,041 19,685 24,785 34,364 42,242 48,890 54,063 57,556 59,035 Depreciation 80,748 83,329 87,040 88,577 88,355 88,134 87,914 87,694 87,475 87,256 Capex -71,512 -65,446 -67,760 -70,025 -75,312 -80,012 -83,956 -86,995 -89,005 -89,895 ∆WC -5,562 -11,596 -10,957 -15,893 -14,641 -15,554 -16,321 -16,912 -17,303 -17,476 FCFF 13,776 21,328 28,009 27,443 32,766 34,811 36,527 37,849 38,724 38,920 Discount factor 0.9150 0.8373 0.7661 0.7011 0.6415 0.5870 0.5371 0.4915 0.4497 0.4115 Discounted FCF 12,606 17,858 21,459 19,239 21,019 20,433 19,619 18,602 17,415 16,016 Total discounted FCF 184,265 WACC 9.3% Terminal growth rate 1% Terminal value 195,231 Enterprise value 379,496 Net cash (122,802) Minority interest - Equity value (CNY) 256,694 Equity value (HKD) 302,899 Outstanding shares 23,947 Equity value/ share (HKD) 12.65 Source: RHB

Our TP also implies a 4x FY17F EV/EBITDA, which is close to 1SD above its 3-year forward mean. We see this as justified: i. ARPU should be on an uptrend in coming years, driven by rising 4G adoption; ii. The company should see positive operating leverage. Its bottomline is likely to grow faster than topline; iii. Capex should be on a stable downtrend in coming years, given 4G investment peak has already passed; iv. Given rising ARPU and falling capex, FCF should be on a stable uptrend in the coming years. A higher payout is also in the cards.

Figure 11: CU’s 3-year forward EV/EBITDA band

Source: RHB

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CU is currently trading at 3.4x forward EV/EBITDA, which is 0.5SD below its 3-year forward mean. We consider this unjustified given that its 4G service has started to catch up with peers. We believe that with improving revenue growth momentum, margins and ROE, CU should re-rate going forward.

Figure 12: Sensitivity of FY17F revenue growth FY17F ARPU Subscribers' growth (%) 48.35 49.35 50.35 51.35 52.35 53.35 54.35 3.6 -3.5% -1.5% 0.5% 2.5% 4.5% 6.5% 8.5% 3.1 -3.9% -2.0% 0.0% 2.0% 4.0% 6.0% 8.0% 2.6 -4.4% -2.4% -0.5% 1.5% 3.5% 5.5% 7.4% 2.1 -4.9% -2.9% -0.9% 0.0% 3.0% 5.0% 6.9% 1.6 -5.3% -3.4% -1.4% 0.5% 2.5% 4.4% 6.4% 1.1 -5.8% -3.9% -1.9% 0.0% 2.0% 3.9% 5.9% 0.6 -6.3% -4.3% -2.4% -0.5% 1.5% 3.4% 5.4% Source: RHB

Figure 13: Sensitivity of FY17F recurring earnings growth EBITDA margin (%) Revenue growth (%) 25.4 27.4 29.4 31.4 33.4 35.4 37.4 13.4 -140% -75% -11% 54% 118% 182% 247% 11.4 -154% -91% -28% 36% 99% 162% 226% 9.4 -169% -107% -44% 18% 80% 142% 204% 7.4 -183% -122% -61% 0% 61% 122% 183% 5.4 -198% -138% -78% -18% 42% 102% 162% 3.4 -212% -153% -94% -36% 23% 82% 141% 1.4 -226% -169% -111% -54% 4% 62% 119% -0.6 -241% -184% -128% -71% -15% 42% 98% Source: RHB

Figure 14: Sensitivity of TP WACC (%) TG (%) 6.3 7.3 8.3 9.3 10.3 11.3 12.3 2.5 33.44 24.95 19.39 15.48 12.58 10.34 8.56 2 29.62 22.62 17.86 14.42 11.80 9.76 8.12 1.5 26.59 20.70 15.56 13.48 11.12 9.24 7.71 1 24.13 19.08 15.43 12.65 10.50 8.76 7.34 0.5 22.09 17.70 14.44 11.94 9.95 8.33 7.00 0.25 21.20 17.08 14.00 11.60 9.69 8.13 6.84 0 20.38 16.51 13.58 11.29 9.45 7.94 6.69 Source: RHB

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Key Risks

Regulatory/policy The Chinese telco industry is strictly regulated by the Chinese Government. For example, Chinese telcos were required to launch a one-month data rollover plan in 4Q15. Although it would not have had any impact to cash flow, it did however cause a delay in some data revenue recognition during the quarter.

On the other hand, the Chinese Government’s push for lower data tariff and higher speed  We believe risk from lower data tariff has also been a key concern for market recently. However, we believe these risks from and higher speed may be overstated. that may be overstated, given: i. Lower data tariff – we noticed that the per unit data tariff has been on a downtrend in China in recent years. But in fact, this is natural for data tariff to go down when telecommunication technology evolves to a more advanced generation. Take 4G as an example, its capacity is ~3-5x of that of 3G. In other words, cost of data would decline sharply when moving from 3G to 4G (~60-80%). Therefore, as long as there is no unlimited data plan (which would cap data revenue growth) and data elasticity is more than 1 (Growth in data usage is greater than the decline in data tariff), it is only rational for telcos to lower data tariff to drive 4G adoption and encourage more data consumption. Therefore, even without a push from the Chinese Government, data tariff would still be on a downtrend; ii. For higher speed, the market was once concerned on the need for higher capex going forward. As capex for the three telcos have already gone down this year and very likely to continue declining in coming years (based on guidance from the respective management), we believe this risk is reduced greatly.

Stiffer-than-expected competition; We believe that this is unlikely. We have analysed the competitive intensity in the 4G segment via two aspects: S&M expenses and data tariff of the three telcos:

*S&M expenses Although the three telcos should still be striving to raise their 4G adoption in FY16F-18F,  We also believe stiffer-than-expected we believe that their S&M expenses would stay under control going forward, given: competition as unlikely. i. Profitability is one of the major key performance index (KPI) applied by the SASAC; ii. CM and CU have also already guided that S&M expenses would stay under control. (For details, please refer to “Selling & marketing expenses to stay under control” in “Investment Thesis” section.)

Data tariff Recently, CU launched two new promotional packages – daily data card and unlimited data plan – in recent months in selective provinces. CT followed suit in launching a similar daily data card, but it was at a relatively smaller scale. (For details of those plans, please refer to “Part VI/ Competition in 4G segment” in “Industry dynamics – 4G in China”).

We do not believe that this would evolve into an industry-wide price war, given that CM  We believe the new promotional and CT have not responded aggressively to CU’s new promotional packages. Further, we packages would likely be withdrawn also believe that CU has only launch those packages in selective provinces to drive 4G once CU’s 4G momentum has built up. adoption. And this is likely to be a short-term promotion (similar to the case of the national standard data package mentioned above). Once the 4G momentum has built up, CU is likely to withdraw these data packages.

Faster-than-expected drop in voice and SMS due to substitution impact from instant messaging apps like Weixin;

We believe the impact from the above would be limited, given:  We believe the impact from declining i. CU had been very successful in driving data revenue growth during 3G era due to its voice and SMS would be limited to better user experience. Therefore, data revenue, as a percentage of mobile revenue, CU.

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has already been higher than voice and SMS since FY14 (FY15: data revenue: 44%; voice and SMS: 34%); ii. Data revenue should also continue to see solid grow (17.9% pa during FY15-18) due to rising 4G penetration, which should be more than enough to offset the weaknesses in voice and SMS segments (-9.6%/ -9.2% pa during FY15-18).

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Peer Comparison

HK-listed peers China Mobile (CM) (941 HK, BUY, TP: HKD112.00) The largest player in China’s mobile segment had a 64% market share (in terms of subs) in 1H16. Due to its first mover advantage in 4G services, CM’s 4G adoption has been leading CU and CT, with a much higher market share at 72% in 1H16. CM is relatively a newcomer in the fixed broadband (FBB) segment (began in 2013). After acquiring China TieTong last year, it has turned more aggressive, with its market share (in terms of subscribers) increasing to 24% in 1H16, from 21% at the end of last year. Revenue, EBITDA and recurring NP are expected at +10%, +10.6%, +15% YoY respectively in FY16 and grow at a CAGR of +8%, +9.9% and +13.2% during FY15-18F. The company is currently trading at 2.9x FY17F EV/EBITDA. Our TP of HKD112.00 is DCF-derived and implies 4.7x FY17F EV/EBITDA. We believe that its trading at a premium to CU is justified, given: i. Its larger scale in the mobile segment (64% market share vs CU’s 20%); ii. More solid positioning in 4G segment (due to its first mover advantage in the 4G segment); iii. Better margins and ROE (a result of larger scale); iv. Lower gearing (net cash vs CU’s FY16F net gearing of 54.5%); v. Dividend payout hike potential (management has explicitly expressed that it would consider a payout hike for next year); vi. And more attractive dividend yield (FY16F dividend yield 3.1% vs CU’s 0.4%). Given these factors, CM is our Top Pick in the sector.

China Telecom (CT) (728 HK, NR) The third largest player in mobile and largest FBB player, CT’s market shares (in terms of subs) were at 16% and 42% respectively as at 1H16. According to Bloomberg consensus, CT’s revenue, EBITDA and recurring NP are expected to +5.6%, +2%, -5.2% YoY respectively in FY16 and grow at a CAGR of +4.9%, +4.6% and +7.3% during FY15-18F. CT is currently trading at 3.4x FY17F EV/EBITDA.

Figure 15: Market share of different players in the mobile Figure 16: Market share of different players in FBB segment segment in 1H16 (subs) in 1H16 (subs)

Source: RHB Source: RHB

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Figure 17: 4G penetration of the three telcos (Sep 2016) Figure 18: 4G base station no. of the three telcos (1H16)

60.0% 57% 1400 1320

51% 1200 50.0% 1000 40.0% 34% 800 610 588 30.0% 600

400 20.0% 200 10.0% 0 CM CT CU 0.0% CM CT CU 4G BTS no. ('000)

Source: RHB Source: RHB

Figure 19: Mobile ARPU of the three telcos (1H16) Figure 20: FFB ARPU of the three telcos (1H16)

70 60 56 62 51 60 56 50

50 47 40 33 40 30 30 20 20

10 10

0 0 CM CT CU CT CU CM

Mobile ARPU (CNY) FFB ARPU (CNY)

Source: RHB Source: RHB

Figure 21: Revenue breakdown of CM (1H16) Figure 22: Revenue breakdown of CU (1H16)

12% 13%

3%

52%

34%

85%

Mobile Fixed Product Sales Mobile Fixed Product Sales

Source: RHB Source: RHB

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Figure 23: Revenue breakdown of CT (1H16)

11%

38%

51%

Mobile Fixed Product Sales

Source: RHB

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Figure 24: Peer comparison I Company Ticker Price Mkt cap 3-mth EV/ EV/ EV/ EPS EPS EPS 3-Yr Div yld Div yld P/B P/B (USDm) avg t/o EBITDA EBITDA EBITDA FY1 FY2 FY3 EPS Hist (%) FY1 (%) Hist (x) FY1 (x) (USDm) Hist FY1 FY2 YoY% YoY% YoY% Cagr (%) China Unicom 762 HK 9.33 28,794 67.2 3.5 3.9 3.4 (49.1) 242.6 65.5 42.4 2.1 0.3 0.8 0.8

HK listed peers China Mobile 941 HK 82.05 216,511 170.1 3.9 3.6 2.9 15.0 13.1 11.7 13.3 3.2 3.4 1.5 1.4 China Telecom-H 728 HK 3.73 38,904 26.7 3.7 3.5 3.4 (5.2) 13.9 11.5 6.4 2.5 2.6 0.9 0.8 Average 3.8 3.6 3.1 4.9 13.5 11.6 9.8 2.9 3.0 1.2 1.1

Non-HK listed peers Lg Uplus Corp 032640 KS 11,850.00 4,424 9.8 4.0 3.8 3.7 31.1 5.0 9.8 14.8 2.1 2.5 1.1 1.1 Kt Corp 030200 KS 29,850.00 6,665 12.4 2.9 2.9 2.8 26.3 7.8 8.6 13.9 1.7 2.5 0.6 0.7 Sk Telecom 017670 KS 230,500.00 15,915 28.0 5.0 5.1 4.9 (7.6) (3.8) 8.3 (1.3) 4.3 4.4 1.1 1.1 Ntt Docomo Inc 9437 JT 2,638.00 90,085 124.8 7.0 7.1 6.7 26.3 7.8 7.3 13.5 2.8 3.1 1.8 1.8 Kddi Corp 9433 JT 2,977.50 67,310 182.7 6.0 5.8 5.6 13.1 7.5 5.9 8.8 2.5 2.7 2.1 2.0 Softbank Group C 9984 JT 7,782.00 73,890 398.8 8.8 8.3 7.8 111.2 (28.7) 24.4 23.3 0.6 0.6 3.7 2.9 Chunghwa Telecom 2412 TT 105.00 25,582 47.5 9.8 9.7 9.6 (2.3) 2.2 5.1 1.6 5.2 5.1 2.3 2.2 Taiwan Mobile Co 3045 TT 105.00 11,281 17.7 12.7 12.3 11.9 (1.5) 3.0 4.1 1.8 5.3 5.3 5.0 5.1 Far Eastone Tele 4904 TT 72.50 7,420 10.4 10.6 9.7 9.3 1.6 3.5 4.4 3.2 5.2 5.2 3.4 3.4 Hkt-Ss 6823 HK 9.74 9,504 10.8 8.8 8.6 8.4 18.4 2.8 7.4 9.3 5.7 6.0 1.9 1.9 Smartone Telecom 315 HK 10.58 1,472 2.0 4.1 4.1 4.1 3.7 2.3 4.7 3.6 5.7 5.7 2.6 2.5 Hutchtel Hk 215 HK 2.58 1,602 0.9 6.0 6.0 5.8 (15.7) 5.6 10.1 (0.7) 5.0 4.7 1.1 1.1 Hkbn Ltd 1310 HK 8.53 1,106 1.7 12.3 10.6 9.2 45.3 30.3 22.2 32.3 4.7 5.3 6.3 6.9 Singapore Teleco ST SP 3.78 43,125 59.4 14.7 14.0 13.6 1.3 6.1 6.9 4.7 4.6 4.7 2.4 2.3 M1 Ltd M1 SP 2.01 1,306 3.4 6.9 7.1 7.1 (11.5) (6.5) (7.6) (8.6) 7.6 6.8 5.0 4.3 Starhub Ltd STH SP 2.92 3,525 8.8 8.0 7.8 7.9 (4.2) (4.9) (6.1) (5.1) 6.8 6.8 22.0 24.3 Axiata Group Ber AXIATA MK 4.56 9,267 6.2 7.2 7.3 6.8 (31.5) 12.4 9.3 (5.6) 3.7 3.5 1.7 1.7 Maxis Bhd MAXIS MK 6.09 10,361 3.8 12.2 12.3 12.3 7.5 (0.8) (0.4) 2.0 3.3 3.3 10.0 9.9 Digi.Com Bhd DIGI MK 4.99 8,789 6.9 13.7 13.5 13.1 (2.3) 0.0 0.5 (0.6) 4.2 4.3 66.9 69.3 Telekom Malaysia T MK 6.03 5,133 7.9 7.6 7.2 6.9 18.2 9.0 8.3 11.8 3.5 3.3 3.0 2.9 Advanced Info ADVANC TB 147.00 12,247 31.1 8.4 8.6 8.0 (21.9) (2.9) 4.4 (7.5) 8.4 7.0 12.1 9.4 Total Access Com DTAC TB 34.25 2,272 18.8 4.0 4.1 3.9 (49.6) (4.1) 41.2 (12.0) 2.7 2.4 3.0 2.9 True Corp Pcl TRUE TB 7.00 6,545 43.3 10.1 11.8 9.5 N/A N/A N/A (33.5) 0.1 0.0 1.8 1.9 Jasmine Intl Pcl JAS TB 8.30 1,381 40.4 13.4 13.0 11.2 (81.6) 8.0 8.6 (40.0) 7.2 2.8 5.5 3.2 Philipp Long Dis TEL PM 1,314.00 5,698 6.0 6.0 6.7 6.3 20.9 (16.7) (0.9) (0.1) 8.1 6.4 2.7 2.5 Globe Telecom GLO PM 1,403.00 3,738 3.8 5.6 5.5 5.2 (8.9) 1.4 4.9 (1.0) 6.3 6.2 3.1 3.0 Telekomunikasi TLKM IJ 3,960.00 29,898 29.1 7.2 7.0 6.3 27.6 15.8 9.8 17.5 2.4 2.9 4.7 4.5 Xl Axiata Tbk Pt EXCL IJ 2,380.00 1,905 2.5 4.9 4.9 4.5 N/A N/A 84.1 (446.0) N/A 0.8 1.2 1.2 Indosat Tbk Pt ISAT IJ 6,275.00 2,554 0.3 4.5 4.4 4.0 N/A 82.1 41.3 (225.8) N/A 1.3 2.6 2.5 Average 8.0 7.9 7.5 4.4 5.4 11.7 (21.6) 4.4 4.0 6.2 6.1 Note: Share prices are as at 12 Dec 2016 Source: Bloomberg, RHB

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Figure 25: Peer comparison II Company Rev Hist Rev FY1 NP Hist NP FY1 Net Net Unlev Gross Net Net ROE Hist ROE FY1 Sh px Sh px (USDm) (USDm) (USDm) (USDm) gearing gearing beta margin margin margin (%) (%) 1-mth % 3-mth % Hist (%) FY1 (%) Hist (%) Hist (%) FY1 (%) China Unicom 44,116 41,345 673 318 55.3 54.5 0.6 N/A 1.5 0.8 5.8 1.0 8.5 4.1

HK listed peers China Mobile 106,423 108,774 15,291 16,336 N/A N/A 0.8 80.3 14.4 15.0 10.4 11.2 (2.6) (13.2) China Telecom-H 47,902 50,993 2,900 2,775 27.0 30.8 0.7 N/A 6.1 5.4 6.9 6.2 (1.3) (3.9) Average 27.0 30.8 0.8 80.3 10.2 10.2 8.6 8.7 (2.0) (8.5)

Non-HK listed peers Lg Uplus Corp 9,197 9,414 299 359 95.0 95.9 0.2 76.8 3.3 3.8 8.8 9.2 4.1 19.8 Kt Corp 18,982 19,105 471 578 45.8 49.9 0.3 N/A 2.5 3.0 N/A 6.0 3.6 11.9 Sk Telecom 14,599 14,796 1,294 1,317 31.8 40.6 0.2 88.6 8.9 8.9 11.1 9.9 (0.2) (2.6) Ntt Docomo Inc 41,396 42,778 5,014 5,661 0.0 0.0 0.7 52.9 12.1 13.2 10.3 11.4 (0.8) 2.6 Kddi Corp 40,839 42,221 4,521 5,019 24.1 13.7 0.8 43.0 11.1 11.9 15.7 15.6 0.5 6.1 Softbank Group C 83,701 84,512 4,336 5,336 266.8 220.8 0.5 38.5 5.2 6.3 17.4 18.2 (1.4) 9.8 Chunghwa Telecom 7,106 7,211 1,312 1,336 0.0 0.0 0.2 36.1 18.5 18.5 11.7 11.7 0.0 4.7 Taiwan Mobile Co 3,561 3,680 481 479 79.9 68.9 0.2 31.3 13.5 13.0 24.5 25.6 4.7 9.9 Far Eastone Tele 2,983 3,011 352 368 31.8 30.9 0.2 39.6 11.8 12.2 15.3 16.8 4.5 8.5 Hkt-Ss 4,474 4,632 509 573 86.2 89.2 0.1 55.3 11.4 12.4 10.5 11.7 6.0 7.4 Smartone Telecom 2,404 2,447 121 108 0.0 0.0 0.2 N/A 5.0 4.4 23.2 21.2 (8.2) (1.3) Hutchtel Hk 2,840 2,471 118 114 24.3 23.9 0.1 36.2 4.2 4.6 8.0 7.8 (10.4) (0.4) Hkbn Ltd 302 357 13 48 181.7 182.0 N.A 86.9 4.5 13.4 6.6 23.4 (7.6) (10.2) Singapore Teleco 12,405 12,599 2,831 2,935 37.9 32.3 0.6 78.4 22.8 23.3 15.6 15.4 1.3 5.4 M1 Ltd 846 846 131 130 83.2 82.2 0.2 54.2 15.4 15.4 39.5 41.8 (1.7) (7.4) Starhub Ltd 1,788 1,808 272 256 274.0 312.0 0.1 56.9 15.2 14.1 153.9 184.1 0.6 (4.8) Axiata Group Ber 4,946 5,349 635 634 42.4 55.5 0.7 N/A 12.8 11.8 11.5 11.0 (9.3) (9.3) Maxis Bhd 2,139 2,168 433 470 203.3 190.0 0.2 68.3 20.2 21.7 41.8 42.2 (9.6) (12.0) Digi.Com Bhd 1,720 1,736 428 428 204.2 181.8 0.4 70.6 24.9 24.6 287.4 305.6 (6.3) (11.0) Telekom Malaysia 2,916 3,050 174 223 44.2 54.1 0.5 N/A 6.0 7.3 9.1 11.7 (0.6) (0.4) Advanced Info 4,388 4,403 1,107 875 114.0 173.6 0.5 45.4 25.2 19.9 98.1 65.5 3.0 (4.8) Total Access Com 2,466 2,486 167 121 139.1 141.0 0.5 28.4 6.8 4.9 17.2 15.2 (4.4) 5.7 True Corp Pcl 3,357 3,567 125 (113) 116.3 96.6 0.9 23.7 3.7 (3.2) 6.4 (4.2) 1.8 30.5 Jasmine Intl Pcl 395 463 444 (2) 0.0 480.1 1.3 39.9 112.4 (0.4) 20.1 10.9 16.5 61.8 Philipp Long Dis 3,689 3,742 476 611 99.2 104.4 0.5 90.3 12.9 16.3 16.9 23.7 (8.2) (25.2) Globe Telecom 2,587 2,782 356 362 101.7 103.8 0.6 88.6 13.8 13.0 28.2 27.9 3.7 19.4 Telekomunikasi 7,716 8,614 1,166 1,379 2.5 0.1 0.8 N/A 15.1 16.0 21.5 22.4 7.6 13.0 Xl Axiata Tbk Pt 1,722 1,843 (2) 52 174.1 83.6 N.A N/A (0.1) 2.8 6.5 5.0 (13.7) (14.6) Indosat Tbk Pt 2,016 2,208 (99) 76 111.1 146.5 N.A 58.1 (4.9) 3.5 (4.9) 7.2 7.7 23.6 Average 90.2 105.3 0.4 56.0 14.3 10.9 33.3 33.6 (0.6) 4.7 Note: Share prices are as at 12 Dec 2016 Source: Bloomberg, RHB

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Industry Dynamics – 4G In China

Part I/ 4G development in China We believe that 4G has become an important growth driver for Chinese telcos – enhancing user experience to enjoy online services, like video and gaming, on a mobile platform and thus driving rapid growth in data usage.

In fact, since launching in 2014, 4G adoption has been rising rapidly in China. According  4G adoption increased to 52.1% in to data from MIIT, 4G adoption has increased to 52.1% in Sep 2016. Sep 2016 in China.

Figure 26: 4G adoption in China

60.0% 52.1%

50.0%

40.0%

29.6% 30.0%

20.0%

10.0% 7.6%

0.0% 0.0% 4Q13 4Q14 4Q15 3Q16

Source: MIIT, RHB

At the same time, Chinese subs have also raised their adoption of online services on the  At the same time, Chinese have also mobile platform, like instant messaging apps, eCommerce and video and gaming. We raised their adoption of online believe this has already created a virtuous cycle. While 4G enhances the users’ services on mobile platform. experience to enjoy these services on the mobile platform, it also heightens demand (for these services) on that platform. This in turn should help boost higher demand for 4G network and data.

Figure 27: Weixin/ QQ’s monthly active users (MAU), 4Q12- Figure 28: Alibaba’s MAU (Mobile)/ annual active users 3Q16 (AAU), 4Q12-3Q16

1000 500 877 450 439 900 853 846 450 815 407 798 808 393 800 400 697 700 350 334

600 300 265 500 500 250 231

MAU (m) MAU 355

400 200 160 161 MAU/ AAUMAU/ (m) 300 150

200 158 100 66 100 50 0 0 4Q12 4Q13 4Q14 4Q15 3Q16 4Q12 4Q13 4Q14 4Q15 3Q16

Weixin's MAU QQ's MAU Alibaba's MAU (Mobile) Alibaba's AAU Source: Company data Source: Company data

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Figure 29: Online video’s MAU (Mobile/ PC), 4Q12-2Q16 Figure 30: Tencent’s mobile/ PC gaming revenue, 4Q13- 3Q16

12000

9,900 10000 9,033 8,477 8,164 8,266 8000

6000 5,300

CNY (m)CNY 3,800 4000

2000 806

0 4Q13 4Q14 4Q15 3Q16

Mobile gaming revenue PC gaming revenue Source: iResearch Source: Company data

In fact, these factors have been translated into rapid growth of data usage in China.  By end-Sep 2016, data usage had According to data from MIIT, in 2013, DOU was 94MB per month. By end-Sep, it had increased to 525MB per month, increased to 525MB per month, implying a CAGR of 99% during the period. implying a CAGR of 99% during the period.

Figure 31: DOU in China

600 525

500

400

300 269 MB

200 137 94 100

0 FY13 FY14 FY15 2016-Sep

Source: MIIT, RHB

Given: i. The relatively comprehensive 4G coverage. According to OpenSignal, as at 3Q16, 1  According to OpenSignal, as at 3Q16, China’s 4G availability has reached 74%, ahead some major developed nations (eg China’s 4G availability reached 74%, UK, Germany and France) and emerging regions (eg India, Brazil and Russia). We ahead some major developed believe this indicates that China has a relatively comprehensive 4G coverage countries. geographically; ii. There is a wide range of 4G phones (ASP as low as CNY200-300); iii. Still low data usage in China – ~525MB/ ~370MB for the sector and CU in 1H16 – compared to other neighbouring regions (Taiwan/ Korea/ Japan/ Singapore and HK:  DOU is still low in China – ~525MB in 1.4-6GB) which also have rolled out 4G service. This is a huge opportunity for DOU 1H16 – when compared to to catch up further in China going forward; neighbouring regions (1.4-6GB) which also have rolled out 4G service. iv. Continuous robust growth in demand for online services, like video and gaming, on mobile platform. We expect no major obstacle for 4G adoption to rise further in China and DOU should also maintain robust growth in the coming years.

1 4G availability indicates how consistently accessible 4G networks are in each region. This is done by tracking the proportion of time users have access to 4G network. For example if a region has 50% 4G availability, then on average that region's 4G users can find an LTE signal half of the time.

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Figure 32: 4G availability in major regions (3Q16)

120.00%

100.00%

80.00%

60.00%

40.00%

20.00%

0.00%

Source: OpenSignal

Figure 33: A wide range of 4G phones

Source: JD

Figure 34: DOU of different regions

Source: National Communications Commission (TW), Office Of The Communications Authority (HK), Infocomm Development Authority of (SG), Tefficient

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How would rising demand on online services affect DOU?

Figure 35: Data usage of different activities Category Data usage Video (High definition) 4.6MB/ min Video (Standard) 2MB/ min Online gaming 0.3-0.8MB/ min Music 0.5-4MB/ song Web surfing 0.2MB/ page Weixin (uploading photo) 0.05-0.2MB/ photo Weixin (texting) 0.001MB/ text Source: CM, Tencent, RHB

Figure 36: Assuming…… Category Per day Data usage per month (MB) Video (High definition) / Video (Standard) 10min 600 Online gaming 15 min 247.5 Music 5 songs per month 11 Web surfing 25 150 Weixin (uploading photo) 5 18.8 Weixin (texting) 50 1.5 Total 1028.8 Source: RHB

From the chart above, video streaming uses the highest amount of data of an average 4G  Video streaming contributes the sub. Assuming a 4G sub watches 10 minutes of a standard quality video on the majority of data usage of an average handphone per day, data usage would reach 600MB per month. While we view this 4G sub. assumption as conservative, we see it as a huge upside. This is given the increasing amount of video content – from news, sports, to entertainment in the likes of TV programmes and even shows by internet celebrities – provided on different mobile apps eg Weixin and Weibo (WB US, NR).

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Figure 37: Video clip of news on Weixin Figure 38: Video clip of a sport game on Weibo (mobile)

Source: Weixin Source: Weibo

Figure 39: Video clip of a TV show on Weibo (mobile) Figure 40: Video clip of an internet celebrity show on Weibo (mobile)

Note: A singer performs in a singing contest. On bottom right, the figure shown is Note: The programme features one of China’s most famous internet celebrities – the length of the clip (6 minutes and 3 seconds). The figure on the bottom left is the Papi. The length of the clip is 4 minutes and 9 seconds. It had been viewed 100m number of views (4.9m) times. Source: Weibo Source: Weibo

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How would rising 4G adoption affect mobile ARPU? Continuously rising 4G adoption Given the much higher data usage of 4G subs (DOU: 2x more than that of blended  (ARPU: 31-76% higher than that of average), they also have higher ARPUs when compared to non-4G subs (ARPU: 31-76% blended average) should drive mobile higher than that of blended average). Therefore, we believe that continuously rising 4G ARPU up in coming years. adoption should drive mobile ARPU up in the coming years.

Figure 41: ARPUs of 4G subs/ Total subs, 1H16

90 81 81 80 76

70 62 60 56

50 46

40

30

20

10

0 CM CU CT

4G subs Total subs

Source: Company data

Part II/ Data tariff falling, but also driving data usage and revenue growth Falling data tariff may be the major concern from investors. We observed that per unit data tariff has been on a downtrend in China in recent years. But in fact, it is natural for data tariff to go down when telecommunication technology evolves to a more advanced generation.

Take 4G as an example, its capacity is ~3-5x of that of 3G. In other words, the cost of data  As long as there is no nationwide would decline sharply when moving to 4G, from 3G (~60-80%). Therefore, as long as: unlimited data plan and data elasticity i. There is no nationwide unlimited data plan (which would cap data revenue growth); is above 1, it is only rational for telcos to lower data tariff to drive 4G ii. Data elasticity is above 1 (Growth in data usage surpasses the decline in data tariff); adoption and encourage more data it is only rational for telcos to lower data tariff to drive 4G adoption and encourage data consumption. consumption. And that is CU’s pricing mechanism. Please see below:

Figure 42: CU standard nationwide data package’s pricing

Source: Company data

Besides, this kind of pricing mechanism is also common around the world. (Figure 43)

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Figure 43: Verizon, Docomo and LG Uplus’ per unit data pricing

Source: Company data

Moreover, by analysing CM’s operational performance in FY14-1H16 (after the launch of 4G services), we see the lower data tariff being translated to higher data consumption and  Lower data tariff has been translated data revenue. In FY14-1H16, while data tariff was down by 35.3%, 46% and 39.4% YoY, to more data consumption and higher data usage was up by 115.1%, 143.7% and 130.6% YoY respectively. As a result, data data revenue. revenue (adjusted) grew by 39.1%, 45% and 39.7% YoY respectively.

Figure 44: CM’s data usage, tariff and revenue growth in FY14-1H16

200.0%

143.7% 150.0% 130.6% 115.1%

100.0%

45.0% 39.7%39.7% 50.0% 39.1%39.1% 31.7%

0.0% FY14 FY15 1H16

-50.0% -35.3% -46.0% -39.4%

-100.0%

Data usage Data tariff Data revenue Data revenue (adj.)

*Data revenue (adj.) growth in FY15 was adjusted to exclude the impact from one-month data rollover plan Source: Company data, RHB

Part III/ 4G investment peak – already passed

We believe that 4G’s investment peak has already passed in China. CM’s capex and  The three telcos’ capex should keep capex-to-sales ratio began declining in 2015. CU and CT’s capex and capex-to-sales ratio on declining in absolute term in would also fall in 2016. According to the respective managements’ guidance, the three coming years. telcos’ capex should continue declining in absolute term in coming years.

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Figure 45: Capex of the three telcos, FY12-18F Figure 46: Capex to sales ratio of the three telcos, FY12-18F

250 60.0% 215 196 50.0% 200 185 186 177 182 40.0% 150 134 30.0% 102 96 CNY bn CNY 100 85 80 86 82 73 75 71 72 66 20.0%

50 10.0%

0 0.0% FY13 FY14 FY15 FY16F FY17F FY18F FY13 FY14 FY15 FY16F FY17F FY18F

China Mobile China Unicom China Telecom China Mobile China Unicom China Telecom

Source: Company data, Bloomberg, RHB Source: Company data, Bloomberg, RHB

We do not expect that the telcos’ capex to drop sharply in absolute term in coming years. But as rising 4G adoption should drive topline to grow, we believe that the telcos’ capex- to-sales ratio to be on a solid downtrend in coming years.

Figure 47: Capex to sales ratios of telcos in regions which already have high coverage of 4G services

25.0%

20.0%

15.0%

10.0%

5.0%

0.0% FY13 FY14 FY15

LG Uplus KT Corp SK Telecom NTT Docomo KDDI Softbank Chunghwa Telecom Taiwan Mobile Far Eastone HKT Smartone HTHK Singtel M1 Starhub Source: Company data, Bloomberg, RHB

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Figure 48: Capex-to-sales ratios of telcos in regions that are still ramping up 4G services

45.0% 40.0% 35.0% 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% FY13 FY14 FY15

Axiata Maxis Digi Telekom Malaysia AIS DTAC TRUE Jasmine PLDT Globe Telekomunikasi Xl Axiata Indosat Source: Company data, Bloomberg, RHB

Taking reference from neighbouring regions, we also found that the capex-to-sales ratio of most telcos in regions with high coverage of 4G services have been on a downtrend in last two years. Compared to those regions, China’s DOU still lags far behind. China’s telcos should be in a more favourable position to keep capex to sales ratio on a downtrend given their 4G networks still having huge room to cater data usage growth.

Would the rapidly rising data usage derail this trend? The falling data tariff and rapidly rising data usage may lead to investor concerns – the growth in data revenue may not be able to offset rise in depreciation, maintenance  Given higher capacity of 4G (~3-5x of expenses and tower lease fee. This may also cause capex to stay buoyant and derail the that of 3G), rapidly rising data usage trend of falling capex for the three telcos. has not been translated into higher capex for CM. We believe that such a scenario is unlikely to happen. The 4G’s capacity is ~3-5x of that of 3G and as a result, it has a much larger room to cater for data usage growth. Based on our discussions with CM and CU, current utilisation of their 4G networks is still very low. Moreover, by analysing CM’s operational performance in FY14-1H16 (after launch of 4G services), we are of the view:

i. Rapidly rising data usage has not been translated into higher capex (capex actually  An increase in data revenue has also fell in FY15); been much larger than that in ii. An increase in data revenue in terms of absolute amount has been much larger than depreciation, maintenance expenses that of depreciation, maintenance expenses and tower lease fee. And the gap seems and tower lease fee for CM. to be widening.

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Figure 49: CM’s data usage and capex growth in FY14/ FY15 Figure 50: CM’s data revenue, depreciation and maintenance expenses growth in FY14-1H16

160.0% 60,000 143.7% 140.0% 50,000 47,699 115.1% 42,332 120.0% 40,008 40,000 100.0%

80.0% 30,000 21,715 CNY (m)CNY 19,621 60.0% 20,000 17,917 40.0% 10,000 20.0% 13.2% 0 0.0% FY14 FY15 1H16 FY14 FY15 -20.0% -8.3% Increase in data revenue Data usage Capex growth Increase in deprecation, maintenance expenses and tower lease fee* Source: Company data Note: * CM span off its towers to China Tower in 4Q15 and starts to pay a FY tower lease fee in FY16. Source: Company data

Part IV/ 4G landscape in China

Market share of the three telcos in the 4G segment

Since the launch of 4G service, CM has been the most dominant player in this segment.  Given the more than a year first- By the end of Sep 2016, CM’s market share in 4G segment was 71%, while CT/ CU’s mover advantage in 4G, CM has been market shares were only 15.9%/13.1% respectively. The dominance is mainly because the most dominant player in 4G, with CM has more than a year of first-mover advantage in 4G, given the Chinese 71% market share. Government’s policy prioritising the promotion of the self-developed time division (TD) technology. As a result, while TD-LTE licenses were issued in Dec 2013, frequency division duplex -long term evolution (FDD-LTE) licenses were only granted in Feb 2015. CM launched its 4G service once it obtained the TD license, as its 3G technology – TD- SCDMA – was compatible to TD-LTE. However, CT and CU were not as lucky; their 3G technologies – CDMA2000 and WCDMA – were not compatible to TD-LTE. Therefore, they only launched their 4G services when they obtained the FDD-LTE licenses.

Figure 51: 4G segment market share of the three telcos

13.1%

15.9%

71.0%

CM CT CU

Source: Company data

CU has been a laggard in 4G segment. This can be seen from its 4G market share, 4G  By contrast, CU has been a laggard in penetration and 4G base station numbers, which are the lowest in the industry. By the end 4G segment, with 13.1% market of Sep 2016, CU’s 4G penetration was 33.9%, while CM and CT’s were 57% and 50.6% share. respectively.

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By the end of 1H16, CU’s 4G base station numbered at 588,000, while CM and CT had 1.32m and 610,000 respectively. The underperformance is likely because of CU’s reluctance to move from its highly successful 3G network. By end-2014, CU’s 4G base station number was only half to that of CT. The gap narrowed by end-2015, but its 4G base station number still trails CT’s by 110,000.

Figure 52: 4G penetration of the three telcos (Aug 2016) Figure 53: 4G base station number of the three telcos (1H16)

60.0% 57% 1400 1320

51% 1200 50.0% 1000 40.0% 34% 800 610 588 30.0% 600

400 20.0% 200 10.0% 0 CM CT CU 0.0% CM CT CU 4G BTS no. ('000)

Source: Company data Source: Company data

Figure 54: Rollout of 4G base station numbers of the three telcos

1400 1320

1200 1100

1000

800 720 610588 600 510 400

4G BTS BTS 4G no. ('000) 400 200 180 200 90 0 0 0 2013 2014 2015 1H16

CM CT CU

Source: Company data

However, we believe that CU should start catching up with CM and CT in 4G segment,  We believe that CU should start given: catching up with CM and CT in 4G i. CU’s strategy to focus on 139 cities, which contribute 84% of its data traffic, to roll out segment. its 4G network and service. This also enables CU to narrow the gap in 4G network quality with peers more quickly in those cities; ii. Network sharing with CT in rural areas, which also helps CU’s 4G sub net add to pick up in those areas.  In fact, CU’s 4G sub net add has In fact, CU’s 4G sub net adds have picked up. Its 3Q16 average 4G sub net adds picked up. Its 3Q16 average 4G sub increased to 5.5m, from 4.4m in 2Q16. Its 4G penetration also rose to 34% in Sep, from net adds increased to 5.5m, from 19% at the beginning of this year (23% and 28% by end-1Q16 and end -2Q16). 2Q16’s average of 4.4m.

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Figure 55: CU’s 4G subs net adds Figure 56: CU’s 4G penetration

7.0 40% 6.1 6.0 35% 5.4 5.4 34% 5.0 32% 30% 30% 5.0 4.5 4.4 4.5 28% 4.2 26% 25% 25% 4.0 23% 21% 20% 19% 3.0 15% 2.0 10%

1.0 5%

0.0 0% 2016/02 2016/03 2016/04 2016/05 2016/06 2016/07 2016/08 2016/09 2016/1 2016/2 2016/3 2016/4 2016/5 2016/6 2016/7 2016/8 2016/9

Source: Company data Source: Company data

Part V/ Technology and spectrum used by the three telcos to launch 4G services

As mentioned above, CM adopted TDD-LTE technology while CT and CU adopted FDD-  TDD-LTE has a higher data traffic LTE technology. The key differences between these two technologies are: capacity while FDD-LTE has a 1. TDD-LTE uses only one frequency band (uploading and downloading can be broader coverage. conducted via only one frequency band), while FDD-LTE requires the usage of two frequency bands (one for uploading and the other one for downloading); 2. As a result, TD-LTE has a higher data traffic capacity; 3. FDD-LTE has a broader coverage. Theoretically, its data speed is also higher than that of TD-LTE.

Figure 57: Difference between FDD-LTE and TDD-LTE

Source: RHB

Those characteristics also affect the spectrum that the three telcos used to launch 4G services.

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Figure 58: Spectrum resources held by the three telcos CM CU CT Sepctrum- Sepctrum- Bandwidth Network Sepctrum- Sepctrum- Bandwidth Network Sepctrum- Sepctrum- Bandwidth Network Upload Download (MHz) Upload Download (MHz) Upload Download (MHz) (MHz) (MHz) (MHz) (MHz) (MHz) (MHz) 890-909 930-954 24 2G 909-915 954-960 6 2G* 825-840 870-885 15 2G* 1710-1725 1805-1820 15 2G 1745-1755 1840-1850 10 2G 1920-1935 2110-2125 15 3G 2010-2025 2010-2025 15 3G 1940-1955 2130-2145 15 3G 1880-1890 1880-1890 20 4G 1755-1765 1850-1860 10 4G 1765-1780 1860-1875 15 4G 2320-2370 2320-2370 50 4G 2300-2320 2300-2320 20 4G 2370-2390 2370-2390 20 4G 2575-2635 2575-2635 60 4G 2555-2575 2555-2575 20 4G 2635-2655 2635-2655 20 4G Note: *MIIT had already approved CT and CU to refarm the spectrum for 4G services in May and June this year respectively. Source: MIIT, Company data, RHB

Beforehand, we would like to explain the key differences between using higher and lower frequencies in launching telco services:

i. Compared to higher frequencies, lower frequencies have broader coverage and also  Compared to higher frequencies, better penetration. Therefore, given the same area of coverage, lower frequencies lower frequencies have broader would require fewer base stations; coverage and also better penetration, ii. However, there is also a shortfall with lower frequencies. That is frequency resources but relatively fewer frequency are also relatively fewer when compared to higher frequencies (in terms of bandwidth, resources. which can also be seen in Figure 37). Therefore, lower frequencies are ideal to be deployed in rural areas while higher frequencies may be a better choice in urban areas due to a larger sub base and also the dense population.

Figure 59: Difference between low and high frequencies

Source: RHB

As a result, for CM, given: i. A much larger sub base (Number of total subs is almost equivalent to 2x of that of CT and CU combined together); ii. TDD-LTE’s advantage over and disadvantage to FDD-LTE is the higher data traffic capacity and narrower coverage ; CM deployed 2600MHz as the core spectrum to run its 4G network.

On the other hand, for CT and CU, given: i. A smaller sub base; ii. FD-LTE’s advantage over and disadvantage to TD-LTE are broader coverage and lower data traffic capacity.

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CT and CU deployed 1800MHz as the core spectrum to run their respective 4G networks. That also means CT and CU do not have to roll out the same number of base stations as CM in order to compete with the latter, in terms of coverage. Besides, MIIT had already approved CT and CU to refarm their 800MHZ/ 900Mhz spectrum for 4G services in May and June this year respectively. CT and CU have started to deploy the spectrum to run their 4G network in rural areas. This should also further reduce their capex burden going forward.

Part VI/ Competition in the 4G segment We analyse the competitive intensity in the 4G segment via two aspects: S&M expenses and data tariff of the three telcos:

S&M expenses

Even though the three telcos should still be striving to raise their 4G adoption in FY16F-  We believe that the three telcos’ S&M 18F, we believe that their respective S&M expenses would stay under control going expenses would stay under control forward. going forward. i. First of all, China telcos have been required by the Chinese Government to cut S&M expenses in the last two years; ii. Profitability is one of the major key performance index (KPI) applied by the SASAC; iii. CM and CU also already guided that S&M expenses would stay under control. (For details of pt. ii. and iii., please refer to “Selling & marketing expenses to stay under control” in “Investment Thesis” section.)

Figure 60: S&M expenses as a percentage of sales of the Figure 61: S&M expenses YoY change of the three telcos three telcos

16.0% 30.0% 25.5% 14.5% 14.0% 14.1% 20.0% 14.6% 20.0% 14.5% 12.0% 12.2% 12.0% 11.5% 11.8% 10.0% 10.5% 10.0%

8.0% 9.0% 0.0% 6.0% FY13 FY14-0.9% FY15 -10.0% -6.4% 4.0% -10.9% 2.0% -20.0% -17.5% -20.5% 0.0% -21.0% FY13 FY14 FY15 -30.0%

CM CU CT CM CU CT

Source: Company data Source: Company data

Data tariff i. For the national standard data package, we see data tariff from CM and CT in November remains the same compared to that in May. CU’s data tariff on the other hand, saw an increase during the same period after its short-term promotion ended; ii. However, despite the rebound in data tariff for national standard data package, CU also launched two new promotional packages – daily data card and unlimited data plan – in recent months in selective provinces. CT followed suit in launching its daily data card, but it was on a relatively smaller scale.  The daily data card has a basic monthly fee of CNY6 plus a daily fee of CNY1 per 500MB. So far, CU and CT have launched this plan in six and four provinces respectively;

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 For unlimited data plan, the monthly fee is CNY100-250, which is much higher than CU’s (CNY46) and even CM’s ARPU (CNY62) in 1H16. So far, CU has  CU launched two new promotional launched this plan in eight provinces. packages – daily data card and unlimited data plan – in recent months in selective provinces. The major concern of unlimited data plan is that it may cap ARPU growth (just like the  The unlimited data plan is priced at a case in Taiwan, where the unlimited data plan is priced at level close to ARPU). As rich premium when compared to CU CU’s unlimited data plan is priced at a rich premium over its blended ARPU, this and CM’s ARPUs. would not be an obstacle for ARPU growth.

Figure 62: Data tariff for national standard data package Figure 63: Data tariff for national standard data package (November) (May) Tariff (CNY) Tariff (CNY) Data package (MB/ month) CM CU CT Data package (MB/ month) CM CU CT 500 30 30 30 500 30 24 30 1000 50 60 50 1000 50 48 50 2000 70 90 70 2000 70 72 70 3000 100 120 100 3000 100 96 100 Source: Company data Source: Company data

Figure 64: Promotional packages launched by CU and CT in recent months CU CT

Daily data card Unlimited data plan Daily data card Beijing CNY46; Data 1.5GB; after that data speed will be down to 2G; Voice 60min Anhui CNY139 Chongqing Monthly fee: CNY9; Daily fee: CNY1/ 500MB Fujian CNY199 Monthly fee: CNY6; Daily fee: CNY1/ 1GB Guangdong Monthly fee: CNY6; Monthly fee: CNY6; Daily fee: Daily fee: CNY1/ 500MB CNY1/ 800MB Guangxi Monthly fee: CNY6; CNY250 Daily fee: CNY1/ 500MB Guizhou CNY100 Hunan Monthly fee: CNY8; Daily fee: CNY1/ 350MB Hebei 1. Gold Card; CNY60, Data: 1G/ day; 2. Silver card: CNY30, Data 500MB/ day Heilongjiang Monthly fee: CNY6; Daily fee: CNY1/ 200MB Jiangsu CNY150; 1st-3rd month: CNY99; 4th-6th month: CNY 120 7th month onwards: CNY150 Ningxia CNY199 Shaanxi Monthly fee: CNY6; Daily fee: CNY1/ 500MB (limited offer) Zhejiang Monthly fee: CNY6; Daily fee: CNY1/ 200MB Source: Company data

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 We do not believe that would evolve We do not believe that this would evolve to an industry-wide price war, given that CM and to an industry-wide price war CT have not responded aggressively to CU’s new promotional packages. Furthermore, we are of the view that CU launched the packages in selective provinces to drive 4G adoption. It is likely only a short-term promotion (just like the case of national standard data package  For recently launched new mentioned above). Once 4G momentum has built up, CU is likely to withdraw the promotional packages, including packages. unlimited data plan, we believe they would likely be withdrawn once CU’s For the unlimited data plan:- 4G momentum has built up. i. We do not see this trend extending nationwide; ii. And that plan is either:  With certain restrictions -- For example, in Beijing, once data usage goes beyond 1.5GB, data speed would fall to 256 kilobits per second (=32 kilobytes per second as 1 byte = 8 bits, equivalent to the speed of 2G). With such a low data speed, subs can only use Weixin, check email or surf webpage, unable to stream online videos or play online games. We see that data usage growth in China is highly driven by online video or gaming now. If a sub wants to watch more online videos or play more online gaming, the unlimited data provided by the telco’s existing data plan would not meet the needs until an upgrade of the data plan occurs. Therefore, this kind of unlimited data plan should not be a meaningful hindrance to data usage and data revenue growth of CU.  Or priced at a high-level -- For example, except in Guizhou, unlimited data plans are priced at CNY139 or above (vs CU and CM’s mobile ARPU of CNY46 and CNY62 in 1H16). This kind of unlimited data plan should only target a limited segment of high-end and high data usage subs and should not be a meaningful hindrance to data usage and data revenue growth of CU.

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Company Outlook In FY16F-18F We expect that CU’s: i. Revenue to grow at a CAGR of 4.4% in FY15-18F, driven by:  Solid mobile revenue growth, driven by strong data revenue growth due to rising 4G adoption. This should be more than enough to offset declining voice and SMS due to substitution effect from instant messaging apps like Weixin;  Stable fixed segment. Solid FBB and ICT growth should be more than enough to offset declining fixed voice. ii. EBIT margin to expand to 6.4% in FY18F, from 3.9% in FY15. This would be mainly driven by positive operating leverage; iii. Recurring NP to grow at a CAGR of 42.4% in FY15-18F as a result; iv. Capex-to-sales ratio to fall to 20.8% in FY18F, from 48.3% in FY15, as 4G investment peak has already passed; v. FCF yield to rise to 9.1% in FY18F, from -4.9% in FY15, given rising ARPU and falling capex.

Part I/ Revenue (+4.4% pa in FY15-18F) Mobile segment (53% of total revenue in FY16F, +6.8% pa in FY15-18F) Rising ARPU

We expect the mobile segment’s revenue to grow at a CAGR of 6.8% in FY15-18F. This  We expect CU’s mobile revenue to would be mainly driven by ARPU rising ~5% pa and total subs increasing by ~2% pa increase at ~7% pa in FY15-18F. during the period. The rise in ARPU ought to be mainly driven by strong data revenue growth due to rising 4G adoption. This should be more than enough to offset declining voice and SMS due to  We expect CU’s ARPU to rise to substitution effect from instant messaging apps like Weixin. We expect CU’s ARPU to rise CNY47.70 this year, from CNY46.30 to CNY47.70 this year, from CNY46.30 last year and increase further to CNY53.30 in last year and increase further to FY18F. CNY53.30 in FY18F.

Figure 65: CU’s ARPU, FY14-18F

60.0 53.3 51.4 50.0 46.3 47.7 44.6

40.0

30.0

20.0

10.0

0.0 FY14 FY15 FY16F FY17F FY18F

ARPU (CNY) Source: Company data, RHB

The increase in total subs would be slightly above the industry growth rate. This is  We expect CU’s total mobile subs to because we believe that CU should be able gain back some subs with its improved 4G increase by ~2% pa in FY15-18F. network quality during the period after witnessing a subs loss in FY15. We expect CU’s total subs to rebound to 263m, from 252m last year. The figures would, surge further to 275m in FY18F. (Please note that CU had restated its total subs in FY14 and FY15 last year to exclude non-billing subs.)

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Figure 66: CU’s total subs, FY14-18F

280.0 274.7 275.0 268.9 270.0 266.6 265.0 263.4

260.0

255.0 252.3

250.0

245.0

240.0 FY14 FY15 FY16F FY17F FY18F

Total subs (m) Note: * CU restated its total subs in FY14 and FY15 last year to exclude non-billing subs. Source: Company data, RHB

Strong data revenue growth to offset declining voice and SMS

We expect CU’s data revenue to grow 17.7% pa in FY15-18F, mainly due to rising 4G  We expect CU’s data revenue to grow adoption. We expect CU’s 4G penetration would reach 41% by the end of this year and 17.9% pa in FY15-18F. rise further to 61% and 80% by FY17 and FY18 respectively. Given data usage of 4G subs is indeed much higher (DOU: 2x more than that of blended average), this should help drive data revenue growth effectively.

Figure 67: CU’s data revenue, FY13-18F Figure 68: CU’s 4G penetration, FY14-18F

CAGR of 17.7% 120,000 90.0% in FY15-18F 101,983 80.0% 80.0% 100,000 CAGR of 3.9% in 91,837 FY13-15 70.0% 76,580 80,000 60.0% 61.0% 67,012 62,558 57,937 50.0% 60,000 40.0% 41.0%

40,000 30.0%

20.0% 20,000 15.4% 10.0%

0 0.0% 0.0% FY13 FY14 FY15 FY16F FY17F FY18F FY14 FY15 FY16F FY17F FY18F

Data revenue (CNY m) 4G penetration (%) Source: Company data, RHB Source: Company data, RHB

On the other hand, traditional services – voice and SMS – would be on a downtrend due  We expect voice and SMS to decline to the substitution effect from instant messaging apps like Weixin. We expect voice and at -9.6% and -9.2% pa in FY15-18F. SMS to decline at -9.6% and -9.2% pa in FY15-18. However, we believe the drag from these two segments should be limited given: i. CU was very successful in driving data revenue growth in the 3G era due to better user experience. Therefore, the contribution from these two segments has been declining (expected to fall to 11.4% in FY18, from 17.5% in FY15.) ii. On the other hand, data revenue as a percentage of mobile revenue has already been higher than voice and SMS since FY14.

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Figure 69: Contribution from Voice+SMS / data, FY13-18F

35.0% 32.4% 30.0% 30.6% 27.4% 25.0% 23.5% 22.6% 20.0% 20.4% 19.6% 19.0% 17.5% 15.0% 14.4% 12.7% 11.4% 10.0%

5.0%

0.0% FY13 FY14 FY15 FY16F FY17F FY18F

Voice + SMS revenue Data revenue Source: CU, RHB

FBB (33% of total revenue in FY16F, +4.3% pa in FY15-18F)

We expect this segment’s revenue to grow at a CAGR of 4.3% in FY15-18F. We believe  We expect fixed segment’s revenue that given the substitution effect from mobile voice, fixed voice’s revenue should decline at to grow at a CAGR of 4.3% in FY15- 13.2% in FY15-18F. However, this should be offset by solid FBB and ICT growth (+8.1%/ 18F. +21.7% pa in FY15-18F).

Key questions likely asked by investors: Would CM’s aggressiveness in FBB heat up competition in this segment and threaten CU? Unlikely, because:

i. FBB penetration is still low in China (53% by end of 1H16, vs mobile penetration’s  FBB penetration is still low in China 95% by end of 1H16). This provides plenty of room for subs’ growth for all players. In (53% by end of 1H16, vs mobile fact, despite a rapid ramp-up of CM’s FBB subs, CU and CT still maintained stable penetration’s 95% by end of 1H16). FBB subs net adds in 1H16 (0.4% and 0.7% MoM in 1H16, vs 0.4% and 0.5% MoM in FY15); ii. CM is turning its target to ARPU growth now. That’s a positive signal that CM does not intend to heat up competition which would hurt ARPUs and margins of this segment.

Why does CM’s ARPU show a huge discount to CU’s? Does this imply that CM adopts an aggressive subs net add strategy? Not at all. This is because before acquiring China TieTong in 2015, CM only viewed FBB as a complementary and bundling service. Therefore, up till 1H16, 80% of CM’s FBB subs were on bundling plans. That’s the major reason behind the abovementioned huge discount.

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Part II/ EBIT margin (to expand to 6.4% in FY18, from 3.9% in FY15) We believe that would be mainly driven by positive operating leverage:

Figure 70: Breakdown of CU’s operating expenses in FY16F 5% 9% 28%

11%

13%

19%

14%

Depreciation Leased lines and other network related costs Cost of products sold Personnel expenses Marketing expenses Other operating expenses Interconnection fees Source: Company data

Depreciation expenses (28% of total operating expenses in FY16F) – Stronger 4G network capacity keeps depreciation expenses under control

We believe that depreciation expenses would only increase at a moderate rate of 2.8% pa  Stronger 4G network capacity during FY15-18, given: enables CU to grow its data revenue i. Spinoff of towers offset the impact of rollout of 4G network (1H16’s depreciation without incurring much higher expenses -1.6% YoY); depreciation expenses ii. Stronger 4G network capacity (3-5x of that of 3G) enables CU to grow its data revenue without incurring much higher depreciation expenses. Besides, network sharing with CT in rural areas also help reduce some of the capex burden from 4G going forward;

iii. During our recent discussion with management, CU expressed that current utilisation  CU’s depreciation expenses as a of its 4G network was still very low. It also expressed that capex would keep on falling percentage of total revenue would in coming 1-2 years. These coincided with CM management’s comments. decline from 27.7% last year, to We expect that CU’s depreciation expenses as a percentage of total revenue would 27.6% this year, and drop further to decline to 27.6%, from 27.7% last year, and decline further to 26.9% in FY18. 26.9% in FY18F.

Figure 71: CU’s depreciation to sales ratio, FY13-18F Figure 72: CU’s capex to sales ratio, FY13-18F

29.0% 60.0%

28.0% 48.3% 27.7% 27.6% 50.0% 27.0% 26.9% 26.5% 26.0% 25.9% 40.0% 25.0% 29.8% 30.0% 26.8% 24.9% 23.8% 24.0% 20.8% 23.0% 23.1% 20.0%

22.0% 10.0% 21.0%

20.0% 0.0% FY13 FY14 FY15 FY16F FY17F FY18F FY13 FY14 FY15 FY16F FY17F FY18F

Depreciation to sales ratio Capex to sales ratio (%) Source: Company data, RHB Source: Company data, RHB

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Leased lines and other network related costs (19% of total operating expenses in FY16F) – a jump in FY16F mainly due to tower lease fee We believe that leased lines and other network related costs would increase at a rate of  We believe that the rate of increase of 10.7% pa during FY15-18F. The relatively high rate is mainly due to tower lease fee, leased lines and other network related which began in 4Q15 after the spinoff of towers. We believe that the rate of increase is costs would moderate to ~5% p.a. likely to moderate to ~5% pa during FY16-18F. This is based on: during FY16-18F. i. Maintenance, utility charges and non-tower lease fees, which contribute ~70% of total leased lines and other network related costs should grow at a moderate rate, just like depreciation expenses; ii. For tower lease fee, this is correlated to the increase in the number of base stations. As mentioned above, a stronger 4G network capacity (3-5x of that of 3G) and network sharing with CT in rural areas should help control the increase in number of base stations. We expect that CU’s overall towers would increase at a rate of 10%< in coming years. iii. According to the lease terms, co-sharing discounts on “site cost + electricity input cost” and “base price” for two/ three lessees are 40%/ 50% and 20%/ 30% respectively. In short, more tenants of the same tower would reduce a single tenant’s  CU’s leased lines and other network lease fee for the tower. That should also help control the increase in tower lease fee. related costs as a percentage of total We expect that CU’s leased lines and other network related costs as a percentage of total revenue is likely to increase to 18.6% revenue is likely to increase to 18.6% this year, from 15.3% last year but taper off to this year, from 15.3% last year but fall 18.2% in FY18F. to 18.2% in FY18F.

Figure 73: CU’s leased lines and other network related costs to sales ratio, FY13-18F

20.0% 18.6% 18.0% 18.3% 18.2% 16.0% 15.3% 14.0% 13.3% 12.0% 11.4% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% FY13 FY14 FY15 FY16F FY17F FY18F

Leased lines and other network related costs

Source: Company data, RHB

Handset subsidies (including cost of goods sold, 1% of total expenses) – a temporary sharp jump in FY16F to drive 4G adoption To drive 4G adoption, we believe that handset subsidies would increase by 73.4% YoY in FY16 and then decline at a rate of 5.0% pa during FY16-18F. And this is based on: 1. CU’s 4G penetration should reach 42.5% by end of this year. This should reduce the need of using handset subsidies to drive 4G penetration afterwards; 2. A wide range of choices of 4G phones (ASP as low as CNY200-300) should also  CU’s handset subsidies as a help CU control spending on handset subsidies; percentage of total revenue would increase to 1.4% this year, from 0.8% 3. We expect that CU’s handset subsidies as a percentage of total revenue would last year, before declining to 1.1% in increase to 1.4% this year, from 0.8% last year, before declining to 1.1% in FY18. FY18. We expect that CU’s handset subsidies as a percentage of total revenue would increase from 0.8% last year, to 1.4% this year, and down all the way to 1.1% in FY18F.

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Figure 74: CU’s handset subsidies to sales ratio, FY13-18F

2.5% 2.4%

2.0%

1.5% 1.4% 1.3% 1.3% 1.1% 1.0% 0.8%

0.5%

0.0% FY13 FY14 FY15 FY16F FY17F FY18F

Handset subsidies

Source: Company data, RHB

Market expenses (11% of total expenses in FY16F) stay under control from FY17F onwards

We believe that marketing expenses would stay under control and increase at a rate of  We believe that marketing expenses 2.2% pa during FY15-18F on: would stay under control. i. Profitability is one of the major key performance index (KPI) applied by the SASAC; ii. CM and CU also already guided that S&M expenses would stay under control. (For details, please refer to “Selling & marketing expenses to stay under control” in “Investment Thesis” section.)

We expect that CU’s S&M expenses as a percentage of total revenue would decrease  CU’s S&M expenses as a percentage from 11.5% in last year, to 11.2% in this year, then retreat to 10.9% in next year and down of total revenue would decrease from further to 10.8% in FY18F. 11.2% this year, to 10.9%/ 10.8% in FY17F/ 18F.

Figure 75: CU’s S&M expenses to sales ratio, FY13-18F

16.00% 14.5% 14.1% 14.00% 11.5% 12.00% 11.2% 10.9% 10.8%

10.00%

8.00%

6.00%

4.00%

2.00%

0.00% FY13 FY14 FY15 FY16F FY17F FY18F

S&M expenses as a % of total revenue (%) Source: Company data, RHB

As a result, we expect recurring NP to grow at a CAGR of 42.4% in FY15-18F.

Part III/ Dropping capex and FCF on the rise In the 139 focus cities mentioned before, CU’s 4G network coverage has already reached full coverage. In addition, network sharing with CT in rural areas should further reduce CU’s 4G capex burden going forward. Moreover, given the much higher data traffic capacity of 4G network when compared to that of 3G network, strong data usage growth should not lead to corresponding significant increase in capex.

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As a result, we believe that just like CM, CU’s 4G capex has also peaked and should keep on declining in coming years.

We expect that CU’s capex to sales ratio to decline from 48.3% in last year, to 26.8% in  We expect that CU’s FCF yield to this year, and down further to 20.8% in FY18F. Given the backdrop of rising ARPU and rebound to -1.4% this year, from - falling capex, FCF should be on an uptrend going forward. We expect that CU’s FCF yield 4.7% last year. to rebound to -1.4% this year, from -4.7% last year and surge further to 8.8% in FY18.

Figure 76: CU’s capex to sales ratio, FY13-18F Figure 77: CU’s FCF yield, FY13-18F

60.0% 10.0% 8.8% 48.3% 8.0% 50.0% 6.0% 6.4% 40.0% 5.1% 4.0% 29.8% 30.0% 26.8% 24.9% 23.8% 2.0% 20.8% 20.0% 0.0% FY13 FY14 FY15 FY16F FY17F FY18F -1.4% 10.0% -2.0% -2.1% -4.0% 0.0% -4.7% FY13 FY14 FY15 FY16F FY17F FY18F -6.0%

Capex to sales ratio (%) FCF yield (%) Source: Company data, RHB Source: Company data, RHB

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Figure 78: Detailed P&L (CNY m) FY14A FY15A FY16F FY17F FY18F Mobile Cellular Voice 46,010 42,999 35,321 33,669 31,720 Cellular SMS 8,071 5,597 4,818 4,389 4,192 Data 67,012 62,558 76,580 91,837 101,983 Others 34,002 31,466 31,034 34,106 36,021 Subtotal 155,095 142,620 147,753 164,002 173,916

Fixed Fixed Voice 18,979 15,001 13,456 11,944 9,769 Fixed Broadband 50,198 56,629 60,627 65,373 72,491 ICT 3,469 3,469 5,594 6,928 8,253 Others 15,834 16,161 15,983 16,020 16,058 Subtotal 88,481 91,260 95,660 100,265 106,571

Product Sales 39,803 41,770 34,497 34,283 32,281 Others 1,302 1,400 1,575 1,575 1,575 Total revenue 284,681 277,050 279,485 300,125 314,342 YoY Change -3.5% -2.7% 0.9% 7.4% 4.7%

Leased lines and other network related costs 37,851 42,308 51,966 54,900 57,344 Interconnection fees 14,599 13,093 12,852 14,763 15,654 Cost of products sold 43,397 44,046 38,430 38,069 35,828 Personnel expenses 34,652 35,140 36,097 37,935 39,515 Other operating expenses 21,218 22,995 25,510 27,419 28,540 Marketing expenses 40,193 31,965 31,419 32,822 34,078 EBITDA 92,840 87,503 83,216 94,218 103,384 YoY Change 10.5% -5.7% -4.9% 13.2% 9.7% EBITDA margin 32.6% 31.6% 29.8% 31.4% 32.9%

Depreciation & Amortization 73,868 76,738 77,285 80,748 83,329 EBIT 18,972 10,765 5,931 13,470 20,055 YoY Change 19.6% -43.3% -44.9% 127.1% 48.9% EBIT margin 6.7% 3.9% 2.1% 4.5% 6.4%

Other Income 1,362 1,318 982 885 945 Share of P/L of JV 0 -801 181 88 101 Disposal gain 0 12,059 0 0 0 Interest Income 283 438 1,038 1,288 1,349 Interest Expenses 4,617 6,934 5,203 5,896 6,176 Profit Before Tax 16,000 16,845 2,929 9,834 16,275

Income tax 3,876 3,473 698 2,458 4,069 Minority Interests 0 0 0 0 0 Net Profit 12,124 13,372 2,231 7,375 12,206 YoY Change 15.5% 10.3% -83.3% 230.6% 65.5% Net Margin 4.3% 4.8% 0.8% 2.5% 3.9%

Recurring Profit 12,124 4,226 2,153 7,375 12,206 YoY Change 15.5% -65.1% -49.1% 242.6% 65.5% Recurring Net Margin 4.3% 1.5% 0.8% 2.5% 3.9% Source: RHB

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Figure 79: Key assumptions FY14A FY15A FY16F FY17F FY18F YoY (%) Mobile 2.6% -8.0% 3.6% 11.0% 6.0% Cellular Voice -10.8% -6.5% -17.9% -4.7% -5.8% Cellular SMS -7.2% -30.7% -13.9% -8.9% -4.5% Data 15.7% -6.6% 22.4% 19.9% 11.0% Others 3.2% -7.5% -1.4% 9.9% 5.6%

Fixed 2.3% 3.1% 4.8% 4.8% 6.3% Fixed Voice -14.2% -21.0% -10.3% -11.2% -18.2% Fixed Broadband 8.1% 12.8% 7.1% 7.8% 10.9% ICT 16.0% 0.0% 61.3% 23.8% 19.1% Others 5.8% 2.1% -1.1% 0.2% 0.2%

Product Sales -29.5% 4.9% -17.4% -0.6% -5.8% Others 37.1% 7.5% 12.5% 0.0% 0.0% Total revenue -3.5% -2.7% 0.9% 7.4% 4.7%

Revenue contribution (%) Mobile 54.5% 51.5% 52.9% 54.6% 55.3% Cellular Voice 16.2% 15.5% 12.6% 11.2% 10.1% Cellular SMS 2.8% 2.0% 1.7% 1.5% 1.3% Data 23.5% 22.6% 27.4% 30.6% 32.4% Others 11.9% 11.4% 11.1% 11.4% 11.5%

Fixed 31.1% 32.9% 34.2% 33.4% 33.9% Fixed Voice 6.7% 5.4% 4.8% 4.0% 3.1% Fixed Broadband 17.6% 20.4% 21.7% 21.8% 23.1% ICT 1.2% 1.3% 2.0% 2.3% 2.6% Others 5.6% 5.8% 5.7% 5.3% 5.1%

Product Sales 14.0% 15.1% 12.3% 11.4% 10.3% Others 0.5% 0.5% 0.6% 0.5% 0.5% Total revenue 100.0% 100.0% 100.0% 100.0% 100.0%

Mobile Subscribers (m) 4G 0.0 44.2 108.0 163.9 219.7 Total 266.6 252.3 263.4 268.9 274.7

YoY (%) 4G 144.6% 51.7% 34.1% Total -5.1% -5.3% 4.4% 2.1% 2.2%

% of total (%) 4G 0.0% 17.5% 41.0% 61.0% 80.0% Total 100.0% 100.0% 100.0% 100.0% 100.0%

ARPU (CNY) 44.6 46.3 47.7 51.4 53.3 Source: RHB

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3Q16 Results And 4Q16 Preview

Figure 80: 3Q16 results and 4Q16 preview CNY (m) 3Q15 4Q15 1Q16 2Q16 3Q16 4Q16F Mobile 36,053 33,103 36,173 36,867 36,598 38,115 Fixed 23,016 22,057 24,108 24,122 23,678 23,752 Product sales 7,744 9,608 9,499 8,843 6,045 10,110 Others 415 369 560 83 563 369 Total Revenue 67,228 65,137 70,340 69,920 66,884 72,346 YoY change 2.2% -6.1% -5.3% -0.7% -0.5% 11.1%

Leased lines and other network related costs 10,107 13,047 13,256 12,368 13,002 13,340 Interconnection fees 3,331 3,204 3,142 3,224 3,142 3,344 Cost of products sold 8,458 10,508 10,657 9,560 6,815 11,398 Personnel expenses 8,729 8,486 9,077 9,194 9,554 8,272 Other operating expenses 5,742 5,742 6,427 6,427 6,427 6,229 Marketing expenses 7,076 10,896 7,809 7,830 7,407 8,373 EBITDA 23,785 13,254 19,972 21,317 20,537 21,390 YoY change -2.1% -36.2% -21.2% -15.1% -13.7% 61.4% EBITDA margin 35.4% 20.3% 28.4% 30.5% 30.7% 29.6%

Depreciation & Amortization 19,470 18,725 18,772 19,143 19,502 19,868 EBIT 4,315 -5,471 1,200 2,174 1,035 1,522 YoY change -28.5% -367.4% -80.0% -63.4% -76.0% -127.8% EBIT margin 6.4% -8.4% 1.7% 3.1% 1.5% 2.1%

Other Income 198 579 192 384 202 204 Share of P/L of JV -408 67 367 -461 137 138 Disposal gain 0 9,250 0 0 0 0 Interest Income 77 201 233 208 287 310 Interest Expenses 2,555 1,149 1,331 1,137 1,314 1,421 Profit before Tax 1,627 3,477 661 1,168 347 753

Income tax 436 1,095 181 214 115 188 Minority Interests 0 0 0 0 0 0 Net Profit 1,191 2,382 480 949 159 565 YoY change -69.1% -363.6% -84.8% -75.2% -86.6% -114.3% Net margin 1.8% 3.7% 0.7% 1.4% 0.2% 0.8%

Recurring Net Profit 1,191 -3,955 480 949 159 565 YoY change -69.1% -363.6% -84.8% -75.2% -86.6% -114.3% Recurring Net Margin 1.8% -6.1% 0.7% 1.4% 0.2% 0.8% Source: Company data, RHB

3Q16 results review i. 3Q16 total revenue was down 0.5% YoY, 4.3% QoQ to CNY66,884m. 9M16 total revenue was down 2.3% YoY to CNY207,144m and constituted 74% of our FY16 revenue forecasts; ii. For mobile segment, revenue was up 1.5% YoY but down 0.7% QoQ to CNY36,598m. 9M16 revenue was up 0.1% YoY to CNY109,638m and constituted 74% of our FY16 revenue forecasts; iii. 4G ARPU was down slightly to CNY77.7, from CNY79.4 in 3Q16. However, blended ARPU was down to CNY45.9, from CNY47.3 in 3Q16, despite rising 4G penetration (34% in Sep, vs 28% in Jun). We believe that was because the negative impact from removal of domestic roaming fee more than offset the positive impact from rising 4G penetration. While that negative impact should gradually fade out, the positive impact should stay as we expect 4G subs net adds to accelerate in 4Q16 (7.7m per month vs 5.5m in 3Q16). Therefore, we expect blended ARPU to resume QoQ growth from 4Q16 onwards;

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iv. For fixed segment, revenue was up 2.9% YoY but down 1.8% QoQ to CNY23,678m. 9M16 revenue was up 3.9% YoY to CNY71,908m and constituted 75% of our FY16 forecasts; v. EBITDA was down 13.7% YoY, 3.7% QoQ to CNY20,537m. EBITDA margin was down 4.7ppts YoY but improved 0.2ppts QoQ to 30.7%. 9M16 total revenue was down 16.7% YoY to CNY61,826m and constituted 74% of our FY EBITDA forecasts. This was mainly dragged by CU starting to pay a FY tower lease fee from this year onwards. We expected leased lines and other network related costs (including the tower lease fee) as a percentage of sales to rise to 18.6% this year, from 15.3% last year. vi. Recurring NP was down 86.6% YoY, 83.2% QoQ to CNY159m. 9M16 total recurring NP was down 80.6% YoY to CNY1,588m and constituted 73% of our FY16 recurring NP forecasts. This was mainly because the tepid topline growth was not able to offset the surge in leased lines and other network related costs (including the tower lease fee).

4Q16 results preview We expect: i. 4Q16 total revenue to be up 11.1% YoY, 8.2% QoQ to CNY72,826m. FY16F total revenue is likely to be up 0.9% YoY to CNY279,490m; ii. For mobile segment, revenue would increase 15.1% YoY, 4.1% QoQ to CNY38,115m. The jump in YoY growth rate is due to:  Rising 4G adoption;  Low base in 4Q15 which was dragged by the launch of one-month data rollover plan (leading to a delay in recognition of data revenue). FY16F revenue would be up 3.6% YoY to CNY147,753m; iii. Blended ARPU should rebound QoQ to CNY48.4, from CNY46.7 in 3Q16, driven mainly by rising 4G adoption (41% in December, vs 34% in September). FY16 ARPU should also rise to CNY47.7, from CNY46.3 in FY15. iv. For fixed segment, revenue ought to be up 7.7% YoY, 0.3% QoQ to CNY23,752m. FY16F revenue would rise 4.8% YoY to CNY95,660m; v. EBITDA would be higher at 61.4% YoY, 4.2% QoQ to CNY21,390. EBITDA margin is likely to expand 9.2ppts YoY but contract 1.1ppt QoQ to 29.6%. The jump in YoY growth rate is mainly because of rising 4G adoption, low base in 4Q15 and better operating leverage However, FY16F EBITDA would still be down 4.9% YoY to CNY83,216m mainly dragged by impact of FY tower lease fee. Recurring NP would turn profitable YoY and also be up 255.2% QoQ to CNY565m. The former is mainly because of better EBITDA margin. However, FY16F recurring NP would still be down 49.1% YoY to CNY2,153m. This was mainly because of impact of FY tower lease fee.

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5G – a Visible Potential

Figure 81: 5G roadmap in China

Source: CM, RHB

On the 5G road map, China is currently at the stage of “system concept” (3Q16-4Q17) –  5G is expected to start being where the architecture (or standards) of 5G is being set. commercially run from 2020 onwards. 5G has three important functions: i. Enhanced Mobile Broadband (eMMB); ii. Massive Machine Type Communications (mMTC); iii. Ultra-high reliability and low latency (URLLC) (For details, please see below) The standards of these functions would also be set during this period. China would then enter into the stage of the “Large Scale Trial” (1Q18-4Q19), where several cities would be chosen for a trial run of the 5G network, which is expected to start its commercial run from 2020 onwards. There have already been some small scale trial runs being conducted in China. They have provided more visibility of what 5G is going to bring.

First of all, what is 5G? i. Faster  Higher peak data rate of above 10GBps, compared to 4G’s ~1GBps;  Lower latency of below 1ms when compared to 4G’s 10ms. ii. More  Higher data traffic capacity which is ~1,000x of that of 4G;  More connected devices which is 10x-100x of 4G.

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What is a 5G network capable of?

Figure 82:

Source: ZTE  5G provides three important In short, a 5G network should provide three functions: functions – eMMB, mMTC and URLLC. i. Enhanced Mobile Broadband (eMMB) That enables more data to be transferred in a shorter time. For example, a 3D or UHD video can be downloaded within a second.

ii. massive Machine Type Communications (mMTC) That enables fully automatic data generation, exchange, processing and actuation among intelligence devices/ machines. And that would be the foundation for further development of Internet of Things (IoT) and Internet of Everything (IoE), making infrastructure like smart Home, smart Building and smart city (eg dynamic bus scheduling) possible.

iii. Ultra-high reliability and low latency (URLLC) That enables self-driving and also mission critical application. For self-driving, URLLC is very important as a dropped signal in data transmission could cause an accident.

China is already moving towards these new scenarios Smart public transportation network

For smart public transportation network, China has already taken its first step. Currently,  “Beijing real-time public transport” has Beijing citizens can now download an app called “Beijing real-time public transport” and made life more convenient. check information like the arrival time of the next bus. This has made life more convenient.

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Figure 83: APP - Beijing real-time public transport

Source Bjjtw

 5G would make more complicated With the entry of the 5G network, more complicated applications like the dynamic bus applications like dynamic bus scheduling are made possible and more devices – not only passengers, but the buses as scheduling possible and connect well – would be connected. Under dynamic bus scheduling, buses would also be able to more devices interact in the real-time to determine road conditions. This in turn may help shorten the travelling time for passengers. Meanwhile, according to a test conducted by Ericsson, this can effectively reduce the number of buses on a similar route by 15% on average, which may also help reduce emission.

Figure 84: Dynamic bus scheduling

Source: Ericsson

Autonomous cars Aside from smart public transportation network, the 5G network would also be an  Besides smart public transportation important corner stone for autonomous cars, which requires a large amount of highly network, 5G network would also be reliable and ultra-low latency real-time information transmission. In fact, autonomous cars an important corner stone for running on 5G network may not be far away. At the Mobile World Congress (MWC) autonomous cars Shanghai 2016 held in June-July, CM had already showcased mini autonomous cars which are based on the 5G network and co-developed with Nokia.

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Figure 85: Mini 5G autonomous cars

Source: Computerworld

According to Nokia, the emergence of autonomous cars could: i. May shorten travelling time by 1-hour per day on average, due to traffic optimisation; ii. May achieve close to zero fatalities, due to more precise driving.

Mission critical application We also see more possibilities from 5G. Recently, Ericsson also partnered with CM to conduct the world’s first 5G drone prototype field trip. The trial was held in Jiangsu province. A drone flew using CM’s mobile network with 5G-enabled technologies with handovers across multiple sites. The potential usage for this technology includes mission critical communications such as support for emergency services in remote area.

Figure 86: Drone field trip trials using the 5G network by Ericsson and CM

Source: CM

In conclusion, we believe that 5G, which is expected to be rolled out in 2020, would continue to drive more data consumption in the longer-term via: i. Acting as a cornerstone for more complicated applications like smart public transportation network and autonomous cars; ii. More connections to devices beyond smart devices eg buses and cars.

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Senior Management Profile Wang Xiaochu (chairman & chief executive officer). Mr Wang is in charge of the overall management of CU. He joined the board of directors of the company in Sep 2015. He formerly served as (in descending order of chronologically): i. Executive director, chairman and chief executive officer of China Telecom; ii. Chairman & chief executive officer of China Mobile. Mr Wang graduated from Beijing Institute of Posts and Telecommunications in 1989 and received a doctorate degree in business administration from the Hong Kong Polytechnic University in 2005.

Lu Yimin (executive director & president). He joined the board of directors of the company in Oct 2008. At the same time, he also served as: i. Non-executive director of HKT (6823 HK, NR); ii. Deputy chairman of PCCW (8 HK, NR); iii. Non-executive director of PCCW. He formerly served as: i. Senior management of China Network Communications Group Corporation (China Netcom); ii. Secretary at director general level at Information Processing Office; iii. Secretary at deputy director general level at Information Processing Office; iv. Deputy director and the director at Information Processing Office Mr Lu graduated from Shanghai Jiao Tong University with a bachelor’s degree in computer science in 1985 and then was awarded a master’s degree in public administration by the John F. Kennedy School of Government at Harvard University.

Li Fushen (executive director & chief financial officer). He joined the board of directors of the company in Mar 2011. At the same time, he also served as: i. Non-executive director of HKT (6823 HK, NR); ii. Non- executive director of PCCW. He formerly served as: i. Senior vice president of China Netcom; ii. Joint company secretary of China Netcom; iii. executive director of China Netcom; iv. Chief financial officer of China Netcom. Mr Li graduated from the Jilin Engineering Institute with a degree in engineering management in 1988, and from the Australian National University with a master’s degree in management in 2004.

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SWOT Analysis

 One of the two dominant players in fixed broadband  Policy risk from (FBB) market, with 27% of market share in terms of Chinese total number of subscribers. government.  Substitution impact from instant messaging apps, like Weixin, on voice and SMS

 Strong mobile divisions. data usage growth due to  Intensified rising 4G competition in adoption. fixed broadband market.  Network sharing with China Telecom should help reduce capex burden going forward. Further co- operation between the two may be  SOE structure which reduces its operation flexibility. possible in the

future.

Recommendation Chart

Date Recommendation Target Price Price Price Close 2016-12-12 17 Source: RHB, Bloomberg 16

15 14 13 12 11 10 9 8 7 Dec-11 Mar-13 Jun-14 Oct-15

Source: RHB, Bloomberg

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RHB Guide to Investment Ratings

Buy: Share price may exceed 10% over the next 12 months Trading Buy: Share price may exceed 15% over the next 3 months, however longer-term outlook remains uncertain Neutral: Share price may fall within the range of +/- 10% over the next 12 months Take Profit: Target price has been attained. Look to accumulate at lower levels Sell: Share price may fall by more than 10% over the next 12 months Not Rated: Stock is not within regular research coverage

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This report may contain forward-looking statements which are often but not always identified by the use of words such as “believe”, “estimate”, “intend” and “expect” and statements that an event or result “may”, “will” or “might” occur or be achieved and other similar expressions. Such forward-looking statements are based on assumptions made and information currently available to RHB and are subject to known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievement to be materially different from any future results, performance or achievement, expressed or implied by such forward-looking statements. Caution should be taken with respect to such statements and recipients of this

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Communications | Telecommunications report should not place undue reliance on any such forward-looking statements. RHB expressly disclaims any obligation to update or revise any forward- looking statements, whether as a result of new information, future events or circumstances after the date of this publication or to reflect the occurrence of unanticipated events.

The use of any website to access this report electronically is done at the recipient’s own risk, and it is the recipient’s sole responsibility to take precautions to ensure that it is free from viruses or other items of a destructive nature. This report may also provide the addresses of, or contain hyperlinks to, websites. RHB takes no responsibility for the content contained therein. Such addresses or hyperlinks (including addresses or hyperlinks to RHB own website material) are provided solely for the recipient’s convenience. The information and the content of the linked site do not in any way form part of this report. Accessing such website or following such link through the report or RHB website shall be at the recipient’s own risk.

This report may contain information obtained from third parties. Third party content providers do not guarantee the accuracy, completeness, timeliness or availability of any information and are not responsible for any errors or omissions (negligent or otherwise), regardless of the cause, or for the results obtained from the use of such content. Third party content providers give no express or implied warranties, including, but not limited to, any warranties of merchantability or fitness for a particular purpose or use. Third party content providers shall not be liable for any direct, indirect, incidental, exemplary, compensatory, punitive, special or consequential damages, costs, expenses, legal fees, or losses (including lost income or profits and opportunity costs) in connection with any use of their content.

The research analysts responsible for the production of this report hereby certifies that the views expressed herein accurately and exclusively reflect his or her personal views and opinions about any and all of the issuers or securities analysed in this report and were prepared independently and autonomously. The research analysts that authored this report are precluded by RHB in all circumstances from trading in the securities or other financial instruments referenced in the report, or from having an interest in the company(ies) that they cover.

RHB and/or its affiliates and/or their directors, officers, associates, connected parties and/or employees, may have, or have had, interests in the securities or qualified holdings, in subject company(ies) mentioned in this report or any securities related thereto and may from time to time add to or dispose of, or may be materially interested in, any such securities. Further, RHB and/or its affiliates may have, or have had, business relationships with the subject company(ies) mentioned in this report and may from time to time seek to provide investment banking or other services to the subject company(ies) referred to in this research report. As a result, investors should be aware that a conflict of interest may exist.

The contents of this report is strictly confidential and may not be copied, reproduced, published, distributed, transmitted or passed, in whole or in part, to any other person without the prior express written consent of RHB and/or its affiliates. This report has been delivered to RHB and its affiliates’ clients for information purposes only and upon the express understanding that such parties will use it only for the purposes set forth above. By electing to view or accepting a copy of this report, the recipients have agreed that they will not print, copy, videotape, record, hyperlink, download, or otherwise attempt to reproduce or re-transmit (in any form including hard copy or electronic distribution format) the contents of this report. RHB and/or its affiliates accepts no liability whatsoever for the actions of third parties in this respect.

The contents of this report are subject to copyright. Please refer to Restrictions on Distribution below for information regarding the distributors of this report. Recipients must not reproduce or disseminate any content or findings of this report without the express permission of RHB and the distributors.

The securities mentioned in this publication may not be eligible for sale in some states or countries or certain categories of investors. The recipient of this report should have regard to the laws of the recipient’s place of domicile when contemplating transactions in the securities or other financial instruments referred to herein. The securities discussed in this report may not have been registered in such jurisdiction. Without prejudice to the foregoing, the recipient is to note that additional disclaimers, warnings or qualifications may apply based on geographical location of the person or entity receiving this report.

RESTRICTIONS ON DISTRIBUTION

Malaysia This report is issued and distributed in Malaysia by RHB Research Institute Sdn Bhd. The views and opinions in this report are our own as of the date hereof and is subject to change. If the Financial Services and Markets Act of the United Kingdom or the rules of the Financial Conduct Authority apply to a recipient, our obligations owed to such recipient therein are unaffected. RHB Research Institute Sdn Bhd has no obligation to update its opinion or the information in this report.

Thailand This report is issued and distributed in the Kingdom of Thailand by RHB Securities (Thailand) PCL, a licensed securities company that is authorised by the Ministry of Finance, regulated by the Securities and Exchange Commission of Thailand and is a member of the Stock Exchange of Thailand. The Thai Institute of Directors Association has disclosed the Corporate Governance Report of Thai Listed Companies made pursuant to the policy of the Securities and Exchange Commission of Thailand. RHB Securities (Thailand) PCL does not endorse, confirm nor certify the result of the Corporate Governance Report of Thai Listed Companies.

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Indonesia This report is issued and distributed in Indonesia by PT RHB Securities Indonesia. This research does not constitute an offering document and it should not be construed as an offer of securities in Indonesia. Any securities offered or sold, directly or indirectly, in Indonesia or to any Indonesian citizen or corporation (wherever located) or to any Indonesian resident in a manner which constitutes a public offering under Indonesian laws and regulations must comply with the prevailing Indonesian laws and regulations.

Singapore This report is issued and distributed in Singapore by RHB Research Institute Singapore Pte Ltd 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 categories of investors, RHB Research Institute Singapore Pte Ltd and its representatives are not required to comply with Section 36 of the Financial Advisers Act (Chapter 110) (Section 36 relates to disclosure of RHB Research Institute Singapore Pte Ltd ’s interest and/or its representative's interest in securities). Recipients of this report in Singapore may contact RHB Research Institute Singapore Pte Ltd in respect of any matter arising from or in connection with the report.

Hong Kong This report is issued and distributed in Hong Kong by RHB Securities Hong Kong Limited (興業金融證券有限公司) (CE No.: ADU220) (“RHBSHK”) which is licensed in Hong Kong by the Securities and Futures Commission for Type 1 (dealing in securities) and Type 4 (advising on securities) regulated activities. Any investors wishing to purchase or otherwise deal in the securities covered in this report should contact RHB Securities Hong Kong Limited.

United States This report was prepared by RHB and is being distributed solely and directly to “major” U.S. institutional investors as defined under, and pursuant to, the requirements of Rule 15a-6 under the U.S. Securities and Exchange Act of 1934, as amended (the “Exchange Act”). RHB is not registered as a broker- dealer in the United States and does not offer brokerage services to U.S. persons. Any order for the purchase or sale of the securities discussed herein that are listed on Bursa Malaysia Securities Berhad must be placed with and through Auerbach Grayson (“AG”). Any order for the purchase or sale of all other securities discussed herein must be placed with and through such other registered U.S. broker-dealer as appointed by RHB from time to time as required by the Exchange Act Rule 15a-6.

This report is confidential and not intended for distribution to, or use by, persons other than the recipient and its employees, agents and advisors, as applicable.

Additionally, where research is distributed via Electronic Service Provider, the analysts whose names appear in this report are not registered or qualified as research analysts in the United States and are not associated persons of Auerbach Grayson AG or such other registered U.S. broker-dealer as appointed by RHB from time to time and therefore may not be subject to any applicable restrictions under Financial Industry Regulatory Authority (“FINRA”) rules on communications with a subject company, public appearances and personal trading.

Investing in any non-U.S. securities or related financial instruments discussed in this research report may present certain risks. The securities of non-U.S. issuers may not be registered with, or be subject to the regulations of, the U.S. Securities and Exchange Commission. Information on non-U.S. securities or related financial instruments may be limited. Foreign companies may not be subject to audit and reporting standards and regulatory requirements comparable to those in the United States. The financial instruments discussed in this report may not be suitable for all investors.

Transactions in foreign markets may be subject to regulations that differ from or offer less protection than those in the United States.

OWNERSHIP AND MATERIAL CONFLICTS OF INTEREST

Malaysia RHB does not have qualified shareholding (1% or more) in the subject company (ies) covered in this report except for: a) -

RHB and/or its subsidiaries are not liquidity providers or market makers for the subject company (ies) covered in this report except for: a) -

RHB and/or its subsidiaries have not participated as a syndicate member in share offerings and/or bond issues in securities covered in this report in the last 12 months except for: a) -

RHB has not provided investment banking services to the company/companies covered in this report in the last 12 months except for: a) -

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Thailand RHB Securities (Thailand) PCL and/or its directors, officers, associates, connected parties and/or employees, may have, or have had, interests and/or commitments in the securities in subject company(ies) mentioned in this report or any securities related thereto. Further, RHB Securities (Thailand) PCL may have, or have had, business relationships with the subject company(ies) mentioned in this report. As a result, investors should exercise their own judgment carefully before making any investment decisions.

Indonesia PT RHB Securities Indonesia is not affiliated with the subject company(ies) covered in this report both directly or indirectly as per the definitions of affiliation above.

Pursuant to the Capital Market Law (Law Number 8 Year 1995) and the supporting regulations thereof, what constitutes as affiliated parties are as follows:

1. Familial relationship due to marriage or blood up to the second degree, both horizontally or vertically;

2. Affiliation between parties to the employees, Directors or Commissioners of the parties concerned;

3. Affiliation between 2 companies whereby one or more member of the Board of Directors or the Commissioners are the same;

4. Affiliation between the Company and the parties, both directly or indirectly, controlling or being controlled by the Company;

5. Affiliation between 2 companies which are controlled, directly or indirectly, by the same party; or

6. Affiliation between the Company and the main Shareholders.

PT RHB Securities Indonesia is not an insider as defined in the Capital Market Law and the information contained in this report is not considered as insider information prohibited by law.

Insider means: a. a commissioner, director or employee of an Issuer or Public Company; b. a substantial shareholder of an Issuer or Public Company; c. an individual, who because of his position or profession, or because of a business relationship with an Issuer or Public Company, has access to inside information; and d. an individual who within the last six months was a Person defined in letters a, b or c, above.

Singapore RHB Research Institute Singapore Pte Ltd and/or its subsidiaries and/or associated companies do not make a market in any securities covered in this report, except for: (a) -

The staff of RHB Research Institute Singapore Pte Ltd and its subsidiaries and/or its associated companies do not serve on any board or trustee positions of any issuer whose securities are covered in this report, except for: (a) -

RHB Research Institute Singapore Pte Ltd and/or its subsidiaries and/or its associated companies do not have and have not within the last 12 months had any corporate finance advisory relationship with the issuer of the securities covered in this report or any other relationship (including a shareholding of 1% or more in the securities covered in this report) that may create a potential conflict of interest, except for: (a) -

Hong Kong RHBSHK or any of its group companies may have financial interests in in relation to an issuer or a new listing applicant (as the case may be) the securities in respect of which are reviewed in the report, and such interests aggregate to an amount equal to or more than (a) 1% of the subject company’s market capitalization (in the case of an issuer as defined under paragraph 16 of the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (the “Code of Conduct”); and/or (b) an amount equal to or more than 1% of the subject company’s issued share capital, or issued units, as applicable (in the case of a new listing applicant as defined in the Code of Conduct). Further, the analysts named in this report or their associates may have financial interests in relation to an issuer or a new listing applicant (as the case may be) in the securities which are reviewed in the report.

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RHBSHK or any of its group companies may make a market in the securities covered by this report. RHBSHK or any of its group companies may have analysts or their associates, individual(s) employed by or associated with RHBSHK or any of its group companies serving as an officer of the company or any of the companies covered by this report. RHBSHK or any of its group companies may have received compensation or a mandate for investment banking services to the company or any of the companies covered by this report within the past 12 months.

Note: The reference to “group companies” above refers to a group company of RHBSHK that carries on a business in Hong Kong in (a) investment banking; (b) proprietary trading or market making; or (c) agency broking, in relation to securities listed or traded on The Stock Exchange of Hong Kong Limited.

Kuala Lumpur Hong Kong Singapore

RHB Research Institute Sdn Bhd RHB Securities Hong Kong Ltd. RHB Research Institute Singapore Level 11, Tower One, RHB Centre 12th Floor Pte Ltd. Jalan Tun Razak World-Wide House 10 Collyer Quay Kuala Lumpur 19 Des Voeux Road #09-08 Ocean Financial Centre Malaysia Central, Hong Kong Singapore 049315 Tel : +(60) 3 9280 2185 Tel : +(852) 2525 1118 Tel : +(65) 6533 1818 Fax : +(60) 3 9284 8693 Fax : +(852) 2810 0908 Fax : +(65) 6532 6211

Jakarta Shanghai Bangkok

PT RHB Securities Indonesia RHB (China) Investment Advisory Co. Ltd. RHB Securities (Thailand) PCL Wisma Mulia, 20th Floor Suite 4005, CITIC Square 10th Floor, Sathorn Square Office Tower Jl. Jenderal Gatot Subroto No. 42 1168 Nanjing West Road 98, North Sathorn Road, Silom Jakarta 12710, Indonesia Shanghai 20041 Bangrak, Bangkok 10500 Tel : +(6221) 2783 0888 China Thailand Fax : +(6221) 2783 0777 Tel : +(8621) 6288 9611 Tel: +(66) 2 862 9999 Fax : +(8621) 6288 9633 Fax : +(66) 2 862 9799

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