Despite The Benefits, A China Unicom-Telecom Merger May Be Unlikely

Rumors about a possible merger between China Unicom (NYSE:CHU) and China Telecom (NYSE:CHA) – the second and third largest Chinese wireless operators – apparently resurfaced late last week. ^[1] The benefits of a merger appear significant on the surface for both companies, given their high fixed costs and weaker economies of scale compared to larger rival China Mobile. Unicom and Telecom have about 288 million and 194 million wireless subscribers, respectively, compared to China Mobile’s 823 million subscribers. Telecom and Unicom had EBITDA margins of roughly 30% in 2014, per our estimates, compared to over 40% for China Mobile. Revenue synergies could also be meaningful, owing to network integration, the wider marketing and distribution reach and potential for cross-selling wireline and broadband services – as Unicom’s wireline operations are stronger in northern China, while Telecom is stronger in the south. However, despite the potential benefits to shareholders, there’s a very low probability that a merger will materialize, since the carriers are state-backed, and the move could conflict with the government’s current agenda.

Our $15 price estimate for China Unicom is about 25% ahead of the current market price, while our price estimate of $58 for China Telecom is about 15% ahead of the current market price.

See our complete analysis of China Mobile | China Unicom | China Telecom

China Has Been Pushing For Competition, Innovation 

The Chinese government has been promoting competition among state-backed firms over the last several years in order to make them more consumer-friendly and innovative. A merger could damage this narrative, since it would effectively create a duopoly in the wireless market (63% market share for China Mobile and 36% for a merged entity), while creating a virtual monopoly in the landline and broadband space (combined share of over 85%). Moreover, the trend in the Chinese wireless market has been to introduce new market participants. For instance, the government has provided multiple MVNO licenses in recent years. It’s also worth recalling that China Telecom was actually split in 2002 to foster more competition, with its wireline assets in Northern China being transferred to a company called China Netcom, which was eventually merged into Unicom.  A merger of Unicom and Telecom would negate the effects of this prior restructuring.

Infrastructure Collaboration Gaining Traction 

The government recently got the three major wireless carriers to form a tower sharing joint venture dubbed China Tower, which will enable them to reduce capital expenditures and control some operation and maintenance expenses (related: China Tower Transaction: Unicom Gains Most In Interim, Telecom May Be Long-Term Winner). Moreover, there have been reports that China Telecom and China Unicom are preparing to share their 4G base stations as well, in a move that would allowing them to potentially integrate some of their underlying communications equipment, saving on network operation costs. This implies that a meaningful amount of savings on the network front could be achieved without a full-fledged merger. Separately, for a merger to add meaningful shareholder value there would need to be significant operating expense reductions, particularly on the personnel front. This would require large-scale job cuts, which is something that the government may not be open to considering the potential social impacts.

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1. Deja Vu: China Unicom, Telecom Jump On Merger Speculation, Barrons, November 2015 [↩]