China Unicom And Telecom Deepen Cooperation With 4G Resource Sharing Agreement

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China Unicom (NYSE:CHU) and China Telecom (NYSE:CHA), the smaller two Chinese wireless carriers, signed a multi-pronged strategic agreement to share resources, enabling them to cut costs and better compete with larger and better capitalized rival China Mobile (NYSE:CHL) . [1] In this note, we take a look at the scope and benefits of the deal and examine whether it could set the stage for a full-fledged merger between China’s second and third largest wireless carriers.

Our $15 price estimate for China Unicom is about 40% ahead of the current market price, while our price estimate of $58 for China Telecom is about 30% ahead of the current market price.

See our complete analysis of China MobileChina UnicomChina Telecom

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What Is The Scope of The Agreement & What Are The Benefits? 

The broad theme of the pact between the carriers appears to be lower costs via resource sharing and improved bargaining power. The most crucial aspect of the deal is the carriers’ decision to team up for their rural 4G network build out, allowing them to save on network equipment and operation costs. While the three Chinese carriers already share tower infrastructure, the two smaller players will now share some 4G base stations as well, potentially integrating some of their underlying communications infrastructure. Analysts at Bernstein Research peg the capex savings over five years at RMB 19.1 billion ($2.9 billion) and RMB 18.6 billion ($2.83 billion), respectively, for China Telecom and China Unicom, versus building alone. [1] The related operating expense savings could be about 50% versus building the new networks alone.

In addition to network sharing, the two carriers will also jointly negotiate international roaming rates, promote 6-mode handsets as a national standard for high-end smartphones and work together to improve their network quality and customer experience. As of November 2015, Unicom and Telecom had about 287 million and 197 million wireless subscribers, respectively, compared to China Mobile’s 825 million subscribers. (related: Chinese Wireless Industry: 2015 In Review)  Telecom and Unicom’s operating expenses are also considerably higher compared to China Mobile’s, with EBITDA margins of roughly 30% in 2014, per our estimates, compared to over 40% for China Mobile. With the joint network expansion and related cost savings, the smaller carriers should be able to provide better and wider 4G services rivaling China Mobile’s nationwide network, while freeing up cash for potential customer acquisition and marketing activities.

Does This Set The Stage For A Full Fledged Merger?

It is unlikely that the deeper cooperation between the two carriers will eventually result in a merger. Both carriers are state-backed, and a merger will conflict with the government’s current agenda. China 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 create a duopoly in the wireless market (about 63% market share for China Mobile and 36% for a merged entity), while effectively creating a monopoly in the land line and broadband market (combined share of over 85% for Unicom and Telecom). Moreover, the recent collaborations indicate that sizable savings on the network front can be achieved without a full-fledged merger. This implies that operating expense reductions for a merged entity (beyond network savings) would have to come from the personnel front, requiring large-scale job cuts. This is something that the government will be reluctant to carry out, considering the potential social impacts.

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Notes:
  1. China Unicom, Telecom To Share 4G Build: Bernstein Sees $5.7B Savings, Barrons, January 2016 [] []