By David So
With the cell-phone penetration rate exceeding 100% in Hong Kong, mobile operators are now finding it difficult to increase sales. This tough operating environment is magnified, in our opinion at S&P Equity Research, by the fact that six mobile players are fighting for market share in a city with a population of just 7 million. In the long term, we believe that non-third-generation (3G) mobile operators will face difficult times, especially without a long-term growth engine to move up to the next level.
Due to this intensely competitive environment, some major shareholders have recently considered -- or are cashing in on -- mobile businesses without 3G licenses. For example, the initial public offering of People's Telephone on the Hong Kong Stock Exchange in March, 2004, essentially acted as a vehicle for some existing shareholders to offload shares, with the rest of the proceeds raised to largely repay shareholders loans.
More recently, New World Development is proposing to spin off its mobile unit to essentially "backdoor list" the company. Instead of listing the stock through the formal regulatory procedure and meeting the three-year historical profit requirements, New World Development's mobile unit will be sold to Asia Logistics Technology (ALT, essentially a listed shell company) in exchange for shares of ALT. As a result, New World Development will have majority ownership and control of ALT, which will be renamed New World Mobile Holdings.
Because of these newly (or about to be) listed non-3G mobile players, we expect four of the six mobile operators to be publicly traded in Hong Kong by midyear. Of those currently listed, we at S&P Equity Research have a 5-STARS (buy) recommendation on Smartone (its shares are not traded in the U.S.) and 1-STARS (sell) rating on Sunday Communications (SDAY; recent price: $5.26).
We don't have a ranking for Peoples Telephone (its shares are not traded in the U.S.). We prefer Smartone and see it as the best mobile play in Hong Kong, due to a stronger balance sheet, higher quality of subscriber base, larger market share, better quality of earnings, and, importantly, lower valuations and what we see as an attractive dividend yield.
Smartone and Peoples are similar in size, with slightly more than 1 million customers each. Sunday has the smallest subscriber base, at roughly 660,000. However, we believe that Smartone has a higher quality of subscribers than Peoples. About 60% of Peoples' subscribers have signed fixed contracts -- that's low relative to Smartone, which has 80% of its subscribers on fixed contracts (the remainder of the subscribers use prepaid phone cards).
Accordingly, blended average revenue per user (APRU) for Peoples is much lower than Smartone, since customers who use the phone cards normally generate significantly lower APRU. This translates to lower profitability for Peoples, which only generates about half of Smartone's revenue. For Sunday, fixed-contract customers represent about 60% of its subscriber base, but only 30% of new subscriber acquisitions.
Given the matured penetration rate, Hong Kong mobile operators are increasingly relying on rising APRU and handset sales to generate revenue growth. Smartone has been particularly successful with handset sales, which rose 27% in the first half of fiscal 2004 from the year-ago period. This encouraging achievement was aided by the popularity of its Sharp GX22 handset (launched in September, 2003). Handset sales also serve as an effective tool in inducing customers into fixed contracts through attractive subsidies.
We believe that another driver of revenue growth is mobile data, which accounts for only about 5% of APRU for the Hong Kong mobile players. Although it may take a while before 3G-based offerings reach the mass market (as was the case with 2G services in the 1990s), we believe this technology will become a main driving force of data growth. By David So
Unlike Sunday and Smartone, Peoples is not burdened by 3G operating and capital expenditures and therefore should be in a better position to boost profits in the short-to-medium term. However, on a long-term basis, we believe Peoples will lack a growth engine to drive revenue and the ability to maintain and increase profitability in the next three to four years. Peoples might gain some 3G upside by becoming a mobile virtual network operator or by acquiring a CDMA2000 license, but we view these probable moves only as defensive strategies aimed at preventing the loss of market share.
Of the listed 3G mobile players, Sunday seems to be the least aggressive in rolling out 3G. It's taking a wait-and-see approach to the technology. The longer it delays the rollout, the more likely it is that 3G operating and capital expenditures will be lower for the company.
In any case, we're concerned about Sunday's ability to absorb its 3G operating and capital expenditures, since we think the rollout of 3G services will be a drag on its profitability (because of 3G operating losses and higher depreciation and amortization expenses) and free-cash flow (because of 3G capital expenditure of $115 million in a three-year period). Moreover, when Sunday achieved its first-time profit in fiscal year 2003, it was largely driven by its aggressive cost-cutting strategy. So we believe the mobile operator will need to maintain tight cost control to sustain profitability.
In terms of valuation, we find Smartone more attractive than Peoples in terms of operating earnings multiple (enterprise value to earnings before interest, taxes, depreciation, and amortization), according to our forecasts. We see an operating earnings multiple of 4 for Smartone, vs. 5 for Peoples, for fiscal 2004.
If we look at the valuation argument from a different angle, Smartone has a market capitalization of $600 million (based on the Apr. 21 closing price). When stripping out its cash component, the market is essentially valuing Smartone at $340 million, which is even smaller than the $375 million market cap of Peoples. We don't think this is justifiable, given our view that Smartone has a stronger balance sheet, a better quality subscriber base, and generates higher revenue and profitability.
We view Sunday's stock as high-risk and subject to high balance sheet risk as well, especially when 3G operating and capital expenditures kick into its financials.
In conclusion, we believe that Smartone trumps Sunday and Peoples in terms of key valuations, operating metrics, plus its additional potential upside from what we see as its ability to distribute large special dividends to shareholders -- as it did in November, 2003.
Note: David So has no stock ownership or financial interest in any of the companies in his coverage area. Other S&P affiliates may provide services to the companies under discussion.
Analyst So follows wireless telecommunications stocks for Standard & Poor's Equity Research Services in Hong Kong