Commentary

Capital Expenditures Throw Off Chinese Telecom Investments

Tech Market WatchBy Perry Wu
We receive much email from readers of ChinaTechNews and a common question goes something like this: "What are the prospects for other telecom companies coming into China to compete with Unicom and Telecom and/or are they decent investments?" The Queen in Lewis Carroll's Through the Looking Glass says, "Now, here, you see, it takes all the running you can do, to keep in the same place." That aptly sums up the state of two of China's large publicly-listed telecoms, China Telecom and China Unicom, and should be a decent answer to the riddle of the Chinese telecom business.

Much has been written about the seemingly limitless prospects of these two large companies. Some of it is justified. After all, many low-paid workers in China still scrape together enough cash to own a mobile phone, making statisticians glow with the prospects of high mobile (and fixed line) penetration in the countryside. And in China the telecom industry operates a duopoly run by two rivals. The management of both China Telecom and China Unicom are stacked shoulder-deep with Telecom Ministry cadres, giving both companies considerable political clout. And those 2.6 billion ears–it's elixir to the uninitiated.

So China Telecom and China Unicom are compelling stories to investors.

But when we get behind the numbers of those two companies there is a different story. The problem is not customer demand; the problem is economics. As these two companies mature into Chinese bellwether stocks, the basic economics of these two companies will become ever more apparent.

Have you seen these companies' recently released annual regulatory filings for 2003? For China Telecom, it booked net profits of US$2.9 billion. Sounds pretty good, right? But not until you realize that its capital expenditures for the same period were US$5 billion. For China Unicom, the proportions get worse: its recently released reports show net profits of about US$500 million for 2003. And its capital expenditures (drum roll please) totaled: More than US$2 billion.

Yes, internationally-accepted GAAP says that capital expenditures are not part of the profit and loss statement. But a dollar out the door is still out the door no matter what you call it: it is more important to focus on what counts than on how it gets counted. And on this basis, these two telecoms are currently major flops. Ultimately, the invisible hand of the market will see through to this and assign a much reduced valuation.

Here lies a basic truth about market economies: some industries are just better than others. Take for example a well-known automobile company like Ford. Ford's sales are higher than just about any company in the world and have been for many years. But the stock has not been a bonanza for investors. Why? Most of those sales and profits that Ford makes have to be re-deployed in its enormous base of fixed assets. Microsoft, on the other hand, can take its profits and walk away. Which is why Bill Gates is the richest man in the world, according to Forbes magazine.

Similarly, these two telecoms do not have the luxury to take their profits and walk away, but must continually plow them to make into fixed assets, which makes their shareholders none the richer.

These two telecoms know their capex is a problem. In fact, they are currently trying to convince investors that capex is under control. China Telecom in its filing with the U.S. SEC on March 31, 2004 says that "In 2003, we continued to implement our prudent policy on capital expenditures and further optimized the allocation of our capital expenditures." Really?

The upshot is that being a phone company (mobile or otherwise) requires a gargantuan amount of ongoing capital to maintain a phone system. That will be as true 20 years from now as it is today.

Unlike the use of capital expenditures in other industries, such as new retail stores or new restaurants who use capex for acquiring new customers, capex at telecoms gets plowed mainly into maintaining an existing customer base. When McDonalds opens its first restaurant in a new Chinese city, the capex for that restaurant goes to acquiring a whole new customer base in that city. When Carrefour uses capex to open its first superstore in a new Chinese city, it also gets the benefit of a whole new set of customers.

But these telecoms are different–some of the money goes toward servicing new customers but most gets spent largely on keeping up with changes in cellular technology and dealing with a cellular system that requires huge maintenance. This is a fact with Chinese telecoms and it is true for telecoms the world over. In the U.S., AT&T used decades of steady profits to make it a classic "widows and orphans" stock. Why? Not because of its inherently good economics, but because it had a government-protected national monopoly on every phone in the country. But from the day a U.S. judge broke up the monopoly twenty years ago, AT&T has been on the road to perdition. No amount of good management can ever overcome really bad economics.

Gone are the days when a Chinese customer who wanted phone service had only one choice: the local land line phone company. Now, even though China Telecom and China Unicom operate a virtual duopoly over communication services, Chinese consumers will continue to have a growing selection of services from disparate companies. So you can legitimately ask the question: monopoly over what?

These Chinese telecoms do not–and with ever more new voice communications technology, probably will never–have such monopolies as AT&T had. China is a great place to invest, but thinking that business fundamentals magically disappear in a China Miracle are far-fetched. Stick with China Telecom and Unicom as your mobile carriers of choice, but set your sights on something more realistic (a Chinese fast food franchise?). Like the Queen in Lewis Carroll's book, these companies seem like they are running a Chinese marathon, but they are actually on the same old treadmill.

About the author:
Perry Wu is a writer and correspondent for ChinaTechNews.com and can be reached here at the site. Perry Wu does not hold any positions, long or short, on any of the Chinese or American company securities mentioned in this article.

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