January 2012

China/Hong Kong Country Book 2012

Asia China Telecommunications Fixed Line

China Telecom
Reuters: 0728.HK Bloomberg: 728 HK

Buy
Price at 1 Dec 2011 (HKD) Price target - 12mth (HKD) 52-week range (HKD) HANG SENG INDEX 4.69 5.90 5.23 - 3.88 19,002

Smartphones for all segments and seasons

Alan Hellawell III
Research Analyst (+852) 2203 6240 [email protected]

Price/price relative
6.0 5.0 4.0 3.0 2.0 12/09 3/10 6/10 9/10 12/10 3/11 6/11 9/11
China Telecom HANG SENG INDEX (Rebased)

William Bratton

Eva Leung, CFA

Research Analyst (+852) 2203 6190 [email protected]

Research Analyst (+852) 2203 6186 [email protected]

Long-term positives The greater availability of low-end smartphones is behind the strong monthly net adds in recent months. We believe these handsets have increased the affordability of 3G and accelerated the conversion of 2G to 3G. The launch of the iPhone in the near term should be positive to Telecom as it improves CT's relatively weaker handset line-up. Although handset subsidies will increase as a result, we believe the long-term positives outweigh the short-term setback in profitability. Buy. Long-term fundamentals We expect 10% earnings growth in 2011, driven by higher mobile net adds and usage. CT continues to demonstrate strong execution ability, with 3m monthly mobile net adds consistently this year. The apparent successful bundling of broadband with traditional fixed line has prevented significant loss on the latter front, which helps to improve overall fixed-line revenues by slowing the rate of decline. CT also increased capex this year to accelerate broadband network construction and enhance bandwidth speeds. Near-term catalysts: increasing handset subsidy We estimate that CT will spend RMB5.1bn on 2.5m subsidised iPhone subs if it launches the iPhone in 2012. This will increase handset subsidies by 30.5% yoy to RMB20.7bn. The increased subsidy will lower EBITDA by 4% and net profit by 12% to RMB76.4bn and RMB17.9bn in 2012, respectively. We believe the shortterm setback in profitability will be compensated by long-term gains. Basis for target price: DCF valuation results in target price of HKD5.90/share Our DCF analysis uses a 9.1% WACC (reflecting our standard CoE assumptions of 9.3% with a beta of 0.973) and 0% perpetual growth rate. Risks include CT not launching the iPhone in the near term, more intensive competition from China Unicom and China Mobile, ARPU and margin deterioration, fast decline in CTs fixed-line business, more spending on subsidies and marketing, higher capital expenditure than expected.
Forecasts and ratios
Year End Dec 31 Sales (CNYm) EBITDA (CNYm) Reported NPAT (CNYm) Reported EPS FD(CNY) DB EPS FD(CNY) DB EPS growth (%) PER (x) EV/EBITDA (x) DPS (net) (CNY) Yield (net) (%)
Source: Deutsche Bank estimates, company data
1 2

Performance (%) 1m Absolute -1.3 HANG SENG INDEX -1.9

3m -8.4 -7.7

12m 18.7 -18.3

Stock data
Market cap (HKDm) Market cap (USDm) Shares outstanding (m) Free float (%) Avg daily value traded (USDm) 379,573 48,843 80,932.0 16 43.8

Key indicators (FY1)

ROE (%) Net debt/equity (%) Book value/share (CNY) Price/book (x) Net interest cover (x) Operating profit margin (%) 7.3 9.5 3.00 1.3 9.9 10.6

2009A 209,370.0 74,901.0 14,422.0 0.18 0.16 -33.9 18.7 4.3 0.08 2.4

2010A 219,864.0 75,672.0 15,759.0 0.19 0.19 15.0 17.5 4.2 0.07 2.2

2011E 242,936.1 76,461.2 17,253.2 0.21 0.21 12.4 18.1 4.4 0.07 1.9

2012E 263,814.0 76,422.7 17,886.4 0.22 0.22 4.3 17.4 4.1 0.07 1.9

2013E 282,819.8 76,296.6 18,299.5 0.23 0.23 2.3 17.0 3.7 0.07 1.9

DB EPS is fully diluted and excludes non-recurring items Multiples and yields calculations use average historical prices for past years and spot prices for current and future years, except P/B which uses the year end close

Page 296

Deutsche Bank AG/Hong Kong

January 2012

China/Hong Kong Country Book 2012

Model updated: 17 October 2011

Fiscal year end 31-Dec

2008
0.25 0.01 0.07 2.63 80,932 316,413 413,338

2009
0.16 0.18 0.08 2.74 80,932 248,324 320,324

2010
0.19 0.19 0.07 2.86 80,932 266,521 314,769

2011E
0.21 0.21 0.07 3.00 80,932 310,811 334,525

2012E
0.22 0.22 0.07 3.15 80,932 310,811 311,539

2013E
0.23 0.23 0.07 3.30 80,932 310,811 284,251

Running the Numbers Asia China Telecom/Fixed line

Financial Summary
DB EPS (CNY) Reported EPS (CNY) DPS (CNY) BVPS (CNY) Weighted average shares (m) Average market cap (CNYm) Enterprise value (CNYm)

China Telecom
Reuters: 0728.HK Bloomberg: 728 HK

Valuation Metrics
P/E (DB) (x) P/E (Reported) (x) P/BV (x) FCF Yield (%) Dividend Yield (%) EV/Sales (x) EV/EBITDA (x) EV/EBIT (x) 15.8 357.9 0.97 9.7 1.9 2.22 7.0 80.3 18.7 17.2 1.04 14.3 2.4 1.53 4.3 14.1 17.5 16.9 1.21 13.8 2.2 1.43 4.2 13.1 18.1 18.0 1.28 9.8 1.9 1.38 4.4 13.0 17.4 17.4 1.22 9.3 1.9 1.18 4.1 11.8 17.0 17.0 1.16 10.7 1.9 1.01 3.7 10.7

Buy
Price (1 Dec 11) Target price 52-week Range Market Cap HK$ 4.69 HK$ 5.90 HK$ 3.88 5.23 HK$ 379,573m US$ 48,843m
Company Profile
China Telecom Corporation Limited, through its subsidiaries, provides wireline telephone, data, and Internet, as well as leased line services in China.

Income Statement (CNYm)

Sales revenue Gross profit EBITDA Depreciation Amortisation EBIT Net interest income(expense) Associates/affiliates Exceptionals/extraordinaries Other pre-tax income/(expense) Profit before tax Income tax expense Minorities Other post-tax income/(expense) Net profit DB adjustments (including dilution) DB Net profit 186,529 186,529 59,025 53,880 0 5,145 -5,076 112 0 5 186 -793 95 0 884 19,182 20,066 209,370 209,370 74,901 52,243 0 22,658 -4,375 101 0 791 19,175 4,549 204 0 14,422 -1,151 13,271 219,864 219,864 75,672 51,656 0 24,016 -3,600 131 0 361 20,908 5,031 118 0 15,759 -497 15,262 242,936 242,936 76,461 50,724 0 25,738 -2,612 43 0 4 23,172 5,861 58 0 17,253 -98 17,155 263,814 263,814 76,423 50,041 0 26,382 -2,477 0 0 0 23,904 5,976 42 0 17,886 0 17,886 282,820 282,820 76,297 49,613 0 26,683 -2,226 0 0 0 24,458 6,114 44 0 18,300 0 18,300

1yr Price Performance

6 5 4 3 2 Dec-10 Mar-11
0728.HK

Cash Flow (CNYm)

Jun-11 Sep-11
HANG SENG INDEX (Rebased)

Margin Trends
40 30 20 10 0 08 09
EBITDA Margin

Cash flow from operations Net Capex Free cash flow Equity raised/(bought back) Dividends paid Net inc/(dec) in borrowings Other investing/financing cash flows Net cash flow Change in working capital

76,756 -46,032 30,724 0 -6,167 32,348 -50,466 6,439 -1,775

74,988 -39,538 35,450 0 -6,493 -2,242 -19,777 6,938 -5,432

75,571 -38,683 36,888 0 -5,608 -32,501 -7,759 -8,980 -5,485

80,461 -50,000 30,461 0 -5,778 0 -91 24,592 -12,470

78,806 -50,000 28,806 0 -5,778 0 0 23,028 -10,836

78,110 -45,000 33,110 0 -5,778 0 0 27,332 -10,154

Balance Sheet (CNYm)

10 11E 12E
EBIT Margin

13E

Growth & Profitability

14 12 10 8 6 4 2 0 08 09
Sales growth (LHS)

8 6 4 2 0 10 11E 12E
ROE (RHS)

13E

Cash and other liquid assets Tangible fixed assets Goodwill/intangible assets Associates/investments Other assets Total assets Interest bearing debt Other liabilities Total liabilities Shareholders' equity Minorities Total shareholders' equity Net debt

27,866 312,774 44,157 1,456 54,084 440,337 123,279 102,510 225,789 213,036 1,512 214,548 95,413

34,804 297,895 42,233 2,161 49,427 426,520 105,923 97,984 203,907 221,732 881 222,613 71,119

25,824 289,693 39,888 3,945 48,005 407,355 73,576 101,815 175,391 231,468 496 231,964 47,752

50,416 288,969 39,888 3,945 52,825 436,043 73,576 119,104 192,680 242,809 554 243,363 23,160

73,444 288,928 39,888 3,945 56,256 462,461 73,576 133,372 206,948 254,918 596 255,513 132

100,776 284,315 39,888 3,945 59,145 488,069 73,576 146,414 219,990 267,439 640 268,079 -27,200

Solvency
60 40 20 0 -20 08 09 10 11E 12E 13E
Net debt/equity (LHS) Net interest cover (RHS)

15 10 5 0

Key Company Metrics

Sales growth (%) DB EPS growth (%) EBITDA Margin (%) EBIT Margin (%) Payout ratio (%) ROE (%) Capex/sales (%) Capex/depreciation (x) Net debt/equity (%) Net interest cover (x) Source: Company data, Deutsche Bank estimates 5.0 -15.0 31.6 2.8 686.3 0.4 25.0 0.9 44.5 1.0 12.2 -33.9 35.8 10.8 42.1 6.6 19.3 0.8 31.9 5.2 5.0 15.0 34.4 10.9 36.7 7.0 18.9 0.8 20.6 6.7 10.5 12.4 31.5 10.6 33.5 7.3 20.6 1.0 9.5 9.9 8.6 4.3 29.0 10.0 32.3 7.2 19.0 1.0 0.1 10.6 7.2 2.3 27.0 9.4 31.6 7.0 15.9 0.9 -10.1 12.0

Alan Hellawell
+852-2203-6240 [email protected]

Deutsche Bank AG/Hong Kong

Page 297

January 2012

China/Hong Kong Country Book 2012

Outlook for long-term earnings drivers

Revenues Revenues: We expect mobile service revenues to increase 46.65% yoy to RMB79.1bn in 2011E and 29.6% yoy to RMB102.5bn in 20112E as a result of relatively stable ARPUs and a growing mobile subscriber base. Due to the decrease in BB ARPU and stabilization of fixed-line voice business losses, fixed line service revenues will be -1% yoy in 2011E and -1.5% in 2012E. We expect overall operating revenues of RMB242.9bn (+10.5% yoy) and RMB263.8bn (+8.6% yoy) in 2011E and 2012E, respectively. Costs Subsidies: The company will spend RMB15.9bn (about 24% of its mobile service revenues) on handset subsides in 2011E and RMB20.7bn (about 24% of mobile service revenue) in 2011E to expand its mobile market share. Capex: We expect capex to increase by 16.2% yoy in 2011 to RMB50bn, and remain stable in 2012E.

Key events
Upcoming China Telecom may admit wrongdoing and promise to clean up its act, bringing an end to the antitrust probe by the NDRC. Recent The 3Q results announced in October were broadly in line with our expectations, with revenues up 1.3% qoq. The net margin declined marginally on a year-on-year basis from 6.8% in 3Q10 to 6.7% in 3Q11. We expect the margin to drop further in 4Q due to seasonality.

Valuation and rating

Primary valuation methodology Our HKD5.90 target price is DCF-based. We utilise a 9.1% WACC (reflecting our standard CoE assumptions of 9.3% with a beta of 0.973) and a 0% perpetual growth rate. Supporting valuation benchmarks On a relative valuation basis, our target price implies 2012E PE of 21.6x. Valuation DCF summary
Discounted FCF Add: cash Less: debt Less: minority interest NPV NPV per share (RMB) NPV per share (HKD) 411,277 50,416 (73,576) (554) 387,563 4.79 5.91 2011 21.6x 5.4x 2012 21.1x 5.4x

China Telecom forward PE bands

8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 20x 15x 10x 25x

10/2/2007

10/2/2008

10/2/2009

10/2/2010

Source: Deutsche Bank estimates

Source: Deutsche Bank, Bloomberg Finance LP

Page 298

Deutsche Bank AG/Hong Kong

10/2/2011

1/2/2007

4/2/2007

7/2/2007

1/2/2008

4/2/2008

7/2/2008

1/2/2009

4/2/2009

7/2/2009

1/2/2010

4/2/2010

7/2/2010

1/2/2011

4/2/2011

7/2/2011

Implied P/E Implied EV/EBITDA

January 2012

China/Hong Kong Country Book 2012

Company background
Current operations China Telecom is an integrated operator in China. The company offers a range of telecom services including CDMA/CDMA EVDO mobile services, traditional fixed-line voice, PHS, broadband and related services. Competitive landscape China Telecom is the largest full-service integrated operator in China. It has just a 12.6% share of Chinas mobile market, but 28.4% of Chinas 3G market. Nationwide implementation of MNP should not have a large effect on China Telecom since the company uses CDMA technology. Consequently, users will have to change handsets before migrating to and away from the CT network. In the long term, MNP should lead to increased competition in the telecom sector. Broader industry issues High growth seems to be ending for Chinas operators as mobile penetration exceeds 71% and growing competition drives ARPU down. While simple voice has mainly driven mobile uptake in China thus far, we expect mobile data and value-added services running atop Chinas faster 3G networks to drive uptake. Capex is expected to trend higher than previously anticipated due to increasing mobile data usage, which can congest the network. Network convergence initiative led the telco operators to upgrade their broadband networks in anticipation of competition from cable operators. Regulatory risks remain in the market, although the visibility on timelines and processes remains unclear. The antitrust division of China's National Development and Reform Commission (NDRC) confirmed recently that it had started an anti-monopoly investigation of two telecom operators, China Telecom and China Unicom, for their practices in China's broadband market. Service revenue composition
100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 100% 94% 84% 81% 77% 74% 0% 6%

Revenue, EBITDA and margin trend

70,000 60% 50% 40% 30% 20% 10% 0%

16%

19%

23%

26%

31%

60,000 50,000 40,000 30,000

69%

20,000 10,000 -

1H2008

2H2008

1H2009

2H2009

1H2010

2H2010

1H2011

1Q2008

2Q2008

3Q2008

4Q2008

1Q2009

2Q2009

3Q2009

4Q2009

1Q2010

2Q2010

3Q2010

4Q2010

1Q2011

2Q2011

Wireline revenue %
Source: Deutsche Bank, company data

Mobile revenue %

Operating Revenue
Source: Deutsche Bank, company data

EBITDA

EBITDA margin

Major shareholders and historical development China Telecom was established in September 2001, and listed on the Stock Exchange of Hong Kong and the New York Stock Exchange in November 2002. Telecom Group holds 70.89% of the companys shares. Guangdong Rising Assets Management Co. Ltd., Jiangsu Guoxin Investment Group Co., Ltd, Zhejiang Financial Development Company, and Fujian Stateowned Assets Investment Holdings Co., Ltd. together hold a total of 11.96%. The remaining 17.15% of the shares are held by public investors.
Deutsche Bank AG/Hong Kong Page 299

3Q2011