Make the Call: The Best Bets in Chinese Telecom

Most investors are familiar with the major telecommunication companies in the United States, such as Verizon (NYSE:VZ) and AT&T (NYSE:T), simply because most of us are consumers of their services. Many investors also know that telecommunications isn't the wildly growing business that it once was here in America. With high penetration rates and pro-competition government oversight in the U.S., investors more often associate telecom with negative terms like "cutthroat competition" than opportunity.

But other regions around the world are very early in the growth stage of telecommunications. Various factors have led up to this -- some countries have experienced dramatic economic upswings, while others are going through the privatization of previously state-owned telecom monopolies.

In this issue of "Make the Call," we're going to take a gander around the globe to hunt out some solid opportunities in telecom. First up: China, where we have several good opportunities for investment.

1.3 billion people like to talk
With more than 1.3 billion people, China is a favorite growth market among investors. Telecommunications is still wide open for growth. As of January 2007, fixed-line penetration is still less than 30% and mobile penetration is still less than 40%. To give you a sense of the size of the market, China typically signs up 5 million new mobile subscribers every month.

One of the reasons for the dramatic growth is the booming Chinese economy; the Chinese GDP growth rate in 2006 was a stunning 10.7%. Another reason is the dramatic change in government policies and regulations of telecommunications. In conjunction with the entrance of China into the World Trade Organization in 2001, several state-owned telecommunications monopolies were reorganized and privatized. In a series of restructurings, the Chinese government created four major telecommunications entities -- two companies operate and control fixed-line businesses, while another two focus on mobile networks. Happily, all four of these companies trade ADRs on the New York Stock Exchange, making investing in them a simple exercise.

The major players
China's two largest fixed-line operators are:

China Telecom (NYSE: CHA) -- the world's largest wire-line telecommunications provider. China Telecom offers voice, data, and multimedia services mostly in the southern regions of mainland China. It claimed more than 223 million fixed-line subscribers and 28 million broadband customers at the end of 2006.

China Netcom (NYSE: CN) - China's second-largest fixed-line services company is the dominant provider in the northern provinces of China, such as Beijing. The company also offers voice, data, and multimedia services, in addition to a limited-mobility service called Personal Handyphone System (PHS).

The two principal mobile operators are:

China Mobile (NYSE: CHL) -- the largest mobile telephone operator in the world. China Mobile's subscriber base exceeded 300 million at the end of 2006, up 22% from the prior year. With large networks already covering urban regions, China Mobile is now focused on growth in rural areas, which made up almost half of its subscriber additions in 2006.

China Unicom (NYSE: CHU) -- China Unicom is the only full-service operator of both fixed-line and mobile services in China. At the end of 2006, the company increased its base of mobile subscribers by 11% to 142 million, split across the two different mobile networks -- CDMA and GSM -- that it operates. The company also entered into a strategic alliance with Korean operator SK Telecom (NYSE:SKM) in July 2006 to help further develop mobile services on its CDMA network.

With ample room left for growth in telecom services in China, investors don't have to go digging down into China's smaller, higher-risk companies to see great returns. For this reason, we'll stick to a comparison of these four telecom operators to see which may offer compelling value as an investment.

Valuation check
To get a sense of which of these companies may be a good buy, we'll look at both the enterprise value-to-free cash flow and PEG ratios for each. The first ratio of EV/FCF gives us a sense of value for current operations, since it's rooted in the current cash flow from the business.

The second, the PEG, tries to value the company based on an expectation of future growth. Since the growth rate is essentially an educated guess, I like to use it in combination with the EV/FCF to give a good basis for comparison of future prospects. Since we like high growth and high cash flows, the lower these ratios are, the better.

Here's how the stats for each stack up:

Where's the value?
From the data in the chart, we can see that even with its massive size, China Mobile still has a reasonable EV/FCF of 18.3 and the best PEG of the group. I should also note that the company claims a huge cash surplus of more than $15 billion, while the others here still have debt outweighing cash on the books. China Unicom actually trades the cheapest with respect to how much free cash flow the company brings in, but it's estimated to grow at 15.4%, below the 20.3% of China Mobile.

Of the major fixed-line operators, China Netcom is more attractive in terms of growth but is priced high compared to its current free cash flow. Neither of these operators jumps off the page screaming "value!" Both mobile operators show more compelling ratios and appetizing debt loads.

Another bonus is that each of these companies pays a nice dividend on their ADRs, with yields ranging from China Unicom's 1.5% to China Mobile's 3.5%. This is an added bonus to any share growth, further adding to the companies' attractiveness as investments.

The takeaway
While none of the four major Chinese telcos is cheap, they're all compelling alternatives to much pricier neighbors in the U.S. If I had to pick, I'd still put my money behind China Mobile. Even with a 57% appreciation in the shares in the past year, it still trades at a reasonable price for the growth still expected ahead.

Keep in mind, however, that there's still significant risk investing in any Chinese companies, so use this only as a basis for further analysis, not a recommendation to buy.

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