INTRODUCTION

In 1H10, the telecom sector was faced with several unfavorable factors. The large-scale conversion of 3G subscribers hasn`t launched in effect, while the traditional business dropped beyond expectation. And emerging business hasn`t built an efficient profitability model. All these kept revenue growth and profitability of operators at a low level.

As far as equipment demand is concerned, while domestic telecom investment is dropping, key market abroad also appeared equipment embargo and trade protection, constraining equipment suppliers` performance in FY2010.

Given the adverse factors further in 2H10, we maintain our Market performance rating to operators, and downgrade equipment suppliers to Market performance rating.

Ⅰ Turning point of sector revenue appears, yet with low growth

Following new reconstruction in telecom industry, competition had launched in full wing from differentiation model, and pressure for fee decreasing was weighted. Due to operating the new long distance fee scheme, the general fee in 1Q10 dropped 13.5% y/y, deeper than the 9% expected by MIIT at the early of the year.

With the fierce competition of operators, the gap of revenue growth in this industry with GDP growth is widening again. Chinese telecom revenue increased in FY2000 by 2-3 times of that of GDP, and equal to GDP from 2004 before the first lag to GDP in 2007, and then since 2009, the gap has been widening gradually.

Though growth turning point appeared in 3Q09, we believe the revenue in this industry will still keep low and lag the overall GDP growth until 3G business with scale.

A) Various indicators bottom up, and proportion of mobile business increases

From January to May in 2010, overall industry business totally recorded RMB1227.65billion, increased 21.6% y/y. Telecom revenue totally recorded RMB359.51billion, only 5.9% y/y. Though industry boom bottomed up obviously, the 5.9% growth is far less than GDP growth.

From revenue structure, mobile revenue totally recorded RMB246.15billion, 11.5% y/y and the ratio in overall business up to 68.47% from 65.04%. Fixed-line revenue reached to RMB113.36billion, dropping 4.5% y/y, and the ratio in overall down to 31.53% from 34.96%.

B) Investment momentum slow gradually, with focus shifted

In 2009, China finished fixed telecom investment of RMB372.49billion, increasing 26.1% y/y, among which mobile-base station reached to 30.22million information channels, increasing 102% y/y, a new record. However, the Top Three operators plan to gradually cut their CAPEX in the next few years.

Entering into 2010, the slow trend of fixed investment appears in a certain trend. Up to May, 2010, total investment recorded RMB60.64billion, dropping 30.9% y/y, beyond our expectation early in the year, and the full year's cut would be larger than 20%.

Looking forward, drive of investment will come more from 2G network optimization, 3G network improvement, optical development and emerging business investment. Furthermore, quick LTE commercialization will also be an important part of this in telecom sector.

Ⅱ Market pattern changes quietly, with 3G business accelerating

In 2009, Top three operators started to build 3G network in large scale. This year, however, besides furthering 3G network improvement, they focus more on 3G marketing. On one hand, their performance this year is difficult to out-perform dragged by large depreciation and amortization and operating cost. On the other hand, they still expand 3G marketing and add handset subsidy to get a step ahead in 3G business in which they have a same start.

A) Net addition market share changed, with 3G ratio up

New addition market of mobile subscribers changed greatly since operators reconstruction at the end of 2008, and China Mobile's (CM) predominance came to an end. In new addition subscribers, China Telecom's (CT) market share has lifted to 30%, CM maintains 50%, and China Unicom (CU) 20%, the least of the three. In the net addition of 3G subscribers, however, they show not much difference and largely at the same level. Yet CU has began to adjust its marketing strategy in April and May this year, and won a fast growth in 3G subscribers of 1million in May and June.

Versus the relative balance in new addition of 3G subscribers, the Top Three's performance maintained out of balance through the year of 2009, recording the peak in 4Q in 2009. Yet this unbalance status improved from 1Q2010 with CM's revenue ratio dropping 3.5ppt and net profit ratio declining 11.2ppt.

Looking forward to 2H, we expect CM and CT will still be in defensive position in 3G business before the industry chain completion of downstream. And CU will speed its development in 3G subscribers, and breakthrough the current balance with most probability to lead 3G's development in China with WCDMA edge.

B) Strengthening operators` competition, operating cost pressure adds greatly

Given the current pattern, 3G business is still faced with strengthening competition risks. While being an introducing 3G stage, subscribers scale will be the first for competition of which CM aims at low-end customers with large terminal and fee subsidy; CT implements band of fixed-line with mobile as well as large terminal subsidy.

And CU targets middle-and-high end with scale fee subsidy assisted with terminal subsidy as its active policy, from the passive low fee subsidy with industry leading edge. Overall speaking, 3G competition strategy of subscriber scale first and profit second will continue 1-2 years at least in China. Therefore, operators` profit has limited up room without large growth of industry revenue.

C) Still low performance in fixed-line business, with broad band stable growth

Versus mobile business, domestic fixed-line and broad band business faced the less competition. According to the data in 1H, from January to June, CU cut 3.78million customers in fixed-line, and newly added 5.21million in broad band, and CT with cutting 7.49million and increasing 4.87million.

Overall, CU started to drive its broad band business after integrating China Netcom and largely caught CT's growth.

D) Maintaining market performance rating, and waiting for the breakthrough of profitability

Given still in large scale investment period, and also active launching of 3G business as well as subscribers adding, combined with flat traditional profitability drive, we still rate operators with market performance rating, and suggest to wait for the breakthrough of profitability with patience.

Yet mobile value added service obtains a good platform to develop with 3G business and the triple-network integration progress. It is also preferred by the market by huge development room of “Not impossible, only the unexpected”. We initiate with outperform rating to value added service.

Ⅲ Investment peak down, with chances for sub-sectors

In its 2009 annual report, CM announced capital expense (CAPEX) of 2010 was RMB123billion, 5.0% drop y/y, and that of 2011 and 2012 would be RMB98billion and RMB80.4billion respectively. Furthermore, CT's CAPEX in 2010 will cut more than RMB20bilion and CU's cut RMB40billion. Therefore, this cycle of investment in this sector will turn in 2010.

While domestic telecom investment is dropping, key market abroad also appeared equipment embargo and trade protection, constraining equipment suppliers` performance. We therefore believe future investment opportunity will mainly come from sub-sectors, such as network optimization and optical communication.

A) Operators` CAPEX decline, and equipment suppliers launch to oversea market

According to the investment plans, CM mainly cut mobile communication network building, about 16% y/y. Transmission network investment improved 19% y/y to RMB12.3billion, the only sector of CM with relative fast increase. Network support, new technology, emerging business and other investment scales largely remain as ever.

As total investment dropped 33%, CU's sub-business investment mostly dropped in large. After the over RMB20billion investment in 2009, GSM's investment this year is only RMB8billion. Meanwhile, investment on 3G business cut is in accordance with the total cut. It is worth mention that broad band investment is RMB15.3billion, 18.6% drop y/y due to the triple-network integration. Otherwise, CU's investment on innovation and value added platform rises obviously and will be added in the future.Despite of official investment plan announced, CT's investment focus in 2010 shifts to fixed network and broad band building from last year's mobile network building. On one hand, after last year's large input, CDMA's network capacity is enough for subscribers` fast increase and the key target in 2010 is to improve network coverage and optimization. On the other hand, the company will seize the chance of triple-network integration to greatly improve bandwidth and quality, maintaining its leading edge in broad band business.

Affected by domestic demand shrink, equipment supplies have started to aim at oversea market, especially at emerging market breakthrough. Yet following the fierce competition of international trade, especially the recent embargo in India, oversea market exploration and order margin, we think, will fail the expectation.

B) Downgrade to Market performance rating and focus on optical communication sector

At the beginning of this year, listed companies in telecom equipment sector reported overall net profit increase by over 40% due to investment scale in 2009. So the annual reports season before May witnessed an outperform sector. After May, however, equipment sector index has felt greatly dragged by operating capital cut, embargo in India and the broader market drop.

Given the boom down, we believe this industry has little chance in overall for 2H, yet still prefer sub-sectors with good prospect such as network optimization and optical communication. Private stocks also have band opportunities. We downside equipment sector to market performance rating.

Furthermore, we specially note to focus on optical communication sector which we believe with the best boom for three reasons. First, due to triple-network integration, operators and CRT will start FTTH building. Second, following 3G subscribers scale and bandwidth upgrade, branch network and MAN have expanding demand in capacity. Third, future internet of things and smart grid will greatly spur the optical demand.

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