Have you ever experienced a loss of network connection while in the midst of an important teleconference, as you step into a lift or drive into an underground car park? I have and my mind will flash across various complaints on my service providers – why have they not enhanced their network connection especially since Singapore is so small? Mutiply this problem by about 100x and you will be able to experience the waves of frustration felt when I went to China.

There is a company listed in Singapore, which is set up to provide solutions to the aforementioned problem. It has been catching the limelight recently with the announcement of its American depository receipt (ADR) facility. It has actually been mentioned on issue 371 of Shares Investment (Singapore) in the article How Have The 5 Fared So Far?. I will give a more detailed analysis on this company below.

DESCRIPTION OF SINOTEL

Sinotel was listed on SGX Main Board on 12 Nov 2007 at an IPO offer price of S$0.51. After hitting an intraday high of S$0.755 on 14 Nov 2007, it went into a prolonged decline and reached a low of S$0.065 on 28 Oct 2008. This came amidst the worries over the health of the US financial firms such as Citigroup, AIG etc. and also on concerns that Sinotel may not be able to get sufficient loans to fund its business operations. However, much has changed, since Sinotel increased its public profile by organizing talks with retail investors. It also communicated more openly with the financial community by organising site visits and road shows with fund managers and analysts.

Sinotel has two main business divisions, viz. wireless network solutions division and distribution solutions division. The wireless network solutions division contributed about 98% of its 9MFY09 results. It can be further segregated into the following three segments:

1. Provision of network infrastructure solutions

   Sinotel provides mobile phone network solutions for the likes of China Unicom (biggest customer), and China Mobile, two of China’s largest telecommunication companies (telcos)¹ which have a 95% market share in mobile phone services market in 2008. Sinotel’s network solutions enhance telephony signals and effectively extend the network coverage of the cellular base stations. This allows users of China Unicom and China Mobile to make and receive calls in areas where network coverage is low or in blind spots like basements, lifts and trains where network signals are weak. This segment contributes the bulk of the revenue.

2. Provision of network support solutions

   Sinotel’s network support solutions can be integrated into the telcos’ existing telecommunication network infrastructure to deploy new and enhanced voice communication services for wireless communication users and manage provision of increasingly popular value added data services. For example, the Mobile Data Internet System allows telcos to track the identity of subscribers connected to the network and record internet usage durations for billing purposes.

3. Emergency mobile communications system (EMCS)

   Sinotel is the only company in China to be able to provide this EMCS. The EMCS is a mobile RF (radio frequency) communications system mounted on top of a vehicle. It is able to restore network coverage to trouble stricken areas or functions as a booster at places with high capacity demands.

Sinotel also distributes 3G network cards, which is booked under distribution solutions Segment. This segment is currently insignificant.

INVESTMENT MERITS

A) Bright industry outlook

The telecom industry has tremendous growth potential from three fronts, namely low penetration rate, increasing rate of urbanisation, and government initiatives. Firstly, mobile phone penetration in China is still less than 50%, compared with 75% in North America. Secondly, urbanisation continues to drive the rapid development of new residential and commercial buildings, as well as expansion of transportation networks in China. This is likely to lead to further investments from major telcos to improve network coverage. In addition, for far flung cities, it is cheaper to install mobile service infrastructure than fixed lines. Thirdly, according to China’s Ministry of Industry and Information Technology, it is aiming to increase the 3G subscribers from around the current 2.5m to 240m by end 2011. Data usage is likely to follow rapidly, leading to higher capacity and capital expenditure (capex) requirements.

B) 3G network rollout – unprecedented in scale and size

According to Sinotel, the 3 telcos spent RMB80b for capex in 1H09 alone. They are likely to spend a similar amount (if not larger) for 2H09. Historically, about 10-15% of this will be awarded to wireless network solution providers. 10% of this will constitute about RMB16b (i.e. 10% of RMB80b x 2) spent in wireless enhancements, as compared to RMB9b spent in 2007. This represents a 33.3% compound annual growth rate since 2007. Furthermore, each of the telcos has adopted a different 3G platform, which means every building requires 3 systems, instead of one.

C) 2G network capex continues to rise

Besides 3G network, 2G network capex is set to grow. China Mobile, with its 2G (GSM) network capacity perpetually close to full utilisation, will continue to spend on 2G network capex. So will China Unicom (GSM) and China Telecom (CDMA) which will continue to spend to improve their patchy network coverage. Typically, about 6-7% of this capex will be awarded to wireless network solution providers.

D) Able to cherry pick contracts

According to company management, there were as many as close to a thousand wireless network services vendors 10 years ago, but only 40 to 50 are still in business today. New entrants are likely to face high barriers of entry as firstly, they have to face extensive certification checks from the three telcos. Secondly, these new entrants are required to have strong cash flow and good credit terms with the banks to finance the projects as this industry has a long cash conversion cycle. Thus, with limited players in this sector, and being one of the top ten players, Sinotel is able to cherry pick contracts to work.

E) Future growth drivers – EMCS and 4G

Sinotel started these EMCS solutions in 2008 and they are currently in the certification phrases before they can be utilized by the government organisations. Once it is certified, EMCS is set to grow rapidly as Sinotel enjoys monopolistic position in this segment. Moreover, China’s government requires all major cities (with population greater than 250K) to strengthen their disaster communications capability following the Sichuan earthquake in 2008.

Next year, China Mobile plans to have a trial 4G network in Shanghai (using TDD-LTE). Although this may not have a direct impact to Sinotel, the continuous improvement of network is likely to ensure an endless stream of jobs to Sinotel.

F) Operational efficiencies

With reference to Table 1, it is apparent that Sinotel has better operational efficiencies than its peers. Its net and operating margins are significantly higher than its peers, attributed mainly to its unique business model of deeper penetration, as opposed to wider coverage. Most of its peers have presence in more than 20 provinces whereas Sinotel has presence in nine provinces. Sinotel prefers to establish a strong footing in one province before venturing into a neighbouring province.

 
Table 1: Comparison of margins of Sinotel and its peers
Source: Bloomberg and Company’s Financials

G) ADR to close valuation gap

Since Sinotel announced that it had embarked on listing its shares as ADRs in the US market in August, investors have been waiting for the announcement of a market maker with bated breath. On 14 Dec 09, Sinotel announced that Hudson Securities has officially been granted approval by FINRA to be the market maker for Sinotel’s ADR commencing from 11 Dec 09. From now on, Sinotel’s ADR can start trading over-the-counter market in US, which should close the huge valuation gap between Sinotel and its peers. Sinotel’s competitors are trading at an average FY09F PE of about 13.7x, vis-à-vis 7.3x for Sinotel (see Table 2 below for the disparate valuation gaps between Sinotel and its competitors).

Table 2: Comparison of valuations of Sinotel and its competitors
Source: Bloomberg

INVESTMENT RISKS

A) Long cash conversion cycle

Sinotel typically pays its equipment suppliers first in order to secure the relevant supplies. It typically takes about six months to complete a project. Its customers will commence to pay about 50% and 45% of the contract value two months and eight months respectively after the project is completed. Thus, Sinotel has a long cash conversion cycle of around 13 months². The balance of 5% will be paid about eighteen months after the project is completed. This is the industry norm and cannot be avoided. What Sinotel can do and has done is to ensure that it has sufficient cash flow for its working capital.

B) Margins may be pressured

Gross margins may be pressured to slightly below 40% as there was a change in the telcos’ procurement policy, which now encourages central bulk purchasing for certain contracts. Although Sinotel is not actively participating in this, it is likely to be affected to a certain extent.

Moreover, net margin is likely to be lower as its tax-exempt status expires in 2010 which subjects Sinotel to a 7.5% income tax.

C) 4Q may be soft

Several projects have been completed ahead of schedule in 3Q, due to the pressing timeline given by customers. Most existing contracts are scheduled for completion in 1Q10 and 2Q10, rather than 4Q09. Thus, 4Q09 may be soft and it is unlikely to replicate the 3QFY09 57.9% yoy and 52.0% yoy growth in both revenue and profits respectively.

CONCLUSION

With reference to Table 2 above, Sinotel is trading at a huge discount to its peers. Applying a conservative PE of 9.1x, its share price would translate to about S$0.835. This represents an approximate 27% upside since its close of S$0.66 on last Fri.

By my measure, this indicates that Sinotel is undervalued1. Wonder, what does Mr Market think?

DISCLOSURE: Writer has been vested since July 2009.

1 There are three big telcos in China, namely China Mobile, China Unicom and China Telecom.

2 Cash conversion cycle measures the amount of time that Sinotel takes to convert resource inputs into cash flows.