Sinotel has dropped 20.9% from S$0.645 on 16 Dec 09 to S$0.510 on 24 Mar 10. Investors are typically more concerned when their shares drop by more than 10%. It is natural as nobody wants to make losses in the stock market. According to Warren Buffett’s Number 1 Rule, he cautioned investors against losing their capital. So what has changed for Sinotel to warrant this drop in share price?

I will first discuss its FY09 results and provide some updates on Sinotel’s ADR and the central procurement system adopted by the telcos.

Highlights of FY09 results

As expected, 4Q09 results are a tad soft

Sinotel released 4QFY09 results which are a tad soft on its bottom-line. After removing the effect of the non-recurring RMB11m gain from the disposal of its Mobile Media Streaming Platform, 4QFY09 net profit would be around RMB15m, which would be 21.8% lower than 4QFY08 net profit. However, with reference to my article on Sinotel (16 Dec 09, Is Sinotel Still An Undervalued Stock?), this was expected as Sinotel’s several projects have been completed ahead of schedule in 3QFY09, due to the pressing timeline given by customers. Most existing contracts are scheduled for completion in 1QFY10 and 2QFY10, rather than 4QFY09.

Readers may have been alarmed by the drop in gross margins in 4QFY09. This was partly attributed to the change in product mix as there is an increase in contribution from system integration projects which command a lower margin of approximately 10.2%. Another contributing factor was that Sinotel ventured into the business of sales of equipment as its customers adopted the centralised procurement policy (more about central procurement policy below) in late 2008. This venture is also to provide comprehensive services to its customers. For this new venture, Sinotel incurred a minor loss as more expenses were incurred during the preliminary stage of the business. Notwithstanding the drop in gross margins in 4QFY09 and FY09, Sinotel still has the highest FY09 gross margins among the top ten players in this industry.

Table 1: Key information at a glance (Source: Bloomberg)

*No of shares refer to the actual number of shares as at that period under review and
do not refer to weighted average of shares
**SGD / RMB fixed at 4.86

Other updates since my last report

ADR – approximately six market markers till date

According to Ben Ng, VP of Sinotel Corporate Communications and Investor Relations, he said that he has gone to U.S. thrice since Sep 09 to promote Sinotel ADR. Till date, there are approximately six market makers for Sinotel’s ADR but he cautioned that the U.S. market is extremely large and it takes time and effort to penetrate the large U.S. investor’s community. Thus, it may take some time for the ADR to close the valuation gap between Sinotel and its peers. However, he indicated that interest among the U.S investors through the one on one meetings, have been generally positive, as the U.S. investors are keen in the sector, as well as, Sinotel.

More about the central procurement system

The three telcos in China have started a central procurement system in late 2008 with the objective of streamlining the development of wireless infrastructure. This approach has several benefits to the telcos. Firstly, this reduces costs. Secondly, this is more systematic as it allows the telcos to select companies which are good in a particular area. For this matter, the telcos segregate the development of wireless infrastructure into three segments, viz. procurement of equipment, design and installation.

The telcos have just completed the process of qualifying vendors capable of providing design solutions. Those smaller vendors without the requisite competency to properly engineer the design infrastructure would be limited to either equipment supply (i.e. this would be procurement of equipment from the vendors’ perspective) or installation. Margins are dependant on the type of work done. Equipment supply has the lowest margins but allows the company to book large revenues. Comba is a case in point. Based on its upside guidance on 24 Feb 10, its FY09F revenue should be at least HK$4.3b with profits of at least HK$455m. This would arrive at a FY09F net margin of around 10.5% as compared to Sinotel’s FY09 net margins of 26.1%.

On 12 Mar 10, Sinotel announced that it has been qualified as a design vendor for China Mobile. This commands the highest margins among the three segments. With this qualification, Sinotel will now be allowed to bid for design contracts across all provinces in China where China Mobile operates. However, Sinotel will mainly bid for those contracts which suit Sinotel’s requirements (e.g. in provinces where Sinotel already has a presence; acceptable timeline with good margins etc). This development is expected to bode well for Sinotel.

Ceasing the distribution of 3G cards

Readers who have noticed that Sinotel actually booked a sale of 3G cards amounting to RMB7.0m in 1Q09 may be wondering whether Sinotel is continuing with this business segment. According to management, Sinotel is no longer actively promoting this business as there has been a tremendous influx of competitors. As a result, margins were severely eroded. Thus, management decided to focus their attention on wireless infrastructure projects as they are abundant and fetch higher margins.

Outlook remains positive

According to government data, the telco industry spent a total of US$21b on 3G technology last year, with 3G subscribers reaching more than 10 million by the end of the year. Sinotel’s two biggest customers China Mobile and China Unicom have announced big plans for their 3G network. China Mobile, in an interview with Reuters a week ago, said it will spend RMB45b to extend its 3G coverage and roll out more than 80 types of TD-SCDMA handset to address market concerns about its lukewarm 3G push. China Unicom also reiterated its focus on this 3G segment and will not slow the pace of 3G development. Sinotel is expected to be a beneficiary from the aforementioned capital expenditure.

Conclusion – Unjustified sell down

With reference to Table 2 below, Sinotel is trading at a huge discount to its peers. Assuming that Sinotel trades at a 50% discount to Comba Telecom’s valuations, this would arrive at a FY10F PE of around 10.0x with a corresponding target price of around S$0.84. This represents an approximate 65% upside since its close of S$0.51 on 24 Mar 10. I believe this sell down is unwarranted and unjustified. Sinotel remains a “buy” in my buy list.

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Table 2: Comparion of Sinotel and its competitors* (Source: Bloomberg)

*I have added in 1 more competitor, Telestone since my last report.

Disclosure: Writer is vested