Why Merrill Lynch Wants US Investors Buying Chinese Telecom and Wireless Shares

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If you thought that the U.S. telecom and wireless players have a big opportunity as the world goes mobile, imagine being a Chinese carrier with some 1.3 billion people in the local economy as potential customers. It turns out that the research team at Merrill Lynch sees a big opportunity for the top three players in the China telecom and wireless market.

A driving force behind this call that the industry’s free cash flow yield is expected to more than double in two years, up from 6% to 13%. A new report from Mandy Chan and Emerson Chan has Buy ratings on all three carriers.

The Chan team said:

We believe less government interference, declining capital spending and quadruple-play will drive growth and free cash flows. We also believe potential TowerCo IPO could unlock TowerCo value and lift the three telco valuation.

China Telecom Corp. Ltd. (NYSE: CHA) is the top pick of the three telecoms in the report. Merrill Lynch’s price objective is $65.81 for its American depositary shares (ADSs), almost 30% higher than Friday’s close of $50.90. Another driver here is that the Chinese government has set a target of 88% broadband household penetration (400 million subscribers) by 2020. Merrill Lynch expects an additional 115 million broadband subscribers in the next five years, and the Chans believe it will get its fair share of this growing market.

The Chan team’s rationale showed four reasons for rating China Telecom as Buy:

1) its aggressive 4G deployment, based on FDD-LTE, could help it emerge as a strong 4G operator in the long term,
2) CT has rich fixed-line fiber and backhaul resources, as well as a large corporate customer base for its future 4G services,
3) CT has a good execution track record,
4) its attractive valuation.

China Unicom (Hong Kong) Ltd. Co. (NYSE: CHU) was also reinstated as Buy, with an implied total return opportunity of 17% upside. The firm believes a rerating is coming from the free cash flow yield. The Chans said the valuation is attractive, as follows:

The stock is trading at 2.9 times EV/EBITDA for 2017 estimates, at a 29% discount to its five-year average. As China Unicom holds a 28.1% stake in China Tower, we believe potential TowerCo IPO could unlock TowerCo value and lift China Unicom’s valuation.

China Mobile Ltd. (NYSE: CHL) was given a Buy rating and the Chans see 24% implied upside. That upside will come from a rapid 4G migration and a mobile data traffic boost. The report said:

We believe China Mobile is entering into a harvest period, given rapid 4G migration, mobile data traffic boost and improving free cash flow. We believe stronger free cash flow in the coming years bodes well for a dividend hike.

China Telecom ADSs were last seen down eight cents at $50.82, in a 52-week trading range of $42.23 to $59.79.

China Unicom ADSs were trading up four cents at $10.74 after the opening bell on Monday, in a 52-week range of $9.89 to $15.00.

China Mobile was last seen trading up 31 cents at $63.67, with a 52-week range of $50.12 to $65.16.

Does it seem weird that the firm’s top pick of the three with the most total return upside is the only one of them that is trading lower?