Description

Chunghwa Telecom is the dominant telecommunications provider in Taiwan with a near-monopoly wireline business, dominant broadband business, and #1 wireless business. Due to its solid operational prospects and significant capital redeployment opportunities, I would argue that CHT appears to be very attractive at current levels. Valuing the company at a 2008 FCF yield of 8% argues for a share price of NT$ 92, representing more than 50% upside from current prices, which seems attractive given a 7+% dividend yield and the potential for significant one-time capital returns in the mid term as the company rationalizes its balance sheet.

*****NOTE: All calculations have been prepared in NT$. CHT also has an NYSE listed ADR. Current NT$/US$ exchange rate is about NT$ 32=$1*********

Currently, CHT is undervalued by investors due to a perceived lack of revenue growth driven by a continued decline in its wireline business and limited opportunities for subscriber growth in a mature wireless market. However, focusing on the top line ignores the potential returns to shareholders created by restructuring an extremely inefficient balance sheet due to CHT’s has significant net cash on the balance sheet as well as excess land holdings. CHT has announced its intentions to return this excess cash to shareholders as well as to monetize its excess land holdings, leading to an increase of buybacks and the likelihood of a significant capital reduction as the company aims to achieve a significant net debt position (tgt at least 10% net debt/equity). Furthermore, sustainable double-digit FCF yields allow for continued returned to shareholders through dividends and buybacks. While the company will not post exciting growth figures (FCF should growth at a 5% CAGR to 2008), growth in the broadband and wireless division should more than offset the slow decline in the wireline division, and the mix shift to higher margin wireless and broadband as well as cost cutting opportunities should at least maintain LT margins (although margins will be pressured in the near term by 1-time labor costs (buyouts).

Valuation

Current Price NT$ 60.40
Shares Out 9,647.7
Market Cap 582,723
Net Deb/(Cash) (55,562)
Enterprise Value 527,161

2004 2005 2006 2007 2008 2009
EV / Revs 2.9 2.7 2.7 2.5 2.4 2.3
EV / EBITDA 6.3 5.3 5.1 4.7 4.4 4.2
P/E 17.5 12.6 11.4 10.5 10.0 9.7
FCF Yield 10.9% 10.5% 10.9% 11.7% 11.9% 12.2%


WIRELESS(40% of 2005 revs, 47% of EBITDA-
CHT currently enjoys 41% mkt share (38% in 2004) and basically splits the Taiwan mkt with two other major players (Taiwan Mobile and FarEastOne). According to Taiwan Business Today, CHT is the preferred operator with the best voice quality. Currently, competition in that Taiwan market appears to be very rational as the players appear focused on cutting costs instead of competing for subscribers. Thus, a destructive price war appears extremely unlikely as the major market participants appear satisfied with the status quo. Furthermore, margin expansion appears possible over the LT as the company focus on cutting handset subsidies. During my meetings with each company, both CHT and TM commented that their focus going forward was to work to cut costs and increase ARPU instead of competing for subscribers, as they say there is not point aggressively competing for subscribers in a mature mobile market. FE has publicly stated a desire to focus on cutting handset subsidies instead of trying to gain market share. #4 and #5 APBW and Vibo both have expressed an unwillingness to compete on price, noting the difficulty of later raising prices.

Due to this benign competitive environment, CHT has phenomenally low churn (2005 avg churn-1.4%, 2004-1.9%) compared to other developed markets and this level of churn has been declining with the lower competition, despite the impact of mobile number portability (MNP was enacted in Taiwan in October 2005 without material impact minimal impact (Churn lower Oct 05-Jan 06 vs. Jan-Oct 05))

Jun-05 Jul-05 Aug-05 Sep-05 Oct-05 Nov-05 Dec-05 Jan-06
Churn rate (%) 1.28% 1.60% 1.55% 1.45% 1.25% 1.27% 1.08% 1.12%

This low churn helps keep marketing costs low and allows CHT to generate significantly better EBITDA margins than competitors in its wireless business.

While the Taiwan mobile market is fully penetrated (87% Jan 06), revenue growth should be driven by continuing increasing ARPU (ARPU increased 4.5% in 2005) as subscriber growth will be neglible. Further increases in ARPU should drive low to mid single digit revenue growth as value added services become an increasing part of the wireless mix. VAS revenue grew 37% last year and now accounts for 5.5% of wireless revenue. CHT still has significant opportunity to increase VAS penetration which should help improve ARPU. TM VAS revenue represents almost 7% of wireless revs and TM expects 20% growth in VAS revenues. More importantly, further ARPU upside should be driven by the shift from 2G to 3G (3G launched middle of 05, currently 3% of current subs) which has significantly higher ARPUs (3G ARPU 60% higher than 2G ARPU) due to the significant increases of data usage among 3G users (streaming video, gaming, music etc.) As 3G phone prices continue to decline, 3G adoption should accelerate.

Fixed Line (36% of 2005 revs, 29% of EBITDA)-.
CHT enjoys dominant market position in all wireline segments. The company has 97% share in local, 86% in domestic long distance, 64% international long distance. The company currently has 13.3m subscribers and subscribers have be flat/slightly increasing due to .8% increase in the number of business lines.

Increased wireline competition (Cable MSOs, VOIP etc) is mainly a threat to the international long distance business, which only accounts for 7.5% of CHT’s revenue and has already faced significant declines due to increasing competition from Skype and other VOIP providers. CHT already offers a business and PC-PC VOIP service but the levels of subscribers is very low (similar to entire VOIP mkt). While overall international minutes have been increasing, ILD rates have decreased faster due to these competitive threats. A continued decline in ILD (rates down 10% y/y in 2006 and 2007) is expected going forward. DLD (5.8% 2005 revs) is also likely to continue to decline due to VOIP pricing pressures and wireless substitution putting pressure on DLD minutes. CHT has already introduced its own PC-PC and business VOIP solution but consumer uptake has been slow.
I would argue that the competitive threat to the local wireline business (61% of wireline revs) is not that significant given that CHT’s local rates are low (Local ARPU $7.21/month) compared to other wireline providers in the region. Furthermore, Taiwan’s regulators have attempted to open the local fixed line market by opening the market to new licenses. However, there have been no applicants (even though the entry requirements were lowered in 2004) due to its relatively unattractive characteristics of the market (declining revenues and CHT’s 97% mkt share). Local rates have grown at a 5% CAGR since 2001 and local subscribers have grown about 1% annually for the last 3 years as the number of households in Taiwan continues to grow (driven by less young people living with family members). I would note however, that I do not assume that either of these growth trends continue in the future due to my desire to be very conservative with the wireline business. Local MOU will continue to decline due to continued mobile substitution.

While the revenue decline in wireline will continue in the mid to high single digits (driven by ILD and DLD declines), it should begin to abate as a greater percentage of the revenues begins to be driven by more stable subscription and interconnection fees. CHT is also aiming to lower costs over the LT by offering a voluntary retirement plan to employees with the plan to cut the labor costs by NT$ 4.5B over the next three years.

Broadband (23% of 2005 revs, 26% of EBITDA)
CHT has the largest internet access network in Taiwan with 254 gigabits of bandwith capacity and 83% market share. Total internet revenues increased 5.4% in 2005, driven by 7.1% broadband revenue growth. Broadband revenue should continue to increase in the high single digits as subscriber growth and mix shift towards higher speed/higher rate plans offset rate declines at each level of service. CHT’s broadband service is also stickier with consumers as 80% of CHT’s subscribers also subscribe to its ISP service. This software addition both increases ARPU, it also increases the stickiness of CHT’s broadband service as customers are more reluctant to switch to a competing broadband service.

Increased Capital Efficiency-
CHT has an incredibly inefficient balance sheet. The company currently has a significant net cash position (about 10% of mkt cap expected for end of 05), a completely inappropriate capital structure for a dominant telco in a slow growth market. This inefficiency has been created by Taiwan regulations preventing the company from returning cash to shareholders in excess of 90% of net income. Thus, while the company currently returns as much cash to shareholders as possible under the current regulatory regime through a large dividend and smaller buybacks, the cash continues to build on the balance sheet. CHT understands that its current capital structure is not optimal. The company is working with the regulators to figure out a way to return cash to shareholders and expects to be able to undertake a significant capital reduction in the mid-term. Other potential uses of cash include buying back shares held by the government (which would make it easier for CHT to buyback more stock). Mid-term target is to move the company from about 10% net cash to 10% net debt/equity. A quick and dirty analysis suggests that CHT could return about NT$ 90bn to shareholders, or about 15% of the current market cap during the capital reduction, with significantly higher payouts possible were the company to pursue a higher level of leverage. CHT’s normal should also increase as an easing depreciation burden increases net income and allows the company to raise its payout while remaining under the 90% threshold.

The company also has significant excess real estate assets that it is beginning to monetize. As the company moves to an IP based network, and reduces staff, there is significant excess land and office space that can be redeveloped. Currently, the company has identified 100 hectares of space for redevelopment. The company is currently in talks with financial institutions and others but is unwilling to quantify the size of the opportunity. Estimates suggest that this 100 hectares redeveloped land could be worth NT$100bn. Total land (410 hectares) is valued at cost on the Sept 05 balance sheet at NT$102bn, suggesting a significant value not captured on the current balance sheet. Note however, that this is a long-term opportunity as the company is in the process of getting governmental approval (1+yr process) and has only begun negotiations with financial institutions and potential buyers. However, assuming the company is able to sell the 100 hectares of land for NT$100bn, it could return cash to shareholders equaling another 17% of the mkt cap. Thus, overall, by rationalizing the balance sheet, CHT has the potential to return 30+% of the current mkt cap to shareholders.

Conclusion
Overall, I would argue that CHT is attractive due to its strong FCF, solid operations, and current and potential cash returns to shareholders.

Negatives/Risks
- Mature end markets, slow revenue growth. Wireline market declining slowly, Taiwan wireless market mature
- Change from current market rationality or entrant of new competition could put pressure on current ARPU across all business lines. If Taiwan mobile market becomes less rational, revenues and costs would be negatively affected
- Taiwan government owns 41%. Risk that they will use ownership to force company to do something irrational or may interfere with attempts to return capital to shareholders
- Unionized labor force. Company limited room to cut employees, instead relies on buyouts

Catalyst

News on capital return to shareholders
Further details on real estate sales