Taiwan's telecom majors have tough calls to make

Despite the industry's stable outlook, the operating environment is changing fast for Taiwan's major telecom operators.
They have built up large war chests as a result of successful consolidation and are eager to spend. But as they eye up expansion opportunities and contemplate shareholder-friendly moves, they'll need to tread carefully. Despite the industry's stable outlook, the operating environment is changing fast, with tariff reductions taking effect this month and the next generation of wireless technology set to launch in the second half of this year, sparking a potential bidding war for licenses. While the sound financial profiles of major telecom operators should support their strong credit quality over the medium term, effective cash management and investment planning will be the key to constraining credit risks as they start to drain their surplus cash.

The industry is no stranger to upheaval. Deregulation and consolidation have taken their grip over the past few years, successfully transforming it from an outright monopoly into a competitive market. As the industry continues to modernize and liberalize, the three biggest players are setting the pace: Chunghwa Telecom Co. Ltd. (Chunghwa Telecom; global scale rating AA/Stable/--; national scale rating twAAA/Stable/twA-1), Far EasTone Telecommunications Co. Ltd. (Far EasTone; global scale rating A-/Stable/--; national scale rating twAA+/Stable/twA-1), and Taiwan Mobile Co. Ltd. (Taiwan Mobile; national scale rating twAA+/Watch Neg/twA-1).

For two of these players, at least, changing industry conditions have had a largely positive effect. The credit profiles of Chunghwa Telecom and Far EasTone have improved over the past few years due to solid cash flow generation and substantial debt repayment. As a result, Standard & Poor's Ratings Services raised the global scale foreign currency corporate credit rating on Chunghwa Telecom to 'AA/Stable/--' from 'AA-/Watch Pos/--' on Jan. 22, 2007 and the foreign and local currency ratings on Far EasTone to 'A-/Stable/--' from 'BBB+/Stable/--' on March 2, 2006.

Taiwan Mobile hasn't fared so well. Taiwan Ratings Corp., a subsidiary of Standard & Poor's, placed the 'twAA+/ twA-1' national scale corporate credit rating on CreditWatch with negative implications on March 2, 2007, following the company's plans to gain full ownership of a fixed-line affiliate. This highlighted the need for companies to balance their investment appetites with a solid financial footing.

Three factors help in evaluating industry trends and the motivation for future change:
+ Industry dynamics and market conditions;
+ Capital management; and
+ Investment activities.

Industry dynamics and market conditions

Regulatory uncertainty clouds stable outlook Taiwan's telecom and broadcasting regulator, the National Communication Commission (NCC), is placing the tariffs that leading operators charge under tighter scrutiny. Formed in November 2005, the commission is already making an impact by approving or rejecting the tariff schemes of operators with a market share of 25% or higher and by setting their general terms of service. Its aim? To ensure a fair competitive environment for all telecom operators and stimulate market competition by increasing customer choice over service providers and pricing structures.

Tariff cuts that take effect over the next three years, starting in April 2007, will likely dampen earnings for the leading service providers--but only marginally. This should allow major operators to maintain sound financial profiles over the medium term. Under the NCC proposals, the three biggest players must lower their mobile voice tariff by at least 4.88% a year over the next three years, with the asymmetric digital subscriber line (ADSL) circuit rate scheduled to drop by at least 5.35% (see table 1).

Chunghwa Telecom will be the hardest hit, as it faces a 5.35% tariff cut for its dominant ADSL services in 2007. The operator forecasts that this will slice off Taiwan dollar (NT$) 2 billion from its revenue this year. For the other two wireless operators, the revenue impact will be less significant, ranging from NT$300 million to NT$350 million, or less than 1% of their total revenue.

Mobile number portability has had limited impact

Mobile number portability (MNP)--which enables mobile telephone users to retain their mobile telephone numbers when changing from one mobile network operator to another--has had a limited effect on the market since its introduction in October 2005. That's largely due to the lack of incentive for customers to switch to a new service provider, given the dominance of the major players. Elsewhere in the region, results have been mixed. In Hong Kong, for example, the churn rate rose to 4.5% from 3.5% in the first year of MNP availability, but it sank to 1.3% from 2% in Singapore.

The biggest winner from the introduction of MNP is Chunghwa Telecom, due to its ability to attract new customers by offering a "bundle" of services--such as voice, Internet, and wireless--which other providers cannot do at present.

Generation gap grows as 3G is rolled out slowly

The success of third-generation (3G) services is less critical in Taiwan than in other developed markets because of the island's cheaper upfront license fees and the strong financial profiles of its leading operators. Major wireless operators in Taiwan have cautiously allocated capital expenditure for 3G equipment and network roll-outs, but take-up for these services remains low. Second-generation (2G) services, however, should continue to generate solid profitability, reflecting the significant portion of revenue derived from voice services. Over the medium term, several factors will be important in raising customer acceptance and stimulating demand for 3G services, such as wireless operators' ability to provide better network coverage and more attractive pricing packages for 3G handsets and content.

Advanced technology could shake things up, but not over the near term

Future technology could eventually rattle the market dominance of Chunghwa Telecom in the fixed-line sector. Chunghwa Telecom currently has a market share of more than 90% and controls the last-mile connection to most households. The upcoming introduction of Worldwide Interoperability for Microwave Access (WiMAX) offers future license holders the technology to challenge its advantage in this sector, though not immediately.

WiMAX is regarded as the next generation of wireless technology, with a longer transmission range and faster speed. However, the lack of maturity and stability of WiMAX technology, as well as the timeframe needed to build up network coverage, means its introduction is unlikely to have a near-term impact on the industry. All three major operators are readying their bids for one of the six WiMAX licenses that the NCC plans to award in the second half of 2007.Capital Management

Effective controls will become increasingly important

Solid and stable operating performances have generated strong cash flow for the leading operators over the past few years, but they now have to decide how best to channel their sizable cash balances, which comprise cash and short-term investments (see chart 1). Some are turning their attention to business
expansion and shareholder-friendly activities, such as capital reductions and share buybacks.

Standard & Poor's takes a cautious view toward shareholder-friendly action, as over-aggressive activity can weaken a company's financial profile. While adequate capital management could lead to more efficient balance sheets, increased leverage as a result of share buybacks requires careful financial
planning. Nevertheless, the telecom operators' moves to reduce capital are likely to be conservative in nature and should not have a significant impact on their credit quality.

Chunghwa Telecom is already exploring ways to reduce its cash surplus and is the most likely of the top three operators to do so over the near term. However, the timing and size of any capital reduction is yet to be determined. Taiwan Mobile is the least likely to reduce capital or buy back shares, as it needs to tighten its belt over the near term following its recently announced plan to acquire up to a 100% stake in its fixed-line affiliate, Taiwan Fixed Network Co. (TFN), by buying shares on the open market.
Investment Targets

Interest in investment opportunities will rise across the industry

We expect investment activities in the telecom sector to rise over the near term. For Taiwan's major wireless operators, 2006 was characterized by stagnant growth in the overall subscriber base and a 1.9% decline in market service revenue. The prospect of future pricing pressure for both wireless and fixed-line sectors under a more challenging regulatory environment is fueling operators' interest in spending some of their large cash balances on investments.

Given its dominant position in the domestic market, Chunghwa Telecom is looking to expand overseas. Other wireless operators are exploring options in fixed-line, broadband, and/or digital cable services to increase their ability to provide bundle services and differentiate themselves from competitors. Although providing bundle services does not necessary boost revenue, the operators would be in a better position to retain subscribers and improve margins.

While investment activities may improve operators' market positions and increase synergies, they'll need to keep a close eye on credit quality. For example, Taiwan Ratings Corp. placed Taiwan Mobile on CreditWatch with negative implications in March 2007 as a result of the potential sizable cash outflow and expected increase in leverage from its planned acquisition of TFN, as well as concerns over the affiliate's weak market position in the fixed-line sector.

What's down the line?

They may be cashed up and hungry to invest or appease shareholders, but caution is warranted for Taiwan's major telecom operators. Much depends on their ability to maintain their financial strength amid an increasingly tough regulatory environment and technological advances. Some will be able to protect or enhance their strong credit profiles, others will need to avoid weakening their positions. Deep pockets shouldn't always be dipped into.


Patrick Huang, Taipei (886) 2-8722-5829; [email protected]

Ryan Tsang, CFA, Hong Kong (852) 2533-3532; [email protected]

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