20110603-BNP Paribas-China Equipment - The Speed of Light

THEMATIC RESEARCH
China Telcos/Equipment: The speed of light
3 JUNE 2011
Rich multimedia content to triple Internet data traffic in five years China optical broadband connections to triple in three years Optical network/component suppliers exposed to Asia Pacific will benefit Initiate coverage on O-Net and CCS with BUY ratings
Demand-driven network upgrades

While we expect Internet traffic in Asia Pacific to more than triple in five years, the region has historically allocated a smaller proportion of telecom capex to broadband networks compared to the developed markets. We expect continuing investments in broadband networks in the coming years due to sharply rising demand for more data capacity. For China, we estimate a tripling of optical broadband connections and RMB187b in capex in the next three years.
Alen Lin
+852 2825 1801 alen.lin@asia.bnpparibas.com
Chinese optical network supply chain to benefit

Chinese system integrators, Huawei and ZTE, already dominate the optical communications space in the Asia Pacific region, with a combined market share of 70% in optical transport network and a 57% share in the broadband access network. Optical component suppliers and engineering service providers exposed to the regional growth cycle should also benefit.
Joyce Zhou
+852 2825 1120 joyce.zhou@asia.bnpparibas.com
Initiate coverage on O-Net Communications and China ComService

We initiate coverage of O-Net Communications and China ComService, both with BUY recommendations. We believe their exposure to the optical network upgrade cycle in China provides a solid foundation for a multi-year growth cycle.
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THIS MATERIAL HAS BEEN APPROVED FOR U.S DISTRIBUTION. IMPORTANT DISCLOSURES CAN BE FOUND IN THE DISCLOSURES APPENDIX.
ALEN LIN
CHINA TELCOS & EQUIPMENT
3 JUNE 2011
Contents
1) Executive Summary .................................................................................................................................................................... 3 Tripling of optical broadband access in China..................................................................................................................... 3 Demand-driven network upgrades ...................................................................................................................................... 3 Optical networks at the core of higher data capacity........................................................................................................... 3 Initiate coverage of O-Net Comm, China ComService with BUY ........................................................................................ 3 2) Insatiable demand for data ......................................................................................................................................................... 5 Asia/Pacific data traffic to more than triple in five years ................................................................................................... 5 Data infrastructure capex set to rise.................................................................................................................................... 6 The rise of Chinese system and component suppliers ........................................................................................................ 7 China upgrades to optical broadband ............................................................................................................................... 10 3) The big deal about transmitting light ...................................................................................................................................... 12 Long-haul networks ........................................................................................................................................................... 12 Metro networks.................................................................................................................................................................. 14 Access networks ............................................................................................................................................................... 15 Key components in optical communications equipment .................................................................................................... 15 4) Demand-driven investments .................................................................................................................................................... 18 5) Company updates .................................................................................................................................................................... 19 O-Net................................................................................................................................................................................. 20 China ComService ............................................................................................................................................................ 36 ZTE Corp........................................................................................................................................................................... 55
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Please see Telecoms, Media & Technology Research Team list on page 59.
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Executive Summary
Tripling of optical broadband access in China
We estimate China will continue its optical broadband upgrades through 2013, to provide broadband access of >20Mbps to nearly all of the 238m households located in cities that have more than 1.5m households. By the end of 2010, the number of households with >20Mbps connections was 80.5m, which implies a near-tripling in optical broadband access within three years. We estimate this represents approximately RMB187b in capex over the three-year timeframe. Of this total capex, we estimate RMB84b would be spent directly on broadband equipment, and the remaining on ancillary equipment and engineering/civil work.
Demand-driven network upgrades

Multimedia content has already become the main driver for increasing data demand in North America, where Netflix alone represents nearly 30% of peak data traffic. We believe similar services such as PPTV, BitTorrent, and IPTV will also drive data demand in Asia Pacific (ex-Japan). A 2010 Cisco analysis forecasts data traffic in Asia Pacific will more than triple between 2009 and 2014, a CAGR of 34.8%, compared to 30% for North America. While we expect Internet traffic in Asia Pacific to more than triple in the same five-year period, the region has historically allocated a smaller proportion of telecom capex to broadband networks (broadband access, optical transport, and carrier routers/switches). The proportion of capex spent on data infrastructure was 28% in 2007, and rose to 31.8% in 2010. Despite the increase, this is still below the levels in mature markets including North America, Western Europe and Japan, each allocating 40-55% of telecom capex for data infrastructure in recent years. We believe higher spending on data infrastructure will be necessary for Asia Pacific in the coming years, driven by the higher demand for data capacity.
Optical networks at the core of higher data capacity

We provide an architectural overview of optical networks in this report to identify opportunities along the optical communications value chain. While Chinas national fiber backbone network is mostly complete (Exhibit 19), we believe a significant portion of future investments would be to increase user access to the backbone network; this would involve the use of passive optical network equipment in the access networks including EPONs and GPONs, and extending metro networks to cover a larger population. Chinas home-grown system integrators, including Huawei, ZTE and Fiberhome, could be major beneficiaries of the upgrades. Huawei and ZTE already had a combined 57% market share in Asia Pacific access networks in 2010. In the optical data transport category, the pair had a combined market share of 70% in the region. As we move up the value chain, we believe that increasing Chinese component contents for these products would benefit the suppliers to these system integrators.
Initiate coverage of O-Net Comm, China ComService with BUY

Alongside the China optical communications theme, we initiate coverage of O-Net Communications (O-Net) with a BUY rating and target price of HKD4.90; we also initiate coverage of China ComService with a BUY rating and target price of HKD6.06. We also believe ZTE (763 HK, HOLD) will be a beneficiary of the optical communications upgrade cycle; however, we believe the slowdown in mobile networks revenue would limit its earnings growth in the near term. Other major Chinese players that are exposed to the upgrade cycle include network equipment suppliers Huawei (privately held) and Fiberhome Telecommunications (600498 CH, Not rated); optical fibre suppliers Yangtze Optical Fibre and Cable Co (privately held) and Jiangsu Zhongtian Technology (600522 CH, Not rated); and component supplier Accelink (002281 CH, Not rated).
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O-Net Communications (877 HK, BUY, CP: HKD3.55; TP: HKD4.90) As one of the worlds major passive optical component (OC) provider, we believe the company is well positioned to benefit from the massive global broadband build-out and upgrade, with its wide range of products and diversified customer base. Its advanced design and manufacturing technologies as well as the vertically-integrated business model should help O-Net maintain higher-than-industry growth rate and enjoy high margins in the coming years. Our target price of HKD4.90 is based on DCF valuation, with WACC of 12.5% and terminal growth of 2%. It translates to 20.1x 2011E P/E. ONet has a market cap of USD380m and three-month average daily trading volume of USD3.2m. China ComService (552 HK, BUY, CP: HKD4.81; TP: HKD6.06) With its leading position in the telecom infrastructure service (TIS) business and strong relationships with the three China telecom operators, we believe CCS will generate healthy revenue growth from China operators continuing capex on broadband upgrade and 3G network build-out. CCS is also increasing its exposure to operators opex by providing business process outsourcing (BPO) services, and applications, content and other services (ACO). In addition, we see further upside from the companys nonoperator business, which will benefit from the fast-growing government and enterprise IT spending in China. We also see huge upside from its overseas business, which we forecast will accelerate and contribute over 10% of revenue in 2013 (5% in 2010). Our target price of HKD6.06 is based on DCF valuation, assuming WACC of 10% and terminal growth of 2%. CCS has a market cap of USD3,569m and three-month average daily trading volume of USD7.0m. ZTE (763 HK, HOLD, CP: HKD27.05; TP: HKD31.00) We expect ZTE to be one of the beneficiaries of Chinas broadband upgrade cycle, as we estimate its combined revenue for the optical transport and wire line segments will grow 36% in 2011. However, we believe weaker mobile network revenue growth and weak handset margins will limit ZTEs overall profit growth in the near term, and we estimate net profit will grow 6.3% in 2011. Given the weak profit growth prospect, we maintain our HOLD recommendation and target price of HKD31.00 based on 25x 2011E P/E multiple. ZTE has a market cap of USD11.404b and three-month average daily trading volume of USD22.0m.
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Insatiable demand for data

With the increasing popularity of multimedia content and applications available over the Internet, there seems to be no end to the increasing demand for data in the foreseeable future. A Spring 2011 report by network monitoring equipment supplier, Sandvine (SVC CT, Not rated), says that Netflix alone represents nearly 30% of peak-hour downstream Internet traffic in the US. Other bandwidth intensive multimedia services such as YouTube, BitTorrent, PPTV, and IPTV are also gaining in popularity. The desire for better user experience would translate into even more demand for data capacity. In a 2010 Cisco (CSCO US, Not rated) white paper, the company estimated the amount of global Internet traffic would quadruple between 2009 and 2014, from 14.7EB/month (exabyte = 1b GB) to 63.9EB/month (Exhibit 1). Despite the already high contribution to data demand from North America, Western Europe and Asia Pacific, these regions would represent 81% of growth during this five-year period. Consistent with the view that rich multimedia content would drive much of the demand, Cisco forecasts that Internet video, Internet video to TV, and video calling will be the main drivers for growth, with five-year CAGRs of 48%, 107%, and 48%, respectively. While North America generates around one-third of global IP data traffic currently, Western Europe and Asia Pacific are projected to close the gap with North America by 2014; Western Europe and Asia Pacific are estimated to see five-year data CAGRs of 35.8% and 34.8%, respectively, compared to 30% for North America. In our view, this represents significant opportunities for network equipment providers that are leveraged to these regions. Exhibit 1: Monthly global internet traffic
(Petabyte of data) 70,000 60,000 50,000 40,000 30,000 20,000 10,000 0 2009
Source: Cisco
North America Asia Pacific Latin America Middle East and Africa
Western Europe Japan Central Eastern Europe
2010
2011
2012
2013
2014
Asia/Pacific data traffic to more than triple in five years

Based on various industry data, we estimate the number of broadband connections in Asia Pacific (ex-Japan) will increase from 144.8m in 2009 to 246.9m in 2014, a 71% increase. During the same period, Internet traffic is projected to grow by more than 3x, from 3.9EB/month to 17.4EB/month. This implies Internet traffic per broadband connection would increase 161%, or by a 21% CAGR (Exhibits 2-3). During the same period, the number of Internet video users in the region is expected to increase 95%, or by a CAGR of 14%. All the data is pointing to explosive growth for Internet data traffic in the Asia Pacific region, driven by strong growth of broadband connections and richer content. In our view, such a trend will demand more network data capacity and continued spending on network equipment. Furthermore, we expect much of the spending to increase capacity to be related to optical communications. While many of the major system integrators are in Europe and North America, including Alcatel-Lucent (ALU FP, Not rated), Ericsson (ERICB SS, Not rated), and Nokia Siemens Networks (752212Z FH, Not rated), Chinabased system integrators are becoming serious beneficiaries. These include Huawei, ZTE and Fiberhome. In 2010, Huawei managed to reach the top spot in terms of global
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market share for both optical transport and access network (Exhibits 9-10). ZTE also placed in the top four for both categories. Similarly, among the upstream suppliers, Chinese optical component suppliers including Accelink Technologies (002281 CH, Not rated) and O-Net Communications are becoming more important in the optical communications space. While the component space is still dominated by traditional suppliers including Finisar (FNSR US, Not rated), JDSU (JDSU US, Not rated), Avago (AVGO US, Not rated) and others; Accelink Technologies and O-Net Communications registered 2010 revenue growth of 25% and 95%, respectively. We believe Chinese component suppliers will also become more relevant going forward, as they increase their exposure to Chinese system integrators. Exhibit 2: Asia Pacific (ex-Japan) broadband and monthly Internet traffic
(Thousand connections) 300,000 250,000 200,000 150,000 100,000 50,000 0 2009
Source: BNP Paribas
(GB/connection per month) 80 70 60 50 40 30 20 10 0 2010 2011 2012 2013 2014
Broadband Internet connections (LHS) Internet traffic/broadband connection (RHS)
Exhibit 3: Monthly regional Internet traffic

(PB/month) 20,000 18,000 16,000 14,000 12,000 10,000 8,000 6,000 4,000 2,000 0 North America Western Europe Asia Pacific Japan Latin America Central Eastern Europe Middle East and Africa 2009 2010 2011 2012 2013 2014
Source: BNP Paribas
Data infrastructure capex set to rise

Historical data suggests that emerging markets have relatively under-spent on data infrastructure in recent years. Regions that have historically allocated the largest portion of their telecom capex to data infrastructure (broadband access, optical transport and carrier routers/switches) are North America, Western Europe and Japan, each spending 40-55% of total telecom capex on data infrastructure since 2007 (Exhibit 4). In contrast, data accounted for 28% of Asia Pacifics total telecom capex in 2007, rising to 31.8% by 2010 (Exhibit 6); Eastern Europe and Latin America are in a similar range, while the
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MEA has been in the 20% range in recent years. Globally, in 2010, capex on data infrastructure represented 39% of total telecom capex (Exhibit 5-6). Given the strong growth forecast in data traffic, as we discussed earlier, we believe spending on data infrastructure will remain robust, particularly for emerging markets that have under-spent in this category (Exhibit 4). Thee Gartner forecast indicates that while global spending on data infrastructure would see a five-year CAGR of 6.1% during 2010-15, Asia Pacific and Latin America would see stronger CAGRs of 8.3% (from USD7.9b to USD11.7b) and 8.8% (from USD1.7b to USD2.6b), respectively. Given the relatively high base of Asia Pacific, this is the region that offers the greatest opportunity for equipment providers; the region contributed to 24.5% of global spending on data infrastructure in 2010, second only to North America, which contributed 32.8% (Exhibit 7). Japan, Eastern Europe, Latin America and MEA all contributed to 5.1-6.4% each. Exhibit 4: Regional spending on data infrastructure/total capex
(%) 60 50 40 30 20 10 0 2007 2008 2009 2010 2011 2012 2013 Asia/Pacific Latin America Western Europe Eastern Europe Middle East & Africa Japan North America
Sources: Gartner; BNP Paribas estimates
Exhibit 5: Global telecom capex (2010, USD m)

Voice switching, control and applications 5,077 Traditional switching 1,278 Service provider routers and switches 12,086
Exhibit 6: Asia Pacific telecom capex (2010, USD m)

Voice switching, control and applications 1,403
Broadband access 6,373
Traditional switching Service 166 provider routers and switches 2,584 Optical transport 3,640
Broadband access 1,679
Optical transport 13,820
Mobile infrastructure 43,808
Mobile infrastructure 15,402
Sources: Gartner; BNP Paribas
The rise of Chinese system and component suppliers

As Asia Pacific spending on data infrastructure equipment is likely to rise, driven by strong growth in data traffic in the coming years, we believe equipment providers that are leveraged to the Asia Pacific market would be the greatest beneficiaries of the rising capex. In 2010, Asia Pacific contributed to 24.5% (USD7.9b) of global data infrastructure spending (Exhibit 7). The spending on data infrastructure in Asia Pacific
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represented 31.8% of the regions total telecom capex (Exhibit 8); this is likely to continue rising as it is still below the levels of the mature markets. Exhibit 7: Regional contribution to global data infrastructure capex (2010)
Western Europe 19.9% Asia/Pacific 24.5% Eastern Europe 6.0% Japan 6.4% North America 32.8% Latin America 5.4%
Exhibit 8: Asia Pacific capex spending distribution

(USD m) 30,000 25,000 20,000 15,000 10,000 5,000 0 2007 2008 2009 2010 2011 2012 2013 Data infrastructure Traditional switching Mobile infrastructure Others
Middle East & Africa 5.1%
Sources: Gartner; BNP Paribas estimates
System integrators Huawei and ZTE rise to top At the global level, Chinese equipment providers, Huawei and ZTE, are increasingly becoming major players in the optical communications space. In 2010, Huawei topped the optical transport segment with 20.1% global market share, and ZTE came in third with 7.3% market share (Exhibit 9). Similarly for the access network category, Huawei topped the list with 14.7% global market share, and ZTE was fourth with a 10% share. Our discussions with Huaweis product team responsible for optical networks also indicate its dominance in this space. Huawei indicated that it held 27% global market share in signal aggregation equipment, 26% share in bandwidth management category, 18% share in metro WDM, and 25% in backbone WDM. Overall, it estimates that it holds a 23.2% market share in optical data transport. Within the Asia Pacific region, in 2010, Huawei and ZTE captured the top two positions in optical transport with market shares of 47.5% and 22%, respectively (Exhibit 11). Similarly for access network where Huawei and ZTE also occupied the top two positions with 29.5% and 27.7%, respectively (Exhibit 12). The market share data clearly illustrates the high leverage Huawei and ZTE have to the Asia Pacific region. We believe Huawei and ZTE would be key beneficiaries in the coming years driven by strong data traffic growth in Asia Pacific.
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Exhibit 9: Global optical transport market share (2010)

Huawei 20.1%
Exhibit 10: Global access network market share (2010)

Huawei 14.7%
Others 31.0%
Others 27.3%
Nokia Siemens Networks 4.0% Ericsson 4.3%
AlcatelLucent 16.1%
Ericsson 3.5% Motorola 4.0% Nokia Siemens Networks 4.7%
AlcatelLucent 14.6%
Tellabs 4.4%
ZTE 7.3% Ciena 6.0% Fujitsu 6.7%
Samsung 12.1% Cisco 9.2% ZTE 10.0%
Exhibit 11: AsiaPac optical transport market share (2010)

Others 14.2% ECI 4.4% AlcatelLucent 11.9% Huawei 47.5%
Exhibit 12: AsiaPac access network market share (2010)

Nokia Siemens Networks 5.3% Cisco 5.4% AlcatelLucent 8.9% ZTE 27.7% Others 13.2% Huawei 29.5%
ZTE 22.0%
Samsung 9.9%
Optical component suppliers early phase for Chinese suppliers Going up the value chain, we note that traditional optical component suppliers are mostly dominated by US and Japanese suppliers including Finisar, Sumitomo (5802 JP, Not rated), JDSU, Avago and others (Exhibit 13). Chinese optical component suppliers are gaining traction; they include Accelink Technologies and O-Net. While they still lack the full breadth of products that their foreign competitors have, the Chinese suppliers are expanding their respective customer bases and product offerings. Accelink indicated that it derived about 40% of revenue from its optical amplifier products, and 35% from domestic equipment providers, primarily Huawei, ZTE and Fiberhome. For O-Net, 96% of 2010 revenue was derived from its power management, transmission management, and wavelength management products; we provide more details on O-Net in our initiation report, O-Net: Speeding up the internet. Other Chinese suppliers include Jiangsu Zhongtian Technology (600522 CH, Not rated) and Yangtze Optical Fibre and Cable Co (private) that specializes in optical fibers and cables.
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Exhibit 13: Global optical component market share (4 quarters ending 2Q10)
Finisar 14.9% Sumitomo 10.6%
Others 42.9%
JDSU 9.0%
Opnext 6.6%
Oclaro 7.4%
Avago 8.6%
Sources: Ovum; BNP Paribas
China upgrades to optical broadband

A measure of growth in Chinas overall fiber network would be the total length of the fiber installed; based on data from MIIT, the total length reached 10.4m km at the end of 1Q11, and the five-year CAGR through end-2010 was 19.7% (Exhibit 14). As illustrated in Exhibit 19, Chinas long-haul fiber network is mostly in place. However, we estimate broadband connections of over 20Mbps were at only 80.5m ports, or 36% of the 224m households in cities with >1.5m households at the end of 2010. Based on comments from the Chinese telecom operators and Chinas 12th Five-Year Plan, we believe China is aiming to have the majority of households within cities >1.5m households covered by optical broadband by 2013. We estimate this would translate to 149m new FTTx ports to be added by 2013 (Exhibit 15). We believe most of the capex in the coming years would involve spending on metro rings to provide coverage in additional cities, and access networks to connect individual households via FTTx. We also interviewed telecom operators and equipment providers to understand the costs associated with FTTx upgrades; we estimate the cost of adding each optical connection to be about RMB1,200-1,400; this includes the cost associated with adding data transport capacity. Our research also suggests that, of the total capex for broadband upgrades around 45% is spent on communications equipment. Of the remainder, we estimate around half is spent on cables and ancillary equipment, and the rest on civil and engineering work (Exhibit 16). This would translate to total capex needs of RMB187b during 2011-13 to provide incremental connections and data capacity upgrades. This implies RMB84b total available market in the next three years for equipment providers including Huawei, ZTE and Fiberhome, and component suppliers including O-Net and Accelink Technologies. For engineering and civil work activities, suppliers such as China ComService also stand to benefit from the RMB51b available market in the next three years.
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Exhibit 14: China's cumulative length of optical cable

(m kilometers) 12 10
Exhibit 15: FTTx penetration in major Chinese cities

(m) 250 200 Aggregate households in cities with >1.5mn households (LHS) FTTx penetration (RHS) (%) 120 100 80 150 60 100 40 50 0 20 0 2008 2009 2010E 2011E 2012E 2013E
8 6 4 2 0 2003 2004 2005 2006 2007 2008 2009 2010 1Q11

Sources: MIIT; BNP Paribas
Sources: Companies; China Statistics Bureau; BNP Paribas estimates
Exhibit 16: FTTx capex distribution estimation

FTTH construction cost breakdown
Equipment cost 40-50%
Cable and accessories cost 25-30%
Installation cost 25-30%
Source: BNP Paribas
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The big deal about transmitting light

The increasing demand for rich content and applications led to continuous exponential increase in data demand in recent years. Particularly in the developed markets including North America, Western Europe, and Japan, close to 50% of the total telecom capex has been on data infrastructure (broadband access, optical transport, and data routers/switches) (Exhibit 4). In this section, we provide a high-level overview of the technical aspects of these networks, and key subsystems and components involved in building these networks. Broadband network infrastructure is mostly based on optical communications to provide ultra-high data capacity. The networks can generally be divided into three levels to satisfy specific requirements: 1) long-haul networks; 2) metro networks; and 3) access networks. Generally, the long-haul networks serve as the national data backbone (Exhibits 19-20); the access networks provide individual users with broadband data connections; and the metro networks connect the backbone with local access.
Long-haul networks
This part of the data network provides data transport between major metropolitan areas and serves as the backbone of the data network. The main characteristics of long-haul networks are to provide high capacity over long distances. The equipment employed includes Dense Wavelength Division Multiplex (DWDM) transmission and detection equipment that transport data over fiber cables. On DWDM networks, signals are effectively carried on multiple wavelengths (channels) and transmitted over single strands of fiber lines (Exhibit 17); as more wavelengths are packed into limited optical spectrum, the accuracy of transmission and reception equipment becomes increasingly critical. In addition, as distance and data capacity are increased on these fiber cables, equipment to amplify and condition the signals also become necessary to retain signal integrity. Exhibit 17: DWDM network concept
Source: Cisco
While the optical fiber cables are very costly to install, and are mostly fixed, the capacity supported over the cables continues to increase with equipment upgrades that enable more data to be transported. Capacity increase can be achieved through increasing data speed per wavelength, and increasing the number of wavelengths per strand of fiber. The former approach utilized more advanced signal modulation techniques, such as DQPSK (differential quatrature phase shift keying); the latter approach is to reduce the spacing between distinct wavelengths (carriers), thus packing more carriers onto the optical fiber. Current commercial systems mostly utilize 2.5Gb/s (2.5G) and 10Gb/s (10G) per wavelength, and can support up to 80 wavelengths per strand of fiber. 40G upgrades are currently in progress on high-traffic networks (Exhibit 18). According to Huawei, it has captured 44% of the 40G market share globally, with Ciena (CIEN US, Not rated) in second position with 15% market share. 100G systems have also been demonstrated in
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trials; however, the current high cost is prohibitive for mass commercial rollout of such technology. Our checks with industry experts suggest that mainstream commercial deployment of 100G systems may be close to five years away. Exhibit 18: DWDM interface modules spending
(USD m) 1,200 1,000 800 600 400 200 0 2008
Sources: Ovum; BNP Paribas
10G
40G
100G
2009
2010
2011
2012
2013
A sample national fiber backbone China Telecom An illustration of China Telecoms national fiber network backbone is shown in Exhibit 19. The network map indicates major network hubs in the cities of Beijing, Nanjing, Shanghai, Wuhan, Guangzhou, Xian, and Chengdu. From these network hubs, an extensive web of network extends to all major cities throughout China, and to overseas networks in Japan, the US, Korea, Europe, and Southeast Asia. Our checks with China Telecom (728 HK, BUY, CP HKD4.67) indicate that most of its backbone network is on 2.5G and 10G technologies; 40G technology is currently in the testing phase and likely to be rolled out in the near future. Also, unique to China Telecom is its CN2 network it is effectively a parallel network to the public fiber backbone that is intended to offer better quality of service for enterprise customers compared to the public data network.
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Exhibit 19: China Telecom's national fiber network
Source: China Telecom
Metro networks
Metro networks, frequently referred to as metro rings, are extensions from the backbone network to provide metropolitan data coverage. They connect from the national backbone and provide local data bus for access networks (Exhibit 20). These systems utilize many of the same subsystem components as in long-haul networks including DWDM equipment; however, they are configured for metropolitan coverage rather than long-haul data transport. As such, they are likely to include components such as OADM (optical add/drop module) to route signals out of and on to the metro ring. Also, as the distance of data transport tends to be shorter than on long-haul networks, trade-offs can be made in network designs. For example, CWDM (coarse wavelength division multiplexing) may be used in place of DWDM for short distance transmission; CWDM can use lower precision lasers that are cheaper than those used in DWDM systems.
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Exhibit 20: Metro rings and access networks
Access networks
Metro DWDM rings
Sources: Cisco; BNP Paribas
Access networks
Access networks make the connection between a users device and the core network via metro networks. One common approach is to provide optical broadband access using FTTx (fiber to the premise) approach where optical signals are routed to/from the user premise. These networks are mostly enabled with EPON (Ethernet passive optical network) and GPON (Gigabit passive optical network), which connects the metro ring and the user premise. This approach is also referred to as a centralized network where the active routing of signals occurs at the operators facilities. The use of passive optical network has the advantage of lower maintenance cost, as there is limited use of active components that are frequent source of failures. A different approach that is utilized by Hong Kongs City Telecom (1137 HK, Not rated) is a distributed network where data routers are placed inside large residential buildings, and traditional copper based Ethernet cables connect the users to the routers. As copper cables can only support high-speed data over short distance, such architecture is only feasible in high density areas such as Hong Kong. According to City Telecom, the setup cost for such network architecture is only 25% of GPON setup as no user premise equipment is necessary. Additional details on City Telecom were published in our Greater China Connections dated 23 May 2011.
Key components in optical communications equipment

The components that make up the overall long-haul backbone and metro networks consist mostly of key subsystems including optical signal transmitters and receivers, amplifiers, signal conditioners, and components to add/drop signals. The key functions are to transmit and receive signals while ensuring signal integrity. Laser diode is a common type of light source used on the transmitting end; and photodetector is used on the receiving end to detect the light signal. In the access network portion, the key functions are to connect individual users to the core network; these mostly involve components that combine and split optical signals. PON (passive optical network) components are a significant part of the access network. DWDM subsystem As we discussed earlier, the DWDM sub-system is a key element in the overall optical communications system as it increases data capacity by enabling multiple streams of data to be transmitted over a single strand of fiber (Exhibit 17). Depending on the type of optical cables used, and the required distance for transmission, the optical signals are transmitted on 850nm, 1310nm, or 1550nm; these bands are chosen to minimize signal distortion for the specific applications required (Exhibit 21). The 850nm band is only used for short distance transmission due to its high signal degradation characteristics; 1550nm band is most commonly used for long distance transmission.
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A number of optical components manufactured by O-Net are used for the DWDM subsystem (refer to the O-Net report, Speeding up the internet); they include DPSK demodulators (differential phase-shift keying), tunable filters, signal isolators, signal amplifiers, and wavelength locker. In some DWDM subsystems, OADM (optical drop/add modules) can also be used to extract signals from a cable, and insert signals into a cable where needed. For high bit rate transmission such as 40G networks, TDC (tunable dispersion compensator) products are also necessary to maintain signal integrity; this is potentially a strong growth driver for O-Net as the ASP for TDC is estimated to be over USD1,000 per unit. The company indicated that it plans to launch its TDC product around mid-2011. Exhibit 21: Optical spectrum allocations
Source: Cisco
Access network subsystem components At the access network level, passive components that combine and split signals, and customer premise equipment that convert optical signals to electrical signals, make up much of the network. The main function at this level is to maximize termination points for the network like maximizing the number of on/off ramps for highways. Specific components used in access network subsystems include PON (passive optical networks), splitter modules, isolators, optical triplexers, etc.
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Exhibit 22: Optical networks supply chain
Fiber cable and optical components suppliers

O-Net Communications Accelink Technologies Oclaro Inc 877 HK 002281 CH OCLR US OPLK US FNSR US JDSU US AFOP US OPXT US AVGO US NPTN US MRVC US EMKR US
System integrators
ZTE Corp Huawei Ericsson Alcatel-Lucent Motorola Solutions Tellabs Inc Juniper Networks Ciena Corp Cisco Systems 763 HK Private ERICB SS ALU FP MSI US TLAB US JNPR US CIEN US CSCO US
Telecom operators Cable operators

China Telecom China Unicom Chunghwa Telecom Singapore Telecom KT Corp Telecom Italia SpA AT&T Inc Verizon Vodafone Group NTT DoCoMo Cablevision Telefonica SA 728 HK 762 HK 2412 TT ST SP 030200 KS TIT IM T US VZ US VOD LN 9437 JP CVC US TEF SM
Key Players
Oplink Communications Finisar Corp JDS Uniphase Corp Alliance Fiber Optic Opnext Inc Avago NeoPhotonics MRV Communications Emcore Corp
Source: BNP Paribas
17 17
BNP PARIBAS
ALEN LIN
3 JUNE 2011
Demand-driven investments
Despite the short-term volatility in optical communications equipment cycles, we believe the secular trend of investments in more bandwidth and more broadband connections will continue. We believe bandwidth-hungry multimedia services such as Netflix, PPTV, BitTorrent, and others will rapidly gain popularity and continue to drive up demand for more data capacity. While high-quality multimedia streaming services are becoming more common in developed markets such as the US, we believe they are still in the early stages for the emerging markets. These high-quality multimedia services are the main driver for potential tripling of data traffic in Asia Pacific over a five-year span. In order to satisfy such high growth in data capacity demand, we believe optical communications will play a central role in data infrastructure. While the traditional communications equipment providers still play an important role in the optical communications space, increasingly, Chinese suppliers such as Huawei and ZTE have risen to become relevant. As these Chinese system integrators are also highly leveraged to the emerging markets, including the Asia Pacific markets, we believe they are well positioned for above-average industry growth in the current upgrade cycle. Going upstream to the optical component suppliers, this space is dominated by US and Japanese suppliers. However, Chinese suppliers such as Accelink Technologies and O-Net are starting to gain momentum on sub-categories of optical components. We believe as their respective exposures to the Asia Pacific markets increase, they are also well positioned for continuing growth. As China undergoes the multi-year upgrade cycle of its broadband network, we expect a significant part of the overall capex to be allocated to engineering and civil work. We believe companies such as China ComService that have strong relationships with telecom operators and solid experience in communication networks will also benefit from the upgrade cycle. Exhibit 23: Valuation comparison
Share Company BBG code price Market cap P/E 2011E (x) 14.9 35.5 15.3 na 10.9 14.3 20.5 13.4 na 62.5 27.6 na 20.4 2012E (x) 12.2 28.0 12.7 49.7 12.4 13.4 17.2 9.6 na 22.5 12.5 34.6 18.2 EV/EBITDA 2011E (x) 10.0 25.8 9.0 21.3 4.3 9.4 12.0 4.6 (10.2) 8.4 5.5 na 11.6 2012E (x) 8.0 20.5 8.1 10.4 3.2 7.8 9.3 3.3 15.9 6.5 3.2 na 9.5 P/BV 2011E (x) 2.1 4.9 2.8 1.8 1.5 3.1 4.2 na 1.0 1.1 na na 3.5 2012E (x) 1.8 4.3 2.3 1.6 1.3 2.7 3.8 na 1.1 1.2 na na 3.1 Yield 2011E (%) 0.0 0.7 na na na na na na 0.1 2012E (%) 0.0 0.8 na na na na na na na 0.1 ROE 2011E (%) 15.0 14.0 21.3 (8.4) 10.4 19.0 8.5 na (13.0) 3.2 na na 11.5 2012E (%) 15.6 15.5 21.2 11.2 8.5 18.8 13.2 na (13.8) 5.2 na na 14.5
(LC) (USD m) Optical components & fiber O-Net Communications Accelink Technologies Jiangsu Zhongtian Oclaro Oplink Communications Finisar JDS Uniphase Alliance Fiber Optic Opnext NeoPhotonics MRV Communications Emcore Corp 877 HK 002281 CH 600522 CH OCLR US OPLK US FNSR US JDSU US AFOP US OPXT US NPTN US MRVC US EMKR US 3.63 36.35 23.54 8.90 18.33 22.29 19.18 9.14 2.72 9.50 1.38 2.42 389 898 1,166 449 379 1,998 4,353 81 245 234 217 214
Optical components & fiber - mcap weighted average Equipment & service ZTE Corp China ComService Fiberhome Telefonaktiebolaget Alcatel-Lucent Motorola Solutions Tellabs Juniper Networks Ciena Corp Cisco Systems 763 HK 552 HK 600498 CH ERICB SS ALU FP MSI US TLAB US JNPR US CIEN US CSCO US 27.50 4.89 26.75 94.20 3.96 46.88 4.52 32.97 25.48 16.38 10,507 3,629 1,824 49,711 13,213 15,917 1,642 17,575 2,421 90,549
21.7 11.3 22.8 15.2 17.6 20.2 na 21.7 463.3 10.2 19.6
19.2 10.1 18.0 13.6 11.5 18.5 68.5 17.5 23.5 9.5 13.0
11.1 5.2 16.5 6.9 5.7 7.3 32.4 12.4 19.5 5.2 7.2
10.3 4.6 12.9 6.1 5.0 6.5 9.8 9.7 10.2 4.7 6.0
2.7 1.5 3.0 2.0 2.3 2.4 0.9 2.4 31.6 1.9 2.4
2.4 1.4 2.6 1.8 2.0 2.1 0.9 2.2 14.9 1.7 2.0
0.9 3.5 0.8 2.6 1.8 0.7 1.1
1.0 4.0 1.0 2.9 0.3 1.8 1.5 1.5
13.5 14.2 13.1 12.7 11.3 12.4 (0.8) 11.4 30.9 17.9 15.0
13.5 14.9 14.7 13.2 15.3 10.1 1.5 11.9 363.7 17.2 18.9
Equipment & service - mcap weighted average

Share prices as of 1 June 2011 Source: Bloomberg; BNP Paribas estimates
18 18
BNP PARIBAS
ALEN LIN
3 JUNE 2011
Company updates
O-Net............................................................................................................................................................................................. 20 China ComService....................................................................................................................................................................... 36 ZTE Corp ...................................................................................................................................................................................... 55
19 19
BNP PARIBAS
O-Net
877 HK
CHINA / TECHNOLOGY HARDWARE & EQUIPMENT
TARGET PRIOR TP CLOSE UP/DOWNSIDE
HKD4.90 N/A HKD3.55 +38.0%
BUY
INITIATION
HOW WE DIFFER FROM THE STREET

BNP Consensus Target Price (HKD) EPS 2011 (HKD) EPS 2012 (HKD) 4.90 0.24 0.30 Positive Market Recs. 7 5.29 0.28 0.35 Neutral 1 % Diff (7.4) (14.3) (14.3) Negative 2
INDUSTRY OUTLOOK
Speeding up the Internet

Broadband upgrades, driven by data growth, will aid OC industry Benefiting from vertical integration and advanced tech Expanded customer base to help catch China/overseas growth Initiate with BUY, DCF-based target price of HKD4.90
KEY STOCK DATA

YE Dec (HKD m) Revenue Rec. net profit Recurring EPS (HKD) Prior rec. EPS (HKD) Chg. In EPS est. (%) EPS growth (%) Recurring P/E (x) Dividend yield (%) EV/EBITDA (x) Price/book (x) Net debt/Equity ROE (%) 2011E 799 203 0.24 N/A (3.3) 14.6 0.0 9.7 2.0 (28.0) 15.0 2012E 973 248 0.30 N/A 21.9 11.9 0.0 7.8 1.7 (34.1) 15.6 2013E 1,178 303 0.36 N/A 22.3 9.8 0.0 5.9 1.5 (39.9) 16.2
Initiating coverage with BUY

We initiate coverage on O-Net with a BUY rating and target price of HKD4.90. As one of the worlds major passive optical component (OC) providers, we believe the company is well positioned to benefit from the massive global broadband build-out and upgrade, with its wide range of products and diversified customer base. Its advanced design and manufacturing technologies and vertically-integrated business model should help the company maintain higher-than-industry growth and enjoy high margins in the coming years.
Joyce Zhou
Alen Lin
(HKD) 6.00 5.00 4.00 3.00 2.00 May-10
O-Net Rel to MSCI China
(%)
Right products, right time
Aug-10
Nov-10
1 Month (22.5) (19.3)
69 49 29 9 (11) Feb-11 May-11

3 Month (18.4) (24.5) 12 Month 11.1 (1.5) August 2011 380 3.2 43 O-Net Holdings (30%) 6.31/3.10 53.0 -
Share price performance Absolute (%) Relative to country (%) Next results Mkt cap (USD m)
A sharp increase of data traffic has driven the worldwide broadband capacity and speed upgrades. Gartner data suggest worldwide FTTx/ Ethernet subscribers will grow at 12.3% five-year CAGR and account for 21% of total broadband subscribers in 2015 (16% in 2010). China has also started its broadband upgrade with fixed-line operators increasing their capex on broadband networks for 2011. Increasing data demand will drive the whole industry supply chain. We believe O-Net, with advanced design and manufacturing technologies and well developed product portfolio (from sub-component and component to module and subsystems in five product lines) is going to enjoy the huge boom in the OC industry. The upcoming TDC products for 40G applications will be one of the key growth drivers for the next three years, due to limited supply in the market.
3m avg daily turnover (USD m) Free float (%) Major shareholder 12m high/low (HKD) 3m historic vol. (%) ADR ticker ADR closing price (USD)
Sources: Bloomberg consensus; BNP Paribas estimates
Favourable customer base

The OC industry has high entry-barriers with a long R&D/qualification process and high initial investment. This has stopped new players entering this high-margin industry. O-Net has been in the industry for more than 10 years and has established a solid client base. We believe that with its diversified client base, including Alcatel-Lucent, Huawei, Ciena and newly qualified ZTE and Fiberhome, O-Net is in a good position to capture growth from both domestic and overseas markets.
Valuation: BUY with target price of HKD4.90

We forecast O-Net will see top-line growth of over 20% y-y and maintain net margin of over 20% for the next three years. We estimate O-Nets reported EPS at HKD0.24 for 2011E, HKD0.30 for 2012E and HKD0.36 for 2013E. We set our DCF-based target price at HKD4.90, with WACC of 12.5% and terminal growth of 2%. Our target price translates to 20.1x 2011E P/E. The stock is trading at 14.6x 2011E P/E and 11.9x 2012E P/E.
20
3 June 2011
JOYCE ZHOU
O-NET
3 JUNE 2011
Base Year-end 31 Dec Gross margin (%) EPS (HKD) Change (%) 2011E 50.6 0.24 2012E 50.6 0.30
Best 2011E 50.6 0.25 3.3 2012E 49.8 0.31 3.3
Worse 2011E 49.6 0.24 (3.3) 2012E 49.6 0.29 (3.3)
Key Earnings Drivers & Sensitivity

We believe O-Net earnings sensitivity is mainly dependent on revenue and margins. The margin level is influenced by the revenue mix by different product categories as different products hold different margin levels. In the adjacent table, we test the sensitivity of O-Nets EPS to +/-1% of blended gross margin.
Sources: BNP Paribas estimates
O-Net and MXCN Index (3M and 6M realised-vol)

(%) 400 350 300 250
O-Net
Regression O-Net to MXCN Index
16.00% 11.00% 6.00% 1.00% -22.00% -17.00% -12.00% -7.00% -2.00% -4.00% -9.00% -14.00% MSCI China O-Net = 3 + 0.0366 * MXCN Index R Square = 0.2878 Regression based on 57 observations of 5 years weekly data. Please refer to Appendix 1 for the explanation of R-square Sources: Bloomberg; BNP Paribas 3.00% 8.00% 13.00% 18.00%
200 150 100 50 0 Apr-10

O-Net - 3M Realised - Vol MSCI China - 3M Realised - Vol
Apr-11
O-Net - 6M Realised - Vol MSCI China - 6M Realised - Vol
Sources: Bloomberg; BNP Paribas
China sector correlation matrix at 31 March 2011

Banks Banks Insurance Metal & Mining Oil & Gas Property Telecom Utilities Coal
Source: BNP Paribas Sector Strategy
Insurance 0.77 1.00
Metal & Mining 0.78 0.76 1.00
Oil & Gas 0.81 0.79 0.82 1.00
Property 0.73 0.67 0.70 0.64 1.00
Telecom 0.71 0.69 0.69 0.76 0.55 1.00
Utilities 0.61 0.61 0.63 0.64 0.54 0.61 1.00
Coal 0.78 0.76 0.84 0.83 0.67 0.68 0.56 1.00
1.00
Long/short chart
(x) 0.26 0.24 0.22 0.20 0.18 0.16 0.14 0.12 0.10 Apr-10 Oct-10
O-Net - ZTE Corp
The risk experts
The Risk Experts
+2s +1s Mean -1s -2s
Our starting point for this page is a recognition of the macro factors that can have a significant impact on stockprice performance, sometimes independently of bottom-up factors. With our Risk Expert page, we identify the key macro risks that can impact stock performance. This analysis enhances the fundamental work laid out in the rest of this report, giving investors yet another resource to use in their decision-making process.
Apr-11
Sources: Bloomberg, BNP Paribas
21 3
BNP PARIBAS
JOYCE ZHOU
O-NET
3 JUNE 2011
Initiate with BUY and TP of HKD4.90

We initiate coverage on O-Net with a BUY rating and target price of HKD4.90. Our target price is based on a DCF valuation, with WACC of 12.5% and terminal growth of 2%, the same as the telecom sector. We believe the company is one of the emerging beneficiaries of the intensive worldwide optical network upgrade, especially in China. We think O-Net has positioned itself well with advanced design and manufacturing technologies, a vertically-integrated business model and competitive customer base including both global leading telecom equipment providers and China-based equipment providers.
Benefiting from broadband network upgrades

We believe O-Net is one of the emerging beneficiaries of the intensive worldwide optical network upgrade, especially in China. As a key upstream player in the whole broadband industry value chain, we believe optical component providers will benefit from the increasing capex spent by telecom operators to ease network capacity bottlenecks. According to Gartner data, worldwide infrastructure spending on fiber broadband access grew 17.1% in 2010, compared to a 5.5% decline in DSL broadband access spending (Exhibit 1). Gartner also forecast fiber broadband access spending will grow at 16.6% CAGR in the next five years, compared with overall carrier network infrastructure spending growth of 4.3% CAGR in the next five years. O-Net is one of the top-five passive optical component providers with 5.1% market share in 2009, according to the company. We believe O-Net will be one of the key beneficiaries of the global optical network upgrade. Exhibit 1: Broadband access spending: Fiber vs DSL
(USD m) 4,500 4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 0 2007 2008 2009 2010 2011E 2012E 2013E 2014E 2015E Fiber broadband access DSL broadband access
Source: Gartner (March 2011)
Key player in passive optical components

O-Net is one of the leading passive optical component providers, with 5.1% market share in the industry and ranked number-five, based on data from Infostone Communication Consultants. It is number-one in free space optical isolators with a 33.9% market share, number-three in WDM products with 10% market share and among the top 10 of VOA and EDFA products. Ovums optical component report published in December 2010 also suggested O-Net is the world number-seven provider of amplifiers and ROADMs and filters during 3Q09-2Q10 period (Exhibits 2-3).
22 4
BNP PARIBAS
JOYCE ZHOU
O-NET
3 JUNE 2011
Exhibit 2: Amplifiers market share

O-Net 3.1% Oplink 3.7% Sumitomo 4.1% Accelink 10.4% Furukawa 17.5% Others 12.0% Oclaro 26.0%
Exhibit 3: ROADMs and filters market share

Others 14.8%
Oclaro 4.4% Ignis 4.7% AFOP 4.7% O-Net 6.0%
JDSU 16.5%
Finisar 12.4%
JDSU 23.2%
Sumitomo 6.8% NeoPhotonics 8.1%

Sources: Ovum (December 2010); BNP Paribas
NEL 11.2% Oplink 10.2%
Sources: Ovum (December 2010); BNP Paribas
Optical network upgrade driven by data traffic growth

We have seen increasing demand for high-speed networks driven by high-bandwidth applications such as video downloads and streaming, P2P file sharing, IPTV and HDTV. Cisco research estimates that global IP traffic will reach 767 exabytes per year or 64 exabytes (1018) per month by 2014, increased from 20 exabytes per month in 2010. The growth is driven by the innovative data consuming applications such as Youtube (Private), Netflix (NFLX US, Not rated) and Facebook (Private), etc. Exhibit 4: Bandwidth need for different services
Source: BNP Paribas
Optical component to see growth in next five years

In addition to the increasing data traffic per broadband user, we also expect the broadband subscribers, especially FTTx/Ethernet subscribers, to see strong growth in the next five years. According to Gartner, worldwide broadband connections will grow to 683m by 2015; FTTx/Ethernet subscribers will grow at 12.3% CAGR in the next five years and take 21% of total broadband subscribers, up from 16% in 2010 (Exhibit 5). We believe the telecom operators will need to increase their capex on broadband network upgrades to handle the huge data traffic increase from both new subscribers and existing customers.
23 5
BNP PARIBAS
JOYCE ZHOU
O-NET
3 JUNE 2011
Exhibit 5: Consumer broadband connections worldwide

(subs m) 800 700 600 500 400 300 200 100 0 2008 2009 2010 2011 2012 2013 2014 2015 FTTH/FTTP/Ethernet DSL Cable modem Other high-speed
China broadband upgrade driven by network convergence

The Chinese government has broadly proposed a network convergence plan by upgrading existing cable TV networks to offer converged services voice, broadband, and video, conventionally known as triple-play. And the State Administration of Radio, Film, and Television (SARFT) has chosen 12 cities to trial network convergence. Though we do not believe cable TV operators can compete with telecom operators on broadband service in the near future due to their current industry structure and network condition, we think this policy is one of the key drivers for the massive broadband upgrade in China. In 2010, China Telecom (728 HK, BUY) and China Unicom (762 HK, HOLD) spent RMB27.6b and RMB22.5b on broadband and internet, with growth of 34.3% and 19.4% y-y, respectively. In 2011, China Telecom plans to cover 70% of the cities with 20M network (from 58% in 2010) and add 12m broadband subscribers, China Unicom also plans to cover 40m households with 20M broadband access capability in 2011 (up from 25m households, or 38% of total access ports).
24 6
BNP PARIBAS
JOYCE ZHOU
O-NET
3 JUNE 2011
High entry barriers protect industry value

The optical component industry is a high entry-barrier industry, with most of the top-tier players having been in this industry for more than 10 years. O-Net started its R&D investment in optical component products as a subsidiary under Shenzhen Kaifa Technology Co, Ltd, an A-Share listed company (000021 CH, Not rated) in 1994 before it was incorporated. O-Net was separated from its parent group and incorporated in 2000, and then turned profitable in 2005. Generally the first few products need around 10 years to become commercially ready in this industry. The company needs to invest heavily in the necessary technology and manufacturing processes (e.g., coating, packaging and testing) for the first few products before approaching potential customers for qualification. Also the company needs to work closely with its customers as most of the products need to be customised to fit specific needs of the customer. Therefore, we do not see many threats from newcomers, and do not expect margins to go down significantly in this industry, even for legacy products.
Long qualification process for customers

After the 10-year preparation for the first few products, optical component suppliers need to get qualification from their customers to enter their supply chain, and also need to get qualification for each product before delivering the product to their customers. In general, to get qualification from a new customer needs around one year, and for each new product need another nine months to design for the customer and get approval (Exhibit 6). This whole process further raises entry barriers to the industry as it requires large initial investment and resources to acquire each customer.
25 7
BNP PARIBAS
JOYCE ZHOU
O-NET
3 JUNE 2011
Exhibit 6: Customer qualification process
Source: O-Net
Expanding customer base, adding China exposure

During the last 10 years, O-Net has established a competitive customer base including global leading telecom equipment providers such as Alcated-Lucent (ALU FP, Not rated), Huawei (privately held), and the contract manufacturers to Ciena (CIEN US, Not rated) and Infinera (INFN US, Not rated). O-Net passed Alcated-Lucent qualification back in 2004, and has been its top-three optical supplier for the last few years. The cooperation also has a long history with Ciena, of over five years. Huawei and Infinera are relatively new to its customer base, but already contribute significantly to its revenue base. The company also got qualification from ZTE (763 HK, HOLD) and Fiberhome (600498 CH, Not rated) recently the company expects revenue contribution from ZTE and Fiberhome to be 5% and 3% respectively for 2011. We believe the expansion of its customer base will help the company reduce dependence on its key customers, and lower the volatility caused by their destocking and restocking activities during market ups and downs. Moreover, the expansion to China equipment providers such as ZTE and Fiberhome should help O-Net capture growth from the network upgrade in China and other developing markets such as Latin America, the Middle East and Africa, which we expect will see stronger data traffic growth than developed markets such as North America.
26 8
BNP PARIBAS
JOYCE ZHOU
O-NET
3 JUNE 2011
Exhibit 7: Regional IP data traffic growth

(%) 60 50 40 30 20 10 0 2010
Sources: Cisco; BNP Paribas
North America Asia Pacific Latin America Middle East and Africa
Western Europe Japan Central Eastern Europe Total IP traffic
2011
2012
2013
2014
In 2010, O-Net has 50.4% of total revenue coming from its top-five customers. AlcatelLucent alone contributes nearly 20% of total revenue and Huawei also contributes over 10% of total revenue. We expect the revenue source to be further diversified with new customers including ZTE and Fiberhome to contribute around 10% of total revenue in 2011E.
Diversified product portfolio

O-Nets products are divided into five product categories: Power management, Transmission, Wavelength management, Signal conditioning & monitoring, and Others. Each product category includes tens or hundreds of products (Exhibit 8 and Exhibit10). Those products can be used in Long Haul network, Metro Ring, as well as local access networks such as FTTx. Exhibit 8: Products by segment
Signal conditioning and monitoring
Power management
Transmission
Wavelength Management
Others
Amplifier (EDFA) EDFA module VOA Isolator Hybrid Filter Coupler
DPSK demodulator DQPSK demodulator Wavelength locker Isolator Optical Circulator Optical Switch
WDM WDM module Optical Interleaver Arrayed Waveguide - Crating (AWG)
Channel Monitor Tap-PD Monitor Tunable Dispersion -Compensator (TDC) Tap-PD Array module Integrated Module & Subsystem
PON WDM Transceiver module Transmitter PLC Splitter Receiver Etalon Compensator & Waveplate
Sources: O-Net; BNP Paribas
27 9
BNP PARIBAS
JOYCE ZHOU
O-NET
3 JUNE 2011
Exhibit 9: Revenue by segment

(HKD m) 700 600 500 400 300 200 100 0 2007
Sources: O-Net; BNP Paribas
Power management Wavelength management All other segments
Transmission management Signal conditioning and monitoring mgt
2008
2009
2010
Exhibit 10: O-Net product range
Source: O-Net
O-Net is also adding new products in each category, with 331 new products launched in total during 2010. We expect more new products to come during 2011 including the TDC products for 40G applications, which the company announced would achieve mass production in 2H11. We believe the new product launches will not only provide additional growth drivers for the company, but also help keep O-Nets margin level high, and enhance its competitive advantage over peers.
28 10
BNP PARIBAS
JOYCE ZHOU
O-NET
3 JUNE 2011
Competition: mainly with US companies on different products

The optical component industry is mainly dominated by US companies. Due to its wide product range, O-Net is competing with different companies in different product categories. For example, on amplifiers, the companys major competitors include Oclaro (OCLR US, Not rated), JDSU (JDSU US, Not rated), Accelink and Oplink (OPLK US, Not rated); while in the WDM category, its major competitors include Oplink and Photop (privately held). Its upcoming new product, TDC, will compete with Oclaro. We believe O-Net holds several key competitive advantages compared to its peers, including the advanced design and manufacturing technologies in coating, assembly and packaging, vertically-integrated business model from sub-component and component to module and subsystems, and also efficient and flexible manufacturing process enabling lowvolume high-mix in-house production. Those competitive edges help O-Net keep its advantage on the technology side, and also maintain a high margin level due to lower cost.
Capacity expansion and looking for M&A opportunities

Listed in April 2010, O-Net has a strong cash position. By the end of 2010, the company has HKD918m on hand. With the HKD519m IPO proceeds and HKD326m from private placement in November 2010, the company is expanding its capacity to meet market needs, and is looking at M&A targets to extend its product portfolio. Hiring PricewaterhouseCoopers (PWC) as its Independent auditor, we believe the company is solid both on business management and financial management. Exhibit 11: Use of proceeds
As per placement (HKD m) 2010E per IPO (HKD m) 41.5 2011E per IPO (HKD m) 163.5 Revised 2011E after private placement on November 2010 (HKD m) 210
As per IPO (HKD m) New production facilities : Construction and build-out of new facilities located in Pingshan New District, Shenzhen City (Leasehold land owned of approx. 38,000 sqm) Production line and research & development expansion Repayment of Shenzhen Kaifa for rent and operating expenses paid on behalf of O-net Working capital Others including M&A Total
Source: O-Net
2010 (HKD m) 9.1
200
115 34 33 137 519 326 326
46 34 33
44.5 34 101.8
64
75
45 137 319.5 649.5
154.5
189.4
364.5
During 2010, the companys overall capacity increased by 50%, and the company expects it to increase another 30% in 2011. The companys total headcount will also increase by nearly 40% to capture the fast demand growth. The new facilities in Shenzhen are still under construction the company expects to complete the first phase in 2011 and achieve operation before end of this year. In addition to organic growth, O-Net is also looking for M&A opportunities. It has increased its funds for M&A and others from HKD137m to HKD319.5m in 2011, and it is actively looking for good targets that either can help enhance its product portfolio with complementary technology or that has strong synergy with O-Nets current products.
29 11
BNP PARIBAS
JOYCE ZHOU
O-NET
3 JUNE 2011
Financials
Impressive top-line growth
O-Net has been enjoying higher-than-market growth since 2008. Even in the financial crisis period during 2009, O-Net achieved 18.9% revenue growth, compared to the market which saw 13% revenue declines. Though we do not expect O-Net to achieve the same growth level as 2010 in the next three years, we believe it will continue to achieve higher-than-average growth in the future due to its competitive product portfolio and good operation management. Exhibit 12: Revenue growth vs OC market growth
(%) 120 100 80 60 40 20 0 (20) 2008 2009 2010 2011 2012 2013 Optical component market growth O-Net revenue growth
Sources: O-Net; Ovum; BNP Paribas estimates
Margin highest among its peers

Though we see some of O-Nets existing products as having downward margin pressures as they become mature, we continue to see new products with higher margins being added to the product portfolio to help maintain the overall high margins of the company. We expect the TDC products that the company plans to launch in 2011 to enjoy around 70% gross margin, which is much higher than company average of 4050%. The companys high margin is also related to its innovative production process know-how, which allows it to use cheaper raw materials such as glass instead of crystal, and help improve production efficiency and achieve better product quality. Compared to its peers, who outsource most of the sub-component and production process to third parties, O-Nets vertically-integrated business model helps it capture the additional margin (around 20%) which is generally enjoyed by those upstream suppliers and OEM partners for its competitors.
30 12
BNP PARIBAS
JOYCE ZHOU
O-NET
3 JUNE 2011
Exhibit 13: Gross margin comparison 2010

Emcore corp Mrv comm Neophotonics cor Opnext inc Alliance fiber Jds uniphase Finisar corp Oplink communica Oclaro inc Accelink tech-a O-Net communicat 0 10 20 30 40 50 (%) 60
Exhibit 14: Net margin comparison 2010

Emcore corp Mrv comm Neophotonics cor Opnext inc Alliance fiber Jds uniphase Finisar corp Oplink communica Oclaro inc Accelink tech-a O-Net communicat (40) (20) 20 (%) 40
Sources: O-Net; Company data; BNP Paribas
Sources: O-Net; Company data; BNP Paribas
Benefits from previous R&D investment

We believe in technology-intensive industries, such as the optical component industry, companies need to invest aggressively in R&D so as to keep competitive advantages, and thus enjoy higher-than-average revenue growth and margin levels. O-Net has been investing in R&D in the optical component industry for more than 10 years, which provides it with a technology lead in the industry and enables O-Net to launch hundreds of new products each year to drive revenue growth. With the high growth during 2010, its R&D expense as a percentage of revenue has dropped to 4.8%, which is much lower than its previous 7-8% level and global peer average of 11%. Exhibit 15: R&D cost as % of total revenue
Emcore corp Mrv comm Neophotonics cor Opnext inc Alliance fiber Jds uniphase Finisar corp Oplink communica Oclaro inc Accelink tech-a O-Net communicat 0
(%) 5 10 15 20 25
We believe O-Net needs to invest more in R&D in the coming years to keep its leading position in the industry and prepare for future growth. We forecast O-Net will gradually increase its R&D spending from 4.8% of total revenue in 2010 to 7% of total revenue in 2013E. In addition, O-Net is also budgeting HKD319.5m on future M&A and targeting part of the acquisition at new technology. Even if we assume 30% of this M&A budget is to be spent on new technologies and amortise it into the next three years, the R&D plus acquisition of new technology spending will be in the range of 7-9% of total revenue in next three years, in line with its peers.
31 13
BNP PARIBAS
JOYCE ZHOU
O-NET
3 JUNE 2011
Initiate with BUY

We believe the optical component industry will be driven by the massive network upgrade by broadband operators. With an expanding customer base, we believe O-Net will enjoy higher-than-industry revenue growth. The advantage in design and manufacturing technologies and the vertically-integrated business model will help O-Net maintain over-20% net margin in the next three years. We estimate that O-Nets reported EPS will be HKD0.24 for 2011E, HKD0.30 for 2012E and HKD0.36 for 2013E. We initiate coverage with a BUY recommendation and a target price of HKD4.90. Our target price is based on a DCF valuation with WACC of 12.5% and 2% terminal growth. Our target price translates to 20.1x 2011E P/E. The stock is trading at 14.6x 2011E P/E and 11.9x 2012E P/E. Exhibit 16: DCF assumptions
WACC (%) Mid-term revenue growth (%) Mid-term EBIT margin (%) Mid-term tax rate (%) 16.8 28.0 15.0 Terminal growth (%) Terminal EBIT margin (%) Terminal tax rate (%) 12.5 2.0 25.0 15.0
Target price (HKD)

Source: BNP Paribas estimates
4.90
Investment risk
The system integrators are cutting their orders in 1H11 to digest their own inventory. The process may take longer than expected, which may have a negative impact on our revenue forecast for 2011. Lower-than-industry R&D expenses may not be enough to keep the companys technology lead, and may have an impact on the companys future growth. Exhibit 17: Shareholding structure
Kaifa Technology (HK) Ltd (Hong Kong) 27.32% Mandarin IT Fund I (Cayman Islands) 49.18% O-Net Employee Plan Ltd (BVI) 18.48%
Mariscal Ltd (Hong Kong)
Na Qinglin
Xue Yahong
Public Shareholders 42.67%
23.70%
6.95%
1.69%
O-Net Holdings (BVI) (investment holding) 30.01% The Company (Cayman Islands) (investment holding) 100%
O-Net BVI (BVI) (investment holding)
100% O-Net Shenzhen (PRC)

Source: O-Net
100% O-Net Hong Kong (HK)
32 14
BNP PARIBAS
JOYCE ZHOU
O-NET
3 JUNE 2011
Exhibit 18: Management profile

Director Mr Na Qinglin Executive Director, Co-Chairman and CEO. Joined O-Net as chief executive officer in January 2002 and was appointed as co-chairman in the same year. He is responsible for our overall corporate strategy, management team development and daily operations. Mr. Na worked at Salomon Smith Barneys Hong Kong & New York office from 1995 to 2000. In 2000, he co-founded became the comanaging partner of Mandarin Venture Partners in HK. Mr Na holds a Masters degree in Business Administration from Vanderbilt University in 1995 and a Bachelors degree in International Economics from Peking University in 1989 Executive Director and VP of Operations. Joined O-Nets operations team in March 2001. He is responsible for the overall supervision of the production, engineering and logistics of the Group. Mr Xue has participated in the development and production of O-Net products and has assisted in the transformation of its manufacturing facility to a semi-automatic system. Prior to joining O-Net, Mr Xue worked at Shenzhen Kaifa from 1990 to 2000. Mr Xue earned a Masters degree in Engineering from Harbin Institute of Technology in 1985. Non-Executive Director and Co-Chairman. Mr Tam was a director of O-Net Cayman, the holding company of the Group before the Reorganization. He is not involved in the day-to-day operations of the Group as a non-executive Director, but is engaged in providing business, financial and investment advice to the Company. Mr. Tam has been a director and subsequently became the chairman and the president of Shenzhen Kaifa since July 1985 and China Great Wall Computer Shenzhen Co Ltd (000066 CH) since 1999. Non-Executive Director. Mr Chen was a director of O-Net Cayman, the holding company of the Group before the Reorganization. He is not involved in the day-to-day operations of the Group as a non-executive Director, but is engaged in providing industry-related information and advice to the Group. Mr Chen is a qualified engineer and economic administrator. He previously served as a director and general manager of Shenzhen Huaming Computer Co, Ltd, and served as the vice-chief of office of China Great Wall Computer Shenzhen Co Ltd (000066 CH), Mr Chen received a Bachelors degree in engineering from Tianjin University in 1989 and a Masters degree from the Business School of Jilin University in 2007. Non-Executive Director. He is also a director of the following subsidiary of the company: O-Net Shenzhen. Mr Huang was a director of O-Net Cayman, the holding company of the Group before the Reorganization. He is not involved in the day-to-day operations of the Group as a nonexecutive Director, but is engaged in providing financial and investment advice to the Group. Mr Huang joined Mandarin Venture Partners Limited in 2000 and has been responsible for investment project origination since then. Prior to that, Mr. Huang worked for Citibank, Lehman Brothers and Salomon Brothers. Mr. Huang earned a Bachelors degree in Economics from Harvard University in 1985.
Mr Xue Yahong
Mr Tam Man Chi
Mr Chen Zhujiang
Mr Huang Bin
Senior management Mr Eddie Kung VP of Finance. Mr Kung is an associate member of the Association of International Accountants and the Hong Kong Institute of Certified Public Accountants. Prior to joining O-Net, He had held various positions including CFO, company secretary, and authorised representative in the company listed in HKEx. He has over 13 years of experience in finance, accounting, auditing, taxation and company secretarial services. VP of R&D Modules and Subsystems. Dr Yu joined the Company in 2004 and has been involved in the optical communications industry since 1982 when he graduated from Nanjing Institute of Technology) (now Southeast University), specializing in electrical engineering. He also held the position of Chief Research Officer in the Department of Electronic Systems Engineering of Essex University between 1992 and 1997. Dr Yu received his Doctorate degree in electronic systems engineering in 1993 from Essex University in the United Kingdom. He completed his MS in electrical engineering in 1984 at Nanjing Institute of Technology. VP of R&D - Components. Ms Xie She became Head of Research and Development on 3 January 2001 focused on research and development related to optical components. She joined Shenzhen Kaifas fiber optic department in 1999. Ms Xie holds a Master's degree from Zhejiang Unicersity in 1988 and a Bachelor's degree from Zhejiang University in 1983. From 1983 through 1997, Ms Xie was a faculty member at Zhejiang University, teaching optical engineering courses. VP of Sales and Marketing. He has been leading the Companys international sales since 2002 and global sales and marketing since 2004. He joined Shenzhen Kaifa in 1998 where he was responsible for project engineering. Prior to that Mr.Tan worked as technical staff at Thomson Electric (Malaysia) Sdn. Bhd. and Seagate Technologies (Malaysia) Sdn Bhd. Mr Tan graduated with a Bachelors degree in physics from the National University of Malaysia in 1994.
Dr Yu Aihua
Ms Xie Hong
Mr Steven Tan
Source: O-Net
33 15
BNP PARIBAS
JOYCE ZHOU
O-NET
3 JUNE 2011
FINANCIAL
STATEMENTS
O-Net
Profit and Loss (HKD m) Year Ending Dec
Revenue Cost of sales ex depreciation Gross profit ex depreciation Other operating income Operating costs Operating EBITDA Depreciation Goodwill amortisation Operating EBIT Net financing costs Associates Recurring non operating income Non recurring items Profit before tax Tax Profit after tax Minority interests Preferred dividends Other items Reported net profit Non recurring items & goodwill (net) Recurring net profit Per share (HKD) Recurring EPS * Reported EPS DPS Growth Revenue (%) Operating EBITDA (%) Operating EBIT (%) Recurring EPS (%) Reported EPS (%)
2009A
338 (175) 163 0 (66) 98 (10) 0 87 1 0 0 0 88 (9) 79 0 0 0 79 0 79 0.14 0.14 0.00 18.9 134.9 186.5 244.2 244.2
2010A
661 (308) 352 0 (132) 220 (15) 0 206 (2) 0 0 0 204 (22) 182 0 0 0 182 0 182 0.25 0.25 0.00 95.2 125.7 135.0 84.7 84.7 51.1 33.3 31.1 27.5 10.9 0.0 107.2 101.2 121.7 157.9 41.6 38.7 25.3 21.1
2011E
799 (374) 425 0 (169) 257 (21) 0 236 3 0 0 0 239 (36) 203 0 0 0 203 0 203 0.24 0.24 0.00 21.0 16.5 14.8 (3.3) (3.3) 50.6 32.1 29.5 25.4 15.0 0.0 124.3 136.7 155.7 23.2 22.4 15.0 13.0
2012E
973 (452) 520 0 (204) 316 (28) 0 288 3 0 0 0 291 (44) 248 0 0 0 248 0 248 0.30 0.30 0.00 21.7 23.2 22.2 21.9 21.9 50.6 32.5 29.6 25.5 15.0 0.0 125.3 136.3 156.9 23.2 22.5 15.6 13.5
2013E
1,178 (554) 624 0 (241) 383 (30) 0 353 3 0 0 0 356 (53) 303 0 0 0 303 0 303 0.36 0.36 0.00 21.1 21.1 22.5 22.3 22.3 50.5 32.5 30.0 25.7 15.0 0.0 124.4 136.7 155.9 26.3 25.5 16.2 14.0
We forecast over 21% revenue growth for the next three years
Operating performance Gross margin inc depreciation (%) 45.3 Operating EBITDA margin (%) 28.8 Operating EBIT margin (%) 25.9 Net margin (%) 23.4 Effective tax rate (%) 10.6 Dividend payout on recurring profit (%) 0.0 Interest cover (x) Inventory days 107.1 Debtor days 139.3 Creditor days 227.9 Operating ROIC (%) 71.5 Operating ROIC WACC (%) ROIC (%) 55.5 ROIC WACC (%) ROE (%) 53.7 ROA (%) 28.5 * Pre exceptional, pre-goodwill and fully diluted
Sources: O-Net; BNP Paribas estimates
34 16
BNP PARIBAS
JOYCE ZHOU
O-NET
3 JUNE 2011
O-Net
Cash Flow (HKD m) Year Ending Dec
Recurring net profit Depreciation Associates & minorities Other non-cash items Recurring cash flow Change in working capital Capex - maintenance Capex new investment Free cash flow to equity Net acquisitions & disposals Dividends paid Non recurring cash flows Net cash flow Equity finance Debt finance Movement in cash Per share (HKD) Recurring cash flow per share FCF to equity per share
2009A
79 10 0 4 93 (68) (6) 0 19 0 0 0 19 0 (25) (7) 0.16 0.03
2010A
182 15 0 12 208 (139) (55) 0 13 0 0 (383) (369) 847 (4) 474 0.29 0.02
2011E
203 21 0 13 237 (50) (75) (210) (99) 0 0 0 (99) 0 0 (99) 0.28 (0.12)
2012E
248 28 0 15 290 (64) (50) 0 177 0 0 0 177 0 0 177 0.35 0.21
2013E
303 30 0 17 349 (75) (50) 0 224 0 0 0 224 0 0 224 0.42 0.27
HKD210m capex on new factory in Shenzhen
Balance Sheet (HKD m) Year Ending Dec
2009A
2010A
2011E
2012E
979 (250) 729 369 1,098 0 1 0 33 1,132 (586) 0 0 (586) 0 0 1,718 0 1,132
2013E
1,100 (304) 796 389 1,186 0 1 0 34 1,220 (810) 0 0 (810) 0 0 2,031 0 1,220
Working capital assets 226 795 878 Working capital liabilities (134) (168) (206) Net working capital 92 627 672 Tangible fixed assets 40 82 347 Operating invested capital 132 709 1,019 Goodwill 0 0 0 Other intangible assets 0 1 1 Investments 0 0 0 Other assets 29 32 32 Invested capital 162 742 1,052 Cash & equivalents (27) (508) (409) Short term debt 0 0 0 Long term debt * 0 0 0 Net debt (27) (508) (409) Deferred tax 0 0 0 Other liabilities 0 0 0 Total equity 188 1,249 1,461 Minority interests 0 0 0 Invested capital 162 742 1,052 * includes convertibles and preferred stock which is being treated as debt Per share (HKD) Book value per share Tangible book value per share Financial strength Net debt/equity (%) Net debt/total assets (%) Current ratio (x) CF interest cover (x) 0.32 0.32 (14.1) (8.2) 1.9 1.50 1.50 (40.6) (35.8) 7.7 7.9 1.75 1.75 (28.0) (24.6) 6.3 -
2.06 2.06 (34.1) (29.8) 6.3 -
2.44 2.44 (39.9) (34.7) 6.3 -
Valuation
2009A
2010A
2011E
2012E
11.9 16.5 11.9 0.0 10.2 16.7 1.7 1.7 7.8 11.3 2.1
2013E
9.8 13.5 9.8 0.0 8.5 13.2 1.5 1.5 5.9 8.8 1.8
Recurring P/E (x) * 26.0 14.1 14.6 Recurring P/E @ target price (x) * 35.9 19.4 20.1 Reported P/E (x) 26.0 14.1 14.6 Dividend yield (%) 0.0 0.0 0.0 P/CF (x) 22.2 12.3 12.5 P/FCF (x) (30.0) 108.9 192.0 Price/book (x) 10.9 2.4 2.0 Price/tangible book (x) 11.0 2.4 2.0 EV/EBITDA (x) ** 21.0 10.2 9.7 EV/EBITDA @ target price (x) ** 29.0 14.5 14.1 EV/invested capital (x) 12.6 3.3 2.4 * Pre exceptional, pre-goodwill and fully diluted ** EBITDA includes associate income and recurring non-operating income
Sources: O-Net; BNP Paribas estimates
35 17
BNP PARIBAS
China ComService
CHINA / DIVERSIFIED TELECOMMUNICATION HOW WE DIFFER FROM THE STREET
BNP Consensus Target Price (HKD) EPS 2011 (RMB) EPS 2012 (RMB) 6.06 0.36 0.40 Positive Market Recs. 10 5.46 0.36 0.41 Neutral 9 % Diff 11.0 0.0 (2.4) Negative 1
552 HK
HKD6.06 N/A HKD4.81 +26.0%
BUY
INITIATION
INDUSTRY OUTLOOK
Expansion on the way

Expect continuing operator capex on broadband and 3G Operator revenue growth from market share gains Incremental growth driven by non-operator and overseas markets Initiate at BUY with a DCF-based target price of HKD6.06
KEY STOCK DATA

YE Dec (RMB m) Revenue Rec. net profit Recurring EPS (RMB) Prior rec. EPS (RMB) Chg. In EPS est. (%) EPS growth (%) Recurring P/E (x) Dividend yield (%) EV/EBITDA (x) Price/book (x) Net debt/Equity ROE (%) 2011E 52,033 2,081 0.36 N/A 14.5 11.1 3.6 5.1 1.5 (45.6) 14.2 2012E 59,212 2,334 0.40 N/A 12.2 9.9 4.0 4.5 1.4 (44.7) 14.9 2013E 67,038 2,641 0.46 N/A 13.1 8.8 4.6 3.9 1.3 (43.9) 15.7
Initiating coverage with BUY

We initiate coverage on China ComService (CCS) with a BUY rating and target price of HKD6.06. With the leading position in the telecom infrastructure service (TIS) business and strong relationship with the three China telecom operators, we believe CCS will generate healthy revenue growth from China operators continuing capex on broadband Joyce Zhou upgrades and 3G network build-out. CCS +852 2825 1120 is also increasing its exposure to joyce.zhou@asia.bnpparibas.com operators opex by providing business Alen Lin process outsourcing services (BPO) and +852 2825 1801 alen.lin@asia.bnpparibas.com applications, content and other services (ACO). In addition, we see more upside for the companys non-operator and overseas businesses.
(HKD) 6.00 5.00 4.00 3.00 May-10
China ComService Rel to MSCI China
(%) 57 37 17 (3) May-11

12 Month 46.3 29.2 August 2011 3,569 7.0 35
Multi-dimensional expansion provides growth potential

In our view, CCSs incremental growth will come from its multidimensional expansion both in the non-operator and overseas markets. We believe the company will benefit from the fast-growing government and enterprise IT spending in China, which Gartner forecasts will show 11.6% CAGR in the next five years. The company has also been aggressively developing the overseas market since 2008 and has built a good foundation. We expect the overseas business to accelerate and contribute to over 10% revenue in 2013 (5% in 2010) and CCS to win more high-margin turnkey projects from overseas.
Aug-10
Nov-10
1 Month 2.2 6.3
Feb-11
3 Month (5.6) (8.1)
Expect market-share gains on operator capex

We forecast operator revenue will contribute over 50% to total revenue in the next three years, with the non-operator and overseas businesses helping to diversify revenue sources for CCS. The company has built a strong position in the TIS market with around 90% market share in China Telecoms (728 HK) projects and around 25% in both China Mobile (941 HK) and China Unicoms (782 HK) projects. As CCSs top three customers are also its top three shareholders, we believe the company will be able to maintain its dominant market share in China Telecoms projects while gaining share in China Mobile and China Unicoms projects.
Sources: Bloomberg consensus; BNP Paribas estimates
China Telecom Corp. (53%) 5.50/3.26 45.7 -
Valuation: BUY with target price of HKD6.06

We estimate CCSs reported EPS at RMB0.36 for 2011, RMB0.40 for 2012 and RMB0.46 for 2013. The company has announced that it plans to issue rights share worth up to RMB4b, implying potential EPS dilution of 4.8% for 2011, based on our assumptions. Our model does not account for the proposed rights issue as it is pending approval. We set our DCF-based target price at HKD6.06, assuming WACC of 10% and terminal growth of 2%. The stock trades at 11.1x 2011E P/E and 9.9x 2012E P/E.
36
3 June 2011
JOYCE ZHOU
CHINA COMSERVICE
3 JUNE 2011
Base Year-end 31 Dec Gross margin (%) EPS (RMB) Change (%) 2011E 16.6 0.36 2012E 16.8 0.40
Best 2011E 17.1 0.40 9.9 2012E 17.3 0.44 10.0
Worse 2011E 16.1 0.32 (9.9) 2012E 16.3 0.36 (10.0)

We believe CCSs earnings sensitivity is mainly dependent on revenue and margins. Revenue is related to the telecom capex budget while margins are influenced by revenue mix since the ACO business generally generates higher margins than the TIS and BPO business. In the adjacent table, we test the sensitivity of CCSs EPS to +/- 0.5% of blended gross margin.
CCS and MXCN Index (3M and 6M realised-vol)

(%) 800 700
China ComService
Regression CCS to MXCN Index
12.00% 2.00% -22.00% -17.00% -12.00% -7.00% -2.00% -8.00% -18.00% -28.00% -38.00% MSCI China China ComService = 0 + 0.0765 * MXCN Index R Square = 0.3729 Regression based on 234 observations of 5 years weekly data. Please refer to Appendix 1 for the explanation of R-square Sources: Bloomberg; BNP Paribas 3.00% 8.00% 13.00% 18.00%
600 500 400 300 200 100 0 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10
China ComService - 3M Realised - Vol MSCI China - 3M Realised - Vol
China ComService - 6M Realised - Vol MSCI China - 6M Realised - Vol

Insurance 0.77 1.00
Metal & Mining 0.78 0.76 1.00
Oil & Gas 0.81 0.79 0.82 1.00
Property 0.73 0.67 0.70 0.64 1.00
Telecom 0.71 0.69 0.69 0.76 0.55 1.00
Utilities 0.61 0.61 0.63 0.64 0.54 0.61 1.00
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1.00
Long/short chart
(x) 0.65 0.60 0.55 0.50 0.45 0.40 0.35 0.30 0.25 Jun-08 Dec-08 Jun-09 Dec-09 Jun-10 Dec-10
The risk experts
The Risk Experts

+2s +1s Mean -1s -2s
China ComService - China Unicom
37 3
BNP PARIBAS
JOYCE ZHOU
CHINA COMSERVICE
3 JUNE 2011
Initiate with BUY and target price of HKD6.06

We initiate coverage of China Communication Services (CCS) with a BUY rating and target price of HKD6.06. Our target price is based on a DCF valuation, assuming WACC of 10% and terminal growth of 2%, the same as our assumptions for the telecom sector. As the biggest telecom infrastructure service provider in China, we believe the company will benefit from the heavy capex by the three telecom operators toward upgrading their fixed-line broadband network and expanding their 3G network coverage. We expect operator revenue to see sustainable growth over the next few years on the back of market share gains by CCS from China telecom operators. We also see stronger growth potential from the non-operator and overseas businesses.
One-stop telecom infrastructure service provider

CCS is targeting to provide operators with one-stop supporting services, including telecom infrastructure services (TIS), business process outsourcing services (BPO), and applications, content and other services (ACO). The three business segments include services from design and construction of the network to maintenance and management of the network and facilities to other value-added services. Exhibit 1: Business segment breakdown
TIS - Design - construction - Supervision
Source: China ComService
BPO - Maintenance - Distribution - Facility management
ACO - IT Application - Internet services - Voice VAS
CCS holds the leading position in the TIS business: it is the biggest network design service provider, the biggest network construction provider, and the biggest project supervision service provider in the telecom industry in China. Currently, the TIS business is the biggest revenue contributor of the three business segments, contributing 47.6% of total revenue in 2010. Exhibit 2: Revenue breakdown
(RMB m) 50,000 45,000 40,000 35,000 30,000 25,000 20,000 15,000 10,000 5,000 0 2005 2006 2007 2008 2009 2010 TIS BPO ACO
Sources: China ComService; BNP Paribas
Licence: An entry barrier for the industry

Any entity that wants to work on telecom projects needs to get a licence from the Chinese government. The government issues three tiers of licences based on different criteria, such as scale of operations, industry experience, registered capital, etc. For most of the business categories where CCS has a presence, it holds the highest level of licences issued by the central or provincial governments. For the design business, CCS holds 11 Class-A qualifications and membership in the international federation of consulting engineers. For the construction business, CCSs engineering and construction subsidiaries hold eight Class-1 qualifications. For project supervision
38 4
BNP PARIBAS
JOYCE ZHOU
CHINA COMSERVICE
3 JUNE 2011
and management services, CCS holds a number of qualification certificates such as the Class-A Communication Construction Project Supervision and Management Qualification and Class-A Project Supervision and Management Enterprise Qualification.
Deep industry experience, established customer relationships

In addition to the licences and qualifications, CCSs long industry experience and strong relationship with all three China telecom operators is another competitive advantage. CCS has been working with China Mobile and China Telecom since they were established in 1997 and 2000. CCS was involved in the design, construction and the subsequent upgrade and expansion of a series of large telecom projects in China, including the first Total Access Communication System (TACS), the GSM networks, and the 3G networks. In March 2009, CCS completed the transfers of 506.9m and 236.3m domestic shares of the company to China Mobile and China Unicom. Now all the three telecom operators in China are shareholders of CCS, with holdings of 52.6% (China Telecom), 8.78% (China Mobile) and 4.09% (China Unicom) (Exhibit 26). Also several of the companys board members and senior management are from the three telecom operators or related government authorities (Exhibit 27). We believe the shareholding structure and management profile will help CCS maintain a close relationship with its major customers and secure future contracts from them.
39 5
BNP PARIBAS
JOYCE ZHOU
CHINA COMSERVICE
3 JUNE 2011
Operator business: Healthy growth ahead

With more than 10 years of telecom industry experience and strong relationship with the three China operators, we believe telecom operators will remain the main revenue source for CCS. In 2010, revenue from operators stood at RMB29.5b, or 64.9% of total revenue (Exhibit 3). Within operator revenue, China Telecom was the biggest contributor at RMB19.9b, while China Mobile and China Unicom together contributed RMB9.5b in 2010 (Exhibit 4). Exhibit 3: Revenue: Operator vs non-operator
(RMB m) 50,000 45,000 40,000 35,000 30,000 25,000 20,000 15,000 10,000 5,000 0 2006 2007 2008 2009 2010
Exhibit 4: Operator revenue breakdown
Operator revenue
Non-operator revenue China Mobile & China Unicom 32.4%
China Telecom 67.6%
Benefiting from broadband expansion and upgrade in China

We believe CCS will benefit from the aggressive broadband network construction plan in China. In April 2010, the Ministry of Industry and Information Technology (MIIT) posted the Opinions to promote the construction of optical fiber broadband network jointly issued by seven ministries, and set a target to invest a total RMB150b in fiber optical network construction over the next three years and add over 50m broadband subscribers. Also, Chinas 12th Five-Year Plan reiterated that China will promote FTTx in city areas and also accelerate broadband penetration in rural areas. Operators increasing broadband capex China Telecom and China Unicom are actively upgrading their broadband access network from DSL to FTTx. China Telecom has added extra RMB10b capex on broadband development, taking the total 2011 capex to RMB50b from RMB40b. In southern China it targets to achieve 8Mbps bandwidth in all cities, and over 70% of its broadband access in cities to achieve 20Mbps bandwidth in 2011. By 2013, China Telecom targets to achieve full coverage of 20Mbps bandwidth in cities, and FTTH with bandwidth of over 100Mbps to cover 80m families. China Unicom also targets to achieve 40m households of >20Mbps bandwidth by 2011. As the largest telecom infrastructure service provider and close partner of China Telecom and China Unicom, we believe CCS will benefit from the increasing broadband capex of China Telecom and China Unicom. Network convergence: Cable companies to catch up As network convergence is coming to the second year of its trial period, we are expecting to see more activities from cable companies. Within the 12 trial cities, eight are within CCSs geographic coverage, and it is already involved in some related projects. Though revenue from the cable industry still represents only a tiny portion of CCSs total revenue, we believe the company will also generate revenue from the cable industry, in addition to that from telecom operators on broadband networks.
3G network: Still far from completion

The three telecom operators have announced that their 3G networks have covered all county level and above cities in China. However, we believe this is still far from the
40 6
BNP PARIBAS
JOYCE ZHOU
CHINA COMSERVICE
3 JUNE 2011
completion of Chinas 3G network construction. The number of 3G base stations is only 403,000, compared to 2G base stations of 883,000 (Exhibit 5). Operators still need to improve coverage in second- and third-tier cities, and there is more to do on indoor coverage. Exhibit 5: China 3G base stations vs 2G base station 2010
('000) 600 500 400 300 200 100 0 China Mobile
Sources: China Mobile; China Unicom
Number of 2G base station
Number of 3G base station
China Unicom
The three China telecom operators have together allocated a combined capex of RMB67.5b on 3G networks during 2011, including RMB25b from China Mobiles parent company for TD-SCDMA network, RMB23b from China Telecoms parent company for CDMA2000 network, and RMB19.5b from China Unicom for WCDMA network (Exhibit 6). We believe 3G operators will continue to spend on 3G with the 3G subscriber growth and 3G coverage expansions. Exhibit 6: China 3G Capex: 2010 vs 2011E
(RMB b) 80 70 60 50 40 30 20 10 0 2010
Sources: China Mobile, China Unicom,China Telecom, BNP Paribas estimates
China Mobile parent company China Unicom
China Telecom parent company
2011E
Revenue from opex to offset capex slowdown

During 2008-09, total telecom capex in China increased significantly due to the 3G network build-out. In 2010, when China operators capex declined 14.2% y-y on 3G investment slowdown (Exhibit 7), operators opex excluding depreciation showed good growth of 10.9%, which completely offset the drop in capex.
41 7
BNP PARIBAS
JOYCE ZHOU
CHINA COMSERVICE
3 JUNE 2011
Exhibit 7: China telecom sector capex plus opex, 2005-13E

(RMB b) 1,200 1,000 800 600 400 200 0 2005 2006 2007 2008 2009 2010 2011 2012 2013 Capex Opex ex. depreciation
Sources: China Mobile; China Telecom; China Unicom; BNP Paribas estimates
In the next three years we believe China operators capex will remain high due to the continuous investment needs from both fixed and mobile networks. Meanwhile, we see higher growth from operators opex. Currently, under operator revenue, the majority of BPO and ACO revenues are coming from telecom operators opex. Exhibit 8: BPO revenue breakdown 2010 Exhibit 9: ACO revenue breakdown 2010
Facility management 12.3%
Maintenance 23.1%
Others 27.4%
IT applications 50.0% Voice VAS 13.4% Internet services 9.2%
Distribution 64.6%
Within operator revenue we expect the growth rates of BPO and ACO revenue to exceed that of TIS revenue in the next three years on the back of increasing revenue from operators opex (Exhibit 10). This is in line with CCSs strategy of transforming itself from being a labour-intensive company to being a tech- and service-intensive company. This would also help maintain or even improve margins, as the ACO business tends to generate higher margins than the TIS and BPO businesses.
42 8
BNP PARIBAS
JOYCE ZHOU
CHINA COMSERVICE
3 JUNE 2011
Exhibit 10: Operator revenue growth

(%) 14 12 10 8 6 4 2 0 2010 2011E 2012E 2013E TIS BPO & ACO
Sources: China ComService; BNP Paribas estimates
Expect healthy growth with market-share gains

We expect operator revenue to grow at high single digits in the next three years. We believe CCS will be able to maintain a 90% market share in China Telecoms projects thanks to its close relationship with them. We also expect contributions from China Mobile and China Unicom to increase gradually on market-share gains on their projects. Exhibit 11: Operator revenue forecast by customer
(RMB m) 40,000 35,000 30,000 25,000 20,000 15,000 10,000 5,000 0 2008 2009 2010 2011E 2012E 2013E China Telecom China Mobile & China Unicom
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BNP PARIBAS
JOYCE ZHOU
CHINA COMSERVICE
3 JUNE 2011
Multi-dimensional expansion
We believe CCSs incremental growth will come from multi-dimensional expansion. Since its listing in 2006, the company has expanded its business through several asset injections from its parent company, China Telecom Group, and acquisitions. Also, CCS has entered into the non-operator business and is aggressively exploring the overseas market.
Business expansion in the telecom industry

Since the IPO, CCS has completed acquisitions in every business segment to extend its geographic coverage and service portfolio. At the beginning of its separate listing, CCS only included operations in six provinces: Shanghai, Guangdong, Zhejiang, Fujian, Hubei and Hianan. In August 2007, China Telecom group injected the related businesses in 13 other provinces into CCS for a consideration of RMB4.6b. In 2008, CCS completed the acquisition of a 100% stake in China International Telecommunications Construction Corp (CITCC) for a consideration of RMB505m. The acquisition enhanced CCSs geographic coverage, as CITCC mainly operated the TIS business in 10 Northern provinces and had strong relationships with China Mobile and China Unicom. Exhibit 12: Geographic coverage
In May 2009, CCS announced the acquisition of equity interests in Guoxin Lucent (51%), Shanghai Tongmao Import & Export (95.95%) and Shenzhen Telecom Engineering (40%) for a total consideration of RMB115m. In April 2010, CCS acquired the remaining 49% stake in Guoxin Lucent. In 2009, CCS and Accenture also set up a joint venture (JV), China Communication Service Application Solution Technology Co, which focuses on telecom support software and service business. The series of corporate activity helped CCS complete the business lines from hardware import and export, to equipment installations, and also software supporting. Going forward, we believe the company will continue to look for good acquisition opportunities in operatorrelated areas. We see more such potential in the BPO and ACO segments as the
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CHINA COMSERVICE
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market in these two areas is more fragmented than in the TIS segment. The company is also involved in the tower-sharing projects led by SASAC and MIIT. Though the revenue contribution is very small as the tower-sharing project is still in trial period, we believe CCS is well positioned to provide this service if it is rolled out nationwide.
Next step focus: Expanding new markets

Non-operator markets In the past few years, CCS has actively diversified its revenue source and expanded its business into the non-operator markets. The acquisition of CITCC has also helped the company enter the government and enterprise markets, as around 40% of CITCCs revenue came from the non-operator markets at the time of acquisition. In the past two years, CCS has shown accelerating progress in the non-operator business. It has done several big projects for big events including the Shanghai World Expo, Guangzhou Asian Games and well-known enterprises. Exhibit 13: List of key non-operator projects
2009 Shanghai World Expo: Ancillary communications engineering projects Guangzhou Asian Games: Ancillary communications engineering projects Chow Tai Fook: Integrated network solutions for PRC stores (Phase I) A domestic cable company: One-stop supply service in network reconstruction Subway construction in major cities: Ancillary communications engineering projects 2010 Guangzhou Asian Games: Ancillary communications engineering projects Chow Tai Fook: Integrated network solutions for PRC stores (Phase II) China's national expressways: Communications cable relocation projects Ningbo International Finance Service Center: Weak current engineering system projects Yum! Brands, China: National network construction and video conference system build-up Xian Hi-Speed Co Ltd: Weak current engineering project Guangzhou Tian He Sports Center: Video monitoring system project Sichuan Wenchuan County Cable Network: Cable network reconstruction project after severe earthquake
We are positive on CCSs growth potential in the government and corporate IT market. Based on Gartner forecasts, government and enterprise IT spending in China will show 11.6% CAGR in the next five years, with highest growth coming from the software and IT services category, at 14.7% CAGR and 17.8% CAGR, respectively (Exhibit 14). Industry-wise, Gartner projects similar growth among different industries, all within the 10-13% range (Exhibit 15). Exhibit 14: Government and enterprise IT spending in China
(USD b) 180 160 140 120 100 80 60 40 20 0 2009
Source: Gartner (April 2011)
Hardware (LHS) Software (LHS) Telecommunications (LHS)
Internal services (LHS) IT services (LHS) Growth (RHS)
(%) 14 12 10 8 6 4 2 0
2010
2011E
2012E
2013E
2014E
2015E
45 11
BNP PARIBAS
JOYCE ZHOU
CHINA COMSERVICE
3 JUNE 2011
Exhibit 15: : Government and enterprise IT spending in China by industry

(USD b) 180 160 140 120 100 80 60 40 20 0 2009
Source: Gartner (April 2011)
Manu. & Natural Res. Banking & Securities
Comm., Media & Ser. Others
Government
2010
2011E
2012E
2013E
2014E
2015E
Overseas markets Back in 2007, CCS established China Communications Services (Hong Kong) International (CCSI) as its overseas business arm. The company is responsible for coordinating and supporting the overseas projects. Gartner estimates that developing markets such as Latin America, Middle East and Africa will enjoy higher-than-average network infrastructure expense growth in the next five years. The Asia Pacific region will also start to accelerate in 2011 (Exhibit 16). In addition to telecom-related projects, CCS is also involved in some overseas non-operator projects. Gartner data also shows that developing markets such as Latin America, the Middle East and Africa will enjoy aboveaverage government and enterprise IT spending growth than developed markets in the next five years (Exhibit 17). In our view, CCS has been focusing on the right markets (mainly Africa, the Middle East, Latin America, Hong Kong, Macau and Southeast Asia) where both telecom infrastructure investment and government and enterprise IT spending have higher growth potential and China equipment suppliers such as Huawei (privately held) and ZTE (763 HK) have higher market shares. Exhibit 16: Carrier network infrastructure expenses growth by region
(%) 10 8 6 4 2 0 (2) (4) (6) (8) (10) 2010
Source: Gartner
Asia/Pacific Latin America Western Europe
Eastern Europe Middle East & Africa
Japan North America
2011E
2012E
2013E
2014E
2015E
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BNP PARIBAS
JOYCE ZHOU
CHINA COMSERVICE
3 JUNE 2011
Exhibit 17: Government and enterprise IT spending growth by region

(%) 14 12 10 8 6 4 2 0 (2) (4) 2010
Source: Gartner
Asia/Pacific Latin America Western Europe
Eastern Europe Middle East & Africa
Japan North America
2011E
2012E
2013E
2014E
2015E
Currently, most of CCSs overseas projects are subcontracted projects from ZTE and Huawei. Only a few projects, such as the Congo and Tanzania projects, are turnkey and led by CCS. However, the company guides that it will try to win more turnkey projects as they generate higher margins (generally over 30% vs around 15% for the subcontracted projects). By end-2010, CCS had set up 27 overseas platforms to develop the overseas business (Exhibit 18) with more than 3,000 staff. In 2010, overseas revenue reached RMB2.2b and represented 5% of the companys total revenue. With the more completed overseas presence and the past years operating experience, we believe the companys overseas business will accelerate in the coming years, and represent over 10% of total revenue in 2013E. Exhibit 18: CCSI overseas subsidiaries
47 13
BNP PARIBAS
JOYCE ZHOU
CHINA COMSERVICE
3 JUNE 2011
Exhibit 19: Key overseas projects by CCS

Bahamas Yemen Tanzania Australia - New Zealand
Leisure venues - weak current engineering projects, mechanical and electrical engineering projects Campus intranet construction National fiber optic backbone & transmission network construction (Phase 1) Submarine cable projects
Expect non-operator growth to exceed operator market

Revenue from the non-operator market and the overseas market was nearly RMB16b in 2010 (+32.7% y-y), together contributing 35.1% of the companys total revenue. We believe non-operator revenue will continue to grow faster than operator revenue with over 20% y-y growth in the next three years. By 2013, we estimate non-operator revenue will contribute 43.8% to total revenue. Exhibit 20: Operator revenue vs non-operator revenue
(%) 100 90 80 70 60 50 40 30 20 10 0 2006 2007 2008 2009 2010 2011E 2012E 2013E Non-operator revenue as % of total revenue Operator revenue as % of total revenue
Announced share placement funding for future growth

Given the increasing funding needs for the non-operator and overseas markets, CCS announced plans in March 2011 to issue rights shares to raise up to RMB6b, mainly for expansion and M&A. However, on 9 May, the company made another announcement and trimmed down the rights issue size from up to 4 rights shares for every 10 existing shares to up to 2 rights shares for every 10 existing shares. The total fund raising size was also adjusted down to no more than RMB4b. CCS maintained its initial plans of proceed usage, but cut the RMB1b spending planned for general corporate purposes. The company guides that the gap of RMB1b will be financed through debt financing. Exhibit 21: Proposed use of proceeds
Up to RMB2.0b Groups overseas expansion as well as the continuing development of nontelecommunications operator businesses in our domestic markets, including the initial deployment of capital and ongoing financial resources required for our projects, such as the purchase of equipment Potential acquisition of strategic assets and joint venture opportunities Groups operations centre and investment in research and development and related infrastructure
Up to RMB1.5b Up to RMB1.5b
The company has got the SASACs approval for the rights issue, but still needs to get approvals from shareholders and the CSRC. We believe CCS needs more working capital to bid for big overseas projects on its own (compared to subcontracting projects for ZTE and Huawei), as most of such projects require initial capital and continued spending before revenue starts coming in. On the acquisition side, CCS is targeting several business segments including submarine cable construction and maintenance.
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BNP PARIBAS
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CHINA COMSERVICE
3 JUNE 2011
There are also several JV opportunities under discussion in the ACO segment. On the R&D side, the company plans to focus on 4G technology, cloud computing and wireless broadband technology. The proceeds will be mainly used for the BPO and ACO businesses and also for the non-operator/overseas markets, where the company sees greater growth potential. We believe the proposed capital raising will further strengthen CCSs financial position and prepare it for future growth. The company expects the rights issue to be completed in 3Q11. Our model currently does not account for the proposed rights issue as it is still pending approvals. Assuming the deal is closed at the end of 3Q11 with the maximum of 2 rights shares per 10 existing shares, we estimate EPS dilution of 4.8% for 2011 and 16.7% for 2012-13. However, this does not factor in revenue from possible acquisition and other corporate activity.
Stable margin outlook

CCS has set a clear internal target of maintaining gross margin of over 16% in the long run. The new business expansion and potential acquisitions will be benchmarked against this target. We forecast the companys gross margin will be stable in the range of 16.6-17.1% through 2013. Key items in COGS include purchase of materials and products, subcontracting charges and direct personnel costs, representing 29.7%, 26.2% and 16.4% of total revenue respectively in 2010 (Exhibit 22). For the next three years, we forecast CCSs direct personnel cost as a percentage of total revenue will decline and that subcontracting charges will increase, as the companys transforms itself into a tech- and service-intensive model. Exhibit 22: COGS breakdown (as % of revenue)
(%) 90 80 70 60 50 40 30 20 10 0 2005 2006 2007 2008 2009 2010 2011E 2012E 2013E Depreciation and amortization Purchase of materials & products Operating lease charges and others Direct personnel costs Subcontracting charges
49 15
BNP PARIBAS
JOYCE ZHOU
CHINA COMSERVICE
3 JUNE 2011
Healthy outlook initiate at BUY

We believe the China telecom operators will maintain their capex in broadband and 3G network in the next few years and that the opex of telecom companies will increase. As a leading telecom infrastructure service provider in China, we believe CCS will be able to maintain stable revenue growth from the operator market. In addition, we see higher growth potential from the non-operator and overseas businesses on the back of continuous investments. We estimate CCSs reported EPS at RMB0.36 for 2011, RMB0.40 for 2012, and RMB0.46 for 2013. We have not included the rights issue in our model as it is still pending approval. We set our DCF-based target price at HKD6.06, assuming WACC of 10% and terminal growth of 2%, same as our assumptions for the telecom sector. Our target price translates into 14.0x 2011E P/E. The stock trades at 11.1x 2011E P/E and 9.9x 2012E P/E. Exhibit 23: DCF assumptions
WACC (%) Mid-term revenue growth (%) Mid-term EBIT margin (%) Mid-term tax rate (%) 8.8 5.0 23.0 Terminal growth (%) Terminal EBIT margin (%) Terminal tax rate (%) 10.0 2.0 5.0 25.0
Target price (HKD)

Source: BNP Paribas estimates
6.06
Risk to our investment case

The rights issue is still pending shareholders approval, and the total amount and price are still not decided. The rights issue would lead to EPS dilution and, if the issue price is much lower than the trading price, it would be a downside risk for the share price. As the companys overseas expansion is mainly focused on developing countries in Africa, the Middle East, Latin America and the Southeast Asia regions, there may be risk of revenue delay. Exhibit 24: P/E band chart
(HKD) 16 14 12 10 8 6 4 2 0 Dec-06 15x 10x 4 1.0x 2 0 Dec-06 30x 25x 20x 6
Exhibit 25: P/BV band chart

(HKD) 12 10 8 3.0x 2.5x 2.0x 1.5x
Jan-08
Feb-09
Mar-10
Apr-11
Jan-08
Feb-09
Mar-10
Apr-11
50 16
BNP PARIBAS
JOYCE ZHOU
CHINA COMSERVICE
3 JUNE 2011
Exhibit 26: Corporate structure
China Telecommuncations Corp 52.60%
China Mobile Communications Corp 8.78%
China United Network Communications Group Co Ltd 4.09%
Public Shareholders
34.53%
China Communications Services Corp Ltd
100% Guangdong Communications Services Co Ltd Zhejiang Communications Services Co Ltd 100% Shanghai Communications Services Co Ltd Fujian Communications Services Co Ltd 100% Hubei Communications Services Co Ltd Jiangsu Communications Services Co Ltd 100% Anhui Communications Services Co Ltd Jiangxi Communications Services Co Ltd 100% Hunan Communications Services Co Ltd Guangxi Communications Services Co Ltd 100% Chongqing Communications Services Co Ltd Sichuan Communications Services Co Ltd 100% Guizhou Communications Services Co Ltd Yunnan Communications Services Co Ltd 100% Shaanxi Communications Services Co Ltd Gansu Communications Services Co Ltd 100% Qinghai Communications Services Co Ltd Xinjiang Communications Services Co Ltd China International Telecommunications Communications Corp Guoxin Lucent Technologies Network Technologies Co Ltd 100% 100% China Communications Services (Hong Kong) International Ltd 100% 100% 100% 100% 100% 100% 100% 100%
100%
100%
51 17
BNP PARIBAS
JOYCE ZHOU
CHINA COMSERVICE
3 JUNE 2011
Exhibit 27: Management profile

Li Ping Executive Director (Chairman). Mr Li is also Vice President of China Telecommunications Corp and Executive Vice President of China Telecom Corp. Prior to joining China Telecommunications Corp in August 2000, Mr Li served as Chairman and Chief Executive Officer of China Telecom (Hong Kong) International, Vice Chairman and Chief Operating Officer of China Mobile and Deputy Director General of the Directorate General of Telecommunications (DGT) of the former Ministry of Posts and Telecommunications (MPT) of the PRC. Mr Li graduated from the Beijing Institute of Posts and Telecommunications in 1976 with a major in Radio Telecommunications. He also received an MBA degree from the State University of New York at Buffalo, US in 1989. Mr Li has extensive administrative experience in the management of listed companies and has 35 years of operational and managerial experience in the telecommunications industry in China. Executive Director (President). Mr Zheng is also a Managing Director of the Sideline Industrial Management Department of China Telecommunications Corp. Mr Zheng previously served as a Managing Director of Shanghai Telecom Corp and Dean of China Telecom Corp Shanghai Research Institute, Executive Vice Dean of China Telecom Corp Beijing Research Institute and the Managing Director of the Corporate Strategy Department of China Telecommunications Corp. Prior to that, Mr Zheng served as Deputy General Engineer of Shanghai Posts and Telecommunications Bureau, Dean of Shanghai Telecom Technology Research Institute and General Manager of Shanghai Telecom Long Distance Communication Division. Mr Zheng graduated from Shanghai Second Polytechnic University in 1986 and received a bachelor degree in mechanical engineering, received an EMBA degree from China Europe International Business School in 1998, and a doctoral degree in Political Economics from Fudan University in 2003. Mr Zheng has 33 years of operational and managerial experience in the telecommunications industry in China. Executive Director (Executive Vice President). Mr Yuan is also the Deputy Managing Director of the Sideline Industrial Management Department of China Telecommunications Corp and the Chairman of China Satcom Guomai Communications Co. Until 30 December 2010, Mr Yuan was the Chief Financial Officer of the company. Prior to that, he served as the Deputy Director of Finance Department of Shanxi Provincial Post and Telecommunications Bureau, the General Manager of Shanxi Provincial Posts and Telecommunications Industrial Co, Director of Xinzhou Posts and Telecommunications Bureau in Shanxi Province, the General Manager of Taiyuan Branch of Shanxi Telecom Co, Deputy General Manager of Shanxi Telecom Co, Deputy Managing Director of the Sideline Industrial Management Department of China Telecommunications Corp and Vice President and Chief Accountant of Hunan Telecom Co. Mr Yuan received an MBA degree from the Ukrainian-American Humanitarian Institute "Wisconsin International University (US) Ukraine" in 2002. Mr Yuan has over 33 years experience in the telecommunications industry. Executive Director (Executive Vice President & CFO). Prior to joining the company, Ms Hou was Deputy Managing Director of the Finance Department in China Telecommunications Corp. Prior to that, Ms Hou served as Divisional Director of General Finance Division and Budgeting Division of China Telecommunications Corp's Finance Department and Director and Chief Accountant of Guangxi Telecom Co. Ms Hou received a master degree in Management Engineering from Beijing University of Posts and Telecommunications in 1995 and a master degree in International Commercial Accounting from The University of New South Wales in 2002. Ms Hou has over 16 years experience in telecommunications industry and financial management. Non-executive Director. Mr. Liu is Executive Director and Vice President of China Mobile. He is also Vice President of China Mobile Communications Corp. Mr Liu previously served as Deputy Director General of Shandong Mobile Telecommunications Administration, Director General of Shandong Mobile Telecommunications Administration and General Manager of Shandong Mobile Communications Enterprises, Vice President of Shandong Mobile Communications Co, Director-General of the Network Department of China Mobile Communications Corp, Chairman and President of Shandong Mobile and Zhejiang Mobile. Mr Liu received a master of management degree and a doctoral degree in Business Administration. He is a professor-level senior engineer with over 28 years of management experience in the telecommunications industry. Non-executive Director. Mr Zhang is a member of Party Leadership Group, Vice President of China United Network Communications Group Co Ltd, a Senior Vice President of China Unicom (Hong Kong). Prior to joining China Unicom in December 2005, Mr Zhang served as Deputy General Manager and General Manager of the Anhui Provincial Telecommunication Co, and Chairman and General Manager of Anhui Provincial Telecommunication Co. Mr. Zhang had served as Director of Bengbu Municipal Posts and Telecommunications Bureau in Anhui province and Deputy Director of Anhui Provincial Posts and Telecommunications Bureau. Mr Zhang graduated from the Nanjing University of Posts and Telecommunications majoring in carrier communication in 1982, received a master degree in Business Administration from the National Australian University in 2002 and received a Doctor of Business Administration from Hong Kong Polytechnic University in October 2008. Mr Zhang has long and extensive management experience in the telecommunications industry.
Zheng Qibao
Yuan Jianxing
Hou Rui
Liu Aili
Zhang Junan
52 18
BNP PARIBAS
JOYCE ZHOU
CHINA COMSERVICE
3 JUNE 2011
FINANCIAL
STATEMENTS
China ComService
Profit and Loss (RMB m) Year Ending Dec
Revenue Cost of sales ex depreciation Gross profit ex depreciation Other operating income Operating costs Operating EBITDA Depreciation Goodwill amortisation Operating EBIT Net financing costs Associates Recurring non operating income Non recurring items Profit before tax Tax Profit after tax Minority interests Preferred dividends Other items Reported net profit Non recurring items & goodwill (net) Recurring net profit
Per share (RMB) Recurring EPS * Reported EPS DPS Growth Revenue (%) Operating EBITDA (%) Operating EBIT (%) Recurring EPS (%) Reported EPS (%) Operating performance Gross margin inc depreciation (%) Operating EBITDA margin (%) Operating EBIT margin (%) Net margin (%) Effective tax rate (%) Dividend payout on recurring profit (%) Interest cover (x) Inventory days Debtor days Creditor days Operating ROIC (%) Operating ROIC WACC (%) ROIC (%) ROIC WACC (%) ROE (%) ROA (%) * Pre exceptional, pre-goodwill and fully diluted
2009A
39,499 (32,518) 6,982 521 (4,768) 2,734 (610) 0 2,124 (88) 2 0 0 2,038 (427) 1,610 12 0 0 1,622 0 1,622 0.28 0.28 0.11 19.7 9.5 10.6 20.4 20.4 16.1 6.9 5.4 4.1 21.0 39.4 24.0 16.0 91.5 93.1 41.4 27.9 28.1 14.7 12.9 5.8
2010A
45,417 (37,396) 8,022 630 (5,698) 2,953 (623) 0 2,331 (58) 3 0 0 2,276 (460) 1,816 1 0 0 1,818 0 1,818 0.31 0.31 0.13 15.0 8.0 9.7 12.1 12.1 16.3 6.5 5.1 4.0 20.2 40.0 40.4 17.0 93.8 90.8 38.1 24.7 26.3 12.9 13.3 5.8
2011E
52,033 (42,878) 9,155 650 (6,574) 3,231 (543) 0 2,687 (58) 3 0 0 2,633 (553) 2,080 1 0 0 2,081 0 2,081 0.36 0.36 0.14 14.6 9.4 15.3 14.5 14.5 16.6 6.2 5.2 4.0 21.0 40.0 46.6 16.7 97.0 89.1 35.0 21.6 25.1 11.7 14.2 6.0
2012E
59,212 (48,666) 10,546 650 (7,590) 3,606 (598) 0 3,008 (58) 3 0 0 2,953 (620) 2,333 1 0 0 2,334 0 2,334 0.40 0.40 0.16 13.8 11.6 11.9 12.2 12.2 16.8 6.1 5.1 3.9 21.0 40.0 52.2 16.8 97.3 89.3 34.9 21.5 25.9 12.5 14.9 6.1
2013E
67,038 (54,915) 12,123 650 (8,718) 4,055 (659) 0 3,396 (58) 3 0 0 3,341 (702) 2,639 1 0 0 2,641 0 2,641 0.46 0.46 0.18 13.2 12.4 12.9 13.1 13.1 17.1 6.0 5.1 3.9 21.0 40.0 58.9 16.8 97.5 89.5 35.2 21.8 26.9 13.5 15.7 6.2
We expect stable margins for next three years
Revenue By Division (RMB m)

TIS BPO ACO
Sources: CCS; BNP Paribas estimates
2009A
19,289 15,943 4,267
2010A
21,637 18,508 5,272
2011E
24,607 21,099 6,326
2012E
27,667 23,954 7,592
2013E
31,208 26,720 9,110
53 19
BNP PARIBAS
JOYCE ZHOU
CHINA COMSERVICE
3 JUNE 2011
China ComService
Cash Flow (RMB m) Year Ending Dec
Recurring net profit Depreciation Associates & minorities Other non-cash items Recurring cash flow Change in working capital Capex - maintenance Capex new investment Free cash flow to equity Net acquisitions & disposals Dividends paid Non recurring cash flows Net cash flow Equity finance Debt finance Movement in cash Per share (RMB) Recurring cash flow per share FCF to equity per share
2009A
1,622 610 0 (7) 2,225 (516) (725) 0 984 0 (309) (89) 585 0 (602) (17) 0.39 0.17
2010A
1,818 623 0 (55) 2,385 (1,669) (820) 0 (104) 0 (1,298) (235) (1,637) 0 437 (1,200) 0.41 (0.02)
2011E
2,081 543 0 0 2,625 (749) (850) 0 1,025 0 (727) 0 298 0 0 298 0.45 0.18
2012E
2,334 598 0 0 2,933 (818) (950) 0 1,165 0 (833) 0 333 0 0 333 0.51 0.20
2013E
2,641 659 0 0 3,300 (904) (1,050) 0 1,347 0 (934) 0 413 0 0 413 0.57 0.23
We have not factored in the up to RMB4b rights issue as it is still pending approvals from shareholders and the regulator
Balance Sheet (RMB m) Year Ending Dec
2009A
2010A
2011E
2012E
24,620 (22,938) 1,682 5,138 6,820 103 152 633 1,372 9,079 (9,098) 1,781 0 (7,318) 0 32 16,233 133 9,079
2013E
27,828 (25,876) 1,952 5,679 7,631 103 152 633 1,372 9,891 (9,510) 1,781 0 (7,729) 0 32 17,455 133 9,891
Working capital assets 15,428 18,958 21,673 Working capital liabilities (15,681) (17,702) (20,217) Net working capital (253) 1,256 1,456 Tangible fixed assets 3,986 4,180 4,636 Operating invested capital 3,733 5,436 6,092 Goodwill 103 103 103 Other intangible assets 148 152 152 Investments 318 633 633 Other assets 1,308 1,372 1,372 Invested capital 5,611 7,696 8,352 Cash & equivalents (8,870) (8,470) (8,767) Short term debt 1,268 1,781 1,781 Long term debt * 0 0 0 Net debt (7,602) (6,690) (6,986) Deferred tax 0 0 0 Other liabilities 36 32 32 Total equity 13,069 14,221 15,174 Minority interests 109 133 133 Invested capital 5,611 7,696 8,352 * includes convertibles and preferred stock which is being treated as debt
Per share (RMB) Book value per share Tangible book value per share Financial strength Net debt/equity (%) Net debt/total assets (%) Current ratio (x) CF interest cover (x)
2.26 2.22 (57.7) (25.2) 1.4 12.1
2.46 2.42 (46.6) (19.8) 1.4 (0.8)
2.63 2.58 (45.6) (18.7) 1.4 18.8
2.81 2.77 (44.7) (17.8) 1.4 21.2
3.02 2.98 (43.9) (17.1) 1.4 24.3
Valuation
2009A
2010A
2011E
2012E
9.9 12.5 9.9 4.0 7.9 19.8 1.4 1.4 4.5 5.6 1.8
2013E
8.8 11.0 8.8 4.6 7.0 17.2 1.3 1.3 3.9 4.9 1.6
Recurring P/E (x) * 14.3 12.7 11.1 Recurring P/E @ target price (x) * 18.0 16.0 14.0 Reported P/E (x) 14.3 12.7 11.1 Dividend yield (%) 2.8 3.1 3.6 P/CF (x) 10.4 9.7 8.8 P/FCF (x) 23.5 (222.7) 22.5 Price/book (x) 1.8 1.6 1.5 Price/tangible book (x) 1.8 1.7 1.5 EV/EBITDA (x) ** 5.9 5.4 5.1 EV/EBITDA @ target price (x) ** 7.4 6.8 6.4 EV/invested capital (x) 2.8 2.2 1.9 * Pre exceptional, pre-goodwill and fully diluted ** EBITDA includes associate income and recurring non-operating income
Sources: CCS; BNP Paribas estimates
54 20
BNP PARIBAS
ZTE Corp
763 HK
CHINA / TECHNOLOGY HARDWARE & EQUIPMENT
HKD31.00 HKD31.00 HKD27.05 +14.6%
HOLD
UNCHANGED
HOW WE DIFFER FROM THE STREET

BNP Consensus Target Price (HKD) EPS 2011 (RMB) EPS 2012 (RMB) 31.00 1.05 1.19 Positive Market Recs. 20 31.87 1.14 1.39 Neutral 12 % Diff (2.7) (7.9) (14.4) Negative 1
INDUSTRY OUTLOOK
NEW INFORMATION
Near-term soft patch

Benefits from optical network upgrades, key driver for ZTE Overall growth dragged by slower wireless contracts Strong handset growth, but negative impact on GM Maintain HOLD with target price of HKD31.00
KEY STOCK DATA

YE Dec (RMB m) Revenue Rec. net profit Recurring EPS (RMB) Prior rec. EPS (RMB) Chg. In EPS est. (%) EPS growth (%) Recurring P/E (x) Dividend yield (%) EV/EBITDA (x) Price/book (x) Net debt/Equity ROE (%) 2011E 87,361 3,456 1.05 1.05 N/A (0.9) 21.4 0.9 10.9 2.6 (6.1) 13.5 2012E 102,323 4,099 1.19 1.19 N/A 13.1 18.9 1.1 10.1 2.4 (9.0) 13.5 2013E 113,585 4,842 1.41 1.41 N/A 18.1 16.0 1.2 9.0 2.0 (13.2) 13.7
Optical upgrade beneficiary

We expect optical communications to be the main profit growth driver for ZTE in the next one to two years, supported by Chinas continuing investments to upgrade its fixed-line broadband networks. As ZTE is a relatively new supplier for these products, we expect combined revenue for this category to show strong growth. For 2011, we estimate revenue of RMB25.5b (29% of total revenue), a 36% y-y increase. Growth in this category should offset the lower revenue we forecast for domestic wireless networks, leading to stable total domestic revenue for 2011E.
Alen Lin
Joyce Zhou
(HKD) 30 25 20 15 10 May-10
ZTE Corp Rel to MSCI China
(%) 31 11 (9) May-11

12 Month 28.8 12.8 July 2011 11,404 22.0 64
Slower wireless contracts dampen growth potential

We believe ZTEs recent contract wins have slowed, including in India, where we believe European vendors Ericsson (ERICB SS, Not rated) and NSN (Not listed) continue to dominate. Local media reports indicate that ZTE may have secured 12 of the 68 circles awarded. This would be consistent with our previous expectation that ZTE would secure ~20% of contracts. We estimate India will contribute 7% to ZTEs 2011 revenue, vs 5% in 2010. As market share for mobile networks tends to shift with major technology upgrades, such as 2G to 3G in India, we expect ZTEs global market share gain to slow in the next one to two years until the next major wireless upgrade cycle accelerates.
Aug-10
Nov-10
1 Month (0.9) (0.8)
Feb-11
3 Month (4.1) (13.6)
Strong handset growth a mixed blessing

While we expect ZTEs terminal device growth to remain strong at 22.7% y-y in 2011, this segments below-average GM has a negative impact on overall margins. In 2010, terminal device GM declined to 20.3% (from 25.3% in 2009), due to severe margin pressure on USB data modem products; the category contributed 25.5% to ZTEs 2010 revenue. With increasing 3G handsets and smartphones in 2011, we estimate GM will rebound to 21.5%. However, this is still below the GM for network products, which ranges between 30% and 40%.
Sources : Bloomberg consensus; BNP Paribas estimates
Zhongxingxin (36%) 30.50/18.88 31.8 -
Maintain HOLD with TP of HKD31.00

We maintain our 2011-13 EPS of RMB1.05/RMB1.19/RMB1.41. We also leave our target price of HKD31.00 and HOLD rating; our target price is based on a 25x forward P/E multiple. While we believe ZTE could be a beneficiary of the optical network upgrades in China, we believe the slower growth in its wireless network business will limit its upside potential. We believe the next wireless network upgrade cycle could be the next catalyst for share price appreciation.
RECENT COMPANY & SECTOR RESEARCH

Awaiting new growth cycle ...............................18 Apr 2011 Revenue source diversifies.............................. 18 Mar 2011 Win8 extends ecosystem ................................... 2 Jun 2011 Time to evolve ..................................................... 2 Jun 2011
55
3 June 2011
ALEN LIN
ZTE CORP
3 JUNE 2011
Base Year-end 31 Dec Net sales (RMB m) EPS (RMB) Change (%) 2011E 2012E
Best 2011E 2012E
Worse 2011E 82,993 1.00 (4.9) 2012E 97,207 1.14 (4.5)

Downside risk: India 3G roll-out, margin risks due to competitive pressure, and China network contract allocation and profitability. Poor handset profitability. Upside risk: Strong growth of optical network would have a positive impact on margins.
87,361 102,323 1.05 1.19
91,729 107,439 1.11 4.9 1.25 4.5
ZTE Corp and MXCN Index (3M and 6M realised-vol)

(%)
Regression ZTE Corp to MXCN Index

30.00% 20.00%
140 120
ZTE Corp
10.00% 0.00% -2.00% -10.00% -20.00% -30.00% -40.00% MSCI China ZTE Corp = 3 + 0.2199 * MXCN Index R Square = 0.3505 Regression based on 261 observations of 5 years weekly data. Please refer to Appendix 1 for the explanation of R-square Sources: Bloomberg; BNP Paribas
100 80 60 40 20 0 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10
-22.00% -17.00% -12.00% -7.00%
3.00%
8.00%
13.00%
18.00%
ZTE Corp - 3M Realised - Vol MSCI China - 3M Realised - Vol
ZTE Corp - 6M Realised - Vol MSCI China - 6M Realised - Vol

Insurance 0.77 1.00
Metal & Mining 0.78 0.76 1.00
Oil & Gas 0.81 0.79 0.82 1.00
Property 0.73 0.67 0.70 0.64 1.00
Telecom 0.71 0.69 0.69 0.76 0.55 1.00
Utilities 0.61 0.61 0.63 0.64 0.54 0.61 1.00
Coal 0.78 0.76 0.84 0.83 0.67 0.68 0.56 1.00
1.00
Long/short chart
(x) 9.352559749 8.352559749 7.352559749 6.352559749 5.352559749 4.352559749 3.352559749 Apr-10 +2s +1s Mean -1s -2s Oct-10
ZTE Corp - O-NET
The risk experts
The Risk Experts

Apr-11
56 2
BNP PARIBAS
ALEN LIN
ZTE CORP
3 JUNE 2011
FINANCIAL
STATEMENTS
ZTE Corp
Profit and Loss (RMB m) Year Ending Dec
Revenue Cost of sales ex depreciation Gross profit ex depreciation Other operating income Operating costs Operating EBITDA Depreciation Goodwill amortisation Operating EBIT Net financing costs Associates Recurring non operating income Non recurring items Profit before tax Tax Profit after tax Minority interests Preferred dividends Other items Reported net profit Non recurring items & goodwill (net) Recurring net profit Per share (RMB) Recurring EPS * Reported EPS DPS Growth Revenue (%) Operating EBITDA (%) Operating EBIT (%) Recurring EPS (%) Reported EPS (%)
2009A
60,273 (40,896) 19,376 0 (15,675) 3,702 (772) 0 2,930 (641) 0 1,036 0 3,325 (629) 2,696 (238) 0 0 2,458 0 2,458 0.82 0.82 0.20 36.1 9.4 4.8 41.3 41.3
2010A
70,264 (47,731) 22,532 0 (18,506) 4,026 (868) 0 3,159 (628) 0 1,829 0 4,360 (884) 3,476 (226) 0 0 3,250 0 3,250 1.06 1.06 0.21 16.6 8.8 7.8 29.9 29.9 30.8 5.7 4.5 4.6 20.3 20.0 7.9 81.9 157.3 200.1 16.0 6.5 16.2 6.7 16.3 5.1
2011E
87,361 (59,401) 27,960 0 (22,626) 5,333 (1,158) 0 4,175 (700) 0 1,210 0 4,685 (898) 3,786 (330) 0 0 3,456 0 3,456 1.05 1.05 0.21 24.3 32.5 32.2 (0.9) (0.9) 30.7 6.1 4.8 4.0 19.2 20.0 7.7 83.5 154.9 195.1 17.5 7.9 14.0 4.4 13.5 4.7
2012E
102,323 (70,065) 32,258 0 (26,399) 5,859 (1,164) 0 4,694 (700) 0 1,585 0 5,580 (1,150) 4,429 (330) 0 0 4,099 0 4,099 1.19 1.19 0.24 17.1 9.9 12.4 13.1 13.1 30.4 5.7 4.6 4.0 20.6 20.0 9.0 85.5 159.2 199.7 17.3 7.7 14.1 4.6 13.5 4.6
2013E
113,585 (77,525) 36,059 0 (29,305) 6,754 (1,170) 0 5,585 (700) 0 1,616 0 6,501 (1,329) 5,172 (330) 0 0 4,842 0 4,842 1.41 1.41 0.28 11.0 15.3 19.0 18.1 18.1 30.7 5.9 4.9 4.3 20.4 20.0 10.3 87.9 163.2 205.3 18.9 9.3 14.8 5.2 13.7 4.7
RMB440m contribution from disposal of non-core investments
Operating performance Gross margin inc depreciation (%) 30.9 Operating EBITDA margin (%) 6.1 Operating EBIT margin (%) 4.9 Net margin (%) 4.1 Effective tax rate (%) 18.9 Dividend payout on recurring profit (%) 24.4 Interest cover (x) 6.2 Inventory days 81.7 Debtor days 142.1 Creditor days 191.1 Operating ROIC (%) 18.8 Operating ROIC WACC (%) 9.3 ROIC (%) 18.3 ROIC WACC (%) 8.7 ROE (%) 15.8 ROA (%) 5.3 * Pre exceptional, pre-goodwill and fully diluted
Revenue By Division (RMB m)

Carrier networks Terminal SW systems and services
Sources: ZTE Corp; BNP Paribas estimates
2009A
39,982 13,072 7,219
2010A
41,990 17,927 10,346
2011E
53,861 22,000 11,500
2012E
61,923 26,000 14,400
2013E
71,485 30,000 12,100
57 3
BNP PARIBAS
ALEN LIN
ZTE CORP
3 JUNE 2011
ZTE Corp
Cash Flow (RMB m) Year Ending Dec
Recurring net profit Depreciation Associates & minorities Other non-cash items Recurring cash flow Change in working capital Capex - maintenance Capex new investment Free cash flow to equity Net acquisitions & disposals Dividends paid Non recurring cash flows Net cash flow Equity finance Debt finance Movement in cash Per share (RMB) Recurring cash flow per share FCF to equity per share
2009A
2,458 772 0 0 3,230 (3,117) 0 (1,591) (1,478) 0 (447) 2,308 383 22 2,310 2,715 1.08 (0.49)
2010A
3,250 868 0 0 4,118 (4,135) 0 (1,869) (1,886) 0 (630) (906) (3,421) 3,913 375 867 1.35 (0.62)
2011E
3,456 1,158 0 0 4,614 (4,066) 0 (1,200) (652) 0 (698) 1,636 286 0 0 286 1.41 (0.20)
2012E
4,099 1,164 0 0 5,264 (3,491) 0 (1,200) 573 0 (725) 1,487 1,335 0 0 1,335 1.53 0.17
2013E
4,842 1,170 0 0 6,011 (2,816) 0 (1,200) 1,996 0 (820) 964 2,140 0 0 2,140 1.75 0.58
Capex-to-sales ratio has remained less than 5% for recent years and we expect it to decline gradually as it benefits from greater economy of scale
Balance Sheet (RMB m) Year Ending Dec
2009A
2010A
2011E
2012E
75,834 (61,073) 14,761 7,798 22,559 0 1,583 1,301 11,715 37,156 (16,526) 7,901 5,475 (3,150) 0 5,501 32,812 1,993 37,156
2013E
84,087 (67,475) 16,613 7,828 24,441 0 1,583 1,321 13,004 40,348 (18,666) 7,901 5,475 (5,289) 0 5,501 37,809 2,327 40,348
Working capital assets 42,652 51,996 64,682 Working capital liabilities (35,371) (41,670) (51,925) Net working capital 7,280 10,327 12,757 Tangible fixed assets 6,058 7,720 7,762 Operating invested capital 13,338 18,047 20,519 Goodwill 0 0 0 Other intangible assets 877 1,583 1,583 Investments 694 1,261 1,281 Other assets 5,108 8,044 10,002 Invested capital 20,018 28,934 33,384 Cash & equivalents (14,076) (14,905) (15,191) Short term debt 6,846 7,901 7,901 Long term debt * 6,029 5,475 5,475 Net debt (1,200) (1,529) (1,815) Deferred tax 0 0 0 Other liabilities 3,269 5,501 5,501 Total equity 16,825 23,094 27,994 Minority interests 1,124 1,868 1,704 Invested capital 20,018 28,934 33,384 * includes convertibles and preferred stock which is being treated as debt Per share (RMB) Book value per share Tangible book value per share Financial strength Net debt/equity (%) Net debt/total assets (%) Current ratio (x) CF interest cover (x) 5.61 5.31 (6.7) (1.7) 1.3 1.2 7.56 7.04 (6.1) (1.8) 1.3 1.0 8.54 8.05 (6.1) (1.8) 1.3 1.8
9.54 9.08 (9.0) (2.7) 1.3 3.5
10.99 10.53 (13.2) (4.2) 1.4 5.6
Valuation
2009A
2010A
2011E
2012E
18.9 21.7 18.9 1.1 14.7 135.3 2.4 2.5 10.1 10.6 2.1
2013E
16.0 18.3 16.0 1.2 12.9 38.8 2.0 2.1 9.0 9.5 1.8
Recurring P/E (x) * 27.5 21.2 21.4 Recurring P/E @ target price (x) * 31.5 24.3 24.5 Reported P/E (x) 27.5 21.2 21.4 Dividend yield (%) 0.9 0.9 0.9 P/CF (x) 20.9 16.7 16.0 P/FCF (x) (45.7) (36.5) (113.3) Price/book (x) 4.0 3.0 2.6 Price/tangible book (x) 4.2 3.2 2.8 EV/EBITDA (x) ** 13.9 11.7 10.9 EV/EBITDA @ target price (x) ** 14.6 12.2 11.4 EV/invested capital (x) 3.4 2.4 2.2 * Pre exceptional, pre-goodwill and fully diluted ** EBITDA includes associate income and recurring non-operating income
Sources: ZTE Corp; BNP Paribas estimates
58 4
BNP PARIBAS
ALEN LIN
3 JUNE 2011
BNP Paribas Telecoms, Media & Technology Research Team

WEIYEE IN
Telecoms, Media & Technology Strategy BNP Paribas Securities (Asia) Ltd +852 2825 1813 weiyee.in@asia.bnpparibas.com
SUN CHUNG
Head of Research, Korea BNP Paribas Securities Korea Co Ltd +822 2125 0532 sun.chung@asia.bnpparibas.com.
CHARLES CHENG, CFA

Technology Strategy BNP Paribas Securities (Asia) Ltd +852 2825 1825 charles.cheng@asia.bnpparibas.com
SZEHO NG, CFA

Packaging & Testing, Foundry, Displays BNP Paribas Securities (Asia) Ltd +852 2825 1167 szeho.ng@asia.bnpparibas.com
PETER YU, CFA

Semiconductors, Displays, Handsets BNP Paribas Securities Korea Co Ltd +822 2125 0535 peter.yu@asia.bnpparibas.com
ALEN LIN
Telecom Services and Equipment BNP Paribas Securities (Asia) Ltd +852 2825 1801 alen.lin@asia.bnpparibas.com
FOONG CHOONG CHEN

ASEAN Telecom BNP Paribas Capital (Malaysia) Sdn. Bhd. +603 2050 9938 choongchen.foong@asia.bnpparibas.com
DOUGLAS KIM
Alternative Energy BNP Paribas Securities Korea Co Ltd +822 2125 0540 douglas.kim@asia.bnpparibas.com
YVONNE YANG
Internet BNP Paribas Equities (Asia) Ltd Shanghai Representative Office +8621 6096 9046 yvonne.q.yang@asia.bnpparibas.com
ABHIRAM ELESWARAPU
Software & Services BNP Paribas Securities India Pvt Ltd +91 22 6628 2406 abhiram.eleswarapu@asia.bnpparibas.com
AVINASH SINGH
Tech - IT (Associate) BNP Paribas Securities India Pvt Ltd +91 22 6628 2407 avinash.singh@asia.bnpparibas.com
SAMEER NARINGREKAR
Tech - Telecom BNP Paribas Securities India Pvt Ltd +91 22 6628 2454 sameer.naringrekar@asia.bnpparibas.com
SCOTT FOSTER
Technology BNP Paribas Securities Japan +81 3 6377 2240 scott.foster@japan.bnpparibas.com
KEI RAMEAU
Technology BNP Paribas Securities (Japan) Ltd +81 3 6377 2232 kei.rameau@japan.bnpparibas.com
HENRY AI
IT Service BNP Paribas Securities (Asia) Ltd Shanghai Representative Office +8621 6069 9037 henry.ai@asia.bnpparibas.com
JOYCE ZHOU
Telecom Services and Equipment BNP Paribas Securities (Asia) Ltd +852 2825 1120 joyce.zhou@asia.bnpparibas.com
HIROSHI YAMASHINA
Telecoms and Internet BNP Paribas Securities Japan +81 3 6377 2235 hiroshi.yamashina@japan.bnpparibas.com
VIVIAN WAN
Telecoms BNP Paribas Securities Japan +81 3 6377 2239 vivian.wan@japan.bnpparibas.com
CHARLES HSU
Displays, Touch Panels, LED BNP Paribas Securities (Taiwan) Co Ltd + 886 2 8729 7055 charles.hsu@asia.bnpparibas.com
LAURA CHEN
Handset/Hardware BNP Paribas Securities (Taiwan) Co Ltd +886 2 8729 7052 laura.chen@asia.bnpparibas.com
PATTY LIU
PC/Downstream BNP Paribas Securities (Taiwan) Co Ltd +886 2 2175 7049 patty.liu@asia.bnpparibas.com
KYNA WONG
Research Associate BNP Paribas Securities (Asia) Ltd +852 2825 1823 kyna.wong@asia.bnpparibas.com
KUNAL VORA, CFA

Research Associate BNP Paribas Securities India Pvt Ltd +91 22 6628 2453 kunal.d.vora@asia.bnpparibas.com
YIFAN LAI
Research Associate BNP Paribas Securities (Taiwan) Co Ltd +886 2 8729 7056 yifan.lai@asia.bnpparibas.com
YOUNG SHIN
Research Associate BNP Paribas Securities Korea Co Ltd +822 2125 0546 young.shin@asia.bnpparibas.com
JAMES WANG
Research Associate BNP Paribas Securities (Taiwan) Co Ltd +886 2 8729 7058 james.m.wang@asia.bnpparibas.com
KYUN JANG
Research Associate BNP Paribas Securities Korea Co Ltd +822 2125 0537 kyun.jang@asia.bnpparibas.com
59 20
BNP PARIBAS
ALEN LIN
3 JUNE 2011
HISTORY
OF
CHANGE
IN
INVESTMENT
RATING
AND/OR
TARGET
PRICE
ZTE Corp (763 HK)
(HKD) 34.00 29.00 24.00 19.00 14.00 9.00 4.00 Jun-07
ZTE Corp
Target Price
Date 1-Apr-07 16-Nov-07
Reco HOLD BUY
TP 14.83 12.50
Jun-08
Jun-09
Jun-10
Jun-11
Alen Lin started covering this stock from 16 September 2009 Price and TP are in local currency Valuation and risks: Risks to our P/E-based TP are India 3G rollout and margin risks due to competitive pressure and China network contract allocation and profitability. Sources: Bloomberg, BNP Paribas
60 21
BNP PARIBAS
ALEN LIN
3 JUNE 2011
NOTES
61 22
BNP PARIBAS
ALEN LIN
3 JUNE 2011
DISCLAIMERS
&
DISCLOSURES
ANALYST(S) CERTIFICATION Alen Lin, BNP Paribas Securities (Asia) Ltd, +852 2825 1801, alen.lin@asia.bnpparibas.com. Joyce Zhou, BNP Paribas Securities (Asia) Ltd, +852 2825 1120, joyce.zhou@asia.bnpparibas.com. The analyst(s) or strategist(s) herein each referred to as analyst(s) named in this report certifies that (i) all views expressed in this report accurately reflect the personal view of the analyst(s) with regard to any and all of the subject securities, companies, or issuers mentioned in this report; (ii) no part of the compensation of the analyst(s) was, is, or will be, directly or indirectly, relate to the specific recommendation or views expressed herein; and (iii) is not aware of any other actual or material conflicts of interest concerning any of the subject securities companies, or issuers referenced herein as of the time of this certification. GENERAL DISCLAIMER This report was produced by BNP Paribas Securities (Asia) Ltd, a member company of the BNP Paribas Group. "BNP Paribas is the marketing 1 name for the global banking and markets business of BNP Paribas Group . This report is for the use of intended recipients only and may not be reproduced (in whole or in part) or delivered or transmitted to any other person without our prior written consent. By accepting this report, the recipient agrees to be bound by the terms and limitations set forth herein. BNP Paribas analysts prudently perform analysis and create quantitative models and estimates derived from their own review of publicly available data without any assistance from any represented company. BNP Paribas analyst estimates and models reflect the analysts current judgment only; they are neither all-inclusive nor can they be guaranteed. The analysts analysis and models are subject to change based on various other factors. Valuations are based on internal quantitative models and qualitative interpretation. No representation or warranty, express or implied, is made that such information or analysis is accurate, complete or verified and it should not be relied upon as such. Analysts' compensation is not linked to investment banking or capital markets transactions performed by BNP Paribas or the profitability or revenues of particular trading desks. BNP Paribas analysts may participate in company events such as site visits and are prohibited from accepting payment by the company of associated expenses unless pre-approved by authorized members of Research management. This report does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual clients. Customers are advised to use the information contained herein as just one of many inputs and considerations prior to engaging in any trading activity. This report does not constitute a prospectus or other offering document or an offer or solicitation to buy or sell any securities or other investments. This report is not intended to provide the sole basis of any evaluation of the subject securities and companies mentioned in this report. Information and opinions contained in this report are published for reference of the recipients and are not to be relied upon as authoritative or without the recipients own independent verification, or taken in substitution for the exercise of judgment by the recipient. Additionally, the products mentioned in this report may not be available for sale in certain jurisdictions. BNP Paribas is not aware of any other actual or material conflicts of interest concerning any of the subject securities and companies referenced herein as of the time of publication of the research report. This report is prepared for professional investors and is being distributed in Hong Kong by BNP Paribas Securities (Asia) Limited to persons whose business involves the acquisition, disposal or holding of securities, whether as principal or agent. BNP Paribas Securities (Asia) Limited, a subsidiary of BNP Paribas, is regulated by the Securities and Futures Commission for the conduct of dealing in securities, advising on securities and providing automated trading services. This report is being distributed in the United Kingdom by BNP Paribas London Branch to persons who are not private customers as defined under U.K. securities regulations. BNP Paribas London Branch, a branch of BNP Paribas, is regulated by the Financial Services Authority for the conduct of its designated investment business in the U.K. This report may be distributed in the United States by BNP PARIBAS SECURITIES ASIA or by BNP Paribas Securities Corp. 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This report is being distributed in Australia by BNP Paribas Sydney Branch, registered in Australia as ABN 23 000 000 117 at 60 Castlereagh Street Sydney NSW 2000. BNP Paribas Sydney Branch is licensed under the Banking Act 1959 and the holder of Australian Financial Services Licence no. 238043 and therefore subject to regulation by the Australian Securities & Investments Commission in relation to delivery of financial services. By accepting this document you agree to be bound by the foregoing limitations, and acknowledge that information and opinions in this document relate to financial products or financial services which are delivered solely to wholesale clients (in terms of the Corporations Act 2001, sections 761G and 761GA; Corporations Regulations 2001, division 2, reg. 7.1.18 & 7.1.19) and/or professional investors (as defined in section 9 of the Corporations Act 2001). To our readers in Taiwan: Information on securities that trade in Taiwan is distributed by BNP Paribas Securities (Taiwan) Co., Ltd. Such information is for your reference only. The reader should independently evaluate the investment risks and is solely responsible for their investment decision. Information on securities that do not trade in Taiwan is for informational purposes only and is not to be construed as a recommendation or a solicitation to trade in such securities. BNP Paribas Securities (Taiwan) Co., Ltd. may not execute transactions for clients in these securities. This publication may not be distributed to the public media or quoted or used by the public media without the express written consent of BNP Paribas. The distribution of this report in other jurisdictions or to residents of other jurisdictions may also be restricted by law, and persons into whose possession this report comes should inform themselves about, and observe, any such restrictions. By accepting this report you agree to be bound by the foregoing instructions. This report is not directed to, or intended for distribution to or use by, any person or entity that is a citizen or resident of or located in any locality, state, country, or other jurisdiction where such distribution, publication, availability or use would be contrary to law or regulation. All research reports are disseminated and available to all clients simultaneously through our internal client websites. For all research available on a particular stock, please contact the relevant BNP Paribas research team or the author(s) of this report.
62 23
BNP PARIBAS
ALEN LIN
3 JUNE 2011
1 No portion of this report was prepared by BNP Paribas Securities Corp. personnel, and references to BNP Paribas in this General Disclaimer section and in the immediately following Important Disclosures section refer to BNP Paribas Securities (Asia) Ltd only.
IMPORTANT DISCLOSURES The disclosure column in the following table lists the important disclosures applicable to each company that has been rated and/or recommended in this report: Company O-Net Communications China ComService ZTE Disclosure (as applicable) NA NA 2, 5
BNP Paribas represents that: 1. Within the past year, it has managed or co-managed a public offering for this company, for which it received fees. 2. It had an investment banking relationship with this company in the last 12 months. 3. It received compensation for investment banking services from this company in the last 12 months. 4. It beneficially owns 1% or more or the market capitalization of this company. 5. It makes a market in securities issued by this company. 6. The analyst(s) or an individual who assisted in the preparation of this report (or a member of his/her household) has a financial interest position in securities issued by this company or derivatives thereof. 7. The analyst (or a member of his/her household) is an officer, director, or advisory board member of this company. Additional Disclosures Within the next three months, BNP Paribas may receive or seek compensation in connection with an investment banking relationship with one or more of the companies referenced herein. Target price history, stock price charts, valuation and risk details, and equity rating histories applicable to each company rated in this report is available in our most recently published reports available on our website: http://equities.bnpparibas.com, or you can contact the analyst named on the front of this note or your BNP Paribas representative. All share prices are as at market close on 2 June 2011 unless otherwise stated. RECOMMENDATION STRUCTURE Stock Ratings Stock ratings are based on absolute upside or downside, which we define as (target price* - current price) / current price. BUY (B). The upside is 10% or more. HOLD (H). The upside or downside is less than 10%. REDUCE (R). The downside is 10% or more. Unless otherwise specified, these recommendations are set with a 12-month horizon. Thus, it is possible that future price volatility may cause a temporary mismatch between upside/downside for a stock based on market price and the formal recommendation.
* In most cases, the target price will equal the analyst's assessment of the current fair value of the stock. However, if the analyst doesn't think the market will reassess the stock over the specified time horizon due to a lack of events or catalysts, then the target price may differ from fair value. In most cases, therefore, our recommendation is an assessment of the mismatch between current market price and our assessment of current fair value.
Industry Recommendations Improving ( ): The analyst expects the fundamental conditions of the sector to be positive over the next 12 months. Neutral ( ): The analyst expects the fundamental conditions of the sector to be maintained over the next 12 months. Deteriorating ( ): The analyst expects the fundamental conditions of the sector to be negative over the next 12 months. Country (Strategy) Recommendations Overweight (O). Over the next 12 months, the analyst expects the market to score positively on two or more of the criteria used to determine market recommendations: index returns relative to the regional benchmark, index sharpe ratio relative to the regional benchmark and index returns relative to the market cost of equity. Neutral (N). Over the next 12 months, the analyst expects the market to score positively on one of the criteria used to determine market recommendations: index returns relative to the regional benchmark, index sharpe ratio relative to the regional benchmark and index returns relative to the market cost of equity. Underweight (U). Over the next 12 months, the analyst does not expect the market to score positively on any of the criteria used to determine market recommendations: index returns relative to the regional benchmark, index sharpe ratio relative to the regional benchmark and index returns relative to the market cost of equity. RATING DISTRIBUTION (as at 1 June 2011) Total BNP Paribas coverage universe Buy Hold Reduce 557 366 139 52 Investment Banking Relationship Buy Hold Reduce (%) 4.10 4.32 1.92
Should you require additional information concerning this report please contact the relevant BNP Paribas research team or the author(s) of this report. 2011 BNP Paribas Group
63 24
BNP PARIBAS
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KUALA LUMPUR
BNP Paribas Capital (Malaysia) Sdn Bhd Vista Tower, Level 48C The Intermark, 182 Jalan Tun Razak 50400 Kuala Lumpur Malaysia Tel (60 3) 2179 6222 Fax (60 3) 2179 6226
MUMBAI
BNP Paribas Securities India Pvt Ltd BNP Paribas House 1 North Avenue, Maker Maxity Bandra Kurla Complex Bandra East Mumbai 400 051 Tel (91 22) 3370 4000 Fax (91 22) 3370 4386
SEOUL
BNP Paribas Securities Korea Co Ltd 22/F, Taepyeongno Building 310 Taepyeongno 2-ga Jung-gu, Seoul 100-767 Korea Tel (82 2) 2125 0500 Fax (82 2) 2125 0593
SINGAPORE
BNP Paribas Securities (Singapore) Pte Ltd (Co. Reg. No. 199801966C) 20 Collyer Quay #08-01 Tung Centre Singapore 049319 Tel (65) 6210 1288 Fax (65) 6210 1980
TAIPEI
BNP Paribas Securities (Taiwan) Co Ltd 72/ F, Taipei 101 No. 7 Xin Yi Road, Sec. 5 Taipei, Taiwan Tel (886 2) 8729 7000 Fax (886 2) 8101 2168
TOKYO
BNP Paribas Securities (Japan) Ltd GranTokyo North Tower 1-9-1 Marunouchi, Chiyoda-Ku Tokyo 100-6740 Japan Tel (81 3) 6377 2000 Fax (81 3) 5218 5970
NEW YORK
BNP Paribas The Equitable Tower 787 Seventh Avenue New York NY 10019, USA Tel (1 212) 841 3800 Fax (1 212) 841 3810
BASEL
BNP Paribas Aeschengraben 26 CH 4002 Basel Switzerland Tel (41 61) 276 5555 Fax (41 61) 276 5514
FRANKFURT
BNP Paribas Mainzer Landstrasse 16 60325 Frankfurt Germany Tel (49 69) 7193 6637 Fax (49 69) 7193 2520
GENEVA
BNP Paribas 2 Place de Hollande 1211 Geneva 11 Switzerland Tel (41 22) 787 7377 Fax (41 22) 787 8020
LONDON
BNP Paribas 10 Harewood Avenue London NW1 6AA UK Tel (44 20) 7595 2000 Fax (44 20) 7595 2555
LYON
BNP Paribas Equities France Socit de Bourse 3 rue de L Arbre Sec 69001 Lyon France Tel (33 4) 7210 4001 Fax (33 4) 7210 4029
MADRID
BNP Paribas SA, sucursal en Espana Hermanos Becquer 3 PO Box 50784 28006 Madrid Spain Tel (34 91) 745 9000 Fax (34 91) 745 8888
MILAN
BNP Paribas Equities Italia SIM SpA Piazza San Fedele, 2 20121 Milan Italy Tel (39 02) 72 47 1 Fax (39 02) 72 47 6562
PARIS
BNP Paribas Equities France Socit de Bourse 20 boulevard des Italiens 75009 Paris France Tel (33 1) 4014 9673 Fax (33 1) 4014 0066
ZURICH
BNP Paribas Talstrasse 41 8022 Zurich Switzerland Tel (41 1) 229 6891 Fax (41 1) 267 6813
MANAMA
BNP Paribas Bahrain PO Box 5253 Manama Bahrain Tel (973) 53 3978 Fax (973) 53 1237
www.equities.bnpparibas.com

20110603-BNP Paribas-China Equipment - The Speed of Light

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20110603-BNP Paribas-China Equipment - The Speed of Light

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THEMATIC RESEARCH

China Telcos/Equipment: The speed of light

Demand-driven network upgrades

Chinese optical network supply chain to benefit

Initiate coverage on O-Net Communications and China ComService

PREPARED BY BNP PARIBAS SECURITIES ASIA

CHINA TELCOS & EQUIPMENT

Asia Pacific Sector Swap

CHINA TELCOS & EQUIPMENT

Demand-driven network upgrades

Optical networks at the core of higher data capacity

Initiate coverage of O-Net Comm, China ComService with BUY

CHINA TELCOS & EQUIPMENT

CHINA TELCOS & EQUIPMENT

Insatiable demand for data

Western Europe Japan Central Eastern Europe

Asia/Pacific data traffic to more than triple in five years

CHINA TELCOS & EQUIPMENT

(GB/connection per month) 80 70 60 50 40 30 20 10 0 2010 2011 2012 2013 2014

Broadband Internet connections (LHS) Internet traffic/broadband connection (RHS)

Exhibit 3: Monthly regional Internet traffic

Source: BNP Paribas

Data infrastructure capex set to rise

CHINA TELCOS & EQUIPMENT

Sources: Gartner; BNP Paribas estimates

Exhibit 5: Global telecom capex (2010, USD m)

Exhibit 6: Asia Pacific telecom capex (2010, USD m)

Broadband access 6,373

Broadband access 1,679

Optical transport 13,820

Mobile infrastructure 43,808

Mobile infrastructure 15,402

Sources: Gartner; BNP Paribas

Sources: Gartner; BNP Paribas

The rise of Chinese system and component suppliers

CHINA TELCOS & EQUIPMENT

Exhibit 8: Asia Pacific capex spending distribution

Middle East & Africa 5.1%

Sources: Gartner; BNP Paribas

Sources: Gartner; BNP Paribas estimates

CHINA TELCOS & EQUIPMENT

Exhibit 9: Global optical transport market share (2010)

Exhibit 10: Global access network market share (2010)

Nokia Siemens Networks 4.0% Ericsson 4.3%

Ericsson 3.5% Motorola 4.0% Nokia Siemens Networks 4.7%

ZTE 7.3% Ciena 6.0% Fujitsu 6.7%

Samsung 12.1% Cisco 9.2% ZTE 10.0%

Sources: Gartner; BNP Paribas

Sources: Gartner; BNP Paribas

Exhibit 11: AsiaPac optical transport market share (2010)

Exhibit 12: AsiaPac access network market share (2010)

Sources: Gartner; BNP Paribas

CHINA TELCOS & EQUIPMENT

Sources: Ovum; BNP Paribas

China upgrades to optical broadband

CHINA TELCOS & EQUIPMENT

Exhibit 14: China's cumulative length of optical cable

Exhibit 15: FTTx penetration in major Chinese cities

8 6 4 2 0 2003 2004 2005 2006 2007 2008 2009 2010 1Q11

Sources: Companies; China Statistics Bureau; BNP Paribas estimates

Exhibit 16: FTTx capex distribution estimation

Equipment cost 40-50%