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

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3 JUNE 2011

China Telcos/Equipment: The speed of light

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.

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.

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.

Alen Lin +852 2825 1801

[email protected]

Joyce Zhou +852 2825 1120

[email protected]

THEMATIC RESEARCH

PREPARED BY BNP PARIBAS SECURITIES ASIA 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

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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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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 China’s 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. China’s 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 world’s 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. O-Net 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 company’s non-operator 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 China’s 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 ZTE’s 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

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

2009 2010 2011 2012 2013 2014

North America Western EuropeAsia Pacific JapanLatin America Central Eastern EuropeMiddle East and Africa

(Petabyte of data)

Source: Cisco

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), China-based 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

0

50,000

100,000

150,000

200,000

250,000

300,000

2009 2010 2011 2012 2013 20140

10

20

30

40

50

60

70

80Broadband Internet connections (LHS)Internet traffic/broadband connection (RHS)

(Thousand connections) (GB/connection per month)

Source: BNP Paribas

Exhibit 3: Monthly regional Internet traffic

02,0004,0006,0008,000

10,00012,00014,00016,00018,00020,000

NorthAmerica

WesternEurope

AsiaPacific

Japan LatinAmerica

CentralEasternEurope

MiddleEast and

Africa

(PB/month) 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 Pacific’s 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

0

10

20

30

40

50

60

2007 2008 2009 2010 2011 2012 2013

Asia/Pacific Eastern Europe JapanLatin America Middle East & Africa North AmericaWestern Europe

(%)

Sources: Gartner; BNP Paribas estimates

Exhibit 5: Global telecom capex (2010, USD m) Exhibit 6: Asia Pacific telecom capex (2010, USD m)

Voice switching, control and applications

5,077 Traditional switching

1,278

Service provider

routers and switches 12,086

Optical transport 13,820

Mobile infrastructure

43,808

Broadband access 6,373

Voice switching, control and applications

1,403 Traditional switching

166 Service provider

routers and switches 2,584

Optical transport

3,640 Mobile

infrastructure 15,402

Broadband access 1,679

Sources: Gartner; BNP Paribas 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 region’s 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) Exhibit 8: Asia Pacific capex spending distribution

Western Europe19.9%

North America32.8% Middle East

& Africa5.1%

Latin America

5.4%

Japan6.4%

Eastern Europe6.0%

Asia/Pacific24.5%

0

5,000

10,000

15,000

20,000

25,000

30,000

2007 2008 2009 2010 2011 2012 2013

(USD m) Data infrastructure Mobile infrastructureTraditional switching Others

Sources: Gartner; BNP Paribas 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 Huawei’s 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) Exhibit 10: Global access network market share (2010)

Others31.0%

Nokia Siemens Networks

4.0%

Ericsson4.3%

Tellabs4.4% Ciena

6.0%Fujitsu6.7%

ZTE7.3%

Alcatel-Lucent16.1%

Huawei20.1%

Others27.3%

Ericsson3.5%

Motorola4.0%


4.7% Cisco9.2%

ZTE10.0%

Samsung12.1%

Alcatel-Lucent14.6%

Huawei14.7%


Exhibit 11: AsiaPac optical transport market share (2010) Exhibit 12: AsiaPac access network market share (2010)

Others14.2%

ECI4.4%

Alcatel-Lucent11.9%

ZTE22.0%

Huawei47.5%

Others13.2%


5.3%

Cisco5.4%

Alcatel-Lucent8.9%

Samsung9.9%

ZTE27.7%

Huawei29.5%


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)

Others42.9%

Opnext6.6% Oclaro

7.4%

Avago8.6%

JDSU9.0%

Sumitomo10.6%

Finisar14.9%

Sources: Ovum; BNP Paribas

China upgrades to optical broadband A measure of growth in China’s 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, China’s 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 China’s 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 Exhibit 15: FTTx penetration in major Chinese cities

0

2

4

6

8

10

12

2003 2004 2005 2006 2007 2008 2009 2010 1Q11

(m kilometers)

0

50

100

150

200

250

2008 2009 2010E 2011E 2012E 2013E

(m)

0

20

40

60

80

100

120

(%)Aggregate households in cities with>1.5mn households (LHS)FTTx penetration (RHS)

Sources: MIIT; BNP Paribas Sources: Companies; China Statistics Bureau; BNP Paribas estimates

Exhibit 16: FTTx capex distribution estimation

Equipment cost40-50%

Cable and accessories cost

25-30%

Installation cost25-30%

FTTH construction cost breakdown

Equipment cost40-50%

Cable and accessories cost

25-30%

Installation cost25-30%

FTTH construction cost breakdown

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

0

200

400

600

800

1,000

1,200

2008 2009 2010 2011 2012 2013

(USD m) 10G 40G 100G

Sources: Ovum; BNP Paribas

A sample national fiber backbone – China Telecom An illustration of China Telecom’s 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

Metro DWDM ringsAccess networks

Sources: Cisco; BNP Paribas

Access networks Access networks make the connection between a user’s 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 Kong’s 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 sub-system (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.

16


17 BNP PARIBAS

Exhibit 22: Optical networks supply chain

Fiber cable and optical components suppliers System integrators

Telecom operatorsCable operators

Key

Pla

yers

PrivateHuawei

CSCO USCisco Systems

CIEN USCiena Corp

JNPR USJuniper Networks

TLAB USTellabs Inc

MSI USMotorola Solutions

ALU FPAlcatel-Lucent

ERICB SSEricsson

763 HKZTE Corp

AVGO USAvago

EMKR USEmcore Corp

MRVC USMRV Communications

NPTN USNeoPhotonics

OPXT USOpnext Inc

AFOP USAlliance Fiber Optic

JDSU USJDS Uniphase Corp

FNSR USFinisar Corp

OPLK USOplink Communications

OCLR USOclaro Inc

002281 CHAccelink Technologies

877 HKO-Net Communications

TEF SM Telefonica SA

CVC USCablevision

9437 JP NTT DoCoMo

VOD LN Vodafone Group

VZ US Verizon

T US AT&T Inc

TIT IM Telecom Italia SpA

030200 KSKT Corp

ST SPSingapore Telecom

2412 TT Chunghwa Telecom

762 HKChina Unicom

728 HKChina Telecom

Fiber cable and optical components suppliers System integrators

Telecom operatorsCable operators

Key

Pla

yers

PrivateHuawei

CSCO USCisco Systems

CIEN USCiena Corp

JNPR USJuniper Networks

TLAB USTellabs Inc

MSI USMotorola Solutions

ALU FPAlcatel-Lucent

ERICB SSEricsson

763 HKZTE Corp

AVGO USAvago

EMKR USEmcore Corp

MRVC USMRV Communications

NPTN USNeoPhotonics

OPXT USOpnext Inc

AFOP USAlliance Fiber Optic

JDSU USJDS Uniphase Corp

FNSR USFinisar Corp

OPLK USOplink Communications

OCLR USOclaro Inc

002281 CHAccelink Technologies

877 HKO-Net Communications

TEF SM Telefonica SA

CVC USCablevision

9437 JP NTT DoCoMo

VOD LN Vodafone Group

VZ US Verizon

T US AT&T Inc

TIT IM Telecom Italia SpA

030200 KSKT Corp

ST SPSingapore Telecom

2412 TT Chunghwa Telecom

762 HKChina Unicom

728 HKChina Telecom

Source: BNP Paribas

17


18 BNP PARIBAS

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 Market ——— P/E ——— — EV/EBITDA — —— P/BV —— —— Yield —— —— ROE —— Company BBG code price cap 2011E 2012E 2011E 2012E 2011E 2012E 2011E 2012E 2011E 2012E (LC) (USD m) (x) (x) (x) (x) (x) (x) (%) (%) (%) (%) Optical components & fiber O-Net Communications 877 HK 3.63 389 14.9 12.2 10.0 8.0 2.1 1.8 0.0 0.0 15.0 15.6 Accelink Technologies 002281 CH 36.35 898 35.5 28.0 25.8 20.5 4.9 4.3 0.7 0.8 14.0 15.5 Jiangsu Zhongtian 600522 CH 23.54 1,166 15.3 12.7 9.0 8.1 2.8 2.3 na na 21.3 21.2 Oclaro OCLR US 8.90 449 na 49.7 21.3 10.4 1.8 1.6 - - (8.4) 11.2 Oplink Communications OPLK US 18.33 379 10.9 12.4 4.3 3.2 1.5 1.3 na na 10.4 8.5 Finisar FNSR US 22.29 1,998 14.3 13.4 9.4 7.8 3.1 2.7 - - 19.0 18.8 JDS Uniphase JDSU US 19.18 4,353 20.5 17.2 12.0 9.3 4.2 3.8 - - 8.5 13.2 Alliance Fiber Optic AFOP US 9.14 81 13.4 9.6 4.6 3.3 na na na na na na Opnext OPXT US 2.72 245 na na (10.2) 15.9 1.0 1.1 - na (13.0) (13.8) NeoPhotonics NPTN US 9.50 234 62.5 22.5 8.4 6.5 1.1 1.2 na na 3.2 5.2 MRV Communications MRVC US 1.38 217 27.6 12.5 5.5 3.2 na na na na na na Emcore Corp EMKR US 2.42 214 na 34.6 na na na na na na na na Optical components & fiber - mcap weighted average 20.4 18.2 11.6 9.5 3.5 3.1 0.1 0.1 11.5 14.5 Equipment & service ZTE Corp 763 HK 27.50 10,507 21.7 19.2 11.1 10.3 2.7 2.4 0.9 1.0 13.5 13.5 China ComService 552 HK 4.89 3,629 11.3 10.1 5.2 4.6 1.5 1.4 3.5 4.0 14.2 14.9 Fiberhome 600498 CH 26.75 1,824 22.8 18.0 16.5 12.9 3.0 2.6 0.8 1.0 13.1 14.7 Telefonaktiebolaget ERICB SS 94.20 49,711 15.2 13.6 6.9 6.1 2.0 1.8 2.6 2.9 12.7 13.2 Alcatel-Lucent ALU FP 3.96 13,213 17.6 11.5 5.7 5.0 2.3 2.0 - 0.3 11.3 15.3 Motorola Solutions MSI US 46.88 15,917 20.2 18.5 7.3 6.5 2.4 2.1 - - 12.4 10.1 Tellabs TLAB US 4.52 1,642 na 68.5 32.4 9.8 0.9 0.9 1.8 1.8 (0.8) 1.5 Juniper Networks JNPR US 32.97 17,575 21.7 17.5 12.4 9.7 2.4 2.2 - - 11.4 11.9 Ciena Corp CIEN US 25.48 2,421 463.3 23.5 19.5 10.2 31.6 14.9 - - 30.9 363.7 Cisco Systems CSCO US 16.38 90,549 10.2 9.5 5.2 4.7 1.9 1.7 0.7 1.5 17.9 17.2 Equipment & service - mcap weighted average 19.6 13.0 7.2 6.0 2.4 2.0 1.1 1.5 15.0 18.9 Share prices as of 1 June 2011 Source: Bloomberg; BNP Paribas estimates

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19 BNP PARIBAS

Company updates

O-Net............................................................................................................................................................................................. 20

China ComService....................................................................................................................................................................... 36

ZTE Corp ...................................................................................................................................................................................... 55

19

TARGET HKD4.90 PRIOR TP N/A O-Net 877 HK CLOSE HKD3.55

BUY CHINA / TECHNOLOGY HARDWARE & EQUIPMENT UP/DOWNSIDE +38.0%

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

Initiating coverage with BUY We initiate coverage on O-Net with a BUY rating and target price of HKD4.90. As one of the world’s 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.

Right products, right time 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.

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-Net’s 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.

HOW WE DIFFER FROM THE STREET

BNP Consensus % Diff

Target Price (HKD) 4.90 5.29 (7.4)

EPS 2011 (HKD) 0.24 0.28 (14.3)

EPS 2012 (HKD) 0.30 0.35 (14.3)

Positive Neutral Negative Market Recs. 7 1 2

KEY STOCK DATA

YE Dec (HKD m) 2011E 2012E 2013E

Revenue 799 973 1,178

Rec. net profit 203 248 303

Recurring EPS (HKD) 0.24 0.30 0.36

Prior rec. EPS (HKD) - - -

Chg. In EPS est. (%) N/A N/A N/A

EPS growth (%) (3.3) 21.9 22.3

Recurring P/E (x) 14.6 11.9 9.8

Dividend yield (%) 0.0 0.0 0.0

EV/EBITDA (x) 9.7 7.8 5.9

Price/book (x) 2.0 1.7 1.5

Net debt/Equity (28.0) (34.1) (39.9)

ROE (%) 15.0 15.6 16.2

2.003.004.005.006.00

May-10 Aug-10 Nov-10 Feb-11 May-11

(HKD)

(11)9294969

(%)O-NetRel to MSCI China

Share price performance 1 Month 3 Month 12 Month

Absolute (%) (22.5) (18.4) 11.1

Relative to country (%) (19.3) (24.5) (1.5)

Next results August 2011 Mkt cap (USD m) 380

3m avg daily turnover (USD m) 3.2

Free float (%) 43

Major shareholder O-Net Holdings (30%)

12m high/low (HKD) 6.31/3.10

3m historic vol. (%) 53.0

ADR ticker -

ADR closing price (USD) -

Sources: Bloomberg consensus; BNP Paribas estimates

INDUSTRY OUTLOOK INITIATION

Joyce Zhou

+852 2825 [email protected]

Alen Lin +852 2825 1801

[email protected]

3 June 2011

20

JOYCE ZHOU O-NET 3 JUNE 2011

3 BNP PARIBAS

—— Base —— —— Best—— –— Worse –—

Year-end 31 Dec 2011E 2012E 2011E 2012E 2011E 2012E

Gross margin (%) 50.6 50.6 50.6 49.8 49.6 49.6

EPS (HKD) 0.24 0.30 0.25 0.31 0.24 0.29

Change (%) — — 3.3 3.3 (3.3) (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-Net’s EPS to +/-1% of blended gross margin.

Sources: BNP Paribas estimates

O-Net and MXCN Index (3M and 6M realised-vol) Regression – O-Net to MXCN Index

0

50100

150

200250

300

350400

Apr-10 Apr-11

(%)

O-Net - 3M Realised - Vol O-Net - 6M Realised - Vol

MSCI China - 3M Realised - Vol MSCI China - 6M Realised - Vol

Sources: Bloomberg; BNP Paribas

-14.00%

-9.00%

-4.00%

1.00%

6.00%

11.00%

16.00%

-22.00% -17.00% -12.00% -7.00% -2.00% 3.00% 8.00% 13.00% 18.00%

MSCI China

O-N

et

O-Net = 3 + 0.0366 * MXCN IndexR Square = 0.2878Regression based on 57 observations of 5 years weekly data. Please refer to Appendix 1 for theexplanation of R-squareSources: Bloomberg; BNP Paribas

China sector correlation matrix at 31 March 2011 Banks Insurance Metal & Mining Oil & Gas Property Telecom Utilities Coal Banks 1.00 0.77 0.78 0.81 0.73 0.71 0.61 0.78

Insurance 1.00 0.76 0.79 0.67 0.69 0.61 0.76

Metal & Mining 1.00 0.82 0.70 0.69 0.63 0.84

Oil & Gas 1.00 0.64 0.76 0.64 0.83

Property 1.00 0.55 0.54 0.67

Telecom 1.00 0.61 0.68

Utilities 1.00 0.56

Coal 1.00 Source: BNP Paribas Sector Strategy

Long/short chart The risk experts

O-Net - ZTE Corp

-2s

-1s

Mean

+1s

+2s

0.10

0.12

0.14

0.16

0.18

0.20

0.22

0.24

0.26

Apr-10 Oct-10 Apr-11

(x)

The Risk Experts • Our starting point for this page is a recognition of the

macro factors that can have a significant impact on stock-price 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.

Sources: Bloomberg, BNP Paribas

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4 BNP PARIBAS

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

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

2007 2008 2009 2010 2011E 2012E 2013E 2014E 2015E

(USD m) 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. Ovum’s 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).

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5 BNP PARIBAS

Exhibit 2: Amplifiers market share Exhibit 3: ROADMs and filters market share

Others12.0%

O-Net3.1%

Oplink3.7%

Sumitomo4.1%

Accelink10.4%

Furukawa17.5%

JDSU23.2%

Oclaro26.0%

Ignis4.7%

Oclaro4.4%

Others14.8%

JDSU16.5%

Finisar12.4%

NEL11.2%

Oplink10.2%

NeoPhotonics8.1%

Sumitomo6.8%

O-Net6.0%

AFOP4.7%

Sources: Ovum (December 2010); BNP Paribas 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


6 BNP PARIBAS

Exhibit 5: Consumer broadband connections – worldwide

0

100

200

300

400

500

600

700

800

2008 2009 2010 2011 2012 2013 2014 2015

(subs m) FTTH/FTTP/Ethernet DSL Cable modem Other high-speed

Sources: Gartner; BNP Paribas

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


7 BNP PARIBAS

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


8 BNP PARIBAS

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


9 BNP PARIBAS

Exhibit 7: Regional IP data traffic growth

0

10

20

30

40

50

60

2010 2011 2012 2013 2014

(%) North America Western EuropeAsia Pacific JapanLatin America Central Eastern EuropeMiddle East and Africa Total IP traffic

Sources: Cisco; BNP Paribas

In 2010, O-Net has 50.4% of total revenue coming from its top-five customers. Alcatel-Lucent 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-Net’s 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

Power management Transmission Wavelength

Management

Signal conditioning

and monitoringOthers

Amplifier (EDFA)EDFA module

VOAIsolator Hybrid

FilterCoupler

DPSK demodulatorDQPSK demodulator

Wavelength lockerIsolator

Optical CirculatorOptical Switch

WDMWDM module

Optical InterleaverArrayed Waveguide

- Crating (AWG)

Channel MonitorTap-PD Monitor

Tunable Dispersion-Compensator (TDC)Tap-PD Array module

Integrated Module& Subsystem

PON WDMTransceiver module

TransmitterPLC Splitter

ReceiverEtalon

Compensator& Waveplate

Sources: O-Net; BNP Paribas

27


10 BNP PARIBAS

Exhibit 9: Revenue by segment

0

100

200

300

400

500

600

700

2007 2008 2009 2010

(HKD m) Power management Transmission management Wavelength management Signal conditioning and monitoring mgt All other segments

Sources: O-Net; BNP Paribas

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-Net’s margin level high, and enhance its competitive advantage over peers.

28


11 BNP PARIBAS

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 company’s 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 low-volume 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 IPO As per

placement 2010E per

IPO 2010 2011E per

IPO

Revised 2011E after private placement on

November 2010 (HKD m) (HKD m) (HKD m) (HKD m) (HKD m) (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)

200 41.5 9.1 163.5 210

Production line and research & development expansion

115 46 44.5 64 75

Repayment of Shenzhen Kaifa for rent and operating expenses paid on behalf of O-net

34 34 34

Working capital 33 33 101.8 45

Others including M&A 137 326 137 319.5

Total 519 326 154.5 189.4 364.5 649.5 Source: O-Net

During 2010, the company’s overall capacity increased by 50%, and the company expects it to increase another 30% in 2011. The company’s 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-Net’s current products.

29


12 BNP PARIBAS

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

(20)

0

20

40

60

80

100

120

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-Net’s 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 40-50%. The company’s 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-Net’s 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


13 BNP PARIBAS

Exhibit 13: Gross margin comparison – 2010 Exhibit 14: Net margin comparison – 2010

0 10 20 30 40 50 60

O-Net communicat

Accelink tech-a

Oclaro inc

Oplink communica

Finisar corp

Jds uniphase

Alliance fiber

Opnext inc

Neophotonics cor

Mrv comm

Emcore corp

(%)

(40) (20) - 20 40

O-Net communicat

Accelink tech-a

Oclaro inc

Oplink communica

Finisar corp

Jds uniphase

Alliance fiber

Opnext inc

Neophotonics cor

Mrv comm

Emcore corp

(%)

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

0 5 10 15 20 25

O-Net communicat

Accelink tech-a

Oclaro inc

Oplink communica

Finisar corp

Jds uniphase

Alliance fiber

Opnext inc

Neophotonics cor

Mrv comm

Emcore corp

(%)


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


14 BNP PARIBAS

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-Net’s 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 (%) 12.5 Mid-term revenue growth (%) 16.8 Terminal growth (%) 2.0

Mid-term EBIT margin (%) 28.0 Terminal EBIT margin (%) 25.0

Mid-term tax rate (%) 15.0 Terminal tax rate (%) 15.0

Target price (HKD) 4.90 Source: BNP Paribas estimates

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 company’s technology lead, and may have an impact on the company’s future growth.

Exhibit 17: Shareholding structure

Kaifa Technology

(HK) Ltd(Hong Kong)

Mandarin IT Fund I

(Cayman Islands)

Mariscal Ltd (Hong Kong)

O-Net Employee Plan

Ltd (BVI)Na Qinglin Xue Yahong Public

Shareholders

O-Net Holdings (BVI) (investment holding)

The Company(Cayman Islands) (investment holding)

O-Net BVI (BVI) (investment holding)

O-Net Shenzhen(PRC)

O-Net Hong Kong(HK)

27.32% 49.18% 23.70% 18.48% 6.95% 1.69% 42.67%

30.01%

100%

100% 100%

Source: O-Net

32


15 BNP PARIBAS

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 Barney’s 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 Master’s degree in Business Administration from Vanderbilt University in 1995 and a Bachelor’s degree in International Economics from Peking University in 1989

Mr Xue Yahong Executive Director and VP of Operations. Joined O-Net’s 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 Master’s degree in Engineering from Harbin Institute of Technology in 1985.

Mr Tam Man Chi 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.

Mr Chen Zhujiang 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 Bachelor’s degree in engineering from Tianjin University in 1989 and a Master’s degree from the Business School of Jilin University in 2007.

Mr Huang Bin 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 non-executive 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 Bachelor’s degree in Economics from Harvard University in 1985.

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.

Dr Yu Aihua 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.

Ms Xie Hong 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 Kaifa’s 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.

Mr Steven Tan VP of Sales and Marketing. He has been leading the Company’s 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 Bachelor’s degree in physics from the National University of Malaysia in 1994.

Source: O-Net

33


16 BNP PARIBAS

F I N A N C I A L S T A T E M E N T S

O-Net Profit and Loss (HKD m) Year Ending Dec 2009A 2010A 2011E 2012E 2013ERevenue 338 661 799 973 1,178Cost of sales ex depreciation (175) (308) (374) (452) (554)Gross profit ex depreciation 163 352 425 520 624Other operating income 0 0 0 0 0Operating costs (66) (132) (169) (204) (241)Operating EBITDA 98 220 257 316 383Depreciation (10) (15) (21) (28) (30)Goodwill amortisation 0 0 0 0 0Operating EBIT 87 206 236 288 353Net financing costs 1 (2) 3 3 3Associates 0 0 0 0 0Recurring non operating income 0 0 0 0 0Non recurring items 0 0 0 0 0Profit before tax 88 204 239 291 356Tax (9) (22) (36) (44) (53)Profit after tax 79 182 203 248 303Minority interests 0 0 0 0 0Preferred dividends 0 0 0 0 0Other items 0 0 0 0 0Reported net profit 79 182 203 248 303Non recurring items & goodwill (net) 0 0 0 0 0Recurring net profit 79 182 203 248 303

Per share (HKD) Recurring EPS * 0.14 0.25 0.24 0.30 0.36Reported EPS 0.14 0.25 0.24 0.30 0.36DPS 0.00 0.00 0.00 0.00 0.00

Growth Revenue (%) 18.9 95.2 21.0 21.7 21.1Operating EBITDA (%) 134.9 125.7 16.5 23.2 21.1Operating EBIT (%) 186.5 135.0 14.8 22.2 22.5Recurring EPS (%) 244.2 84.7 (3.3) 21.9 22.3Reported EPS (%) 244.2 84.7 (3.3) 21.9 22.3

Operating performance Gross margin inc depreciation (%) 45.3 51.1 50.6 50.6 50.5Operating EBITDA margin (%) 28.8 33.3 32.1 32.5 32.5Operating EBIT margin (%) 25.9 31.1 29.5 29.6 30.0Net margin (%) 23.4 27.5 25.4 25.5 25.7Effective tax rate (%) 10.6 10.9 15.0 15.0 15.0Dividend payout on recurring profit (%) 0.0 0.0 0.0 0.0 0.0Interest cover (x) - 107.2 - - -Inventory days 107.1 101.2 124.3 125.3 124.4Debtor days 139.3 121.7 136.7 136.3 136.7Creditor days 227.9 157.9 155.7 156.9 155.9Operating ROIC (%) 71.5 41.6 23.2 23.2 26.3Operating ROIC – WACC (%) - - - - -ROIC (%) 55.5 38.7 22.4 22.5 25.5ROIC – WACC (%) - - - - -ROE (%) 53.7 25.3 15.0 15.6 16.2ROA (%) 28.5 21.1 13.0 13.5 14.0* Pre exceptional, pre-goodwill and fully diluted

Sources: O-Net; BNP Paribas estimates

We forecast over 21% revenue growth for the next three years

34


17 BNP PARIBAS

O-Net Cash Flow (HKD m) Year Ending Dec 2009A 2010A 2011E 2012E 2013ERecurring net profit 79 182 203 248 303Depreciation 10 15 21 28 30Associates & minorities 0 0 0 0 0Other non-cash items 4 12 13 15 17Recurring cash flow 93 208 237 290 349Change in working capital (68) (139) (50) (64) (75)Capex - maintenance (6) (55) (75) (50) (50)Capex – new investment 0 0 (210) 0 0Free cash flow to equity 19 13 (99) 177 224Net acquisitions & disposals 0 0 0 0 0Dividends paid 0 0 0 0 0Non recurring cash flows 0 (383) 0 0 0Net cash flow 19 (369) (99) 177 224Equity finance 0 847 0 0 0Debt finance (25) (4) 0 0 0Movement in cash (7) 474 (99) 177 224Per share (HKD) Recurring cash flow per share 0.16 0.29 0.28 0.35 0.42FCF to equity per share 0.03 0.02 (0.12) 0.21 0.27Balance Sheet (HKD m) Year Ending Dec 2009A 2010A 2011E 2012E 2013EWorking capital assets 226 795 878 979 1,100Working capital liabilities (134) (168) (206) (250) (304)Net working capital 92 627 672 729 796Tangible fixed assets 40 82 347 369 389Operating invested capital 132 709 1,019 1,098 1,186Goodwill 0 0 0 0 0Other intangible assets 0 1 1 1 1Investments 0 0 0 0 0Other assets 29 32 32 33 34Invested capital 162 742 1,052 1,132 1,220Cash & equivalents (27) (508) (409) (586) (810)Short term debt 0 0 0 0 0Long term debt * 0 0 0 0 0Net debt (27) (508) (409) (586) (810)Deferred tax 0 0 0 0 0Other liabilities 0 0 0 0 0Total equity 188 1,249 1,461 1,718 2,031Minority interests 0 0 0 0 0Invested capital 162 742 1,052 1,132 1,220* includes convertibles and preferred stock which is being treated as debt

Per share (HKD) Book value per share 0.32 1.50 1.75 2.06 2.44Tangible book value per share 0.32 1.50 1.75 2.06 2.44Financial strength Net debt/equity (%) (14.1) (40.6) (28.0) (34.1) (39.9)Net debt/total assets (%) (8.2) (35.8) (24.6) (29.8) (34.7)Current ratio (x) 1.9 7.7 6.3 6.3 6.3CF interest cover (x) - 7.9 - - -Valuation 2009A 2010A 2011E 2012E 2013ERecurring P/E (x) * 26.0 14.1 14.6 11.9 9.8Recurring P/E @ target price (x) * 35.9 19.4 20.1 16.5 13.5Reported P/E (x) 26.0 14.1 14.6 11.9 9.8Dividend yield (%) 0.0 0.0 0.0 0.0 0.0P/CF (x) 22.2 12.3 12.5 10.2 8.5P/FCF (x) 108.9 192.0 (30.0) 16.7 13.2Price/book (x) 10.9 2.4 2.0 1.7 1.5Price/tangible book (x) 11.0 2.4 2.0 1.7 1.5EV/EBITDA (x) ** 21.0 10.2 9.7 7.8 5.9EV/EBITDA @ target price (x) ** 29.0 14.5 14.1 11.3 8.8EV/invested capital (x) 12.6 3.3 2.4 2.1 1.8* Pre exceptional, pre-goodwill and fully diluted ** EBITDA includes associate income and recurring non-operating income

Sources: O-Net; BNP Paribas estimates

HKD210m capex on new factory in Shenzhen

35

TARGET HKD6.06 PRIOR TP N/A China ComService 552 HK CLOSE HKD4.81

BUY CHINA / DIVERSIFIED TELECOMMUNICATION UP/DOWNSIDE +26.0%

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 marketsInitiate at BUY with a DCF-based target price of HKD6.06

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 upgrades and 3G network build-out. CCS is also increasing its exposure to operators’ opex by providing business process outsourcing services (BPO) and applications, content and other services (ACO). In addition, we see more upside for the company’s non-operator and overseas businesses. Multi-dimensional expansion provides growth potential In our view, CCS’s incremental growth will come from its multi-dimensional 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. 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 Telecom’s (728 HK) projects and around 25% in both China Mobile (941 HK) and China Unicom’s (782 HK) projects. As CCS’s top three customers are also its top three shareholders, we believe the company will be able to maintain its dominant market share in China Telecom’s projects while gaining share in China Mobile and China Unicom’s projects. Valuation: BUY with target price of HKD6.06 We estimate CCS’s 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.



Target Price (HKD) 6.06 5.46 11.0

EPS 2011 (RMB) 0.36 0.36 0.0

EPS 2012 (RMB) 0.40 0.41 (2.4)


KEY STOCK DATA

YE Dec (RMB m) 2011E 2012E 2013E

Revenue 52,033 59,212 67,038

Rec. net profit 2,081 2,334 2,641

Recurring EPS (RMB) 0.36 0.40 0.46

Prior rec. EPS (RMB) - - -


EPS growth (%) 14.5 12.2 13.1

Recurring P/E (x) 11.1 9.9 8.8


EV/EBITDA (x) 5.1 4.5 3.9

Price/book (x) 1.5 1.4 1.3

Net debt/Equity (45.6) (44.7) (43.9)

ROE (%) 14.2 14.9 15.7

3.00

4.00

5.00

6.00


(HKD)

(3)

17

37

57(%)China ComService

Rel to MSCI China

Share price performance 1 Month 3 Month 12 Month

Absolute (%) 2.2 (5.6) 46.3

Relative to country (%) 6.3 (8.1) 29.2

Next results August 2011 Mkt cap (USD m) 3,569


Free float (%) 35

Major shareholder China Telecom Corp. (53%)

12m high/low (HKD) 5.50/3.26


ADR ticker -


Sources: Bloomberg consensus; BNP Paribas estimates

INDUSTRY OUTLOOK INITIATION

Joyce Zhou


Alen Lin +852 2825 1801

[email protected]

3 June 2011

36

JOYCE ZHOU CHINA COMSERVICE 3 JUNE 2011

3 BNP PARIBAS

—— Base —— —— Best —— –— Worse –—


Gross margin (%) 16.6 16.8 17.1 17.3 16.1 16.3

EPS (RMB) 0.36 0.40 0.40 0.44 0.32 0.36

Change (%) — — 9.9 10.0 (9.9) (10.0)

Key Earnings Drivers & Sensitivity We believe CCS’s 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 CCS’s EPS to +/- 0.5% of blended gross margin.


CCS and MXCN Index (3M and 6M realised-vol) Regression – CCS to MXCN Index

0

100

200

300

400

500

600

700

800

Dec-06 Dec-07 Dec-08 Dec-09 Dec-10

(%)

China ComService - 3M Realised - Vol China ComService - 6M Realised - Vol



-38.00%

-28.00%

-18.00%

-8.00%

2.00%

12.00%

-22.00% -17.00% -12.00% -7.00% -2.00% 3.00% 8.00% 13.00% 18.00%

MSCI China

Chi

na C

omSe

rvic

e

China ComService = 0 + 0.0765 * MXCN IndexR 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


Insurance 1.00 0.76 0.79 0.67 0.69 0.61 0.76

Metal & Mining 1.00 0.82 0.70 0.69 0.63 0.84

Oil & Gas 1.00 0.64 0.76 0.64 0.83

Property 1.00 0.55 0.54 0.67

Telecom 1.00 0.61 0.68

Utilities 1.00 0.56



China ComService - China Unicom

-2s

-1s

Mean

+1s

+2s

0.25

0.30

0.35

0.40

0.45

0.50

0.55

0.60

0.65

Jun-08 Dec-08 Jun-09 Dec-09 Jun-10 Dec-10

(x)






37


4 BNP PARIBAS

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 BPO ACO - Design - construction - Supervision

- Maintenance - Distribution - Facility management

- IT Application - Internet services - Voice VAS

Source: China ComService

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

05,000

10,00015,00020,00025,00030,00035,00040,00045,00050,000

2005 2006 2007 2008 2009 2010

(RMB m) 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, CCS’s engineering and construction subsidiaries hold eight Class-1 qualifications. For project supervision

38


5 BNP PARIBAS

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, CCS’s 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 company’s 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


6 BNP PARIBAS

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 Exhibit 4: Operator revenue breakdown

05,000

10,00015,00020,00025,00030,00035,00040,00045,00050,000

2006 2007 2008 2009 2010

(RMB m) Operator revenue Non-operator revenue

China Mobile &

China Unicom32.4%

China Telecom67.6%

Sources: China ComService; BNP Paribas Sources: China ComService; BNP Paribas

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, China’s 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 CCS’s geographic coverage, and it is already involved in some related projects. Though revenue from the cable industry still represents only a tiny portion of CCS’s 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


7 BNP PARIBAS

completion of China’s 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

0

100

200

300

400

500

600

China Mobile China Unicom

('000) Number of 2G base station Number of 3G base station

Sources: China Mobile; 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 Mobile’s parent company for TD-SCDMA network, RMB23b from China Telecom’s 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

0

10

20

30

40

50

60

70

80

2010 2011E

(RMB b) China Mobile parent company China Telecom parent companyChina Unicom

Sources: China Mobile, China Unicom,China Telecom, BNP Paribas estimates

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.

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Exhibit 7: China telecom sector capex plus opex, 2005-13E

0

200

400

600

800

1,000

1,200

2005 2006 2007 2008 2009 2010 2011 2012 2013

(RMB b) 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

Distribution64.6%

Maintenance23.1%

Facility management

12.3%

Others27.4%

Voice VAS13.4%

Internet services

9.2%

IT applications

50.0%

Sources: China ComService; BNP Paribas Sources: China ComService; BNP Paribas

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 CCS’s 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.

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Exhibit 10: Operator revenue growth

0

2

4

6

8

10

12

14

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 Telecom’s 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

0

5,000

10,000

15,000

20,000

25,000

30,000

35,000

40,000

2008 2009 2010 2011E 2012E 2013E

(RMB m) China Telecom China Mobile & China Unicom


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10 BNP PARIBAS

Multi-dimensional expansion We believe CCS’s 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 CCS’s 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 operator-related areas. We see more such potential in the BPO and ACO segments as the

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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 CITCC’s 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

Xi’an 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 CCS’s 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

0

20

40

60

80

100

120

140

160

180

2009 2010 2011E 2012E 2013E 2014E 2015E

(USD b)

0

2

4

6

8

10

12

14

(%)Hardware (LHS) Internal services (LHS)Software (LHS) IT services (LHS)Telecommunications (LHS) Growth (RHS)

Source: Gartner (April 2011)

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Exhibit 15: : Government and enterprise IT spending in China by industry

0

20

40

60

80

100

120

140

160

180

2009 2010 2011E 2012E 2013E 2014E 2015E

(USD b)Manu. & Natural Res. Comm., Media & Ser. GovernmentBanking & Securities Others

Source: Gartner (April 2011)

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 above- average 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)02468

10

2010 2011E 2012E 2013E 2014E 2015E

(%) Asia/Pacific Eastern Europe JapanLatin America Middle East & Africa North AmericaWestern Europe

Source: Gartner

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Exhibit 17: Government and enterprise IT spending growth by region

(4)

(2)

0

2

4

6

8

10

12

14

2010 2011E 2012E 2013E 2014E 2015E

(%) Asia/Pacific Eastern Europe JapanLatin America Middle East & Africa North AmericaWestern Europe

Source: Gartner

Currently, most of CCS’s 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 company’s total revenue. With the more completed overseas presence and the past years’ operating experience, we believe the company’s overseas business will accelerate in the coming years, and represent over 10% of total revenue in 2013E.

Exhibit 18: CCSI overseas subsidiaries


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Exhibit 19: Key overseas projects by CCS Bahamas Leisure venues - weak current engineering projects, mechanical and electrical

engineering projects

Yemen Campus intranet construction

Tanzania National fiber optic backbone & transmission network construction (Phase 1)

Australia - New Zealand Submarine cable projects Source: China ComService

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 company’s 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

0102030405060708090

100

2006 2007 2008 2009 2010 2011E 2012E 2013E

(%) Non-operator revenue as % of total revenueOperator 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 Group’s overseas expansion as well as the continuing development of non-

telecommunications 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

Up to RMB1.5b Potential acquisition of strategic assets and joint venture opportunities

Up to RMB1.5b Group’s operations centre and investment in research and development and related infrastructure


The company has got the SASAC’s 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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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 CCS’s 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 company’s 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 CCS’s direct personnel cost as a percentage of total revenue will decline and that subcontracting charges will increase, as the company’s transforms itself into a tech- and service-intensive model.

Exhibit 22: COGS breakdown (as % of revenue)

0

10

20

30

40

50

60

70

80

90

2005 2006 2007 2008 2009 2010 2011E 2012E 2013E

(%) Depreciation and amortization Direct personnel costs Purchase of materials & products Subcontracting charges Operating lease charges and others


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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 CCS’s 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 (%) 10.0 Mid-term revenue growth (%) 8.8 Terminal growth (%) 2.0

Mid-term EBIT margin (%) 5.0 Terminal EBIT margin (%) 5.0

Mid-term tax rate (%) 23.0 Terminal tax rate (%) 25.0

Target price (HKD) 6.06 Source: BNP Paribas estimates

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 company’s 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 Exhibit 25: P/BV band chart

0

2

4

6

8

10

12

14

16

Dec-06 Jan-08 Feb-09 Mar-10 Apr-11

(HKD)

10x

25x

20x

15x

30x

0

2

4

6

8

10

12

Dec-06 Jan-08 Feb-09 Mar-10 Apr-11

(HKD)

1.0x

3.0x

2.0x

1.5x

2.5x

Sources: Bloomberg; BNP Paribas Sources: Bloomberg; BNP Paribas

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Exhibit 26: Corporate structure

China Telecommuncations

Corp

China Mobile Communications Corp

China United Network Communications Group

Co LtdPublic Shareholders

China Communications Services Corp Ltd

Guangdong Communications Services Co Ltd

52.60% 8.78% 4.09% 34.53%

100%

Shanghai Communications Services Co Ltd100%

Hubei Communications Services Co Ltd100%

Anhui Communications Services Co Ltd100%

Hunan Communications Services Co Ltd100%

Chongqing Communications Services Co Ltd100%

Guizhou Communications Services Co Ltd100%

Shaanxi Communications Services Co Ltd100%

Qinghai Communications Services Co Ltd100%

China International Telecommunications Communications Corp

100%

Guoxin Lucent Technologies Network Technologies Co Ltd

100%

Zhejiang Communications Services Co Ltd100%

Fujian Communications Services Co Ltd100%

Jiangsu Communications Services Co Ltd100%

Jiangxi Communications Services Co Ltd100%

Guangxi Communications Services Co Ltd100%

Sichuan Communications Services Co Ltd100%

Yunnan Communications Services Co Ltd100%

Gansu Communications Services Co Ltd100%

Xinjiang Communications Services Co Ltd100%

China Communications Services (Hong Kong) International Ltd100%


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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.

Zheng Qibao 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.

Yuan Jianxing 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.

Hou Rui 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.

Liu Aili 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.

Zhang Junan 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.


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China ComService Profit and Loss (RMB m) Year Ending Dec 2009A 2010A 2011E 2012E 2013ERevenue 39,499 45,417 52,033 59,212 67,038Cost of sales ex depreciation (32,518) (37,396) (42,878) (48,666) (54,915)Gross profit ex depreciation 6,982 8,022 9,155 10,546 12,123Other operating income 521 630 650 650 650Operating costs (4,768) (5,698) (6,574) (7,590) (8,718)Operating EBITDA 2,734 2,953 3,231 3,606 4,055Depreciation (610) (623) (543) (598) (659)Goodwill amortisation 0 0 0 0 0Operating EBIT 2,124 2,331 2,687 3,008 3,396Net financing costs (88) (58) (58) (58) (58)Associates 2 3 3 3 3Recurring non operating income 0 0 0 0 0Non recurring items 0 0 0 0 0Profit before tax 2,038 2,276 2,633 2,953 3,341Tax (427) (460) (553) (620) (702)Profit after tax 1,610 1,816 2,080 2,333 2,639Minority interests 12 1 1 1 1Preferred dividends 0 0 0 0 0Other items 0 0 0 0 0Reported net profit 1,622 1,818 2,081 2,334 2,641Non recurring items & goodwill (net) 0 0 0 0 0Recurring net profit 1,622 1,818 2,081 2,334 2,641

Per share (RMB) Recurring EPS * 0.28 0.31 0.36 0.40 0.46Reported EPS 0.28 0.31 0.36 0.40 0.46DPS 0.11 0.13 0.14 0.16 0.18

Growth Revenue (%) 19.7 15.0 14.6 13.8 13.2Operating EBITDA (%) 9.5 8.0 9.4 11.6 12.4Operating EBIT (%) 10.6 9.7 15.3 11.9 12.9Recurring EPS (%) 20.4 12.1 14.5 12.2 13.1Reported EPS (%) 20.4 12.1 14.5 12.2 13.1

Operating performance Gross margin inc depreciation (%) 16.1 16.3 16.6 16.8 17.1Operating EBITDA margin (%) 6.9 6.5 6.2 6.1 6.0Operating EBIT margin (%) 5.4 5.1 5.2 5.1 5.1Net margin (%) 4.1 4.0 4.0 3.9 3.9Effective tax rate (%) 21.0 20.2 21.0 21.0 21.0Dividend payout on recurring profit (%) 39.4 40.0 40.0 40.0 40.0Interest cover (x) 24.0 40.4 46.6 52.2 58.9Inventory days 16.0 17.0 16.7 16.8 16.8Debtor days 91.5 93.8 97.0 97.3 97.5Creditor days 93.1 90.8 89.1 89.3 89.5Operating ROIC (%) 41.4 38.1 35.0 34.9 35.2Operating ROIC – WACC (%) 27.9 24.7 21.6 21.5 21.8ROIC (%) 28.1 26.3 25.1 25.9 26.9ROIC – WACC (%) 14.7 12.9 11.7 12.5 13.5ROE (%) 12.9 13.3 14.2 14.9 15.7ROA (%) 5.8 5.8 6.0 6.1 6.2* Pre exceptional, pre-goodwill and fully diluted

Revenue By Division (RMB m) 2009A 2010A 2011E 2012E 2013ETIS 19,289 21,637 24,607 27,667 31,208BPO 15,943 18,508 21,099 23,954 26,720ACO 4,267 5,272 6,326 7,592 9,110

Sources: CCS; BNP Paribas estimates

We expect stable margins for next three years

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China ComService Cash Flow (RMB m) Year Ending Dec 2009A 2010A 2011E 2012E 2013ERecurring net profit 1,622 1,818 2,081 2,334 2,641Depreciation 610 623 543 598 659Associates & minorities 0 0 0 0 0Other non-cash items (7) (55) 0 0 0Recurring cash flow 2,225 2,385 2,625 2,933 3,300Change in working capital (516) (1,669) (749) (818) (904)Capex - maintenance (725) (820) (850) (950) (1,050)Capex – new investment 0 0 0 0 0Free cash flow to equity 984 (104) 1,025 1,165 1,347Net acquisitions & disposals 0 0 0 0 0Dividends paid (309) (1,298) (727) (833) (934)Non recurring cash flows (89) (235) 0 0 0Net cash flow 585 (1,637) 298 333 413Equity finance 0 0 0 0 0Debt finance (602) 437 0 0 0Movement in cash (17) (1,200) 298 333 413Per share (RMB) Recurring cash flow per share 0.39 0.41 0.45 0.51 0.57FCF to equity per share 0.17 (0.02) 0.18 0.20 0.23Balance Sheet (RMB m) Year Ending Dec 2009A 2010A 2011E 2012E 2013EWorking capital assets 15,428 18,958 21,673 24,620 27,828Working capital liabilities (15,681) (17,702) (20,217) (22,938) (25,876)Net working capital (253) 1,256 1,456 1,682 1,952Tangible fixed assets 3,986 4,180 4,636 5,138 5,679Operating invested capital 3,733 5,436 6,092 6,820 7,631Goodwill 103 103 103 103 103Other intangible assets 148 152 152 152 152Investments 318 633 633 633 633Other assets 1,308 1,372 1,372 1,372 1,372Invested capital 5,611 7,696 8,352 9,079 9,891Cash & equivalents (8,870) (8,470) (8,767) (9,098) (9,510)Short term debt 1,268 1,781 1,781 1,781 1,781Long term debt * 0 0 0 0 0Net debt (7,602) (6,690) (6,986) (7,318) (7,729)Deferred tax 0 0 0 0 0Other liabilities 36 32 32 32 32Total equity 13,069 14,221 15,174 16,233 17,455Minority interests 109 133 133 133 133Invested capital 5,611 7,696 8,352 9,079 9,891* includes convertibles and preferred stock which is being treated as debt

Per share (RMB) Book value per share 2.26 2.46 2.63 2.81 3.02Tangible book value per share 2.22 2.42 2.58 2.77 2.98Financial strength Net debt/equity (%) (57.7) (46.6) (45.6) (44.7) (43.9)Net debt/total assets (%) (25.2) (19.8) (18.7) (17.8) (17.1)Current ratio (x) 1.4 1.4 1.4 1.4 1.4CF interest cover (x) 12.1 (0.8) 18.8 21.2 24.3Valuation 2009A 2010A 2011E 2012E 2013ERecurring P/E (x) * 14.3 12.7 11.1 9.9 8.8Recurring P/E @ target price (x) * 18.0 16.0 14.0 12.5 11.0Reported P/E (x) 14.3 12.7 11.1 9.9 8.8Dividend yield (%) 2.8 3.1 3.6 4.0 4.6P/CF (x) 10.4 9.7 8.8 7.9 7.0P/FCF (x) 23.5 (222.7) 22.5 19.8 17.2Price/book (x) 1.8 1.6 1.5 1.4 1.3Price/tangible book (x) 1.8 1.7 1.5 1.4 1.3EV/EBITDA (x) ** 5.9 5.4 5.1 4.5 3.9EV/EBITDA @ target price (x) ** 7.4 6.8 6.4 5.6 4.9EV/invested capital (x) 2.8 2.2 1.9 1.8 1.6* Pre exceptional, pre-goodwill and fully diluted ** EBITDA includes associate income and recurring non-operating income

Sources: CCS; BNP Paribas estimates

We have not factored in the up to RMB4b rights issue as it is still pending approvals from shareholders and the regulator

54

TARGET HKD31.00 PRIOR TP HKD31.00 ZTE Corp 763 HK CLOSE HKD27.05

HOLD CHINA / TECHNOLOGY HARDWARE & EQUIPMENT UP/DOWNSIDE +14.6% UNCHANGED

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

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 China’s 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.

Slower wireless contracts dampen growth potential We believe ZTE’s 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 ZTE’s 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 ZTE’s global market share gain to slow in the next one to two years until the next major wireless upgrade cycle accelerates.

Strong handset growth – a mixed blessing While we expect ZTE’s terminal device growth to remain strong at 22.7% y-y in 2011, this segment’s 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 ZTE’s 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%.

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.



Target Price (HKD) 31.00 31.87 (2.7)

EPS 2011 (RMB) 1.05 1.14 (7.9)

EPS 2012 (RMB) 1.19 1.39 (14.4)


KEY STOCK DATA

YE Dec (RMB m) 2011E 2012E 2013E

Revenue 87,361 102,323 113,585

Rec. net profit 3,456 4,099 4,842

Recurring EPS (RMB) 1.05 1.19 1.41

Prior rec. EPS (RMB) 1.05 1.19 1.41


EPS growth (%) (0.9) 13.1 18.1

Recurring P/E (x) 21.4 18.9 16.0


EV/EBITDA (x) 10.9 10.1 9.0

Price/book (x) 2.6 2.4 2.0

Net debt/Equity (6.1) (9.0) (13.2)

ROE (%) 13.5 13.5 13.7

1015202530


(HKD)

(9)

11

31

(%)ZTE CorpRel to MSCI China

Share price performance 1 Month 3 Month 12 Month Absolute (%) (0.9) (4.1) 28.8 Relative to country (%) (0.8) (13.6) 12.8

Next results July 2011 Mkt cap (USD m) 11,404


Free float (%) 64

Major shareholder Zhongxingxin (36%)

12m high/low (HKD) 30.50/18.88


ADR ticker -


Sources : Bloomberg consensus; BNP Paribas estimates

INDUSTRY OUTLOOK NEW INFORMATION

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

Alen Lin


Joyce Zhou +852 2825 1120

[email protected]

3 June 2011

55

ALEN LIN ZTE CORP 3 JUNE 2011

2 BNP PARIBAS

—— Base —— —— Best —— —— Worse ——


Net sales (RMB m) 87,361 102,323 91,729 107,439 82,993 97,207

EPS (RMB) 1.05 1.19 1.11 1.25 1.00 1.14

Change (%) — — 4.9 4.5 (4.9) (4.5)

Key Earnings Drivers & Sensitivity Downside risk: India 3G roll-out, margin risks due to

competitive pressure, and China network contractallocation and profitability. Poor handset profitability.

Upside risk: Strong growth of optical network would have a positive impact on margins.


ZTE Corp and MXCN Index (3M and 6M realised-vol) Regression – ZTE Corp to MXCN Index

0

20

40

60

80

100

120

140

Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10

(%)

ZTE Corp - 3M Realised - Vol ZTE Corp - 6M Realised - Vol



-40.00%

-30.00%

-20.00%

-10.00%

0.00%

10.00%

20.00%

30.00%

-22.00% -17.00% -12.00% -7.00% -2.00% 3.00% 8.00% 13.00% 18.00%

MSCI China

ZTE

Cor

p

ZTE Corp = 3 + 0.2199 * MXCN IndexR 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


Insurance 1.00 0.76 0.79 0.67 0.69 0.61 0.76

Metal & Mining 1.00 0.82 0.70 0.69 0.63 0.84

Oil & Gas 1.00 0.64 0.76 0.64 0.83

Property 1.00 0.55 0.54 0.67

Telecom 1.00 0.61 0.68

Utilities 1.00 0.56



ZTE Corp - O-NET

-2s

-1s

Mean

+1s

+2s

3.352559749

4.352559749

5.352559749

6.352559749

7.352559749

8.352559749

9.352559749

Apr-10 Oct-10 Apr-11

(x)






56


3 BNP PARIBAS


ZTE Corp Profit and Loss (RMB m) Year Ending Dec 2009A 2010A 2011E 2012E 2013ERevenue 60,273 70,264 87,361 102,323 113,585Cost of sales ex depreciation (40,896) (47,731) (59,401) (70,065) (77,525)Gross profit ex depreciation 19,376 22,532 27,960 32,258 36,059Other operating income 0 0 0 0 0Operating costs (15,675) (18,506) (22,626) (26,399) (29,305)Operating EBITDA 3,702 4,026 5,333 5,859 6,754Depreciation (772) (868) (1,158) (1,164) (1,170)Goodwill amortisation 0 0 0 0 0Operating EBIT 2,930 3,159 4,175 4,694 5,585Net financing costs (641) (628) (700) (700) (700)Associates 0 0 0 0 0Recurring non operating income 1,036 1,829 1,210 1,585 1,616Non recurring items 0 0 0 0 0Profit before tax 3,325 4,360 4,685 5,580 6,501Tax (629) (884) (898) (1,150) (1,329)Profit after tax 2,696 3,476 3,786 4,429 5,172Minority interests (238) (226) (330) (330) (330)Preferred dividends 0 0 0 0 0Other items 0 0 0 0 0Reported net profit 2,458 3,250 3,456 4,099 4,842Non recurring items & goodwill (net) 0 0 0 0 0Recurring net profit 2,458 3,250 3,456 4,099 4,842

Per share (RMB) Recurring EPS * 0.82 1.06 1.05 1.19 1.41Reported EPS 0.82 1.06 1.05 1.19 1.41DPS 0.20 0.21 0.21 0.24 0.28

Growth Revenue (%) 36.1 16.6 24.3 17.1 11.0Operating EBITDA (%) 9.4 8.8 32.5 9.9 15.3Operating EBIT (%) 4.8 7.8 32.2 12.4 19.0Recurring EPS (%) 41.3 29.9 (0.9) 13.1 18.1Reported EPS (%) 41.3 29.9 (0.9) 13.1 18.1

Operating performance Gross margin inc depreciation (%) 30.9 30.8 30.7 30.4 30.7Operating EBITDA margin (%) 6.1 5.7 6.1 5.7 5.9Operating EBIT margin (%) 4.9 4.5 4.8 4.6 4.9Net margin (%) 4.1 4.6 4.0 4.0 4.3Effective tax rate (%) 18.9 20.3 19.2 20.6 20.4Dividend payout on recurring profit (%) 24.4 20.0 20.0 20.0 20.0Interest cover (x) 6.2 7.9 7.7 9.0 10.3Inventory days 81.7 81.9 83.5 85.5 87.9Debtor days 142.1 157.3 154.9 159.2 163.2Creditor days 191.1 200.1 195.1 199.7 205.3Operating ROIC (%) 18.8 16.0 17.5 17.3 18.9Operating ROIC – WACC (%) 9.3 6.5 7.9 7.7 9.3ROIC (%) 18.3 16.2 14.0 14.1 14.8ROIC – WACC (%) 8.7 6.7 4.4 4.6 5.2ROE (%) 15.8 16.3 13.5 13.5 13.7ROA (%) 5.3 5.1 4.7 4.6 4.7* Pre exceptional, pre-goodwill and fully diluted

Revenue By Division (RMB m) 2009A 2010A 2011E 2012E 2013ECarrier networks 39,982 41,990 53,861 61,923 71,485Terminal 13,072 17,927 22,000 26,000 30,000SW systems and services 7,219 10,346 11,500 14,400 12,100

Sources: ZTE Corp; BNP Paribas estimates

RMB440m contribution from disposal of non-core investments

57


4 BNP PARIBAS

ZTE Corp Cash Flow (RMB m) Year Ending Dec 2009A 2010A 2011E 2012E 2013ERecurring net profit 2,458 3,250 3,456 4,099 4,842Depreciation 772 868 1,158 1,164 1,170Associates & minorities 0 0 0 0 0Other non-cash items 0 0 0 0 0Recurring cash flow 3,230 4,118 4,614 5,264 6,011Change in working capital (3,117) (4,135) (4,066) (3,491) (2,816)Capex - maintenance 0 0 0 0 0Capex – new investment (1,591) (1,869) (1,200) (1,200) (1,200)Free cash flow to equity (1,478) (1,886) (652) 573 1,996Net acquisitions & disposals 0 0 0 0 0Dividends paid (447) (630) (698) (725) (820)Non recurring cash flows 2,308 (906) 1,636 1,487 964Net cash flow 383 (3,421) 286 1,335 2,140Equity finance 22 3,913 0 0 0Debt finance 2,310 375 0 0 0Movement in cash 2,715 867 286 1,335 2,140Per share (RMB) Recurring cash flow per share 1.08 1.35 1.41 1.53 1.75FCF to equity per share (0.49) (0.62) (0.20) 0.17 0.58Balance Sheet (RMB m) Year Ending Dec 2009A 2010A 2011E 2012E 2013EWorking capital assets 42,652 51,996 64,682 75,834 84,087Working capital liabilities (35,371) (41,670) (51,925) (61,073) (67,475)Net working capital 7,280 10,327 12,757 14,761 16,613Tangible fixed assets 6,058 7,720 7,762 7,798 7,828Operating invested capital 13,338 18,047 20,519 22,559 24,441Goodwill 0 0 0 0 0Other intangible assets 877 1,583 1,583 1,583 1,583Investments 694 1,261 1,281 1,301 1,321Other assets 5,108 8,044 10,002 11,715 13,004Invested capital 20,018 28,934 33,384 37,156 40,348Cash & equivalents (14,076) (14,905) (15,191) (16,526) (18,666)Short term debt 6,846 7,901 7,901 7,901 7,901Long term debt * 6,029 5,475 5,475 5,475 5,475Net debt (1,200) (1,529) (1,815) (3,150) (5,289)Deferred tax 0 0 0 0 0Other liabilities 3,269 5,501 5,501 5,501 5,501Total equity 16,825 23,094 27,994 32,812 37,809Minority interests 1,124 1,868 1,704 1,993 2,327Invested capital 20,018 28,934 33,384 37,156 40,348* includes convertibles and preferred stock which is being treated as debt

Per share (RMB) Book value per share 5.61 7.56 8.54 9.54 10.99Tangible book value per share 5.31 7.04 8.05 9.08 10.53Financial strength Net debt/equity (%) (6.7) (6.1) (6.1) (9.0) (13.2)Net debt/total assets (%) (1.7) (1.8) (1.8) (2.7) (4.2)Current ratio (x) 1.3 1.3 1.3 1.3 1.4CF interest cover (x) 1.2 1.0 1.8 3.5 5.6Valuation 2009A 2010A 2011E 2012E 2013ERecurring P/E (x) * 27.5 21.2 21.4 18.9 16.0Recurring P/E @ target price (x) * 31.5 24.3 24.5 21.7 18.3Reported P/E (x) 27.5 21.2 21.4 18.9 16.0Dividend yield (%) 0.9 0.9 0.9 1.1 1.2P/CF (x) 20.9 16.7 16.0 14.7 12.9P/FCF (x) (45.7) (36.5) (113.3) 135.3 38.8Price/book (x) 4.0 3.0 2.6 2.4 2.0Price/tangible book (x) 4.2 3.2 2.8 2.5 2.1EV/EBITDA (x) ** 13.9 11.7 10.9 10.1 9.0EV/EBITDA @ target price (x) ** 14.6 12.2 11.4 10.6 9.5EV/invested capital (x) 3.4 2.4 2.2 2.1 1.8* Pre exceptional, pre-goodwill and fully diluted ** EBITDA includes associate income and recurring non-operating income

Sources: ZTE Corp; BNP Paribas estimates

Capex-to-sales ratio has remained less than 5% forrecent years and we expect it to decline gradually as it benefits from greater economy of scale

58


20 BNP PARIBAS

BNP Paribas Telecoms, Media & Technology Research Team

WEIYEE IN 殷維一 Telecoms, Media & Technology Strategy BNP Paribas Securities (Asia) Ltd +852 2825 1813 [email protected]

SUN CHUNG Head of Research, Korea BNP Paribas Securities Korea Co Ltd +822 2125 0532 [email protected].

CHARLES CHENG, CFA Technology Strategy BNP Paribas Securities (Asia) Ltd +852 2825 1825 [email protected]

SZEHO NG, CFA Packaging & Testing, Foundry, Displays BNP Paribas Securities (Asia) Ltd +852 2825 1167 [email protected]

PETER YU, CFA Semiconductors, Displays, Handsets BNP Paribas Securities Korea Co Ltd +822 2125 0535 [email protected]

ALEN LIN Telecom Services and Equipment BNP Paribas Securities (Asia) Ltd +852 2825 1801 [email protected]

FOONG CHOONG CHEN ASEAN Telecom BNP Paribas Capital (Malaysia) Sdn. Bhd. +603 2050 9938 [email protected]

DOUGLAS KIM Alternative Energy BNP Paribas Securities Korea Co Ltd +822 2125 0540 [email protected]

YVONNE YANG Internet BNP Paribas Equities (Asia) Ltd Shanghai Representative Office +8621 6096 9046 [email protected]

ABHIRAM ELESWARAPU Software & Services BNP Paribas Securities India Pvt Ltd +91 22 6628 2406 [email protected]

AVINASH SINGH Tech - IT (Associate) BNP Paribas Securities India Pvt Ltd +91 22 6628 2407 [email protected]

SAMEER NARINGREKAR Tech - Telecom BNP Paribas Securities India Pvt Ltd +91 22 6628 2454 [email protected]

SCOTT FOSTER Technology BNP Paribas Securities Japan +81 3 6377 2240 [email protected]

KEI RAMEAU Technology BNP Paribas Securities (Japan) Ltd +81 3 6377 2232 [email protected]

HENRY AI IT Service BNP Paribas Securities (Asia) Ltd Shanghai Representative Office +8621 6069 9037 [email protected]

JOYCE ZHOU Telecom Services and Equipment BNP Paribas Securities (Asia) Ltd +852 2825 1120 [email protected]

HIROSHI YAMASHINA Telecoms and Internet BNP Paribas Securities Japan +81 3 6377 2235 [email protected]

VIVIAN WAN Telecoms BNP Paribas Securities Japan +81 3 6377 2239 [email protected]

CHARLES HSU Displays, Touch Panels, LED BNP Paribas Securities (Taiwan) Co Ltd + 886 2 8729 7055 [email protected]

LAURA CHEN Handset/Hardware BNP Paribas Securities (Taiwan) Co Ltd +886 2 8729 7052 [email protected]

PATTY LIU PC/Downstream BNP Paribas Securities (Taiwan) Co Ltd +886 2 2175 7049 [email protected]

KYNA WONG Research Associate BNP Paribas Securities (Asia) Ltd +852 2825 1823 [email protected]

KUNAL VORA, CFA Research Associate BNP Paribas Securities India Pvt Ltd +91 22 6628 2453 [email protected]

YIFAN LAI Research Associate BNP Paribas Securities (Taiwan) Co Ltd +886 2 8729 7056 [email protected]

YOUNG SHIN Research Associate BNP Paribas Securities Korea Co Ltd +822 2125 0546 [email protected]

JAMES WANG Research Associate BNP Paribas Securities (Taiwan) Co Ltd +886 2 8729 7058 [email protected]

KYUN JANG Research Associate BNP Paribas Securities Korea Co Ltd +822 2125 0537 [email protected]

59


21 BNP PARIBAS

H I S T O R Y O F C H A N G E I N I N V E S T M E N T R A T I N G A N D / O R T A R G E T P R I C E

ZTE Corp (763 HK)

4.00

9.00

14.00

19.00

24.00

29.00

34.00

Jun-07 Jun-08 Jun-09 Jun-10 Jun-11

(HKD) ZTE Corp Target Price

Date Reco TP

1-Apr-07 HOLD 14.83

16-Nov-07 BUY 12.50

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


22 BNP PARIBAS

NOTES

61


23 BNP PARIBAS

D I S C L A I M E R S & D I S C L O S U R E S

ANALYST(S) CERTIFICATION Alen Lin, BNP Paribas Securities (Asia) Ltd, +852 2825 1801, [email protected]. Joyce Zhou, BNP Paribas Securities (Asia) Ltd, +852 2825 1120, [email protected]. 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 name for the global banking and markets business of BNP Paribas Group1. 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 recipient’s 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. 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Reproduction, distribution or publication of this report in any other places or to persons to whom such distribution or publication is not permitted under the applicable laws or regulations of such places is strictly prohibited. This report is distributed in Singapore by BNP Paribas Securities (Singapore) Limited ("BNPPSSL") and may be distributed in Singapore only to an accredited investor or an expert investor, each as defined under the Financial Advisers Regulations ("FAR") and the Securities and Futures Act (Chapter 289) of Singapore, as amended from time to time. In relation to the distribution to such categories of investors, BNPPSSL and its representatives are exempted under Regulation 35 of the FAR from the requirements in Section 36 of the Financial Advisers Act of Singapore, regarding the disclosure of certain interests in, or certain interests in the acquisition or disposal of, securities referred to in this report. 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). 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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


24 BNP PARIBAS

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 Disclosure (as applicable) O-Net Communications NA China ComService NA ZTE 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 557 Investment Banking Relationship (%) Buy 366 Buy 4.10 Hold 139 Hold 4.32 Reduce 52 Reduce 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

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BEIJING

Beijing Representative Office

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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

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 Société 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 Société 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

BNP Paribas Equities (Asia) Ltd

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

MUMBAI

BNP Paribas Equities (Asia) Ltd Shanghai Representative Office Room 2630, 26/F Shanghai World Financial Center 100 Century Avenue Shanghai 200120, China Tel (86 21) 6096 9000 Fax (86 21) 6096 9018

JAKARTA PT BNP Paribas Securities Indonesia Grand Indonesia, Menara BCA, JI. M.H. Thamrin No. 1Jakarta 10 0 Indonesia Tel (62 21) 2358 6586 Fax (62 21) 2358 7587

35/F

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TAIPEI BNP Paribas Securities (Taiwan) Co Ltd 72 F, Taipei 101 No. 7 Xin Yi Road, Sec. 5 Taipei, Taiwan

(886 2) 8729 7000 Fax (886 2) 8101 2168

Tel

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BANGKOK(In cooperation with BNP Paribas)ACL Securities Co Ltd990 Abdulrahim Place, 12/FRama IV Road, BangrakBangkok 10500ThailandTel (66 2) 611 3500Fax (66 2) 611 3551

Room 2016, 20/FChina World Tower1 Jianguomenwai AvenueBeijing 100004, ChinaTel (86 10) 6561 1118 Fax (86 10) 6561 2228

Vista Tower, Level 48CThe Intermark, 182 Jalan Tun Razak50400 Kuala Lumpur

Tel (60 3) 2179 6222Fax (60 3) 2179 6226

BNP Paribas Capital (Malaysia) Sdn Bhd BNP Paribas Securities India Pvt Ltd BNP Paribas House1 North Avenue, Maker MaxityBandra Kurla ComplexBandra EastMumbai 400 051Tel (91 22) 3370 4000Fax (91 22) 3370 4386

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

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