中兴通讯(000063)

ZTE Corporation (ZTE) posted a net profit of RMB564.5m in Q3 2018, which is at mid point of theprevious guidance range. ZTE guided a net loss of RMB6.2bn-7.2bn for 2018, which implies a netprofit of RMB64m-RMB1.0bn for Q4 2018. We acknowledge that the recovery is somewhat slowerthan expected, but the Company is still on the track to recover from the impact of the US export ban.We believe that ZTE will be one of the major beneficiaries of 5G investment in China. We still believe that ZTE’s recovery will be driven mainly driven by a pick-up in CAPEX by local telecom operators, and government and corporate business. But the consumer products segment is expected tolag behind, since it is more reliant on overseas markets. Shares of ZTE may come under pressureafter the Q3 2018 results announcement, given the slower-than-expected recovery. But we still believe infrastructure-related segments such as 5G will be the main investment themes in 2019, andZTE is a major name in the infrastructure-related hardware providers listed in HK and China. We stillbelieve that market confidence in ZTE will be restored. Apart from the recovery in operating performance, news flow on 5G development in China is a major share price catalyst for ZTE. We maintainour BUY rating with a target price of HK$18.67, based on 14x 2019E PER, lower than the Company’s historical mean of 22x. Our target price for ZTE-A (000063.CH) is RMB21.55, and we upgradeour rating from HOLD to BUY on ZTE-A.

Investment Highlights

Q3 2018: Back to profitability. ZTE’s turnover dropped 14.3% YoY, from RMB22,569m in Q32017 to RMB19,332m in Q3 2018. The YoY decline in turnover in Q3 2018 was less than the27% YoY drop in 1H 2018. The Q3 2018 turnover figures were still distorted by the US exportban. The Company reported a net profit of RMB564.5m in Q3 2018, at the mid-point of previous guidance. This represents a 50.4% YoY drop from RMB1,138.4m in Q3 2017, but a turnaround from a net loss of RMB7,824.2m in 1H 2018. ZTE’s blended gross profit margin improved to 36.5% in Q3 2018, a multi-year high, in our view, due to a higher contribution fromthe carrier network segment, which has a higher gross profit margin. ZTE’s Q3 results werealso impacted by some one-off items, such as RMB200m in legal costs, impairment of credits &assets, and a RMB251m mark-to-market loss on investments. ZTE’s core operating performance is solid excluding the impact of these one-off items. Higher R&D expenses, in our view,are another reason for slower recovery progress. R&D expenses were RMB3,465.2m in Q32018 vs. RMB5060.6m in 1H 2018. However, we believe that R&D expenses invested now willtranslate into business opportunities in the coming years. ZTE issued a profit alert for 2018,which guided a net loss of RMB6.2bn-7.2bn. This implies net profit will be in range of RMB60mto RMB1bn. We still expect ZTE to report a QoQ increase in net profit in Q4 2018, as the Company is on the right track to recovery.

Local market potential to drive recovery. We share the view that the market might haveconcerns about the growth outlook for ZTE, given potential market share loss in overseas markets in both the equipment and consumer products segments. We believe the consumer products segment will lag behind, but equipment and non-operator business should drive the recovery in Q4 2018 and 2019, especially given 5G development in China. Since 5G is an area supported by the Chinese government, it will create growth potential for equipment makers such asZTE. In addition to wireless equipment, ZTE has invested in new technologies, which will allowthe Company to benefit from the adoption of new technologies like NB-IoT.

Downward earnings adjustment for 2018. We revised down our net profit forecast for 2018after ZTE’s Q3 2018 results announcement. We keep our 2019 net profit forecasts, as we believe the Company is on the recovery trend. ZTE shares may come under pressure after theQ3 2018 results announcement, which in our view, offers a good buying opportunity, especiallysince infrastructure-related themes will be the focus in the hardware segment in 2019 & 2020.