China's Capital Expenditure Boom Is Over

China's Capital Expenditure Boom Is Over Research Brief Abstract: The days of heady capital expenditure growth in China's telecommunications market are over. Carriers will increasingly focus on better utilizing their assets. By Sumit Malik, Andrew Chetham and Marcus Sigurdsson Recommendations Superior sales opportunities in the China market will increasingly be "sectoral" in nature. Vendors must position themselves to target these as they arise. Vendors bringing operational efficiency and increased service and support to help carriers deliver value-added services will be best positioned. Publication Date:8 August 2003

2 China's Capital Expenditure Boom Is Over Introduction China's spending on telecommunications equipment has been one of the bright spots during some dark years for the global equipment sector. Last year, it came to a sudden end as capital expenditure suddenly declined. Total telecom capital expenditure fell 12 percent to 205 billion yuan (US$24.76 billion) in 2002 from a high of 233.4 billion yuan (US$28.19 billion) in 2001. The reasons for this was threefold: There was a halt to new orders in the fixed-line industry for most of the year as the sector underwent restructuring. The former national fixedline incumbent, China Telecom, was split in two. Thepaceofdevelopmentintheindustryasawholeledtohuge investment growth to roll out basic access, which naturally had to peak at some point before retrenching to more normal levels. This is especially true of the mobile industry, which had an investmentintensive phase from 1996 through 2001. Given the previous investment binge, 2002 began to see an emphasis on optimizing networks over building more infrastructure. Table 1 shows the capital expenditure by the major carriers. Table 1 Capital Expenditure by Major Carriers (Billions of U.S. Dollars) Carrier 1999 2000 2001 2002 2003 Estimates China Mobile 1.41 2.65 4.77 4.95 5.65 China Unicom 1.53 3.04 3.77 2.29 2.03 China Telecom 3.11 3.70 4.18 2.99 3.00 China Railcom NA NA NA 1.19 0.69 China Netcom NA NA NA 2.42 4.95 NA = Not applicable Notes: The numbers for China Mobile, China Unicom and China Telecom apply only for the stock-exchange-listed subsidiaries of the companies. Capital expenditure for the total company, including the parent, is bigger. For example, China Telecom's total capital expenditure for 2003 will be approximately US$7.5 billion according to its guidelines. Source: Gartner Dataquest (July 2003) Capital expenditure by carriers does not equate to spending on telecom equipment. Equipment forms only part of the capital spending that carriers do. Capital expenditure also covers areas such as IT and power infrastructure, land, and buildings. Finding an exact ratio for telecom equipment as a proportion of capital expenditure will vary from carrier to carrier and depend on what place in the telecom spending cycle each carrier is in. 2003 Gartner, Inc. and/or its Affiliates. All Rights Reserved. 8 August 2003

Key Issues for the Future What Momentum Can Capital Expenditure Maintain? China's great telecommunications expansion, which began in the early 1990s when service penetration was at low levels, is clearly at the end of its first explosive phase. Penetration rates in the big cities are now equal to those in some developed markets. And while we still expect robust growth in new cellular and, to a lesser extent, in fixed-line connections through to 2007, much of the investment in basic infrastructure needed to support that growth for the midterm has already been made. Carriers will seek to grow their customer base by making only the necessary extra incremental investment to support those new customers or those new services. A key aim will be to support new customers by better optimizing their networks rather than with new spending. However, against this general background there will be more sector-specific drivers of capital expenditure growth and in some cases major drivers. Perhaps the biggest of these will come when new third-generation (3G) cellular licenses are awarded next year, which will give China Telecom and China Netcom a chance to enter the cellular field. At the moment, they are channeling investment into a lowcost, low-mobility wireless local loop (WLL) service known as Little Smart. Will the Chinese Government Continue to Encourage Carriers to Push Capital Expenditure? As the government controls all China's main carriers, it can ultimately influence their spending plans. The domestic telecommunications boom has provided China a chance to develop its own vendor industry an industry seen as having an important role to play for overall economic and industrial growth. The question is whether the government will push the carriers to spend perhaps more than they need or leave them to market forces and allow them full control over their decisions. A prospective model is South Korea, where the government continues to set ambitious spending and service targets, in part, to help support the local industry, which, in turn, can use the economies of scale it gains to help sell equipment and services abroad. While capital expenditure budgets have been squeezed worldwide, South Korea's carriers have continued to spend heavily. Despite its controlling influence on carriers, the Chinese government may not have as free a hand as it seems. China sees that access to the global capital markets is a key part of fund raising for the sector and can play an important role in creating efficient worldclass companies in time, giving local investors a safe place to invest their capital. Should China's carriers overspend, they will increasingly be open to punishment in the form of falling stock market valuations. The discipline of the market will be an important tempering influence on any government attempting to artificially support the local vendor industry. It is also important to remember that China's capital expenditure boom of the past few years benefited mostly foreign vendors instead of Chinese vendors. 3 2003 Gartner, Inc. and/or its Affiliates. All Rights Reserved. 8 August 2003

4 China's Capital Expenditure Boom Is Over When Will the Deployment of NGN Improve the Capital Expenditure Outlook? To a certain degree, China is already ahead of the curve in adoption of next-generation technologies. As a result of government regulation covering long-distance pricing (which allowed carriers offering Voice over Internet Protocol (VoIP) to set their own prices), we believe that more than half China's long-distance traffic this year will be over Internet Protocol (IP) networks. Another development is that in some cities the Personal HandyPhone System (PHS) WLL networks being deployed for voice are being switched using next-generation soft-switching architecture, thus bypassing or augmenting the public switched telephone network (PSTN). Also, specific projects are tied to China Netcom's move into China Telecom's southern area. In this case, China Netcom is moving straight to the next-generation network (NGN) in greenfield locations. But in general, China has a large, relatively modern switched-voice infrastructure. And, apart from specific applications or services, it is likely to follow a similar path toward full NGN to that adopted by carriers worldwide. Thus, we see a progressive introduction speeding up from 2004 onward. What Is in Store for the Next 12 Months? For 2003, China's Ministry of Information Industry (MII) initially forecast small growth for industry capital expenditure. More recently, it has revised this down. The latest revision is that spending may decrease from 203.5 billion yuan in 2002 to 200 billion yuan in 2003. The end result could be that spending will be broadly flat, but either up or down a few percentage points at the end of the year. What is clear is that capital expenditure growth will be linked much more closely to growth in service revenue, resulting in lowering carrier capital expenditure-to-revenue ratios closer to the long-term norm for carriers. After a decline in 2002, Gartner Dataquest believes that capital expenditure in China will remain flat in 2003. Growth will not come across the board, but will reflect that some segments will continue to decline and some will get a boost from this year's focus of carrier investment activities. Areas that will spur growth above and beyond the general level of capital expenditure needed to support basic subscriber growth for fixed and wireless area are: New Personal Access System (PAS) installations in cities by China Telecom, China Netcom and, to a lesser extent, China Railcom Rollout of code division multiple access (CDMA) 1x RTT by China Unicom Spending by China Telecom and China Netcom to facilitate services delivery into each other's areas 2003 Gartner, Inc. and/or its Affiliates. All Rights Reserved. 8 August 2003

5 Aggressive broadband rollout plans by China Telecom and China Netcom. In July, China Telecom announced a huge order of 2.9 million lines. A China Netcom order of 1.2 million to 1.5 million lines is pending, and China Telecom may well hold a round of bidding for another large contract at the end of the year. Announcement of 3G licenses is expected in early 2004 Table 2 shows China's equipment forecast for 2003. Table 2 China Equipment Forecasts, 2003 (Billions of U.S. Dollars) Technology Segment 2002 Market Size Expected 2003 Market Size Traditional Switching 1.06 1.04 NGN Switching(Including softswitches, multiservice switches and SPR) 0.19 0.24 Access Equipment 1.74 1.87 Optical Transmission 1.27 1.32 Mobile Infrastructure 5.37 4.71 SPR = Service provider router Source: Gartner Dataquest (May 2003) How Will the Market Look by 2005? The biggest spur to midterm capital expenditure growth will be the granting of 3G licenses, likely to occur in 2004. This will enable China Telecom and China Netcom to offer full cellular services for the first time, though their scope is yet unsure. Late 2004 and 2005 is likely to see all the major carriers involved in building out 3G networks, though some could be more regional in nature. China Unicom is also likely to move ahead with Evolution-Data Only (EV- DO) deployments by this time. The PHS equipment market will decline as cellular takes over as the focus for China Telecom and China Netcom. Any PHS investment is likely to be directed to the poorer west of the country, where it help the carriers push basic access quickly. By now, most of the southern and eastern cities of China with more than 500,000 to 100,000 million people have been covered by PAS. After two years of aggressive broadband growth by China Telecom and Netcom, DSL orders fell from its peak, reflecting the end of an intensive phase of deployment. We are likely to see growth in other access, driven by large-scale fiber in the loop (FITL), sub-1100ghz broadband wireless access (BWA) and multiservice platforms. NGN equipment revenue begin to see good growth (though from a small base) as technology standards emerge and demand for multiservice applications put cost and service pressures on carriers. On the back of increasing broadband penetration and the emergence of bandwidthhogging services using this infrastructure, Gartner Dataquest expects carriers will come under pressure to manage such multiservice networks in a cost-effective manner. This would push carriers for applicationspecific deployments of next-generation products (for example, softswitches deployed for Internet offload) tandem replacement, and as 2003 Gartner, Inc. and/or its Affiliates. All Rights Reserved. 8 August 2003

6 China's Capital Expenditure Boom Is Over more class 5 applications begin to emerge, an aggressive deployment will be launched in the local loop close to the customer. Besides, in the longhaul and metro networks, we expect the carriers to deploy next-generation Synchronous Digital Hierarchy (SDH) and wave division multiplexing (WDM) products. Wewillbegintoseeareturntohighergrowthintheopticalmarketonthe back of booming demand for data. China will have 112 million Internet subscribers in 2005, with a high proportion of those accessing through high-speed links. At the same time, we are likely to see increased infrastructure competition across China's larger cities, with rollout of competing metro networks by fixed-line carriers. To some degree, the capital expenditure environment will depend on how much the government wants to see the development of a completing infrastructure and how much it wants to avoid a situation of overbuilding, wasting resources that could be used to improve infrastructure in poorer areas. How Will the Market Look in 2007? By the end of 2007, the number of fixed and cellular connections will be more than 800 million, giving China a penetration rate of around 60 percent. Revenue growth for carriers from new subscriber additions will now be only incremental, and capital expenditure will reflect that. Capital expenditure growth will be driven by demand for new services and applications and the capacity to carry them in access and core networks. Growth in data, however, will remain strong, driven by continuing Internet subscriber growth and data needs of 3G networks. By 2007, the emphasis will be on NGN deployment and services in developed provinces, and this would emerge as the fastest-growing infrastructure segment in China. While the earlier efforts at deploying NGN solutions would come from the need to reduce operating expenditure, Gartner Dataquest believes that by 2007, new applications built around the next-generation products will drive carrier capital expenditure. On the other hand, traditional switching markets would decline, with no fresh investments and all expenditure focused on maintenance only. In the access areas, xdsl uptake will gradually decline and the market is likely to witness and move to deployment of fiber to the business (FTTB)/fiber to the home (FTTH) and Ethernet access solutions. Multiservice access platforms will also emerge as the fastest-growing market segment. Gartner Dataquest Perspective Gartner Dataquest believes that China will continue to dominate the total capital expenditure in the region and will emerge as the second-largest market for telecom equipment spending outside the United States in the midterm. But the days of high growth rates in carrier spending are over. 2003 Gartner, Inc. and/or its Affiliates. All Rights Reserved. 8 August 2003

7 However, whether it is the sheer scale of capital expenditure by China carriers or deployment of new technologies, China will shape vendor product roadmaps and marketing plans. A case in point is an active interest among vendors that are trying to position themselves favorably for setting up local alliances, or technology development (for example, time division-synchronous CDMA). Gartner Dataquest expects the market to become the largest deployment for 3G wireless technologies during the next few years, followed by a ubiquitous deployment of NGN equipment in all segments: switching, access or transmission. As more of China Telecom's services industry is listed for public equity investment, so will capital expenditure grow in importance. A perception exists among international investors that China's carriers do not know how to control their capital expenditure levels. While the industry was growing furiously, this didn't matter, but as it slows cost control will be paramount in investors' minds. Carriers that go on a spending binge especially for 3G will be punished in the stock markets. Recommendations Gartner Dataquest believes that during the next four years, capital expenditure will be driven by sectoral implementation of technologies along this suggested timeline. For superior growth prospects, vendors must position themselves to take advantage as the sector gains speed. Table 3 lists the areas of extra capital expenditure focus. Table 3 Areas of Extra Capital Expenditure Focus and Timeline Focus Areas Broadband Access/Data Networking PAS 1X CDMA 3G Mobile Optical Transmission NGN Investment Source: Gartner Dataquest (July 2003) Timeline Next two years Next12to18months Next 18 months Starting in the next 12 months, lasting for two years Picking up speed again in two to three years Small now: Bulk from 2005 and beyond Key Issue What factors will shape service provider capital expenditure plans? 2003 Gartner, Inc. and/or its Affiliates. All Rights Reserved. 8 August 2003

8 China's Capital Expenditure Boom Is Over This document has been published to the following Marketplace codes: TELC-WW-DP-0578 For More Information... In North America and Latin America: +1-203-316-1111 In Europe, the Middle East and Africa: +44-1784-268819 In Asia/Pacific: +61-7-3405-2582 In Japan: +81-3-3481-3670 Worldwide via gartner.com: www.gartner.com Entire contents 2003 Gartner, Inc. and/or its Affiliates. All rights reserved. Reproduction of this publication in any form without prior written permission is forbidden. The information contained herein has been obtained from sources believed to be reliable. Gartner disclaims all warranties as to the accuracy, completeness or adequacy of such information. Gartner shall have no liability for errors, omissions or inadequacies in the information contained herein or for interpretations thereof. The reader assumes sole responsibility for the selection of these materials to achieve its intended results. The opinions expressed herein are subject to change without notice. 116618