China Telecom (NYSE:CHA) announced its 2012 annual results on March 20. The third largest carrier in China saw net profit for the full year drop almost 10% over 2011 on higher subsidies and marketing spend brought about by the launch of the iPhone earlier last year. However, revenues continued to climb at a good pace, growing by about 16% y-o-y to RMB 283 billion. Most of this growth came on another strong year for the mobile division where data revenues grew close to 50% over 2011 as 3G adoption picked up and ARPUs improved on account of the iPhone’s launch and other marketing initiatives.
Growing 3G penetration also helped China Telecom pick up market share at the expense of the largest carrier, China Mobile (NYSE:CHL), which has lagged rivals due to the lack of the iPhone and an incompatible 3G network. Almost all of China Telecom’s 34 million net adds last year subscribed to its 3G network, helping the carrier capture almost 15% of the overall market and 30% of the 3G market.
However, the carrier’s decision to buy CDMA network assets from its parent company took a toll on its balance sheet, which is now saddled with over $7 billion more net debt than at the end of 2011. The move will however help China Telecom avoid paying network leasing expenses from this year onward, thereby pushing the mobile EBITDA margins up. The carrier had incurred more than $4 billion in network leasing fees last year, which was a 34% jump over 2011 and accounted for almost 22% of its mobile revenues. With the addition of the mobile network to China Telecom’s assets, the carrier will also incur additional capital expenditure in maintaining and upgrading the network to 3G/4G. As a result, its CapEx guidance for 2013 is RMB 75 billion, up by almost 40% from last year. Keeping all these factors in view, we have revised our price estimate for China Telecom to $61, about 20% ahead of the current market price.
China Telecom Benefits From An Equitable 3G Mix
China Telecom’s 165 million subscribers may put some of the biggest U.S. carriers such as Verizon and AT&T to shame. But when it comes to China, the carrier is only the third largest and less than one-fourth the size of the largest wireless carrier there, China Mobile. However, the difference is not nearly as wide in the 3G market. As of February 2013, China Telecom had around 75 million 3G subscribers, only about 30% behind the 105 million that subscribe to China Mobile 3G network. While China Telecom’s overall market share is only about 15%, it has close to 30% share of the 260 million strong 3G market. A low but steadily growing 3G penetration of about 22% is giving smaller wireless carriers such as China Telecom ample opportunity to compete on an even ground with the otherwise dominant China Mobile.
China Telecom has also been helped by the fact that the dominant carrier currently runs its 3G network on a homegrown proprietary TD-SCDMA standard that is not compatible with many smartphones. However, that may soon end as Qualcomm’s newly launched TD-SCDMA compatible chipsets see wider usage. It could also be possible that Apple launches a cheaper iPhone on China Mobile’s network in order to assuage its subsidy concerns, making it tougher for the smaller carriers such as China Telecom to compete. (see Qualcomm Paves the Way for an Apple-China Mobile iPhone Deal) China Mobile’s push into 4G with a TD-LTE network, that is currently being tested out in several cities is likely to give it access to a much bigger set of popular smartphones so China Telecom might find it harder to gain high-end 3G/4G market share going forward.
3G Bolsters Data Revenues
It would therefore be a bad idea for China Telecom to be over-reliant on just the iPhone to drive 3G adoption. Not only is the iPhone extremely costly to subsidize but is an unreliable way of differentiating oneself, especially when one doesn’t have an exclusive right to it. The arrival of 4G and the iPhone on China Mobile could potentially be a huge blow to China Telecom, which is why it is a good sign that the carrier is not banking on the popular smartphone alone to drive 3G adoption.
The carrier recently came up with a strategy to sell low-cost 3G smartphones made by ZTE, Huawei and Lenovo that run on its 3G network. Considering that the Chinese market is still in an evolving stage, the demand for cheaper Android smartphones is huge. Even Nokia, which is trying to push its Lumia line of smartphones and create a third ecosystem with Microsoft, is launching Lumia handsets at lower price ranges. The Lumia 800C was launched on China Telecom at about $200 cheaper than the iPhone last year. China’s huge potential is fostering healthy competition among handset makers and this will help China Telecom manage its subsidies better so as to lessen the impact on its margins going forward. (see Chinese Telcos Get Fat Margins Selling Cheaper Smartphones)
Driving 3G adoption will serve to drive the ARPU levels of China Telecom further, as has been the case in the developed world. Carriers such as Verizon, AT&T and Sprint in the U.S. have seen rapid growth in mobile data revenues over the past few years driven by growing demand for 3G/4G-capable smartphones. This has come even as their voice ARPUs declined, a trend that can be seen in the Chinese telecom market as well. China Mobile’s voice ARPU levels have declined from above $7.30 levels in 2007 to about $6 in 2012, by our estimates. (see China Mobile Sits Atop A Gold Mine As China Tops One Billion Mobile Subscribers) Even as voice ARPUs continue to decline, we expect to see China Telecom’s overall mobile ARPUs increase in the coming years as 3G demand bolsters data ARPUs further.