China Telecom Lowers iPhone Subsidy As 3G Penetration Passes 50%

With 3G adoption increasing strongly, China Telecom (NYSE:CHA) seems to be gradually rolling back subsidies on expensive smartphones in a bid to boost profits. The third largest wireless carrier in China recently started taking pre-orders for the latest iPhones, the 5S and the 5C, and has already seen 100,000 pre-orders submitted online. But the carrier is being less aggressive in pushing the iPhone this time, offering as much as 15% lower subsidy on some of its plans. For example, China Telecom’s 289 RMB monthly plan for the 5S carries a subsidy of 2890 RMB, about 15% lower than the 3400 RMB that it had offered on the iPhone 5 last year. As compared to about 20% for China Mobile (NYSE:CHL) and 40% for China Unicom (NYSE:CHU), China Telecom’s 3G penetration is at an industry-leading 50% allowing the carrier to increase its focus on margins as 3G drives data consumption.

This is not the first time China Telecom has decreased subsidies on the iPhone. When the iPhone 5 was launched last year, China Telecom had reduced subsidy on a similar monthly plan by about 13%. The growing focus on margins has seen China Telecom’s net income in the first half of 2013 rise by almost 16% y-o-y. Despite handset sales increasing by almost 60% in H1 2013, China Telecom’s mobile subsidy costs increased by only about 20% over the same period last year as low-cost smartphones ruled the roost.

Apart from increasing subsidy control, China Telecom has also bought its mobile network from its parent company which may have saddled its balance sheet with debt but also decreased recurring annual costs and improved margins. With data revenues exploding, having full control of its network assets will help the carrier derive greater operating leverage out of its business by eliminating a big variable component of its costs in network leasing fees. However, the carrier will also incur additional capital expenditure in maintaining and upgrading the network to 3G/4G. Its CapEx guidance for 2013 is RMB 75 billion, up by almost 40% from last year. Our $60 price estimate for China Telecom is about 13% ahead of the current market price.

See our full analysis for China Telecom’s stock here

3G competition heating up as 4G nears

China Telecom’s 176 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 July 2013, China Telecom had around 90 million 3G subscribers, only about 38% behind the 147 million that subscribe to China Mobile 3G network. While China Telecom’s overall market share is only about 15%, it has close to 26% share of the 340 million strong 3G market.

However, China Mobile has started pushing 3G as it prepares for an eventual 4G LTE roll-out in the coming months. Its recent 3G additions of 9-10 million per month have been more in line with its overall market position, and it is likely to pull further ahead of the rest in the coming years. The country is also moving to a new 4G LTE standard, which is going to help China Mobile bridge the technology gap with rivals. In the past few years, China Mobile’s 3G efforts have been hindered by a lack of general compatibility of handsets with its proprietary 3G technology called TD-SCDMA. But the transition to a more widely used TD-LTE network is likely to give it access to a much bigger set of popular smartphones and make it harder for China Telecom to gain high-end 3G/4G market share going forward.

Low-cost smartphones rule the roost

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 has therefore been increasing sales of 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. As of Q2 2013, the top six smartphone makers in China use Android while Apple languishes at seventh with only 5% market share, according to Canalys. 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)

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