China Telecom Sees Strong Profit Growth On Cost Controls And Industry-Leading 3G Penetration

China Telecom’s (NYSE:CHA) decision to purchase its mobile network from its parent company seems to be paying off well, with the carrier seeing margin improvements despite splurging on subsides and other mobile promotional activities. The largest CDMA carrier in the world saw its operating profits in the first three quarters this year grow y-o-y by over 27%, at a rate faster than its service revenues, which were up by less than 10% over the same period last year. EBITDA margins for the first nine months of this year were more than 5 percentage points better than the year-ago period.

Most of the revenue growth was driven by the carrier’s 3G business, where it has done well in converting more than 53% its subscriber base to 3G –  far ahead of the industry-wide 3G penetration of 31%. With 3G demand driving data usage, having full control of its network assets is helping China Telecom derive greater operating leverage out of its business by eliminating a big variable component of its costs in network leasing fees. However, buying the mobile network has left its balance sheet saddled with over $7 billion more net debt than at the end of 2011. With the addition of the mobile network to China Telecom’s assets, the carrier is also incurring additional capital expenditures 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. Keeping all these factors in view, we have slightly revised our price estimate for China Telecom to $59, around 15% 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 180 million subscriber base may be large relative to the biggest U.S. carriers, but it is only the third-largest in China, and is 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 Q3, China Telecom had about 96.5 million 3G subscribers, around 43% behind the 170 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 380 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 9-11 million per month have been more in line with its overall market position, and it is likely to pull further ahead of the pack 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 if China Mobile strikes a deal with Apple. 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 recent launch of the iPhone 5S and 5C saw China Telecom being less aggressive in pushing the iPhone, offering as much as 15% lower subsidies 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.

The carrier has instead been promoting sales of low-cost 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 made Android smartphones while Apple languished 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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