China Telecom (NYSE:CHA) has brought in the New Year with both good and bad news. The good news is that it could potentially save as much as $400 million in operating costs this year, after China’s Ministry of Industry and Information Technology (MIIT) revised the network interconnection fees in favor of the smaller Chinese carriers. Interconnection fees, or settlement charges, are what carriers on the calling side of a voice call pay those on the receiving side to cover the costs of interconnecting the two networks. The bad news is that its rising handset subsidy costs will likely more than offset any savings it might realize with the change in interconnection fees. Subsidy costs are on the rise because subscribers are gradually warming up to smartphones and data-intensive applications. Also, increasing competition from China Mobile (NYSE:CHL) in the price-sensitive Chinese market is forcing carriers like China Telecom to increase subsidies on expensive handsets such as the iPhone by a good amount.
We believe that the immediate impact of the aforementioned factors on China Telecom will be an increase of about $200 million in operating expenses, or a wireless EBITDA margin reduction of 60 basis points in 2014. Going forward, we expect the net impact to be even higher, as potential cost savings from voice interconnection decline to increasing migration to 3G/4G networks. Our new $53 price estimate for China Telecom is about 10% ahead of the current market price.
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China Telecom Benefits From Lower Interconnection Fees
The MIIT has lowered interconnection fees for calls from China Telecom or China Unicom (NYSE:CHU) to a China Mobile (NYSE:CHL) number (excluding those on its 3G TD-SCDMA network) from 0.06 yuan per minute to 0.04 yuan per minute ((China adjusts mobile interconnection charges, TelecomPaper, 24 December 2013)). The revision in interconnection fees is most likely an effort by the Chinese government to level the playing field for Telecom and Unicom to a certain extent, as China Mobile has historically dominated the market.
On account of this revision, China Telecom will be paying 33% lower interconnection fees for calls made from its network to China Mobile’s network (excluding its TD-SCDMA 3G network). However, all other outgoing calls will incur the same settlement charges as earlier. Considering that China Mobile’s 2G subscriber base is about 580 million, it makes about 55% of the total subscriber market for which China Telecom will have to pay interconnection fees.
Assuming therefore that about 55% of China Telecom’s interconnection fees will be impacted (by 33%) as a result of this regulatory change, and that Telecom’s wireless interconnection costs have increased by about 25% over the $1.7 billion incurred in 2012, we arrive at a cost savings estimate of about $400 million. This should increase the company’s EBITDA by a similar figure as revenues won’t be impacted by the regulatory change. This can potentially increase Telecom’s valuation by as much as 20% if its impact is sustained in the future. However, considering that the impact of interconnection fees is likely to decline in the medium to long term as subscribers move to 3G and 4G, we estimate that the upside is limited to only about 10%.
Rising Subsidy Costs to Hurt China Telecom’s Margins
However, this will be more than offset by the rising subsidy costs. China Telecom has recently announced a 15% discount on the iPhone 5S for its customers. It is subsidizing the 5S by an additional $132, which will be provided in the form of price reductions as well as gift packages. We see this as an effort by China Telecom to take prospective iPhone buyers from market leader China Mobile, which is launching its iPhone on January 17. The total subsidy costs can be estimated, based on China Telecom’s annual iPhone sales.
In order to estimate China Telecom’s iPhone sales, we look at the annual smartphone sales in China. Research firm IDC estimates that 360 million smartphones were shipped in China in 2013, which is expected to grow to about 450 million this year . According to another research firm Canalys, Apple’s market share in the Chinese telecom market has fluctuated between 8% in the first quarter of 2013 to about 5% in the third quarter  . Since historically, Apple has done much better in the fourth quarter in terms of sales, we estimate an average market share of 7-8% for Apple’s iPhone in the Chinese telecom market in 2013. This gives us a figure of 25-30 million iPhones sold in China in 2013. China Telecom has a 25% share in the overall Chinese 3G subscriber market. We believe that the proportion of iPhone users on China Telecom’s network would be similar to China Telecom’s share of total 3G subscribers in China. Therefore, 25% of 25-30 million iPhone units gives us a figure of 6-7 million China Telecom subscribers using the iPhone. If we exclude 1-2 million subscribers, considering they bought their iPhones in the open market, we estimate that China Telecom sold about 5-6 million iPhone units in 2013.
5 million iPhone sales would translate into more than $650 million in additional costs for China Telecom in the new year, considering it has announced an additional subsidy of $132 on the iPhone 5S. Together with the $400 million in cost savings that China Telecom will realize from the regulatory change, we estimate that the net near-term impact on China Telecom’s mobile EBITDA margins will be in the range of 60-70 basis points. Going forward, as the company realizes the benefits of increased ARPU levels of iPhone users, the subsidy impact should decline. However, the reduction in voice interconnection benefits (due to migration from voice to data) could offset most of that. Therefore, we believe that the net impact on our long-term mobile margin estimate will be around 80 basis points, which translates to a valuation impact of about $5 billion. We have therefore reduced our price estimate by 10% to $53.Notes:
- Apple to See Big Gains in China, IDC Says, IDC, Sept 24 2013 [↩]
- Xiaomi muscles past Apple to take sixth place in China’s smartphone market as Samsung stays on top, Canalys, July 08 2013 [↩]
- China Unicom, Telecom to sell latest iPhone shortly after U.S. launch, Canalys, Sept 06 2013 [↩]