China Telecom Earnings Preview: Sluggish 3G Subscriber Adds To Offset Steady Broadband Expansion

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China Telecom (NYSE:CHA) is expected to release its interim 2014 earnings on Wednesday, August 27. The Chinese telecom carrier reported robust first quarter 2014 earnings, with net profit soaring 18% year-over-year (y-o-y) to RMB 5.57 billion ($910 million) driven by growing 3G and broadband revenues and significant cost savings. The carrier’s operating revenues grew 6.9% y-o-y to RMB 83.2 billion ($13.42 billion) on account of increasing 3G service revenues and consistent growth in fixed broadband. 3G service revenues increased as the carrier added over 26 million new 3G users in the preceding one year period, taking its total 3G subscriber base to 104 million by the end of March 2014. However, the company’s lackluster performance in terms of subscriber adds in the first quarter was reflected in its mobile terminal sales, which declined 2.1% y-o-y to RMB 9 billion ($1.45 billion). [1]

In its upcoming earnings release, we expect the company to report low single-digit y-o-y growth in operating revenues on account of a steady increase in fixed broadband users, but weak quarterly performance in terms of wireless subscriber growth. The third-largest Chinese wireless carrier actually lost about 5.6 million subscribers in the first six months of the year compared to market leader China Mobile‘s (NYSE:CHL) 23 million and second placed China Unicom‘s (NYSE:CHU) 14 million user additions. Going forward, we expect China Mobile’s aggressive expansion in the 3G/4G market and rising tariff pressures (on monthly voice and data plans) to continue to weigh on China Telecom’s subscriber additions and margins.

The carrier received a license towards the end of the second quarter to commence its FDD-LTE and TD-LTE 4G hybrid network trial in 16 cities in the country. We expect this to help improve the carrier’s monthly subscriber additions as well as average revenue per user (ARPU), but only towards the end of the year. We currently have a price estimate of $52 for China Telecom, implying a slight discount to the market price.

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Steady Broadband Subscriber Growth to Drive Top Line

China Telecom is the largest broadband service provider in China, with a share of more than 52% in a 200 million subscriber market. [2] This market has grown at a rapid pace historically, and is likely to continue in the future as the government implements its “Broadband China” strategy to universalize broadband usage in the country. Broadband penetration in the country is currently around 40%. The carrier’s 105 million subscribers are mainly concentrated in southern China, where it enjoys a near-monopoly. The other major player in fixed broadband, China Unicom, has a share of 34% and mainly provides broadband services in the northern part of the country. ((Operating Data, China Unicom, July 2014)) ((Key Performance Indicators, China Telecom, July 2014))

In 2013, China Telecom’s broadband revenues increased over 6% to about RMB 71 billion ($11.5 billion) owing to an 11% increase in the number of subscribers and rising Fiber-To-The-Home (FTTH) penetration. Considering that the company consistently gained subscribers in the first six months of this year as well, we expect broadband revenues to continue their single-digit growth in H1 2014.

Growing 3G/4G Competition to Impact Margins

China Telecom has historically done well in expanding its subscriber base in the Chinese wireless market. It increased its market share from just over 4% in 2008 to 14.2% at the end of June 2014. The carrier also leads the Chinese wireless market in 3G penetration, with about 60% of its total subscribers using 3G services. However, the carrier has lagged behind rivals in the last year in attracting subscribers to its high speed 3G services.

The carrier added just 4.1 million new 3G subscribers in the first six months of this year, compared to an average monthly increase of about 3 million last year. This is attributed to increased competition in the Chinese wireless market, especially with China Mobile upping the ante with its rapid 3G and 4G expansion. Since China Telecom launched its 4G handset service only in July, we do not expect 4G to impact the company’s Q2 earnings. We expect the carrier’s slow subscriber growth and market competition to remain a drag on the company’s margins in the next few quarters. However, the favorable revision in network interconnection fees by the government last year (effective from January 1, 2014) is likely to offset some of this impact.

VAT Could Impact Profits

As part of its tax and fiscal reforms for the country, the Chinese government decided to impose a value added tax (VAT) on telecom services earlier this year, coming into effect across the country on June 1. The VAT rate applicable to basic telecom services and value-added services has been fixed at 11% and 6%, respectively. While the earlier Business Tax (BT) was calculated based on net sales, the VAT is calculated on the difference between net sales and cost of goods sold (COGS). This change is likely to increase the carriers’ tax burden and hurt profits, as the VAT is significantly higher than the currently applicable BT of 3%. [3]

The VAT is likely to hurt China Telecom’s profitability in the near term even as tax experts argue in its favor, citing the need to plug loopholes in the existing Chinese taxation system. However, the new system does allow companies certain cost deductions in the form of input VAT credits, which could offset some of the increase in taxes. It will be interesting to see how much impact this makes on the company’s bottom line in the second quarter and how China Telecom plans to control expenses amid increasing competition. [4]

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Notes:
  1. Press Release, China Telecom, April 28 2014 []
  2. Mainland China Telecoms Statistics, Marbridge Consulting, 2014 []
  3. China to Levy VAT on the Telecom Sector Starting June 1, China Briefing, May 28 2014 []
  4. China Tax Alert, KPMG, Dec 2013 []