China Telecom Earnings Preview: Declining Wireless Subscriber Base In Focus

China Telecom (NYSE:CHA) is scheduled to release its third quarter 2014 earnings on Tuesday, October 28. The carrier reported modest interim 2014 earnings in August, with net profit growing 12% year-over-year (y-o-y) to RMB 11.4 billion ($1.86 billion) and operating revenues growing 5.3% y-o-y to about RMB 166 billion ($27 billion), driven by growing wireless and fixed-line data revenues and significant cost savings. Revenues from 3G service increased as the carrier added about 20 million new 3G users in the preceding one year period, taking its total 3G subscriber base to 107 million by the end of June 2014. However, the company’s lackluster performance in terms of subscriber adds in the first six months this year was reflected in its mobile terminal sales, which declined 9.3% y-o-y to RMB 16.6 billion ($2.7 billion). ^{[1] [2]} ((Key Performance Indicators, China Telecom, Sept 2014))

In its upcoming earnings release, we expect the company to report mid 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 million subscribers in the first eight months of the year compared to market leader China Mobile‘s (NYSE:CHL) 29 million and second placed China Unicom‘s (NYSE:CHU) 15.5 million user additions. Although the carrier has started showing signs of revival in adding wireless subscribers in the last couple of months, 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 going forward.

The carrier received a license towards the end of the second quarter to commence its FDD-LTE and TD-LTE 4G hybrid network trial, which now extends to 40 cities in the country. We expect this to help improve the carrier’s monthly subscriber additions as well as average revenue per user (ARPU) towards the end of the year. We currently have a price estimate of $52 for China Telecom, implying a discount of less than 10% to the market price.

See our complete analysis of China Telecom here

Fixed-Line: Steady Broadband Top Line Gains Expected

China Telecom is the largest broadband service provider in China, with a share of more than 53% in a 200 million subscriber market. ^[3] 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, Oct 2014)) ((Key Performance Indicators, China Telecom, Sept 2014))

In the first half this year, China Telecom’s broadband revenues increased 3.4% to about RMB 36.4 billion ($6 billion) owing to the addition of over 8 million subscribers and rising Fiber-To-The-Home (FTTH) penetration (32%). Considering that the company consistently gained subscribers in 3Q as well, we expect broadband revenues to continue their single-digit growth in the third quarter.

Wireless: Competition, Interconnection Fee Revision 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 over 14% at the end of August 2014. The carrier also leads the Chinese wireless market in 3G penetration, with over 61% of its total subscribers using 3G/4G 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 7.4 million new 3G subscribers in the first eight 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 only launched its 4G handset service in July, we do not expect 4G to significantly impact the company’s Q3 earnings. We also 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 to 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%. ^[4]

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 third quarter and how China Telecom plans to control expenses amid increasing competition. ^[5]

Capital Expenditures Expected to Rise

China Telecom reported in its last earnings release that it had incurred capital expenditures of about RMB 23 billion ($3.74 billion) in the first six months of 2014, compared to RMB 33.1 ($5.38 billion) in the same period last year. The y-o-y decline was explained from the fact that the company did not receive a 4G license from the Chinese government in the first six months of the year, and therefore it wouldn’t have been prudent to spend on network development during that period.

However, since the company was awarded a trial 4G license in July, its capital expenditure is likely to increase going forward as it looks to rapidly expand its 4G coverage and presence in the country. Considering that the carrier spent less than 30% of its yearly estimate in the first six months, its capital expenditures will likely rise rapidly in the second half of the year.

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1. Press Release, China Telecom, Sept 2014 [↩]
2. Presentation H1 2014, China Telecom, Sept 2014 [↩]
3. Mainland China Telecoms Statistics, Marbridge Consulting, 2014 [↩]
4. China to Levy VAT on the Telecom Sector Starting June 1, China Briefing, May 28 2014 [↩]
5. China Tax Alert, KPMG, Dec 2013 [↩]