China Telecom Earnings Preview: Sluggish 3G/4G Adds, VAT To Hurt Profits

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China Telecom (NYSE:CHA) is scheduled to release its fourth quarter and full year 2014 earnings on March 18. The carrier reported modest results last quarter as its net profit rose about 10% year-over-year (y-o-y) to RMB 16.2 billion ($2.64 billion) in the nine month period ending September 2014, driven by growing 3G-4G and fixed-line broadband subscribers and significant cost savings. These cost savings were largely on account of a double-digit decline in handset subsidies as well as a favorable revision of interconnection fees by the government in 2013. The carrier’s operating revenues grew 2.2% y-o-y to about RMB 244 billion ($39.8 billion) on account of increasing 3G service revenues and consistent growth in fixed broadband. However, the company’s lackluster performance in terms of subscriber adds in the first nine months last year was reflected in its mobile terminal sales, which declined 17% y-o-y to RMB 23.3 billion ($3.8 billion). [1] [2]

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 and gain in high speed subscribers (3G and 4G). Notwithstanding a decline in total user base in the first six months, the third-largest Chinese wireless carrier actually gained about 15.5 million subscribers in full year 2014 compared to market leader China Mobile‘s (NYSE:CHL) 144 million and second placed China Unicom‘s (NYSE:CHU) 26.5 million user additions.

China Telecom lagged behind the bigger players, especially China Mobile, owing to limitations in expanding its 4G network coverage because the government hadn’t granted the required licenses (for FDD-LTE) last year. Now, with the full FDD-LTE 4G licenses in place, we expect the carrier to aggressively expand its 4G network coverage and boost its monthly high speed user adds. It has set an ambitious target of 120 million new user adds in 2015, 100 million of which are expected to be 4G customers.

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We have a price estimate of $56 for China Telecom, which is slightly below the current market price.

See our complete analysis of China Telecom here

Wireless: Competition, Interconnection Fee Revision, VAT to Impact Profits

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 December 2014. The carrier also leads the Chinese wireless market in 3G penetration, with about 64% of its total subscribers using 3G/4G services. However, the carrier lagged behind rivals last year in attracting subscribers to its high speed 3G services.

The carrier added just 15.5 million new 3G/4G subscribers last year, compared to an average monthly increase of about 3 million in 2013. 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 had a limited launch of its 4G network last year, we do not expect it to significantly impact the company’s full year earnings. We also expect the carrier’s slow subscriber growth and market competition to remain a drag on the company’s margins. However, the favorable revision in network interconnection fees by the government in 2013 (effective from January 1, 2014) is likely to offset some of this impact.

As part of its tax and fiscal reforms for the country, the Chinese government imposed a value added tax (VAT) on telecom services last year, coming into effect across the country on June 1 2014. The VAT rate applicable to basic telecom services and value-added services are 11% and 6%, respectively. While the earlier Business Tax (3%) 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, much like it impacted China Unicom’s results, reported earlier this month. [3] (China Unicom Reports Mixed 2014 Results On Slowdown In Subscriber Adds, March 4 2015)

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. [4] 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 107 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, Feb 2015)) ((Key Performance Indicators, China Telecom, Feb 2015))

In the first half of last year, China Telecom’s broadband revenues increased 3.4% to about RMB 36.4 billion ($6 billion) owing to the addition of over 4 million subscribers and rising Fiber-To-The-Home (FTTH) penetration. Considering that the company gained about 3 million subscribers in the latter half of the year as well, we expect China Telecom to report single-digit sales growth in the fixed line broadband business for 2014.

Capital Expenditures Expected to Rise

China Telecom reported in its mid year 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 in 2013. 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, after being awarded a trial 4G license in July 2014, China Telecom’s capital expenditure is likely to have increased as it steadily expanded 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, the company is expected to have increased its capital expenditures rapidly in the second half of 2014. It will be interesting to see how much the company expects to spend in 2015 considering that it recently received the full FDD-LTE 4G license to expand its 4G services across the country.

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Notes:
  1. Press Release, China Telecom, Oct 28 2014 []
  2. Key Performance Indicators, China Telecom, Oct 28 2014 []
  3. China to Levy VAT on the Telecom Sector Starting June 1, China Briefing, May 28 2014 []
  4. Mainland China Telecoms Statistics, Marbridge Consulting, 2014 []