A potential new regulatory change could harm China Mobile’s (NYSE:CHL) cash flows by as much as 20%, and somewhat level the playing field that is so heavily lopsided in its favor currently. According to local Chinese reports, the country’s telecom regulator may cut the mobile interconnection fees that China Unicom (NYSE:CHU) and China Telecom (NYSE:CHA) currently pay China Mobile in half, from RMB 0.06 per minute to RMB 0.03 per minute.  China Mobile will, however, continue to pay the existing RMB 0.06 per minute rate to its smaller rivals. Interconnection fees 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.
These revisions, while unconfirmed, could have a significant negative impact on China Mobile’s valuation. From a revenue standpoint, the impact may be negligible since interconnection fees account for less than 5% of its overall revenues. But since the costs associated with this service will hardly change (the business is mostly driven by fixed costs and the interconnection costs remain the same as before), the entire revenue hit will likely impact the bottom line and cash flows. China Mobile’s stock has fallen by over 4% since the news broke, and is currently trading at about 10% below our $60 price estimate. We haven’t revised our price estimate as the report hasn’t been confirmed.
Why The Disparate Treatment?
China Mobile has so far enjoyed unparalleled dominance of the wireless sector in the country. With a subscriber base of over 750 million, China Mobile easily dwarfs its rivals China Unicom and China Telecom – which have a combined 450 million subscribers. This has allowed it to take advantage of economies of scale in a high fixed-cost business, which has rivals accounting for only about 15% of the telecom industry’s total profits. While China Mobile’s margins are at 45%, China Unicom’s and China Telecom’s mobile EBITDA margins are less than half that figure.
Part of the reason for China Mobile’s high margins has been its late 3G focus due to incompatibility concerns with its homegrown TD-SCDMA network, which wasn’t supported by many of the popular smartphones. This preserved its margins while heavy smartphone subsidies ate away at rivals’. However, the subsidies allowed rivals to lead the 3G transition, with both Unicom and Telecom adding about as many monthly 3G subscribers as China Mobile last year. This balance of scales was brief, however, as TD-SCDMA slowly became more mainstream, allowing China Mobile to reassert its dominance this year with 3G monthly net adds that have far exceeded those of rivals. Going forward, Unicom and Telecom could find it increasingly tough to compete with China Mobile, which is getting ready to launch a 4G network that will mitigate concerns associated with its incompatible 3G network and make it an even bigger force to reckon with in the coming years (see China Unicom Faces 3G Headwinds As China Mobile Finds Its Footing).
To avoid this scenario by increasing competition and making the 4G transition less painful for smaller carriers, the government could be looking to cross-subsidize them by reducing their interconnection fees while keeping China Mobile’s constant. Such a move would bolster Unicom’s and Telecom’s finances, and allow them to be more aggressive with their 4G deployment.
20% Impact On Valuation Possible
As for China Mobile, the impact will be twofold. While interconnection revenues will be cut by a half, the costs will remain more or less the same. Currently, China Mobile generates about $100 billion in annual revenues, of which only about $4.5 billion comes from the interconnection fees. If the rumored revision of rates comes into force, China Mobile’s revenues could decrease by about $2 billion since both the smaller carriers will pay half the previous fee. This will be accompanied by a margin hit in the range of 1-1.5%, so that the absolute EBITDA values decrease by the same amount, i.e. $2 billion. This is because we don’t see any material changes that China Mobile could bring to optimize its cost structure to mitigate the revenue impact. Firstly, since China Mobile will continue to pay the same fees as before, its interconnection costs will remain unaffected. Secondly, the high fixed cost nature of the wireless business means that the variable costs associated with interconnection are likely to be minimal at best. It will be tough to decrease these costs materially, without impacting the overall quality of the network and therefore harming its core operations as well.
The overall impact on the cash flows will be even more drastic since China Mobile’s CapEx costs are burgeoning with the build-out of its upcoming 4G LTE network. It has already guided for a 50% increase in its CapEx for 2013, which will cause its cash flows this year to decline by about $10 billion as compared to 2012. As a result, we are currently projecting cash flows to decline to about $10 billion in 2013 – down from $20 billion last year. A $2 billion decrease in interconnection revenues, which is unlikely to be offset by a corresponding decline in costs, could cause its cash flows to decline by a further 20% in the near term. The impact could be less pronounced in the longer term if China Mobile manages to control its capital expenses after the initial LTE build-out. If not, China Mobile’s overall valuation could take a hit of about 20%, or about $10 per share on our current $60 price estimate.
The underlying assumption in our analysis is that China Mobile derives all of its interconnection fees from the wireless operations of China Unicom and China Telecom. However, a certain percentage of these revenues come from fixed-line interconnections as well, which may not see the same reduction in fees. Also, it is not clear if this regulatory change will happen at all or if the reduction in fees will be as high as 50%, which probably explains why the stock has dropped by only 4%.Notes: