China Mobile (NYSE:CHL) recently delivered a mixed set of results for the three quarters ending September, as a slow transition to 3G and burgeoning subsidies and other costs caused profits to fall amid rising competition from competitors and instant messaging apps. The largest wireless carrier in China saw its net profits fall by 9% and EBITDA margins decline by over 400 basis points over the same period last year, even as revenues increased by over 9%. Due to its use of a homegrown 3G standard that was incompatible with many popular smartphones, the carrier has trailed rivals in migrating its subscribers to 3G. This has not only helped rival carriers to compete better and take away market share, especially on the 3G front, but also prevented China Mobile from meaningfully reducing its reliance on traditional sources of revenues such as SMS. SMS messaging has increasingly fallen out of favor amid growing usage of Over-The-Top (OTT) instant messaging alternatives like WeChat that use subscriber’s data plans to send/receive messages.
The carrier is therefore investing in building out a next-generation 4G TD-LTE network that would help it move on from its home-grown TD-SCDMA network and help it better cater to the growing data demand. As a result, it expects to spend around RMB 190 billion on network upgrades and maintenance this year – around 50% higher than last year. Of this, almost 25%, or about $7 billion, will be driven by the build-out of the new TD-LTE network. Going forward, we expect the high network investment to continue as the company looks to expand its LTE network to new regions and uses it as the primary network for data traffic in the future. Keeping in mind the high near-term CapEx and subsidy costs, we have revised our price estimate slightly to $58.
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Growing 3G adoption drives China Mobile’s value
3G services have driven the ARPU levels of many carriers in the developed world. Carriers such as Verizon, AT&T and Sprint in the U.S. have seen rapid growth in mobile data revenues over the past few years driven by growing demand for 3G-capable smartphones. This has come even as voice ARPU declined, a trend that can be seen in the Chinese telecom market as well. China Mobile’s voice ARPU levels have declined from around $7.40 in 2007 to about $6 in 2012, by our estimates.
With voice ARPU on the wane, Chinese telecom operators have been pushing 3G-capable smartphones to drive data ARPU levels. 3G penetration is at just 25% currently, so the opportunity to push 3G is immense. As can be seen from the Chinese telecom data released each month, the carriers are now adding more 3G subscribers than 2G. China Mobile, which is almost seven times the size of Verizon with over 750 million mobile subscribers currently, stands to gain heavily from this transition. Currently, the low 3G penetration means that the impact of the higher 3G ARPU is more than offset by the decline in voice ARPU. China Mobile’s ARPU declined from RMB 67 to RMB 66. Over time, we expect a steadily growing 3G adoption to boost the already increasing data ARPU levels further, more than compensating for the fall in voice ARPU as a result.
However, for this to happen, China Mobile needs to step up its efforts in the 3G arena. As of September, China Mobile’s 3G subscriber base stood at around 170 million, which translates to a 3G penetration of about 22%. This compares poorly to China Unicom and China Telecom, who have converted about 40% and 50% of their subscribers to 3G, respectively. A big shortcoming of China Mobile’s homegrown 3G network has been that handset makers have had to make phones specially for the otherwise incompatible network, making it harder for the carrier to secure supplies of enough 3G handsets to promote the network. The lack of the iPhone can partially be attributed to this fact.
LTE will help overcome 3G shortcomings
In order to overcome this problem, China Mobile will be rolling out a TD-LTE network this year. Considering that the technology is being used by multiple carriers around the world to build out their 4G networks, TD-LTE is expected to be widely supported by handsets. What should also give China Mobile hope is that it has recently started adding 3G subscribers at a rate that is far exceeding expectations. On average, the carrier added more than 9 million 3G subscribers per month in the first three quarters this year, much higher than the average of about 3 million in the previous months. So, while China Mobile has some way to go before it catches up with the competition in terms of 3G penetration, most signs indicate that the transition away from 2G has picked up and will gather more pace in the coming years. The high initial investment in LTE should therefore not be a worry in the long run, as 4G drives demand for data and helps the carrier attract more of the high-end mobile subscribers.
Moreover, the recent strong showing in 3G additions and growing competition in the smartphone market means that China Mobile will not be very hard-pressed to sign an iPhone deal. Considering that Apple will be looking to penetrate the emerging markets where its presence is very low, China Mobile may be able to negotiate lower subsides or gain access to a cheaper iPhone – both of which should limit the margin impact as smartphones start forming a bigger chunk of its handset sales. However, it is tough to say if Apple will be ready to make such a compromise, although one of its handsets recently received regulatory approval to access China Mobile’s network. Even if the deal doesn’t happen, we don’t see China Mobile having a tough time promoting its LTE network considering how competitive the smartphone landscape is with players such as Samsung, Nokia, HTC and several other Asian manufacturers ever ready to pick up the mantle.