In line with rumors, China’s Ministry of Industry and Information Technology (MIIT) has revised the network interconnection fees for Chinese carriers, albeit to a lesser degree than expected. Interconnection fees, or settlement charges, 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. The MIIT has lowered these fees for calls from China Unicom (NYSE:CHU) or China Telecom (NYSE:CHA) to a China Mobile (NYSE:CHL) number (excluding those on its 3G TD-SCDMA network) from 0.06 yuan per minute to 0.04 yuan per minute. However, China Mobile will still have to pay the earlier rate of 0.06 yuan per minute for all calls made from its network (except 3G) to a Unicom or Telecom number. Interconnection charges for all voice calls made to or from China Mobile’s 3G TD-SCDMA network remain the same. The revised charges came into force January 1st. 
The revision in interconnection fees is likely an effort by the Chinese government to level the playing field for Unicom and Telecom to some extent, as China Mobile has historically dominated the market. The revisions could have a significant negative impact on China Mobile’s valuation – as much as 10% by our estimates. Although interconnection fees account for only about 5% of China Mobile’s overall revenues, the entire revenue shortfall will correspondingly impact the bottom line and cash flows since the costs incurred will remain the same (0.06 yuan per minute) as before.
Why The Government is Targeting China Mobile
China Mobile has enjoyed unparalleled dominance in the telecom sector in China. With more than 760 million subscribers, the carrier controls almost 63% of the overall wireless market and accounts for an outsized portion of the industry’s profits. This dominance and wide reach has enabled China Mobile to take advantage of economies of scale in the telecommunication market, which is a high fixed-cost business. While China Mobile’s margins are at 45%, China Unicom’s and China Telecom’s mobile margins are less than half that figure.
China Mobile has been able to maintain such high margins because of its relatively late entry into the 3G market, which ensured that it did not spend much on subsidies. A major reason for the same was its TD-SCDMA 3G technology, which was incompatible with a majority of the available smartphones in the country. Margins of the other players were impacted by their subsidy spends, which China Mobile didn’t have to incur. However, this also allowed the rival carriers to race ahead in 3G subscriber additions. By the end of 2012, Unicom and China Telecom had more than 30% and 45% of their total subscribers using 3G as compared to only about 12-13% for China Mobile. However, this trend changed in favor of China Mobile in 2013 as net 3G additions for China Mobile far exceeded those of Unicom and Telecom combined. Going forward, Unicom and Telecom could find it increasingly tough to compete as 4G mitigates many of the incompatibility issues with China Mobile’s network and makes it an even bigger force to reckon with in the future (see China Unicom Faces 3G Headwinds As China Mobile Finds Its Footing).
To avoid this scenario and provide conditions for fair competition to the smaller carriers, the government could be looking to cross-subsidize them by this revision of interconnection fees. Such a move is bound to boost Unicom’s and Telecom’s finances at China Mobile’s expense, and provide them with some support as they incur heavy expenses in building out their respective 4G networks.
10% Valuation impact
While interconnection fees receivable by China Mobile for its voice calls have been reduced by 33%, its interconnection costs will remain the same. Currently, China Mobile generates about $100 billion in annual revenues, of which only around $4.5 billion comes from interconnection fees. Considering that interconnection charges have not been revised for calls made from the 3G TD-SCDMA network, the revised rate will negatively impact only the 2G subscribers, which at more than 580 million accounts for about 75% of China Mobile’s overall subscriber base. We therefore assume that about 75% of China Mobile’s interconnection fees will be impacted as a result of this regulatory change, causing a shortfall of about $1 billion in revenues for China Mobile.
This decrease may not be significant relative to China Mobile’s $100 billion annual revenues, but this would directly impact EBITDA by $1 billion, thereby reducing margins by about 1%. The reasons for this are two-fold. Firstly, status quo has been maintained for interconnection charges which China Mobile pays the other carriers, so its interconnection costs will remain the same. Secondly, the high fixed cost nature of the telecom business means 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.
Another major factor which will hurt China Mobile’s valuation are its cash flows. China Mobile has already increased its Capex guidance by 50% for 2013, attributed to its 4G LTE rollout. This will cause cash flows to decline by about $10 billion in 2013 as compared to 2012, thereby reducing the cash flows in 2013 to $10 billion. A $1 billion decrease in interconnection fees without any appreciable change in costs, would cause the cash flows to decrease further by about 10% in the near term. China Mobile may be able to counter this impact in the long term when its 4G network has been built and capital expenses decline. However, an inability to do so could hit China Mobile’s valuation by about 10%, or about $5 per share on our $60 estimate.
We have currently decreased our price estimate by about 5%, keeping in mind that the impact of interconnection charges will decline in the medium to long-term as subscribers move away from 2G to 3G and 4G. The market seems to be pricing this in at the moment, with China Mobile’s stock down more than 7% in the past three weeks.Notes: