China Mobile Likely To Be The Biggest Gainer From Handset Subsidy Cuts

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All three wireless providers in China are planning to gradually reduce handset subsidies on smartphones in a bid to improve profitability, according to a recent Chinese media report. [1] The report further states that market leader China Mobile (NYSE:CHL) is likely to trim its total subsidy costs by RMB 10 billion ($1.6 billion), while smaller carriers China Unicom (NYSE:CHU) and China Telecom (NYSE:CHA) are likely to cut their subsidies by RMB 2.5 billion ($400 million) each. However, the report did not mention a timeframe in which these cost reductions would be realized by the carriers.

The news should come as a relief to investors considering that handset subsidies were increasingly weighing on carrier profits in the wake of rising competition in the Chinese 3G and 4G market. The government issued TD-LTE 4G licenses to all three carriers in December last year, and China Mobile was the first to launch 4G services for smartphones. In a bid to outshine its rivals in subscriber additions and sale of high-end smartphones such as the iPhone, China Mobile started aggressively marketing its 3G and 4G services, and offered heavy subsidies on handsets to consumers. Although the wireless major managed to race ahead of the smaller carriers in high-speed (3G & 4G) subscriber adds, its net income declined by 6% year-over-year (y-o-y) in 2013 and by 9% y-o-y in Q1 2014. In comparison, net income for China Unicom and China Telecom grew by 74% and 18%, respectively, in the first quarter this year.

Since competition in the Chinese wireless market is expected to get more intense in the coming months with the introduction of Mobile Virtual Network Operators (MVNOs) and the possibility of FDD-LTE 4G licenses being issued, a reduction in handset subsidies could immensely help the carriers, especially China Mobile, in improving their bottom line. We also expect such a move to partially offset the impact of Value Added Tax (VAT) on their profits, scheduled to be implemented from June 1 this year.

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We currently have a price estimate of $53 for China Mobile, implying a premium of about 10% to the market price.

See our complete analysis of China Mobile here

How Reduced Subsidies Could Benefit China Mobile

China Mobile’s profit declined 9.4% in the first quarter this year, largely on account of higher subsidy expenses incurred by the carrier, in addition to higher marketing costs and discount offerings. In contrast, China’s second largest wireless carrier, China Unicom, increased its first quarter profits by 74% on a growing subscriber base and focus on low-cost smartphones, which reduced its subsidy expenses (see China Unicom’s Profit Rises 74% On Revenue Growth In 3G/4G & Broadband).

Subsidy and marketing expenses were necessary for China Mobile to improve the acceptability of its homegrown 3G network. The company faced intense competition in gaining 3G subscribers earlier because rivals China Unicom and China Telecom used the internationally accepted WCDMA 3G standard, which is compatible with a majority of the popular smartphones available in the Chinese telecom market, unlike China Mobile’s homegrown SCDMA standard. Therefore, because of the limited handset options available for use on its 3G network, China Mobile had to offer much more competitive handset pricing and discounts to attract subscribers, which put pressure on the company’s margins.

China Mobile announced in its Q4 2013 earnings call that its subsidy costs are likely to increase by about 30% y-o-y to $5.7 billion this year as 4G adoption grows and demand for premium handsets rises. However, if it reduces its subsidies by $1.6 billion, it could keep its total subsidy expenses around last year levels of $4 billion in 2014. Since 3G and 4G subscriber additions are expected to improve the carrier’s 3G/4G mix and Average Revenue Per User (ARPU) due to higher Internet data usage, we expect the company’s top line to grow rapidly in the near term. Combined with reduced operating expenses in the form of lower subsidies, higher revenues would translate into improved profits. This is likely to help the carrier tide over financial concerns related to increasing competition from rival carriers as well as Over-The-Top (OTT) applications such as WeChat, introduction of the VAT, and the revenue reduction due to an unfavorable revision in carrier interconnection fees.

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Notes:
  1. Chinese carriers to lower subsidies on smartphone purchases, WantChinaTimes, May 23 2014 []