China Mobile Likely To Increase 4G Handset Subsidies Even As Profitability Concerns Remain

China Mobile (NYSE:CHL) is likely to increase subsidies on its 4G mobile handsets later this year by gradually reducing its 3G handset subsidies, according to a recent Chinese media report. The report also stated that the carrier is looking to reduce – and eventually cancel – its free handset offerings as part of its contract phone sales, and instead switch to service package subsidies. ^[1]

The carrier’s new subsidy strategy to shift focus from 3G to 4G is expected and could prove to be a good decision for the company for two primary reasons. Firstly, the carrier can ill afford to increase its overall subsidy expenses due to their downward pull on profitability. Therefore, it could not have focused on both 3G and 4G subsidies for long without significant adverse impacts on net income. To put things in perspective, China Mobile’s net income declined by 6% year-over-year (y-o-y) in 2013 and by 9% y-o-y in Q1 2014, primarily due to high handset subsidies and marketing expenses. In comparison, net income for smaller rivals China Unicom (NYSE:CHU) and China Telecom (NYSE:CHA) grew by 74% and 18%, respectively, in the first quarter this year.

Secondly, focusing more on 4G instead of 3G and 2G makes more financial sense in the long run considering that future growth is likely to be driven by data rather than voice. This will not only help the carrier provide an improved user experience with better facilities such as high-definition (HD) video streaming and calls, but also aid in increasing its average revenue per user (ARPU) and net income.

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

4G Opportunity And Competition

There are currently over 1.2 billion wireless subscribers in China. Of that total, about 480 million, or 38%, are 3G users and less than 1% currently subscribe to 4G services. Therefore, even though the overall wireless market in the country looks saturated with over 92% of the population using mobile devices, there is immense room for growth in 3G and 4G subscribers. Previously, many people could not jump to 3G from their slower 2G connections due to a lack of low-cost handset options and high monthly data charges. However, with low-cost 3G and 4G handsets (under $160) from manufacturers such as Coolpad, Xiaomi and Lenovo flooding the market and carriers such as China Mobile offering attractive freebies and discounts, we expect the Chinese 3G/4G wireless market to expand at a rapid pace in the near future. ^[2]

With a market share of 62.4%, China Mobile leads the Chinese wireless market by a huge margin, as second placed China Unicom has a share of just over 23%. The carrier has also been at the forefront of 3G and 4G subscriber additions in the country over the past year, especially since the allotment of TD-LTE 4G licenses by the government in December 2013. In the last six months, it gained about 45 million high speed (3G and 4G) users, which is about 75% of all high speed users added in the country in this period. In addition to its aggressive network expansion and high subsidy offerings, the company benefited from the fact that the Chinese government only awarded TD-LTE 4G licenses to carriers, while FDD-LTE 4G licenses were still pending. This prevented China Unicom and China Telecom from rapidly expanding their 4G networks in the country since their existing wireless networks (WCDMA 3G) are more compatible with FDD-LTE, unlike China Mobile’s TD-SCDMA 3G network.

However, since FDD-LTE trial licenses have now been awarded to the smaller carriers, China Mobile has its work cut out to prevent its 2G/3G users from transitioning to the 4G networks of rivals, which run on the globally accepted FDD-LTE standard. In response to such changing market dynamics, the market leader is rumored to have expanded the scope of its 4G handset subsidies in a recent policy revision. Contrary to its earlier decision to only subsidize 5-mode handsets, it will continue to subsidize 3-mode TD-LTE 4G handsets, with a cap of 30% as its subsidy rate. While 5-mode 4G terminals provide global support for TD-LTE, FDD-LTE, TD-SCDMA (3G), WCDMA (3G) and GSM (2G), three-mode terminals leave out WCDMA and FDD-LTE, making them more suited for domestic use on China Mobile’s network. ^[1]

Lower Subsidy Expenses Could Improve Profitability

In its recent first quarter 2014 earnings release, China Mobile reported a 9.4% drop in profits even as its overall revenues increased by about 8%. This decline in net profit was attributed to increasing competition in the Chinese wireless market and growing popularity of over-the-top (OTT) applications such as WeChat. In the wake of rising competition, China Mobile had to offer higher handset subsidies on popular smartphones to gain subscribers. Although higher subsidies immensely helped the carrier expand its subscriber base and 3G/4G mix, it also significantly increased its operating expenses, which led to a decline in the bottom line.

China Mobile announced in its Q4 2013 earnings call that its subsidy costs were likely to increase by about 30% y-o-y to $5.7 billion in 2014 as 4G adoption grows and demand for premium handsets rises. However, a recent report in the Chinese media suggested that the carrier is likely to trim its total subsidy costs by RMB 10 billion ($1.6 billion) this year owing to profitability concerns. If this happens, it could keep the company’s total subsidy expenses around last year’s levels of $4 billion. 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, this would translate into improved profits.

In addition to increasing 3G/4G subscriber adds, the carrier must focus on internet-based value added services to bolster its ARPU. 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, the introduction of the VAT, and the revenue reduction due to an unfavorable revision in carrier interconnection fees.

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1. Rumor: China Mobile to Shift Handset Subsidies from 3G to 4G, Marbridge Consulting, July 7 2014 [↩] [↩]
2. China Said to Tell Carriers to Cut Spending on Marketing, July 9 2014 [↩]