China Mobile’s Profit Declines On Higher Costs Even As 4G Subscriber Base Soars

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China Mobile (NYSE:CHL), the world’s largest wireless carrier, reported a mixed set of interim 2014 results on August 14. The carrier’s net profit declined 8.5% year-over-year (y-o-y) to RMB 57.7 billion ($9.4 billion), even as its operating revenue grew over 7% to RMB 324.7 billion ($52.8 billion). This decline in net profit can be attributed to increasing competition in the Chinese wireless market, a decline in interconnection fee collection, the introduction of a Value Added Tax (VAT) and the growing popularity of over-the-top (OTT) applications. OTT applications such as WeChat allow users to share text/picture/video messages over their phone’s Internet connection, and their increased usage resulted in a massive drop in revenues from traditional SMS & MMS messaging services for the carrier. Overall SMS usage on the carrier’s network declined from about 382 billion messages in the first half of 2013 to 306 billion in 2014. [1] [2]

While growing subsidy costs put a dent in China Mobile’s profits, it helped the carrier grow its 3G/4G subscriber base by over 10% sequentially in Q2 2014 to over 253 million. Considering that data traffic is quickly becoming the primary avenue for future revenue growth, the carrier vigorously expanded and promoted its high speed 4G network, gaining 11 million 4G subscribers in the second quarter and about 14 million in the first six months of the year. The average mobile data usage per subscriber grew from 72 MB per month at the end of 2013 to 119 MB per month at the end of June 2014.

Going forward, we expect China Mobile to continue gaining 3G/4G subscribers faster than its rivals, owing to its larger 4G network and its ability to offer higher handset subsidies. However, higher costs and increasing competition from rival wireless carriers China Unicom (NYSE:CHU) and China Telecom (NYSE:CHA), as well as OTT applications such as WeChat, might continue to weigh on profitability in the near term.

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We currently have a price estimate of $53 for China Mobile, implying a slight discount to the current market price.

See our complete analysis of China Mobile here

Subsidies and Marketing Costs Impact Profits

China Mobile’s profit declined 8.5% in the first half of the year primarily 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 half profits by 26% on a growing subscriber base and focus on low-cost smartphones, which reduced its subsidy expenses (see China Unicom’s Profits Rise 26% On Robust Subscriber Gains).

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 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. It stated that the carrier was likely to shift focus from the 3G subsidies towards 4G handsets. The report also stated that the carrier was looking to reduce – and eventually cancel – its free handset offerings as part of its contract phone sales, and instead switch to service package subsidies. Although the company was silent on this in the recent earnings call, a shift to 4G handsets could keep the company’s total subsidy expenses around last year’s levels of $4 billion. [3]

Since 3G and 4G subscriber additions are expected to improve the carrier’s 3G/4G mix and 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.

Growing 3G/4G Subscribers Drive Revenues

With a share of about 62.5% of the overall Chinese wireless market, China Mobile has a total subscriber count of over 790 million (June 2014), which is about 2.5 times the U.S. population. Adding more than 60 million 3G/4G subscribers in the first six months of the year, China Mobile improved its 3G/4G mix from 25% at the end of December 2013 to 32% by the end of June 2014. This helped the carrier increase its overall revenues by 7% y-o-y to about $53 billion in H1 2014. A higher 3G/4G mix is good for the company’s top line, as 3G/4G subscribers generally use more data than 2G users due to the network’s higher Internet speed, which helps in increasing average revenue per user (ARPU).

China Mobile’s overall ARPU was almost flat y-o-y at RMB 64 ($10.40) at the end of June this year. This was likely because the increase in its internet ARPU offset the decline suffered by voice and SMS/MMS revenues. Going forward, we expect overall ARPU to improve as 3G penetration increases and sales of high-end smartphones such as the iPhone expand in the Chinese market. Growth in 4G is likely to drive ARPU levels even further, as 4G networks are about ten times faster than their 3G counterparts, thus encouraging subscribers to use even more data intensive applications such as high quality video calling and video streaming.

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Notes:
  1. Press Release, China Mobile, Aug 14 2014 []
  2. Presentation, China Mobile, Aug 14 2014 []
  3. Rumor: China Mobile to Shift Handset Subsidies from 3G to 4G, Marbridge Consulting, July 7 2014 []