China Mobile Earnings Preview: 3G, 4G Adds, Subsidies In Focus

China Mobile (NYSE:CHL), the world’s largest wireless carrier by subscribers, is scheduled to release its third quarter 2014 earnings on Monday, October 20. The carrier reported a mixed set of interim 2014 results last quarter, with net profit declining 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 was 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 and MMS messaging services for the carrier in the first half of the year.

In the upcoming earnings release, we expect the company’s revenue growth to sustain its momentum backed by aggressive expansion in the 3G and 4G market. The carrier added over 19 million 3G and 4G users in the two month period ending August 2014, of which over 80% users were on the 4G network. This surge in high speed subscribers is also expected to positively impact the company’s Average Revenue Per User (ARPU), which was almost flat y-o-y at RMB 64 ($10.40) at the end of June this year. However, the rapid user growth would not have been possible without a comparable increase in the company’s handset subsidy costs, discount offerings and marketing expenses. This rise in operating expenses, in addition to the recent introduction of a Value Added Tax (VAT) in the telecom industry, is likely to weigh on China Mobile’s net profit in the third quarter as well. ^[1]

We currently have a price estimate of $56 for China Mobile, implying a slight discount to the market price.

See our complete analysis of China Mobile here

Growing 4G User Base to Drive Top Line

China Mobile added about 5.4 million 3G subscribers and over 15.6 million 4G subscribers in the July-August period this year, taking its total 3G-4G subscriber count to about 272 million, and 3G-4G penetration to over 34%. In comparison, the carrier’s 3G penetration was about 25% at the end of 2013 and 29% at the end of Q1 2014. Higher 3G-4G penetration is good for the company’s top line, as high speed subscribers generally use more data than 2G users due to the network’s higher Internet speed, which helps in increasing ARPU.

Despite the growing high speed user base, China Mobile’s overall ARPU was almost flat y-o-y at RMB 64 ($10.40) in the first half of the year. This was likely because the decline suffered by voice and SMS/MMS revenues offset the increase in its Internet ARPU. 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.

Discounts, Subsidies and Marketing Expenses to Weigh on Profitability

China Mobile witnessed an unprecedented decline in earnings in 2013 owing to higher handset subsidy costs, discount offerings and higher marketing expenses, which continued in the first quarter as well. These expenses were necessary for China Mobile to improve the acceptability of its homegrown 3G network. The company faced intense competition in gaining 3G subscribers because rivals China Unicom and China Telecom used the internationally accepted WCDMA 3G standard, which was compatible with 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 profit margins.

The company took its first steps towards reducing handset subsidies to improve profitability last month. In line with earlier announcements indicative of such a move, the company revised its pricing strategy for high-end smartphones such as the iPhone and also stated that it intends to focus on low-cost handsets to cater to the country’s mass markets. This should certainly help the carrier improve profitability going forward but the impact of such cost-cutting is likely to be minimal in the upcoming Q3 results. ^{[2] [3]} ((Chinese carriers to lower subsidies on smartphone purchases, WantChinaTimes, May 23 2014))

VAT Could Also Impact Profits

As part of its tax and fiscal reforms for the country, the Chinese government decided to impose a value added tax (VAT) on telecom services earlier this year, coming into effect across the country on June 1. The VAT rate applicable to basic telecom services and value-added services has been fixed at 11% and 6%, respectively. While the earlier Business Tax (BT) was calculated based on net sales, the VAT is calculated on the difference between net sales and cost of goods sold. This change is likely to increase the carriers’ tax burdens and hurt profits, as the VAT is significantly higher than the currently applicable BT of 3%. ^[4]

The VAT is likely to hurt China Mobile’s profitability in the near term even as tax experts argue in its favor, citing the need to plug loopholes in the existing Chinese taxation system. However, the new system does allow companies certain cost deductions in the form of input VAT credits, which could offset some of the increase in taxes. It will be interesting to see how much impact this makes on the company’s bottom line in the third quarter and how China Mobile plans to control expenses amid increasing competition. ^[5]

View Interactive Institutional Research (Powered by Trefis):
Global Large Cap | U.S. Mid & Small Cap | European Large & Mid Cap
More Trefis Research

1. Operation Data, China Mobile, September 2014 [↩]
2. China Mobile Taking Steps to Cut Smartphone Subsidies, Bloomberg, Sept 26 2014 [↩]
3. China Mobile Surges on Planned $2 Billion Cut in Subsidy, Bloomberg, Aug 15 2014 [↩]
4. China to Levy VAT on the Telecom Sector Starting June 1, China Briefing, May 28 2014 [↩]
5. China Tax Alert, KPMG, Dec 2013 [↩]