China Mobile’s Q3 Earnings Fall On Rising Competition And Higher Taxes

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China Mobile (NYSE:CHL), the world’s largest wireless carrier, continued to see pressure for the fifth straight quarter with net income declining over 12% year-over-year (y-o-y) to about RMB 25 billion ($4 billion) in Q3 2014. This decline in net income can be attributed to increasing competition in the Chinese wireless market, a decline in interconnection fees, 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. Overall SMS usage on the carrier’s network declined about 21% from 188 billion messages in the third quarter of 2013 to less than 150 billion in Q3 2014, in addition to a decline of 0.5% y-o-y in total voice usage. ((Operating data, China Mobile, Oct 20 2014)) [1]

This decline in SMS and voice usage, along with the interconnection fee revision and tariff concessions due to increasing competition, were key factors resulting in an unexpected fall of 2% in the company’s overall revenue in the third quarter. While growing costs and declining revenues put a dent in earnings, the carrier was able to grow its 3G/4G subscriber base by over 15% sequentially in Q3 2014 to over 285 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 27 million 4G subscribers in the third quarter and about 41 million in the first nine months of the year. The average mobile data usage per subscriber grew to over 124 MB per month at the end of September 2014, from 119 MB per month at the end of June 2014 and 72 MB per month at the end of 2013.

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. This robust growth in 4G subscribers is likely to help the carrier improve its top line performance going forward as 4G subscribers generally use more data than 2G and 3G users, which helps increase ARPU (Average Revenue Per User). 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 $56 for China Mobile, implying a slight discount to the current market price.

See our complete analysis of China Mobile here

Subsidies and Discount Offerings Impact Profits

China Mobile’s net income declined 12% in Q3 and about 10% in the first nine months of the year, primarily on account of higher subsidy expenses incurred by the carrier and higher discount offerings due to rising competition. 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.

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 was to minimal in the recent earnings. [2] [3] ((Chinese carriers to lower subsidies on smartphone purchases, WantChinaTimes, May 23 2014))

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.

Impact of VAT on 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. The company stated in its Q3 earnings release that the VAT increased its tax burdens and hurt operating revenues as well as profits, as the VAT is significantly higher than the currently applicable BT of 3%. [4]

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Notes:
  1. Press Release, China Mobile, Oct 20 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 []