China Mobile Earnings Preview: ARPU, Profitability In Focus

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China Mobile (NYSE:CHL), the world’s largest wireless carrier by subscribers, is expected to release its fourth quarter 2014 earnings on March 19. The carrier’s financials have been under pressure for the last five quarters on account of 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. Owing to the aforementioned factors, the carrier’s net income declined over 12% year-over-year (y-o-y) to about RMB 25 billion ($4 billion) in the previous quarter. 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. This decline in SMS 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 last quarter. ((Operating data, China Mobile, Oct 20 2014)) [1]

In the upcoming earnings release, we expect the company’s revenue growth to return to positive territory backed by aggressive expansion in the 3G and 4G market. The carrier added over 50 million 3G and 4G users in the three month period ending December 2014, of which over 97% 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 last 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 fourth quarter as well. [2]

We currently have a price estimate of about $58 for China Mobile, implying a discount of about 15% to the market price.

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4G User Base Expanding At Rapid Pace

China Mobile added about 1.2 million 3G subscribers and about 50 million 4G subscribers in the September-December period last year, taking its total 3G-4G subscriber count to about 336 million, and 3G-4G penetration to 41.6%. In comparison, the carrier’s 3G penetration was about 25% at the end of 2013 and 32% after the first half of 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-4G penetration increases and sales of high-end smartphones such as the iPhone expand in the Chinese market.

Research firm IDC recently reported that Apple (NASDAQ:AAPL) had a 12.4% share in total smartphone shipments in the fourth quarter last year in China. This translates to over 13 million units of Apple’s smartphones, likely dominated by the new iPhone 6 model. Considering that buyers of this expensive new model are more likely to use 4G for their smartphone data needs and China Mobile is the only established 4G network provider currently in China, it would be fair to say that it is the biggest beneficiary of this boom in iPhone sales in the country, among carriers. Growth in 4G users is likely to drive ARPU levels 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. [3]

Discounts And Subsidies 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 three quarters last year as well. The company’s net income declined 12% in Q3 2014 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. These expenses were necessary for China Mobile to improve the adoption 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 in September. 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 and it will be interesting to see its impact in the upcoming Q4 results. [4] [5] ((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 last year, coming into effect across the country on June 1, 2014. The VAT rate applicable to basic telecom services and value-added services was 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%. [6]

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 fourth quarter and how China Mobile plans to control expenses amid increasing competition. [7]

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Notes:
  1. Press Release, China Mobile, Oct 20 2014 []
  2. Operation Data, China Mobile, September 2014 []
  3. China rings up 420M smartphones in 2014, Xiaomi takes market lead, ZDNet, February 17 2015 []
  4. China Mobile Taking Steps to Cut Smartphone Subsidies, Bloomberg, Sept 26 2014 []
  5. China Mobile Surges on Planned $2 Billion Cut in Subsidy, Bloomberg, Aug 15 2014 []
  6. China to Levy VAT on the Telecom Sector Starting June 1, China Briefing, May 28 2014 []
  7. China Tax Alert, KPMG, Dec 2013 []