Upside & Downside Scenarios to China Telecom’s $68 Value

China Telecom (NYSE:CHA) derives most of its value through mobile services and broadband internet that account for 53% and 30% respectively of our $68 price estimate for the company’s stock. The company offers both mobile voice and value added services like SMS, caller ID, mobile Internet. Landline services though offered by the company are in decline because of its increasing substitution with mobile phones. Revenues from broadband internet facilities, however, are rising because of initiatives in the form of network expansion and greater marketing spend taken by the company. The company faces intense competition not only from market leaders China Mobile (NYSE:CHL) but also from China Unicom (NYSE:CHU).

See out full analysis of the China Telecom

Here, we highlight 3 of the most important drivers for China Telecom’s stock and the upside/downside potential.

1. Average monthly mobile revenue per user: China Telecom generated $6.50 revenues per user through its mobile phone services in 2010.
2. Mobile services and phones EBITDA margin: EBITDA margins of the company’s mobile services and phones division has fallen drastically from 42% in 2008 to 29% in 2010. Though also faced with declining margins, competitor China Mobile, in stark contrast enjoyed margins of 51% in 2010 while China Unicom is in the same boat.
3. Average monthly broadband revenue per user: China Telecom had average monthly broadband revenues per user of $10.7 in 2010.

35% Upside Scenario | $92 Trefis Price Estimate

1. Higher average monthly mobile revenue per user (+5%):

The company currently concentrates on development of industry specific applications to try to increase usage of existing customers and to lure new ones. Average monthly mobile revenue per user has increased from $2.30 in 2008 to $6.50 in 2010, and we currently forecast that it shall increase to $12 by the end of the Trefis forecast period mainly because of the company’s efforts to build brand and quality assurance and increased emphasis on value added services.

But with the increasing popularity and acceptance of smartphones in China, the company might be able to do a better job in developing better applications which gain market wide acceptance. By targeting different segments with personalized offerings, average mobile revenue per user might become higher which could represent a 5% upside to the Trefis price estimate.

2. Withstands margin pressure (+25%):

Mobile phone sales of the company have increased from $100 million in 2008 to $900 million in 2010, growing at very high rates annually. This boost has come because of the high level of subsidies being offered to attract users. The corresponding negative impact is visible on the margins which have declined at a steady rate.

We currently forecast that margins will fall to 23.5% by the end of the Trefis forecast period. However, there could be an upside of 25% to our price estimate if margins do not fall as low as projected because of reduction of subsidies or increasing market share by curbing competition.

3. Average monthly broadband revenue increases at a faster rate (+5%):

We currently forecast that average monthly broadband revenue per user will increase from $10.70 in 2010 to $11.40 by the end of our forecast period mainly because of the initiatives taken by the company for the expansion and enhancement of its broadband networks. In the first half of 2011, 71% of the total capital expenditure was for the broadband division. Also in 2011, the company launched its “Broadband China, Fiber Cities” to significantly expand coverage of broadband networks.

There could be an upside of 5% to the Trefis price estimate if the company is successful in capturing this increased internet usage through its marketing and bundling-of-services initiatives.

35% Downside Scenario | $44 Trefis Price Estimate

1. Weaker average mobile revenue per user (-5%):

China Mobile, the market leader in the Chinese telecom industry, has been facing declining average revenues per user which is expected to continue primarily because of tariff setting by the government and also low usage pattern of new customers. We currently estimate that this figure will increase during our forecast period for China Telecom.

However, there could be a downside of 5% if monthly mobile revenue per user only increases to $7.60 due to spectrum unavailability or decreasing mobile usage by new customers.

2. Margins fall lower than current expectations (-25%):

High level of subsidies on the handsets are squeezing the margins and bringing down profitability sharply for the company. Additional selling and marketing spend for the promotion of handset sales is increasing expenses.

If these margins continue to decline owing to similar or higher level of subsidies and the company is unable to recover the large expenses borne in relation with network expansion, there could be a 25% downside to the Trefis price estimate.

3. Greater substitution and competition decrease broadband revenues per user (-5%):

There has been an increasing trend of landline substitution with mobile phones. If China Telecom’s broadband division suffers a hit due to increased switching to wireless broadband and internet facilities, the average revenues per user might start declining. Also, any adverse tariff setting policies that the government may execute shall harm the company further.

China Unicom might not be able to curb competition from mobile internet as well internet services offered by cable companies. Thus, there could be a downside of 5% to out price estimate.

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